VANCOUVER, BRITISH COLUMBIA--(Marketwired - Aug. 15, 2013) - Deans Knight Income Corporation (the "Company") (TSX:DNC) is pleased to release its Interim Management Report of Fund Performance and Financial Statements for the period ended June 30, 2013.
These documents can be found on SEDAR at www.sedar.com or the Company's website: www.dkincomecorp.com.
Forward-Looking Statements
This press release contains forward-looking statements. More particularly, this press release contains forward-looking statements concerning the Company's corporate objectives, the investment of the Company's proceeds from the sale of investments previously made, availability of tax losses and deductions, the anticipated total return to the Company's shareholders and the Company's intention to pay out earned income in the form of monthly dividends. Although the Company believes that the expectations reflected in these forward-looking statements are reasonable, undue reliance should not be placed on them because the Company can give no assurance that they will prove to be correct since forward-looking statements address future events and conditions and by their very nature, involve inherent risks and uncertainties. The forward-looking statements contained in this press release are made as of the date hereof and the Company disclaims any intention or obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise, unless so required by applicable securities laws.
Interim Management Report of Fund Performance
For the period from January 1, 2013 to June 30, 2013
This interim management report of fund performance (the "Report") contains financial highlights of Deans Knight Income Corporation (the "Company"). This Report should be read in conjunction with the annual financial statements of the Company for the six month period ending June 30, 2013 (the "Financial Statements"), which, if not included with this Report, can be obtained at your request, at no cost by emailing info@dkincomecorp.com, visiting our website at www.dkincomecorp.com for contact details or on SEDAR at www.sedar.com. Readers may also contact us to request a free copy of the Company's proxy voting policies and procedures, proxy voting disclosure record or quarterly portfolio disclosure.
A NOTE ON FORWARD-LOOKING STATEMENTS
This Report contains certain forward-looking statements. In particular, this Report contains forward-looking statements in respect of the Company's targeted dividend payout, investment strategy, behaviour of financial markets and reflects the Company's expectations regarding the growth, results of operations, performance and business prospects and opportunities of the Company and its investments. In some cases, forward-looking statements can be identified by terminology such as "may", "will", "should", "expect", "plan", "anticipate", "believe", "estimate", "predict", "potential", "continue" or the negative of these terms or other comparable terminology. Such forward-looking statements reflect the Company's current beliefs and are based on information currently available to the Company. With respect to such forward-looking statements, the Company has made assumptions regarding, among other things, what type of debt securities will be included in its investment portfolio, currency, exchange and interest rates. A number of factors could cause actual events or results to differ materially from the results discussed in the forward-looking statements. In evaluating these statements, prospective investors should specifically consider various factors, including global equity and capital markets, business competition, technological change, changes in government regulations, unexpected judicial or regulatory proceedings, and catastrophic events and the risks outlined under "Risk Factors" in the AIF (as defined herein), which may cause actual results to differ materially from any forward-looking statement. Although the forward-looking statements contained in this Report are based upon what the Company believes to be reasonable assumptions, the Company cannot assure investors that actual results will be consistent with these forward-looking statements. Forward-looking statements are made as of the date of this Report and, other than as required by applicable law, the Company assumes no obligation to update or revise them to reflect new events or circumstances.
This Report also contains certain financial and operational information obtained from public sources in respect of certain companies included in the Company's investment portfolio. While management believes this data to be reliable, such information is subject to variations and may not be able to be verified due to limits on the availability and reliability of data inputs, the nature of the data gathering process and other limitations and uncertainties inherent in such information. Accordingly, the accuracy, currency and completeness of this information cannot be guaranteed. The Company has not independently verified any of the data from third party sources referred to in this Report or ascertained the underlying assumptions relied upon by such sources.
Investment Objectives and Strategies
The Company is a closed-end, non-redeemable investment company focused on investing in corporate debt securities. The Company's assets are actively managed by Deans Knight Capital Management Ltd. ("Deans Knight"), a respected British Columbia-based investment firm focused on managing high income and growth mandates for high net worth individuals. Deans Knight, formed in 1992, has an experienced management team and a long history of successful investing in corporate debt securities.
The Company's investment objectives are to: (i) maximize the total return for shareholders, consisting of dividend income and capital appreciation; and (ii) provide shareholders with monthly dividends, which to date have been set at $0.0583 per common share per month. The Company intends to continue to achieve these objectives by investing primarily in corporate debt securities rated BBB or below by Standard & Poor's Rating Services ("S&P") or an equivalent rating by another nationally recognized statistical rating organization. The Company may also invest in investment grade debt securities rated above BBB and non-rated debt securities from time to time.
The Company believes there are attractive investment opportunities today in owning corporate debt of businesses with tangible assets, strong cash flows and reasonable leverage.
When evaluating securities to purchase for the Company, Deans Knight focuses on the following:
- amount of security or collateral within a business to support the value of the securities;
- the position of the debt in the capital structure;
- covenants;
- liquidity;
- the business' ability to reduce or refinance the debt; and
- the overall term of the debt and yield to bondholders.
Deans Knight uses the above credit-based analysis to identify corporate debt for inclusion in the Company's investment portfolio with attractive valuations in order to maintain its targeted dividend payment.
Risk
The overall risks of the Company are as described in its annual information form of the Company dated March 11, 2013 (the "AIF").
Prior to the reorganization and change in business as discussed in Note 1 of the Financial Statements, the Company generated significant tax losses and other tax attributes as a result of its prior businesses and research activities. The Company has recorded, as a tax asset, the full amount of the potential tax benefit of such items to the extent of its projected taxable income. There is uncertainty as to whether the tax authorities will allow the Company to deduct some or all of the tax losses and other attributes.
In May 2013, the Company received and responded to a letter from the Canada Revenue Agency (CRA), advising the Company that it is under audit for the taxation years 2008 to 2012, being those that end after the recapitalization and reorganization of the Company. The Company believes the audit is a normal course audit and has provided the CRA with the information requested. The CRA has asserted no opinion on the Company's use of its tax attributes in the years under audit. After consultation with legal counsel, the Company remains of the view that such tax attributes were eligible for use by the Company.
