KeyStone’s Stock Talk Show, Episode 209.
Great to be back with you this week. We have a busy show – starting with a brief discussion of our Research Trip to the Planet Micro-Cap conference in Las Vegas. We will then shift gears to Aaron with another earnings season review segment including a look at the numbers from Microsoft, Alphabet, Amazon and Meta which all reported over the past week. Brett will take a look at one of the biggest stories over the past week the collapse of First Republic Bank. Finally, if he has recovered enough from Las Vegas, Brennan takes a look at the recent strategy of mortgage extending that Canadian Banks have begun en masse in an attempt to help ease the pain some Canadians are facing in the higher interest rates environment.
Let’s get to the show….I welcome my cohosts – Aaron, and the Killer B’s – Brennan and Brett.
Adamas One Corp. (JEWL:NASDAQ)
Market Cap: $16.32 Million
Company Description: Adamas is a lab-grown diamond manufacturer that produces near flawless single-crystal diamonds for gemstone and industrial applications, in its facilities in Greenville, South Carolina. The Company holds 36 patents and uses its proprietary chemical vapor deposition (CVD) to grow gem-sized and smaller diamond crystals. Adamas One™ lab-grown diamonds have the same physical, chemical and optical properties as mined diamonds. The Company’s controlled manufacturing processes enables it to produce very high-quality, high-purity, single-crystal colorless, near colorless and fancy colored Type IIA diamonds to suit a variety of industrial and gemstone applications.
Balance Sheet: (as at December 31st, 2022) Cash:$3.46 million
Total current assets: $5.32 million.
Total current Liabilities: $7.13 million.
There is a working capital deficit of just under $2 million – not something we like to see (but not completely alarming at this start).
What is Driving the Share Price Lower?
The stock is down over 83% since it started trading on the NASDAQ in early December (around 5-months ago) at $4.74 to its current price of $0.77. Why? Generally, the environment for speculative small-cap stocks remains poor, but the valuations in December were high given the lack of significant revenues and what we call, “proof of concept” through sales. Ultimately, the company can forecast numbers all it wants, until the market sees proof, it is just a forecast.
Latest Quarterly Numbers:
Again, the company is just getting started, but in its first quarter as a public company sales were $726,125 and Adamas One produced a loss of from operations of $6.73 million. A huge percentage of the loss was from $3.68 million in stock compentsation and $2 million in warrants issued for conversion. Cash used in operations for the quarter was roughly $1.7 million
The Plan: focus on opening its current facility, which houses 12 diamond growing machines, to full capacity. At which point, management believes, the company will be capable of generating on average 3,000 rough carats of diamonds per month. Recently, the company announced that with reactors at their full production capacity and full marketing underway, the company anticipates more than $12 million in annual sales revenue from the current factory in Greenville, South Carolina.
Additionally, management intends to make a significant investment in building out the new manufacturing facility including building as many as 400 diamond growing machines.
The first phase will consist of the installation of 100 reactors, which at full capacity will be able to generate up to $30 million in topline revenue, or approximately $14 million in EBITDA on a monthly basis, or more than $300 million in topline revenue/$150 million EBITDA on an annual basis.
While the global lab-grown diamond market is estimated to have reached $26 billion in in value as at 2020 and is estimated to grow at a CAGR of 10% during 2021 to 2030, the competition is high and growing: There are a number of companies with far more financial resources than Adamas at present already producing high quality lab grown diamonds including Element Six, a privately held subsidiary of De Beers Group, AOTC Group B.V. (Netherlands), Pure Grown Diamonds (USA, Singapore, and Malaysia), WD Lab Grown Diamonds/Carnegie Institution of Washington, Sumitomo Electric Industries, Ltd., Diamond Foundry Inc., Applied Diamond, Inc., and CORNES Technologies Limited (Japan) and Helzberg Diamonds under the brand, Light Heart, which is backed by Warren Buffett.
The plans for Adamas One are ambitious and the company sites quality, its patented process and insatiable demand for lab grown diamonds as value creative for the business. The company also plans to enlist the services of prominent social media influencers to further its brand which could prove a smart strategy if managed well – but that will take capital, and Adamas is lacking in that area at present. But, the company is only in its initial stages and remains highly speculative. We monitor it, but it does not fit our criteria in terms of existing cash flow at present and is speculative rather than investment quality at this stage.
First Republic Bank Collapse
In March we saw the voluntary wind-down of crypto-bank Silvergate Capital, the swift collapse of Silicon Valley Bank, and Swiss bank Credit Suisse having a shotgun marriage to UBS just before falling apart.
But now after teetering on the edge of failure, JPMorgan Chase has taken over the majority of First Republic Bank’s operations after a Sunday night deal, making it the largest US bank failure since 2008.
Let’s go through a quick timeline of events that led up to the collapse of First Republic.
- Before the collapse, as interest rates have risen the company saw its net interest spread which is the difference between the rate it receives on its loans and assets compared to its cost to borrow shrinking from 2.58% in Q4 2021 to 1.74% in Q4 2022.
