It was an interesting end to the week in the markets regarding the collapse of Silicon Valley Bank. We’ve dedicated a portion of this newsletter to explaining what occurred, because it is fairly important to understand the situation.
We had planned to announce a new stock to the Bull List this weekend but have decided to opt out of making any calls at this time as we feel it’s best to watch the situation in the US unfold from the sidelines.
This is also when we would announce our Value Calls for the month. However, we will also defer those until we have some clarity about the current situation.
We certainly aren’t advocates for timing the market. However, we do realize that there is a chance this development could lead to extensive volatility, and there is nothing wrong with just stepping aside from buying during times like this.
First, let’s tackle some earnings reports and a Bull List removal, then we’ll speak on the SVB situation.
Earnings
Foundational Stocks
Granite REIT (TSE:GRT.UN)
It was another strong quarter for Granite REIT, which topped estimates. The company reported funds from operations (FFO) per unit of $1.20, beating estimates by $0.09 per share and representing 19% year-over-year growth. The company also increased net operating income by 6.0% on a constant currency basis thanks to higher contractual rent increases.
Occupancy increased to 99.6%, and book value per unit sat at $94.68, down 2.67% from $97.28 last quarter. This is unsurprising, given that most REITs are booking net fair value losses on their properties. In Granite’s case, they booked a $230M (~3% of portfolio) fair value loss in the quarter. As a reminder, this is a non-cash expense and not a reflection of the company’s operations but the current macroeconomic environment. That is why it isn’t a reason to panic when you see the company post a net loss of $126.3M in the quarter.
Circling back to solid cash flow growth, the company’s payout ratio against adjusted funds from operations (AFFO) dropped to 75%, down materially from the 84% it posted at the end of Fiscal 2021.
Canadian Natural Resources (TSE:CNQ)
Despite mixed headlines, it was a strong end to Fiscal 2022 for Canadian Natural. Earnings of $1.96 per share missed by $0.30, but the company generated solid cash flows. Cash from operating activities came in at approximately $4.5 billion, and it generated $2.5B of free cash flow after total dividend payments and base capital expenditures. The company also posted record annual production (+4% from 2021 and +8% per share), and previously announced production guidance remained unchanged.
The company also announced that it would move to a 100% allocation strategy regarding free cash flow (FCF). It will now return 100% as incremental returns to shareholders once net debt returns to $10B. For reference, the company exited the quarter with $10.5B in net debt. Hence, its new policy is likely to kick in shortly.
This is big news for those seeking income, as investors will likely see special dividends shortly, given the company’s strong cash flow generation.
Of note, the previous policy called for 80-100% returns of FCF (which it is redefining as adjusted FFO minus dividends and capital expenditures) once net debt hit $8B.
Bull List
Stella Jones (TSE:SJ)
Stella Jones delivered another strong quarter and ended the Fiscal year on a high note. Earnings of $0.61 (+27%) per share beat by $0.02, and revenue of $665M (+22%) topped expectations for $617.27M. Adjusted EBITDA of $87M (+67%) also handily beat estimates for $78.2M.
While the company made no changes to its outlook in which it expects mid-single-digit growth in revenue and earnings over the next 3 years, it now expects to “meet or exceed” guidance. With this in mind, we might see a revision to come along with the annual investor day on May 25th.
Stella Jones also announced a 15% annual raise to the dividend, whereas most analysts were calling for a 10% raise.
We have much more information on Stella and why we think it’s still undervalued in our updated report. You can read it here
Alaris Equity Partners (TSE:AD.UN)
Alaris closed out Fiscal 2022 on a high note, beating revenue expectations. Revenue of $51.1M topped expectations of $47M.
Revenue per unit in Fiscal 2022 was 25% higher than Fiscal 2021, and operating cash flow increased by 18.9% over the same timeframe. The company paid out 3.9% more in distributions, and overall, it was a strong year despite the economic environment being exceptionally volatile.
In mid-February, the company announced a partnership with Brookfield with one of its partners Body Contour Centers LLC, for BCC to access additional funding. BCC is an exceptional partner of Alaris, with 5-year compound growth rates of 20% and 50% on revenue and earnings, respectively. So, the fact they could restructure their partnership and bring Brookfield on board in order to maintain such a high-level client is a good sign.
In the risks section of our Alaris report, we highlight that a single client makes up over 12% of revenue. That client is BCC, and it was critical the company maintain interest in it.
You can read our updated full report on this near 8% fielder here
We’ve removed Enghouse (TSE:ENGH) from the Bull List
Enghouse is certainly a company that has been a frustrating one in terms of its addition to the Growth Bull List. It was added during the pandemic, and the acquisition-based strategy it had deployed so well over the previous decade slowly deteriorated.
We adjusted our thesis in June of 2022, changing Enghouse from a growth play to a value play as it crept toward the $24 level. Our fair value target based on low single-digit cash flow growth was $38. We hoped that the company would exceed this mark. But its latest quarter highlighted its struggles remain, and at this point, the margin of safety is too narrow for it to warrant inclusion.
We have decided to move on from the company. I (Dan) had a stop loss on the company that triggered.
If you have any questions, please utilize the Q and A and we will be happy to answer them.
The Situation With Silicon Valley Bank
Over the last week, particularly near the end of the week and in accelerated fashion, we watched the 2nd largest bank collapse in history in the United States. Silicon Valley Bank, the 16th largest bank in the United States with about $200B in assets, entered receivership.
