Cliff Natural Resources (CLF) recently issued common and preferred shares and, with the recent price drop, we became interested in the company. In particular, with a publicly trading version of the 7% preferred shares (CLV) trading at a decent discount, we became very interested. Upon inspection, however, we found that CLV is overvalued given the deep-in-the-money put embedded in the shares based on the mandatory conversion to common shares in 2016. Investors would be better served owning the senior bonds and selling puts on the common stock vs. this preferred vehicle.
We'll start by stating we do not have a fundamental view on CLF. We became interested in the sector given the recent beating that all mining stocks have received. And, with the recent issuance of new equity, we figured it might be time to start fishing. CLF issued mandatory preferred shares with a 7% coupon in mid-February and, as of Thursday's close, they were trading at $19.09, a 24% discount to face value. This is huge considering that the shares "redeem" via mandatory conversion into common shares in three years time. As always, however, the devil is in the details and, in this case, its the conversion factors that give CLV its zip. In particular, if the stock price is outside of the tight range of $29-$35.53, the conversion factor is fixed implying both upside and downside potential for investors.
Shown in the chart below is the redemption value of the preferred shares on the mandatory conversion date of Feb. 1, 2016. This comes directly from the recent prospectus on page S-35. All the numbers shown, and as we'll discuss, are based on $1,000 par value -- CLV shares represent a 1/40th stake in the preferreds -- so all appropriate numbers can be divided by 40 if desired. The Y-axis is what the value of the shares are worth on the conversion date hence it can be viewed as its redemption value, similar to a bond. In fact, one can equate the mandatory preferred shares to a (junior) bond coupled with a long call and short put in the underlying stock. One thing of note from the chart is the very narrow range that investors will be redeemed at the $1000 par value. For purposes of illustration, if the conversion had occurred on yesterday's close investors would have received only $690 (17.25 for CLV) in value.
Chart 1: Mandatory Preferred Shares Value on Conversion Date
We can value the preferred shares in three parts. First, the underlying bond structure with a 7% coupon and ~3 years to maturity is rather handsome given CLF's 2020 maturity bonds yield about 4.75%. The preferreds are junior to bonds and they may also become junior, on CLFs option, to further capital or preferred stock issued in the future. In addition, the preferreds have the same features as Class A preferred stock (e.g., potential for dividend suspension). For arguments sake, let's assume that a 5% yield (2% north of the common dividend yield) is appropriate. We feel that is reasonably conservative (i.e., low) and would result in the preferreds trading at a 106% premium to par if the conversion rates resulted in a constant $1,000 redemption value. This may or may not be a good investment depending on investor's views of CLF's prospects, which we are agnostic on at the moment.
The other two parts of the preferred are the call option that investors are long and the put option that investors are short on the underlying common stock . As a guide, long-term options (LEAPS) trade and as of Thursday's close, put options that expire on Jan. 17, 2015 with a strike of $30 were valued at $12.55 mid-market (15c bid/offer); the $35 calls were priced at $1.50. Investors who own $1,000 par value of preferred shares (i.e., 40 shares of CLV) are long 28.148 calls on CLF that expire on Feb. 1, 2016, with a strike of $35.53 and are short 34.484 puts with similar expiry and strike of $29. Given that the spot price of CLF was $19.92, the puts are in the money. In fact, with a dividend yield higher than the prevailing interest rate, the "forward" price of CLF on Feb. 1, 2016, is below today's spot price. Option prices (and market makers) do not care about analysts' estimates and growth prospects -- it's just a formula.
We calibrated our options model to the volatility implied by current long-term options trading on CLF and come up with a conservative valuation of $12.79 for the $29 puts expiring on the conversion date and $2.50 for the calls. This implies for every $1,000 face, we are short $441 ($12.79 * 34.484) worth of those "synthetic" puts and long ~$71 worth of the calls resulting in net $370. In other words, this is the discount that the preferred shares require if you were to purchase them today. So net, the shares should be valued at 106% * 1,000 - 370 = $690. This would imply a fair value of $17.25 for CLV, which is 10% below where it closed. We can work backward, given the option values, to produce a true "yield" for the preferreds based on CLV's closing price of $19.09. The fixed bond component would need to yield 2.5% to fit to CLV's market price. Whether that is an appropriate yield is up for consideration but, given the more junior status of the preferreds, relative to bonds, we would venture that it is too low.
Chart 2: P&L -- Long Preferred CLV Vs. Common
Above we show the P&L estimate, on the conversion date, from owning the preferred shares vs. an equal-dollar amount of the common stock ignoring reinvestment of dividends. We also ignore the pricing mechanism for conversion (weighted average pricing over time) to keep it simple. CLV shareholders will receive ~$5.15 in dividends vs ~$1.65 for the common assuming today's common dividend does not change. For example, if CLF is at $10 on the conversion date, CLV will lose $5.32 vs CLF's loss of 7.75. On the other hand, if CLF is $35 on conversion, CLF will gain $16 vs CLV gaining only $11. One may argue that this is an attractive profile, in that CLV will behave like CLF but giving away upside for less downside. However, the issue at hand is that this P&L profile, weighted according to the options market's distribution, has negative expected value. Whether an investor wants to pay-up for CLV's muted profile is a risk-preference choice, but the price is pretty steep in our view.
The option value is a moving target as the price of CLF changes, but our view is that the preferred shares do not offer value relative to the common shares. In fact, investors who are bullish on CLF's prospects might be better owning the senior bonds and implement the options as desired, although differing maturities need consideration.