Should the Company be denied the deductions in full, the recorded amount of the tax assets as well as such amounts claimed to date would be recorded as a charge to income. The total tax assets recognized and tax losses and other attributes claimed to date, which are subject to uncertainty, amount to $19,960,000 (December 31, 2012 - $21,154,044), representing $1.89 per common share at June 30, 2013 (December 31, 2012 - $2.01).
There were no significant changes during the six month period ending June 30, 2013 that affected the overall risk of investing in the Company, other than noted above. Given the type of investments made by the Company, an investment in the Company may be considered to be speculative. An investment in the Company is generally suitable for investors who are looking to receive income, yet are willing to tolerate volatility in the value of their investment.
Results of Operations
The net assets of the Company at June 30, 2013 were $137,209,433 or $13.02 per common share (December 31, 2012 - $142,275,000 or $13.50 per common share). The net assets of the Company consisted of the following components:
| June 30, 2013 | ||||||
$ |
Per common share(1) | % |
||||
| Investments(2) | 110,270,115 | 10.46 | 80.3 | |||
| Cash and short-term deposits | 24,774,944 | 2.35 | 18.1 | |||
| Accrued income | 1,555,115 | 0.15 | 1.1 | |||
| Prepaid expenses | 101,440 | 0.01 | 0.1 | |||
| Future income tax asset(3) | 1,260,000 | 0.12 | 1.0 | |||
| Accounts payable and accrued liabilities | (752,181 | ) | (0.07 | ) | (0.6 | ) |
| 137,209,433 | 13.02 | 100.0 | ||||
| (1) | Based on 10,537,263 common shares, including 10,191,592 voting common shares and 345,671 non-voting common shares, as outlined in the notes to the Financial Statements. |
| (2) | The details of the investments are outlined in the Summary of Investment Portfolio below. |
| (3) | Refer to the Taxation note to the Financial Statements for more detail. |
| December 31, 2012 | ||||||
$ |
Per common share(1) | % |
||||
| Investments(2) | 118,788,753 | 11.27 | 83.5 | |||
| Cash and short-term deposits | 20,091,125 | 1.91 | 14.1 | |||
| Accrued income | 1,662,373 | 0.16 | 1.2 | |||
| Prepaid expenses | 56,460 | 0.00 | 0.0 | |||
| Future income tax asset(3) | 2,390,000 | 0.23 | 1.7 | |||
| Accounts payable and accrued liabilities | (713,711 | ) | (0.07 | ) | (0.5 | ) |
| 142,275,000 | 13.50 | 100.0 | ||||
| (1) | Based on 10,537,263 common shares, including 10,191,592 voting common shares and 345,671 non-voting common shares, as outlined in the notes to the Financial Statements. |
| (2) | The details of the investments are outlined in the Summary of Investment Portfolio below. |
| (3) | Refer to the Taxation note to the Financial Statements for more detail. |
In May, interest rates began to rise with the yield on 10-year US treasuries going from 1.6% on May 2nd to 2.5% at quarter end. Canadian treasuries had a similar result, going from 1.7% to 2.4%.
A graph is available at the following address: http://media3.marketwire.com/docs/gph1dnc.pdf.
This had a negative impact on government and investment grade bonds. The DEX Universe Index, an investment grade bond index primarily comprised of Government bonds, was down 4% from its peak in May. In our view, this is just a preview of what is to come. Interest rates in Canada have gone from 8.5% twenty years ago to 2.4% today. As a result, since 1993, the DEX Universe provided a total annualized return of 6.9% from interest and capital gains, the latter a result of the significant decline in rates. As declining interest rates shift to rising rates, capital gains will turn into capital losses for government and investment grade bonds.
The Company believes the difficulty for bonds last quarter was caused by the Chairman of the US Federal Reserve, Ben Bernanke's remarks that Quantitative Easing (QE) will likely come to an end this year. All Bernanke did was state the obvious. QE has to end, the Fed cannot continue to "print money" in the face of improving economic results. The economy is able to stand on its own feet and, as a result, it is standard practice for the Fed to 'remove the punchbowl once the party gets rolling!' Improved recent employment figures in the US lead the Company to believe the world's largest economy is returning to more normal business activity.
What happens to bonds if rates rise? The simple answer is when interest rates rise, bond prices fall and the longer the term of the bond, the further the price will fall. As we've outlined above, this is certainly true on government and investment grade bonds. However, the high yield market is not impacted to the same extent by rising rates. As an example, the Company produced a -1.0% return year-to-date, based on net asset value, compared to the DEX Universe Index return of -1.7%.
Why? Firstly, the coupon on the securities in the portfolio is significantly higher than the coupon in the DEX Universe. At June 30, 2013, the portfolio provided a yield to maturity of 7.5%, versus the DEX Universe which yields 2.7%. Secondly, the portfolio has a shorter term to maturity of 4.4 years versus the DEX Universe Index at almost 10 years, meaning it is less sensitive to changes in interest rates. Thirdly, interest rates rise because economic conditions are improving, which is positive for corporate earnings and balance sheets, thus positive for high yield bonds.
The Company had a holding which negatively impacted the portfolio's return in the past six months. Northland Resources S.A. bonds, as discussed in more detail in our Q1 2013 Operational Update, were sold in the period and resulted in a decrease to the portfolio of approximately $0.34 per share. This decline, along with the decrease of the future tax asset ($0.11 per share) represents the majority of the decline in the net asset value for the six month period. On balance, the remaining holdings in the portfolio generated a positive return equal to the overall portfolio coupon.
An example of a bond providing a positive return during the six month period, through capital appreciation, was North American Energy Partners Inc. ("NAEP"). In June, NAEP announced the sale of their piling division for $210 million with an option to receive an additional $92.5 million if certain hurdles are met. Proceeds from the sale will be used to pay down the debt, which currently totals $310 million. NAEP retains their mining division, which management expects to generate $45 million over the next twelve months. In addition, the majority of their hard assets, roughly 80%, remain with NAEP after the sale of the piling division. This was positive for the bonds, which rose from $88.5 at December 31, 2012 to $102 at June 30, 2013.