Let’s answer three questions right off the bat.
Q: What is receivership? A: It’s when a third party steps in to supervise the operation and liquidation of a company’s assets.
Q: How “large” is the 16th largest bank in the United States? A: If we convert the company’s USD assets to CAD, it is slightly smaller than the Canadian Imperial Bank of Commerce, the fifth largest bank in Canada.
Q: What is a bank run? A: A bank run occurs when many customers of a bank or other financial institution withdraw their deposits simultaneously over concerns about the bank’s solvency.
How it started
The bulk of Silicon Valley Bank’s client base is venture capitalists and startups. The company states it has done business with almost half of all venture-backed startups in the United States.
This is a number hard to comprehend, considering how many startups have emerged over the last decade. It is also hard to comprehend the lack of risk management regarding the company’s overall customer portfolio.
The company witnessed an influx of deposits in 2021. Economic stimulus, cheap borrowing rates and the highest level of activity in the stock markets in decades fueled massive growth in the company as its share price more than tripled off early 2020 price levels as startups popped up everywhere.
The company deployed half of its deposits received in 2021 into US Treasuries. It is estimated that these treasuries yielded in the mid-1% range. More on this later, as it will prove to be critical to the bank’s collapse.
Where it went wrong
As we’ve witnessed for the last year, rising rates are putting extensive pressure on growth companies, particularly cash flow-negative ones.
Higher rates have caused a sharp, somewhat catastrophic drop in the capital in the startup sector. As intended, rising rates are slowing the money supply in the economy. The money taps have been shut off for many companies that have been spending extensively and ignoring profitability.
Where it collapsed
The bank had invested half of its deposits into US treasury bonds, which unfortunately have fallen in value due to the rising interest rate environment. Remember, when interest rates rise, bond prices fall.
Rising rates and the current economic climate combined with inflation cause less funding to be available to a lot of the companies that Silicon Valley Bank catered to.
Cash flow-negative companies need to do two things to continue operating. They need to raise money, which was relatively easy up until the last year, or they need to dip into cash reserves to continue operations. As mentioned, funding for many startups had dried up, and utilizing cash reserves to maintain operations became the only option.
For a bank with such a high client base concentrated on startups, having deposits tied up in investments while a ton of these companies must withdraw money to maintain operations equates to nothing short of a disaster.
As more and more startups pulled money out to fund operations, with half of the bank’s deposits from 2021 tied up in US treasuries, it became a liquidity issue.
The bank had the option of doing a few things. It could borrow to satisfy withdrawals or sell some of its treasuries at a loss. Considering borrowing costs would be exponentially higher today versus what the bonds it bought in 2021 are paying, it ended up selling some of the bonds and taking a significant loss.
To shore up its balance sheet, the bank announced a share sale of nearly $1.8B, stating it needed the money to cover the losses on the treasury bonds investment.
This sparked outright panic and effectively a bank run as startups yanked money out in fear of deposits becoming unavailable.
Realistically, there was a chance that Silicon Valley Bank could have navigated this situation and came out on top. However, once a panic-induced bank run begins, there’s really nothing it can do.
The impact
The impact of the situation is unclear. As mentioned, this is precisely why we held off from announcing our most recent Bull List pick.
Many startups and tech companies, including former Bull List stocks Acuity Ads and Shopify, have deposits with the bank. With these two companies being cash flow positive and having other accounts at other institutions, they should be able to continue operations.
However, for startups that rely heavily on cash reserves to fuel business, this could have a material impact on operations.
Although deposits are insured, it is a paltry $250,000. Not nearly enough to provide any sort of security. A popular growth company Roku has almost $500M of its $1.3B in cash at Silicon Valley Bank.
At this moment, the situation is up in the air. Deposits will likely be honoured over and above $250,000. It is critical how much and, more importantly, how long it will take to get access.
Employees of these companies need to be paid, and operations need to continue. However, with external funding drying up, for some, the cash they held at Silicon was all they had.
If there is no clear resolution, and quickly at that, there is a chance this could spark panic at other institutions.
It is also possible we see companies pulling funds from smaller institutions and towards larger ones with strong balance sheets out of fear. In reality, a situation like this could end up benefitting the larger banks.
What to do
From an investing perspective, the main issue in an event like this is the short-term volatility that is bound to happen. The situation with Silicon Valley Bank arguably would not have happened if it wasn’t due to panic withdrawals causing a bank run.
If the situation continues to be uncertain, you’re likely to see the panic in the markets as well. We have already witnessed Canadian and US banks see large selloffs in price.
Situations like this are what have soured us from investing in US banks, particularly smaller institutions. Instead, we own Canadian institutions with considerable exposure to the United States.
Although situations like this are certainly scary, with the bank being focused on the startup and tech sector, the situation is highly unlikely to impact any “real world” economy stocks, and the damage is also unlikely to spread to any major institutions that have much more diverse lending and deposit portfolios.
This will likely be a large-scale setback for growth and startups that takes years to recover from. The CEO of one of the largest startup founders in the world called it an “Extinction level event for startups” that will set innovation in the US back a decade.
The situation is complex, and you will undoubtedly feel it inside your portfolio over the short term.
However, we must remember our long-term thesis regarding the companies we own and remove emotions from our investing.