- During the series of bank failures and takeovers in March, First Republic saw roughly $100 Billion in outflows of deposits due to roughly 80% of its $177 Billion in deposits being uninsured. In addition to FDIC backing of deposits, they had received $30 Billion in deposits from a coalition of banks including JPMorgan, but the shortfall was still roughly $70 Billion. In the same announcement of its funding from banks, it announced the suspension of its dividend. First Republic shares fell from roughly $120 to $12, a 90% fall within a couple of weeks.
- After that all was quiet for about a month until the company announced its Q1 earnings, which showed the extent of the bank run and the heightened operating costs. As the short-term loans it had taken on were based on higher interest rates, its running cost to borrow was pushed up to 2.73% from 1.76% in the last quarter and 0.19% last year, a massive increase. On the other hand, its loans were only 3.66% up from 3.51% in the last quarter and 2.78% last year. Yes, the loan portfolio was returning more than previously but the cost to borrow increased substantially more. Leading to a net interest spread of 0.93%, however, this includes non-interest-bearing accounts like checking accounts.
- When you only consider the funds that First Republic pays interest on its cost to borrow is 4.33% higher than what it received from its existing loan portfolio of 3.66%. So, holding onto the loans is costing them money, but if they offload them they would realize significant losses on their books as many of these securities have decreased in market value over the past year compared to their accounting book value, causing additional issues. As the bank effectively had no other choice they announced the plan to offload a significant portion of its loan portfolio. The market did not like any of this.
- The day following the earnings the share price rightfully so, was cut from $16 to $8, and by the end of trading last week the shares were trading at $3.51. Just a reminder, before the fall in March the company was trading in the $120 range, a 97% drop from that point just over a month prior.
- Over the weekend, U.S. regulators seized the bank and had an auction for the bank’s assets with JPMorgan taking over the majority of the assets. JPMorgan will pay the FDIC $10.6 Billion, but this fiasco will still cost the Deposit Insurance Fund an estimated $13 Billion. And as far as First Republic shareholders go, they will receive nothing. This is not the first time JPMorgan has taken advantage of distressed financial companies, they were the purchaser of Bear Stearns and Washington Mutual in 2008. Regulators waved the 10% total US deposit limit which JPMorgan was already above to complete the acquisition.
In summary of events, the bank had a shrinking net interest margin already, then the bank saw significant uninsured deposit outflow, which further crushed its net interest margin to the point of losing money on holding loans. In other words, they failed at the core operation of a bank lending for more than borrowing.
If we look at the causation of events it’s once again similar to the SVB collapse, management failure exacerbated by a bank run. The company could have immunized itself through interest swaps which would have allowed the interest rate margin to stay constant as the policy rate changed, which would have likely lowered the risk of a bank run. As I’ve said before any bank can be susceptible to a bank run but a weaker banking operation increases the likelihood by magnitudes.
Canadian Mortgage Ammortization
Recently it came to my attention that Canadian Banks have begun extending mortgage amortization periods on outstanding mortgages as an attempt to help ease the pain of some Canadian’s facing higher interest rates and ongoing inflationary pressures.
There have been articles out such as this headline which indicates a 3rd of Canadian homeowners with a mortgage now have amortization periods of more than 30 years. With major lenders like RBC, BMO, CIBC and TD seeing sharply higher percentages of their mortgage portfolios with amortization periods north of 30 years.
To put this into perspective, none of these banks had mortgages with amortization periods over 30 years in October 2021. As of the fourth quarter, roughly 30% of their mortgage portfolios had amortization rates above 30 years.
So, let’s pull up a few of these bank’s MORTGAGES BY REMAINING AMORTIZATION tables to see how they really look.
So what does this mean for Canadian’s and Banks?
Well number (1), Canadians who now have an amortization period of over 35 years are going to be paying much more in interest. So using my financial calculator I quickly whipped up this table which compares a $500K mortgage paying an interest rate of 4.5% over a 25 year and 40 year amortization period.
And as you can see from the table, the mortgage with the longer 40 year amortization has a lower monthly payment of approximately $2,250, but 83% of that payment is going to interest while only 17% is going towards paying down the principal……. SO although Canadian’s who have extended are avoiding some near term pain, they are essentially moving closer to “renting” their homes from the bank, as their monthly payment just fractionally goes toward the principal on their mortgage….
And for the banks, while the strategy may be attractive, it is not without risk as it keeps borrowers in debt longer and as I indicated leads to much more interest being paid over the life of the mortgage.
Now the question was recently raised to the Bank of Canada Senior Deputy Governor Carolyn Rogers on whether she was concerned, and she noted that the Bank of Canada asked this very question to several unnamed banks in April and that lenders are concerned about ever-growing amortization periods.
Now there are a few caveats, as from my understanding in most cases, the extended mortgage contracts will revert to the original amortization schedule at the next term renewal. Which will of course translate these Canadians into higher mortgage payments….
And in the Bank of Canada’s Monetary Policy Report for the month of April, they also indicated that mortgage borrowers have been ditching the 5-year-fixed rates and variable mortgages for shorter-term fixed rates. And that both 1- to 2-year fixed and 3- to 4-year fixed rates are on the upswing, comprising roughly 30% and 25% of all new mortgages in 2022, respectively.
Moving forward this is definitely something that we will continue to monitor, and I guess now I will open it up to the guys to see if they have any comments.