The portfolio also has the potential for future capital appreciation. One example being Mirabela Nickel Ltd. bonds, which were trading in the mid- $70's at June 30, 2013. Mirabela produces nickel from a world class sulphide deposit and facility in Brazil. The nickel market is in a very deep slump. The graph below shows the steep decline in the commodity price since March 2011.
A graph is available at the following address: http://media3.marketwire.com/docs/gph2dnc.pdf
At today's nickel price, very few producers make any money, including Mirabela. That said, it has a first class deposit and plant, strong shareholders, great management, they operate in a good jurisdiction (Brazil), and they have cash on hand to help them withstand low nickel prices for an estimated 18 months. Mirabela management has been working hard and has been effective in reducing mining costs. To be sure, a recovery in nickel prices is needed for Mirabela to remain current on their interest payments. The point is that because of the low commodity price, there will be no new nickel mines. Moreover, one may begin to see production cuts or shutdowns from higher-cost mining operations. Mirabela has a $50 million fully drawn bank facility and $395 million of high yield bonds which are currently marked in the low $70's. Assuming this price level, and ignoring cash on hand, the bonds are valuing Mirabela at $325 million. The replacement value of their plant alone is roughly $1 billion.
We have allowed cash to build in the portfolio over the past 12 months. Cash and short term deposits currently represents 18.1% of the portfolio. We did this because yields were declining and attractive opportunities became scarce.
During the period, Deans Knight designed and originated $6 million in short term secured notes with Uranerz Energy Corporation, a uranium company with assets in Wyoming. The Company provided $2,250,000, or 1.7% of the current portfolio value, of the notes. Uranerz has received approval in principle for a $20 million loan under the state of Wyoming's Industrial Development Revenue Bond program and is working with the State to finalize documentation. The secured notes will allow Uranerz to commence drilling of deep disposal wells in advance of the State financing. Uranerz intends to repay the notes in full upon closing of the $20 million loan.
The notes are secured senior obligations of Uranerz, bear interest at 6% per annum, which increase to 10% per annum on August 15, 2013 if the facility is still outstanding. The facility matures on the earlier of (i) 30 days from closing of the State loan, and (ii) December 31, 2013. As additional consideration, Uranerz paid an up-front commitment fee of 1.5%, and issued warrants to purchase 1,600,000 common shares at a price of $1.60 per share, of which 400,000 warrants will be exercisable only if the notes remain outstanding after August 15, 2013.
Recent Developments
Comparison of net asset value and net assets
National Instrument 81-106 ("NI 81-106") permits investment companies to have two different net asset values: (i) one for financial statements, which will be prepared in accordance with Canadian Generally Accepted Accounting Principles ("GAAP") including Section 3855 (and referred to as "net assets") and (ii) another for all other purposes, including unit pricing for investor transactions (referred to as "net asset value"). The main difference in calculating net assets and net asset value is that GAAP requires bid price to be used in valuing securities traded in an active market where quoted prices are readily and regularly available, rather than the use of a price between the bid and the ask price currently used for determining net asset value. This difference results in an insignificant difference of approximately $0.06 per common share at June 30, 2013 (December 31, 2012 - $0.08 per common share), as outlined in the notes to the Financial Statements.
International Financial Reporting Standards
The Company will be required to adopt international financial reporting standards ("IFRS"). The Canadian Accounting Standards Board (AcSB) previously announced January 1, 2011 as the date international financial reporting standards (IFRS) would replace current Canadian standards and interpretations as GAAP for publicly accountable enterprises, which include investment companies.
In December 2011, the AcSB issued a decision to defer adoption of IFRS for investment companies currently applying Accounting Guideline 18 - Investment Companies until years beginning on or after January 1, 2014.
Under the above noted decision, the Company's first set of financial statements to be reported on under IFRS would be for the semi-annual period ending June 30, 2014. These statements would include corresponding comparative financial information for 2013, including an opening statement of net assets as at January 1, 2013. However, the Company has a termination date of April 30, 2014, and as such will not be required to issue statements reported on under IFRS. The Company will continue to monitor any further AcSB decisions that may affect the Company's requirement to adopt IFRS.
Related Party Transactions
The officers, and certain directors, of the Company are also employees of Deans Knight, the Company's investment advisor. These officers, and directors, are not paid by the Company. Deans Knight provides investment management services to the Company, as well as administration, financial reporting and other ancillary services required by a publicly listed company. Management fees, for the services outlined above, are computed and paid quarterly, at an annual rate of 1.5% of the net asset value plus applicable taxes, and adjusted for certain non-investment related assets.
For the six month period ending June 30, 2013, management fees totaled $1,089,013 (2012 - $2,311,284). At June 30, 2013, $536,774 (December 31, 2012- $589,251) was owed to Deans Knight, which was included in accounts payable and accrued liabilities in the statement of net assets, and is payable immediately. In calculating the management fee, the net asset value was reduced by the value of the future income tax asset included in the statement of net assets.
A former director of the Company is a partner at a law firm that provides legal services to the Company. During the six month period ending June 30, 2013, the Company incurred $175,830 (June 30, 2012 - $11,098) in legal services and disbursements received from this related party. At June 30, 2013, accounts payable and accrued liabilities include $103,000 (December 31, 2012 - $226) due to the law firm for legal fees and disbursements.
Financial Highlights
The following tables show selected key financial information about the Company and are intended to help you understand the Company's financial performance since it began operating its new business of investing in corporate debt in March 2009.
The Company's Net Assets per Common Share (1)
| Year ended December 31, | ||||||||||
| Six months ended June 30, 2013 | 2012 $ |
2011 $ |
2010 $ |
Period March 17 to December 31, 2009 $ |
||||||
| Net assets, beginning of year (2) | 13.50 | 13.43 | 13.60 | 12.21 | 9.12 | |||||
| Increase from operations | ||||||||||
| Total revenue | 0.53 | 1.10 | 1.10 | 0.94 | 0.62 | |||||
| Total expenses | (0.14 | ) | (0.26 | ) | (0.26 | ) | (0.24 | ) | (0.20 | ) |
| Realized gains | (0.80 | ) | 0.44 | 0.36 | 1.82 | 1.25 | ||||
| Unrealized losses | 0.39 | (0.27 | ) | (0.52 | ) | (0.27 | ) | 1.21 | ||
| Future income taxes | (0.11 | ) | (0.24 | ) | (0.15 | ) | (0.16 | ) | 0.62 | |
| Total increase from operations (2) | (0.13 | ) | 0.77 | 0.53 | 2.09 | 3.50 | ||||
| Dividends (2)(3) | (0.35 | ) | (0.70 | ) | (0.70 | ) | (0.70 | ) | (0.41 | ) |
| Net assets, end of year (4) | 13.02 | 13.50 | 13.43 | 13.60 | 12.21 | |||||
| (1) | The information is derived from the Company's audited annual and unaudited interim financial statements. Common shares outstanding are 10,537,263, including 10,191,592 voting common shares and 345,671 non-voting common shares. |
| (2) | Net assets, beginning of the period for 2009 reflect the net assets in the Company at March 17, 2009, after giving effect to the conversion of the convertible debenture and interest owing thereon and the issuance of common shares on the Company's initial public offering less total share issue expenses. |
| (3) | Net assets and dividends are based on the actual number of shares outstanding at the relevant time. The increase/decrease from operations is based on the weighted average number of shares outstanding over the period. |
| (4) | Dividends were paid in cash. |
| (5) | The net assets per share presented in the financial statements differs from the net asset value per share calculated for pricing purposes due to the provisions of CICA Handbook Section 3855. An explanation of the differences can be found in the notes to the financial statements. |
| Ratios and Supplemental Data (1) | ||||||||||
| Year Ended December 31, | ||||||||||
| Six months ended June 30, 2013 | 2012 |
2011 |
2010 |
Period March 17 to December 31, 2009 |
||||||
| Net asset value (000's) | $137,775 | $143,065 | $142,178 | $143,880 | $128,930 | |||||
| Number of common shares outstanding (000's) | 10,537 | 10,537 | 10,537 | 10,537 | 10,537 | |||||
| Management expense ratio (2) | 1.09 | % | 1.96 | % | 1.90 | % | 1.91 | % | 5.51 | % |
| Portfolio turnover rate (3) | 14.07 | % | 14.79 | % | 79.90 | % | 86.60 | % | 36.69 | % |
| Trading expense ratio (4) | 0.01 | % | 0.01 | % | 0.00 | % | 0.01 | % | 0.01 | % |
| Net asset value per common share | $13.08 | $13.58 | $13.49 | $13.65 | $12.23 | |||||
| Closing market price - common share | $12.25 | $12.69 | $11.84 | $12.54 | $11.40 | |||||
| (1) | Management expense ratio is annualized and based on total expenses for the period and is expressed as a percentage of weekly average net asset values over the period. For 2009, this ratio is calculated from the date the Company began operating its business as an investment corporation, on March 17, 2009, to December 31, 2009. |
| (2) | The Management expense ratio for 2009 includes offering costs for the IPO of $6,268,800 less the offsetting related future tax benefit of $1,692,500. |
| (3) | The Company's portfolio turnover rate indicates how actively the Company manages its portfolio investments. A portfolio turnover rate of 100% is equivalent to the Company buying and selling all of the securities in its portfolio once in the course of the year. The higher a portfolio turnover-rate in a year, the greater the trading costs payable by the Company in the year. There is not necessarily a relationship between a high turnover rate and the performance of the investment portfolio. |
| (4) | The trading expense ratio represents total commissions and other portfolio transaction costs expressed as an annualized percentage of daily average net asset value during the period. |
Management Fees
Deans Knight provides investment management services to the Company, as well as administration, financial reporting and other ancillary services required by a publicly listed company. Management fees are computed and paid quarterly, at an annual rate of 1.5% of the net asset value plus applicable taxes, and adjusted for certain non-investment related assets.
Past Performance
This section shows the Company's past performance, since it began operating its business as an investment fund. The past performance information includes changes in net asset value and assumes the reinvestment of all dividends paid to common shareholders. It is important to note that the past performance will not necessarily indicate what performance in the future will be.
Year-by-year Returns
The accompanying bar chart shows the Company's performance for the years shown and illustrates how the Company's performance has changed from year to year. The bar chart shows, in percentage terms, how much an investment made from when the Company began its operation as an investment fund on March 17, 2009 to December 31, 2009, and how much an investment made for the years ending December 31, 2010, 2011, 2012, and how much an investment made for the six-month period ending June 30, 2013.
A graph is available at the following address: http://media3.marketwire.com/docs/gph3dnc.pdf.
Summary of Investment Portfolio
The following is a summary of the Company's investment portfolio as at June 30, 2013. This is a summary only and will change due to ongoing portfolio transactions of the Company. A quarterly update is available at www.dkincomecorp.com.
| Top 25 Investments | % of Net | ||
| Asset Value | |||
| PARAMOUNT RESOURCES | 8.250% | 13-Dec-17 | 6.9 |
| NORTH AMERICA ENERGY | 9.125% | 7-Apr-17 | 6.5 |
| WHITECAP RESOURCES | N/A | N/A | 6.1 |
| MIRABELA NICKEL LTD | 8.750% | 15-Apr-18 | 5.9 |
| CALFRAC HOLDINGS LP | 7.500% | 1-Dec-20 | 4.6 |
| SOUTHERN PACIFIC RES | 8.750% | 25-Jan-18 | 3.6 |
| TEMBEC INDUSTRIES | 11.250% | 15-Dec-18 | 3.5 |
| CCS INC | 11.000% | 15-Nov-15 | 3.5 |
| PERPETUAL ENERGY INC | 8.750% | 15-Mar-18 | 3.4 |
| STONE ENERGY CORP | 8.625% | 1-Feb-17 | 3.4 |
| PETROAMERICA OIL | 11.500% | 19-Apr-15 | 2.9 |
| SHERRITT INTL CORP | 8.000% | 15-Nov-18 | 2.8 |
| CARA OPERATIONS LTD | 9.125% | 1-Dec-15 | 2.6 |
| BEAZER HOMES USA | 9.125% | 15-Jun-18 | 2.6 |
| GARDA WORLD SECURITY | 9.750% | 15-Mar-17 | 2.5 |
| GATEWAY CASINOS | 8.875% | 15-Nov-17 | 2.1 |
| PACIFIC RUBIALES | 7.250% | 12-Dec-21 | 1.9 |
| SURE ENERGY | 6.250% | 21-Jan-14 | 1.8 |
| ATHABASCA OIL CORP | 7.500% | 19-Nov-17 | 1.7 |
| URANERZ ENERGY CORP | 6.000% | 31-Aug-13 | 1.7 |
| WESTERN ENERGY SVS | 7.785% | 30-Jan-19 | 1.7 |
| NIKO RESOURCE LTD CV | 7.000% | 13-Dec-17 | 1.6 |
| 99 CENTS ONLY STORES | 11.000% | 15-Dec-19 | 1.6 |
| SHERRITT INTL CORP | 7.500% | 24-Sep-20 | 1.4 |
| JUST ENERGY GROUP | 6.000% | 30-Jun-17 | 1.0 |
| Portfolio Composition | % of Net |
| Asset Value | |
| Fixed Income | |
| Canadian denominated in CAD | 44.8 |
| Canadian denominated in USD | 14.4 |
| United States denominated in USD | 13.9 |
| Other Foreign denominated in EUR | 0.9 |
| 74.0 | |
| Equity and Warrants | 6.4 |
| Investment Portfolio | 80.4 |
| Cash & Short-term Deposits | 18.0 |
| Other Net Assets | 1.6 |
| 100.0 | |
| Sector Breakdown | |
| Energy | 50.5 |
| Materials & Metals | 10.2 |
| Consumer Discretionary | 11.8 |
| Forestry | 3.5 |
| Technology | 1.0 |
| Services | 3.4 |
| Investment Portfolio | 80.4 |
| Cash & Short-term Deposits | 18.0 |
| Other Net Assets | 1.6 |
| 100.0 |
Deans Knight Income Corporation
Interim Financial Statements
June 30, 2013
(Unaudited)
Notice of No Auditor Review of Interim Financial Statements
The accompanying unaudited interim financial statements of the Company have been prepared in accordance with CICA Handbook Section 1751 - Interim Financial Statements and are the responsibility of the Company's management.
The Company's independent auditor has not performed a review of these financial statements. The Company's auditor will perform an audit of the December 31, 2013 financial statements.
| Deans Knight Income Corporation | ||
| Statements of Net Assets | ||
| (Unaudited) | ||
| June 30, 2013 $ | December 31, 2012 $ | |
| Assets | ||
| Investments - at fair value (cost - June 30, 2013 - $104,603,635; December 31, 2012 - $117,207,284) | 110,270,115 | 118,788,753 |
| Cash and cash equivalents | 24,774,944 | 20,091,125 |
| Accrued interest receivable | 1,555,115 | 1,662,373 |
| Prepaid expenses | 101,440 | 56,460 |
| Future income tax benefits (note 7) | 1,260,000 | 2,390,000 |
| 137,961,614 | 142,988,711 | |
| Liabilities | ||
| Accounts payable and accrued liabilities (note 5) | 752,181 | 713,711 |
| Net assets | 137,209,433 | 142,275,000 |
| Shareholders' equity | ||
| Common shares (note 3) | 99,366,429 | 99,366,429 |
| Contributed surplus (note 3) | 9,904,504 | 9,904,504 |
| Retained earnings (note 4) | 27,938,500 | 33,004,067 |
| 137,209,433 | 142,275,000 | |
| Number of common shares outstanding (note 3) | 10,537,263 | 10,537,263 |
| Net assets per common share (notes 7 and 10) | 13.02 | 13.50 |
| Contingencies (notes 1 and 7) | ||
| Commitments (notes 1 and 9) | ||
| Subsequent events (note 11) | ||
| Deans Knight Income Corporation | ||||
| Statements of Operations | ||||
| Six-month period ended June 30, 2013 and 2012 | ||||
| (Unaudited) | ||||
| 2013 $ | 2012 $ | |||
| Investment income | ||||
| Interest and other | 5,603,914 | 6,050,208 | ||
| Expenses | ||||
| Management fees (note 5) | 1,089,013 | 1,147,216 | ||
| Legal fees (note 5) | 176,101 | 11,098 | ||
| Public company reporting costs | 98,088 | 88,938 | ||
| Director's fees and expenses | 79,100 | 77,913 | ||
| Audit, accounting and tax fees | 43,355 | 42,600 | ||
| Custodial fees | 23,798 | 23,379 | ||
| Transaction costs | 11,187 | 11,318 | ||
| Independent Review Committee Fees | 6,225 | 4,500 | ||
| 1,526,867 | 1,406,962 | |||
| Net investment income | 4,077,047 | 4,643,246 | ||
| Realized and unrealized gains (losses) on investments | ||||
| Net realized (loss) gain on investments sold (note 6) | (7,052,919 | ) | 953,729 | |
| Net realized loss on settlement of foreign currency contracts (note 6) | (1,358,770 | ) | (503,955 | ) |
| Change in unrealized appreciation (depreciation) on investments | 5,412,464 | (6,199,089 | ) | |
| Unrealized (depreciation) appreciation on foreign currency contracts | (1,327,454 | ) | 887,767 | |
| Net loss on investments | (4,326,679 | ) | (4,861,588 | ) |
| Decrease in net assets from operations before tax | (249,632 | ) | (218,342 | ) |
| Provision for future income tax (note 7) | (1,130,000 | ) | (870,000 | ) |
| Decrease in net assets from operations | (1,379,632 | ) | (1,088,342 | ) |
| Decrease in net assets from operations per | ||||
| weighted average common share (note 2) | (0.13 | ) | (0.10 | ) |
| Deans Knight Income Corporation | ||||
| Statements of Changes in Net Assets | ||||
| Six-month period ended June 30, 2013 and 2012 | ||||
| (Unaudited) | ||||
| 2013 $ | 2012 $ | |||
| Decrease in net assets from operations | (1,379,632 | ) | (1,088,342 | ) |
| Dividends to common shareholders (notes 4 and 9) | (3,685,935 | ) | (3,685,935 | ) |
| Decrease in net assets during the period | (5,065,567 | ) | (4,774,277 | ) |
| Net assets - Beginning of period | 142,275,000 | 141,539,920 | ||
| Net assets - End of period | 137,209,433 | 136,765,643 | ||
| Deans Knight Income Corporation | ||||||
| Statements of Cash Flows | ||||||
| Six-month period ended June 30, 2013 and 2012 | ||||||
| (Unaudited) | ||||||
| 2013 $ | 2012 $ | |||||
| Cash flows from operating activities | ||||||
| Decrease in net assets from operations | (1,379,632 | ) | (1,088,342 | ) | ||
| Items not affecting cash | ||||||
| Net realized loss (gain) on investments sold | 7,052,919 | (953,729 | ) | |||
| Net realized loss on settlement of foreign currency contracts | 1,358,770 | 503,955 | ||||
| Change in unrealized (appreciation) depreciation on investments | (5,412,464 | ) | 6,199,089 | |||
| Unrealized depreciation (appreciation) on foreign currency contracts | 1,327,454 | (877,767 | ) | |||
| Future income tax provision | 1,130,000 | 870,000 | ||||
| 4,077,047 | 4,643,246 | |||||
| Cost of investments purchased (note 6) | (16,081,596 | ) | (13,398,699 | ) | ||
| Proceeds from investments sold (note 6) | 20,273,556 | 11,055,277 | ||||
| Net change in non-cash balances related to operations | ||||||
| Accrued interest receivable | 107,259 | 307,960 | ||||
| Prepaid expenses | (44,982 | ) | (63,768 | ) | ||
| Accounts payable and accrued liabilities | 38,470 | 22,962 | ||||
| 8,369,754 | 2,566,978 | |||||
| Cash flows from financing activities | ||||||
| Dividends paid to common shareholders (notes 4 and 9) | (3,685,935 | ) | (3,685,935 | ) | ||
| Net increase (decrease) in cash and cash equivalents during the period | 4,683,819 | (1,118,957 | ) | |||
| Cash and cash equivalents - Beginning of period | 20,091,125 | 4,997, 715 | ||||
| Cash and cash equivalents - End of period | 24,774,944 | 3,878,758 | ||||
| Cash and cash equivalents comprise | ||||||
| Cash | 5,817,209 | 3,878,758 | ||||
| Short-term deposits | 18,957,735 | - | ||||
| 24,774,944 | 3,878,758 | |||||
| Deans Knight Income Corporation | ||||
| Statement of Investments | ||||
| As at June 30, 2013 | ||||
| (Unaudited) | ||||
Par value 1 $ | Average cost 2 $ | Fair value 2 $ | Percentage of total fair value3 % | |
| Fixed income - Canadian | ||||
| Denominated in Canadian dollars | ||||
| Athabasca Oil Corp. 7.5% 11-19-2017 | 2,500,000 | 2,442,500 | 2,387,500 | 2.2 |
| Black Press Group Libor + 5.00% 06-26-2018 | 1,250,000 | 1,237,500 | 1,250,000 | 1.1 |
| Black Press Group 10% 12-28-2018 | 1,250,000 | 1,250,000 | 1,237,500 | 1.1 |
| Cara Operations Ltd. 9.13% 12-01-2015 | 3,500,000 | 3,500,000 | 3,578,750 | 3.2 |
| Garda World Security 9.75% 03-15-2017 | 3,250,000 | 3,237,105 | 3,396,250 | 3.1 |
| Gateway Casinos 8.88% 11-15-2017 | 2,750,000 | 2,816,875 | 2,935,625 | 2.7 |
| North American Energy Partners Inc. 9.13% 04-07-2017 | 8,750,000 | 8,793,125 | 8,925,000 | 8.1 |
| Paramount Resources Ltd. 8.25% 12-13-2017 | 9,250,000 | 9,250,000 | 9,458,125 | 8.6 |
| Perpetual Energy Inc. 8.75% 03-15-2018 | 5,000,000 | 5,000,000 | 4,700,000 | 4.3 |
| Petroamerica Oil Corp. 11.50% 04-19-2015 4 | 4,000,000 | 4,000,000 | 4,000,000 | 3.6 |
| Sherritt International Corp. 7.75% 10-15-2015 | 196,000 | 152,233 | 204,330 | 0.2 |
| Sherritt International Corp. 8.00% 11-15-2018 | 3,750,000 | 3,750,000 | 3,778,125 | 3.4 |
| Sherritt International Corp. 7.50% 09-24-2020 | 2,000,000 | 2,000,000 | 1,955,000 | 1.8 |
| Skylink Aviation Inc. 12.25% 05-10-2018 | 495,454 | 495,454 | 302,227 | 0.3 |
| Southern Pacific Resources 8.75% 01-25-2018 | 6,500,000 | 6,500,000 | 4,972,500 | 4.5 |
| Sure Energy Inc. 6.00% 01-21-2014 4 | 2,500,000 | 2,500,000 | 2,500,000 | 2.3 |
| Western Energy Services Corp. 7.88% 01- 30-2019 | 2,250,000 | 2,250,000 | 2,261,250 | 2.1 |
| 59,174,792 | 57,842,182 | 52.6 | ||
| Denominated in United States dollars | ||||
| CCS Inc. 11.00% 11-15-2015 | 4,500,000 | 2,252,568 | 4,754,052 | 4.3 |
| Mirabela Nickel Ltd. 8.75% 04-15-2018 | 10,050,000 | 9,138,320 | 8,029,066 | 7.3 |
| Pacific Rubiales Energy Corp. 7.25% | ||||
| 12-12-2021 | 2,300,000 | 2,365,780 | 2,550,737 | 2.3 |
| Skylink Aviation Inc. 10.00% 03-08-2015 4 | 965,183 | 982,991 | 1,014,600 | 0.9 |
| Tembec Industries 11.25% 12-15-2018 | 4,250,000 | 4,494,779 | 4,780,332 | 4.3 |
| 19,234,438 | 21,128,787 | 19.1 | ||
| Total Canadian fixed income | 78,409,230 | 78,970,969 | 71.7 | |
| Fixed income - United States | ||||
| Denominated in United States dollars | ||||
| 99 Cents Only Stores 11.00% 12-15-2019 | 1,850,000 | 1,926,584 | 2,158,639 | 2.0 |
| Beazer Homes USA, Inc. 9.13% 06-15-2018 | 3,250,000 | 3,327,056 | 3,570,138 | 3.2 |
| Calfrac Holdings LP 7.5% 12-01-2020 | 6,000,000 | 6,130,329 | 6,244,128 | 5.7 |
| Stone Energy Corp. 8.63% 02-01-2017 | 4,250,000 | 4,284,796 | 4,668,642 | 4.2 |
| Uranerz Energy Corp. 6.00% 08-31-2013 4 | 2,250,000 | 2,303,550 | 2,365,200 | 2.1 |
| Total United States fixed income | 17,972,315 | 19,006,747 | 17.2 | |
| Total fixed income | 96,381,545 | 97,977,716 | 88.9 |
| 1 | Par values are presented in their source currency |
| 2 | All amounts are shown in Canadian dollars |
| 3 | Percentages are shown as a percentage of total investments |
| 4 | These investments represent loans receivable |
Par value 1 $ | Average cost 2 $ | Fair value 2 $ | Percentage of total fair value3 % | ||
| Convertible debentures - Canada | |||||
| Denominated in Canadian dollars | |||||
| Just Energy Group 6.00% 06- 30-2017 | 1,850,000 | 1,483,405 | 1,402,115 | 1.3 | |
| Niko Resources Ltd. 7.00% 12-13-2017 | 2,000,000 | 2,000,000 | 2,160,000 | 2.0 | |
| Total convertible debentures | 3,483,405 | 3,562,115 | 3.3 | ||
| Equities - Canada | |||||
| Conifex Timber Inc. - purchase warrants | |||||
| $9.33 strike, 12-31-2014 | 81,726 | - | 17,759 | 0.0 | |
| Petroamerica Oil Corp. - purchase warrants | |||||
| $0.20 strike, 04-19-2015 | 400 | - | 317,846 | 0.3 | |
| Sure Energy Inc. - purchase warrants | |||||
| $1.80 strike, 12-21-2013 | 625,000 | - | - | 0.0 | |
| Uranerz Energy Corp. - purchase warrants | |||||
| $1.60 strike, 12-05-2015 | 600,000 | - | 55,014 | 0.0 | |
| Skylink Aviation Inc. - common shares | 33,765 | - | - | - | |
| Whitecap Resources Inc. - common shares | 769,267 | 4,738,685 | 8,354,240 | 7.6 | |
| Total equities | 4,738,685 | 8,744,859 | 7.9 | ||
| Royalties - Canada | |||||
| Denominated in Euro | |||||
| RapidEye Canada Royalty | - | 1,312,879 | 1.1 | ||
| Investments subtotal | 104,603,635 | 111,597,569 | 101.2 | ||
| Foreign Currency Contracts (note 8) | |||||
| Denominated in United States dollars | |||||
| Payable 07-18-2013 at 1.01785 | 3,000,000 | (102,922) | (0.1) | ||
| Payable 07-18-2013 at 1.01865 | 18,000,000 | - | (603,736) | (0.5) | |
| Payable 08-13-2013 at 1.02175 | 20,000,000 | - | (620,796) | (0.6) | |
| Total foreign currency contracts | - | (1,327,454) | (1.2) | ||
| 104,603,635 | 110,270,115 | 100.0 | |||
| 1 | Par values are presented in their source currency |
| 2 | All amounts are shown in Canadian dollars |
| 3 | Percentages are shown as a percentage of total investments |
| 4 | These investments represent loans receivable |
The accompanying notes are an integral part of these unaudited financial statements.
Deans Knight Income Corporation
Notes to Financial Statements
June 30, 2013
(Unaudited)
1. Nature of operations and basis of presentation
Deans Knight Income Corporation (the "Company") is a corporation continued under the laws of Canada on April 11, 2001. The Company is a closed-end, non-redeemable investment company. It invests, primarily, in corporate debt rated BBB or below by recognized credit rating organizations.
Prior to its reorganization in May 2008, the Company was a life sciences company involved in the research, development and commercialization of innovative products for the prevention and treatment of life-threatening diseases. The Company maintains product liability insurance for certain claims that may arise in the future in connection with its prior business. To date, no such claims or potential claims have arisen. In March 2009, the Company completed an initial public offering, whereby it raised gross proceeds of $100,368,900 and began operating its new business as an investment company.
As per the Company's Articles of Incorporation, the common shares of the Company are to be redeemed on, or around, April 30, 2014, for a cash amount equal to 100% of the net asset value per common share.
The accompanying interim financial statements are prepared in accordance with Part V of the Canadian Institute of Chartered Accountants Handbook, Pre-changeover Accounting Standards (GAAP). All amounts are presented in Canadian dollars, unless otherwise noted.
2 Summary of significant accounting policies
The following is a summary of significant accounting policies followed by the Company, and these policies are consistent with the most recent annual financial statements. These statements should be read in conjunction with the most recent annual financial statements.
Financial instruments
Investments
Investments are held for trading and are recorded at fair values determined as follows:
Fixed income investments
Fixed income investments traded on a public securities exchange or traded on an over-the-counter market are valued at the closing bid price. Where no closing bid price is available, the last sale or close price is used where, in management's opinion, this provides the best estimate of fair value.
Unlisted or non-exchange traded investments, or investments where a last bid, sale or close price is unavailable, or investments for which market quotations are, in the Company's opinion, inaccurate, unreliable, or not reflective of all available material information, are valued at their fair value as determined by the Company using appropriate and accepted industry valuation techniques including valuation models. The fair value determined using valuation models requires the use of inputs and assumptions based on observable market data including volatility and other applicable rates or prices. In certain circumstances, the fair value may be determined using valuation techniques that are not supported by observable market data.
The resulting values for investments not traded in an active market may differ from values that would be determined had a ready market existed, and the difference could be significant.
Foreign currency contracts
Foreign currency contracts are recorded at fair value. The proceeds (payments) on contracts settled during the year are included in the net realized gain (loss) on settlement of foreign currency contracts (note 6). The Company's policy is to hedge 95% - 105% of the fair value of foreign denominated investments with foreign exchange forward sell contracts.
Public company equities
Publicly traded equities are recorded at bid prices as quoted on recognized stock exchanges.
The amounts at which the Company's publicly-traded investments could be disposed of currently may differ from carrying value based on market quotes, as the value at which significant ownership positions are sold is often different than the quoted market price due to a variety of factors such as premiums paid for large blocks or discounts due to illiquidity.
Warrants
Warrants are recorded at their estimated fair value using appropriate and accepted industry valuation techniques.
The impact of changes in fair value of investments is recorded in the statement of operations.
Cash and cash equivalents
Cash and cash equivalents are accounted for at amortized cost. They consist of cash and deposits with maturities, at the time of purchase, of three months or less and are held with a Canadian chartered bank.
Accrued interest receivable
Accrued interest is designated as loans and receivables and is accounted for at amortized cost. Due to the immediate and short-term nature, carrying value approximates fair value.
Financial liabilities
Financial liabilities, consisting of accounts payable and accrued liabilities, are designated as other financial liabilities and are accounted for at amortized cost. Due to the immediate and short-term nature, the carrying value approximates fair value.
Investment transactions
Investment transactions are recorded on the trade date. Transaction costs are incremental costs that are directly attributable to the acquisition, issue or disposal of an investment, which include fees and commissions paid to agents, advisors, brokers and dealers, levies by regulatory agencies and securities exchanges, and transfer taxes and duties. These costs are expensed and are included in the statement of operations.
Income recognition
Income from investments is recognized on an accrual basis. Interest income is accrued based on the number of days the investment is held during the year. Royalty income is recognized on an accrual basis as earned. Gains or losses on the sale of investments, including foreign exchange gain or loss on such investments, are calculated on an average cost basis.
Foreign currency contracts
Foreign currency contracts (note 8) entered into by the Company are valued at an amount that is equal to the gain or loss that would be realized if the position were to be closed out, which is equivalent to the difference between the deliverable asset and the value of the asset to be received. Changes in the value of a forward contract or the assets deliverable under such a contract are included as unrealized appreciation/depreciation on foreign currency contracts in the statement of operations.
Foreign exchange
Assets and liabilities denominated in foreign currencies are translated into Canadian dollars at the exchange rate applicable on the valuation date. Purchases and sales of investments, investment income and expenses are calculated at the exchange rates prevailing on the dates of the transactions.
Income taxes
The Company follows the asset and liability method of accounting for income taxes. Future income tax assets and liabilities are measured using rates expected to apply to the taxable income in the years in which the temporary differences are expected to be settled. The Company accounts for uncertain tax positions using the contingent liability model, whereby a provision is established only where it is likely that a payment will be required to be made.
A valuation allowance is recognized to the extent that it is more likely than not future income tax assets will not be realized. Management has estimated the income tax provision and future income tax balances taking into account its expectation of future taxable income and an interpretation of the various income tax laws and regulations. It is possible, due to the complexity inherent in estimating income taxes, that the tax provision and future tax balances could change (note 7), and the change could be significant.
Use of estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, income and expenses. Actual results could differ from those reported and such differences could be material. Significant areas involving the use of estimates include determining the estimated fair value of investments and future income tax assets.
Net assets per common share
The net assets per common share are computed by dividing the net assets of the Company by the total number of common shares outstanding on the statements of net assets date.
Increase in net assets from operations per weighted average common share
The increase in net assets from operations per common share represents the increase in net assets from operations divided by the weighted average number of common shares outstanding during the period.
The weighted average number of shares outstanding during the six-month period ended June 30, 2013 was 10,537,263 (June 30, 2012 - 10,537,263). This weighted average includes both the voting common shares and non-voting common shares of the Company.
3 Capital stock
The Company is authorized to issue an unlimited number of voting common shares without par value, and an unlimited number of non-voting common shares without par value.
There were no changes in the number of voting and non-voting common shares during the period ended June 30, 2013.
The total shares outstanding are summarized as follows:
| June 30, 2013 | December 31, 2012 | |||
| Number of Shares | Amount $ | Number of Shares | Amount $ | |
| Voting common shares | 10,191,592 | 96,273,343 | 10,191,592 | 96,273,343 |
| Non-voting common shares | 345,671 | 3,093,086 | 345,671 | 3,093,086 |
| Total common shares outstanding | 10,537,263 | 99,366,429 | 10,537,263 | 99,366,429 |
Contributed surplus
Contributed surplus balance did not change during the six-month period, and consists of:
| June 30, 2013 | December 31, 2012 | ||
| $ | $ | ||
| Surplus related to stock compensation, warrants and options associated with common shares | 8,030,295 | 8,030,295 | |
| Surplus relating to warrants associated with previously issued preferred shares | 1,874,209 | 1,874,209 | |
| 9,904,504 | 9,904,504 |
4 Retained earnings
The changes in retained earnings for the six-month period ended June 30 were as follows:
| 2013 $ | 2012 $ | |||
| Retained earnings - opening balance | 33,004,067 | 32,268,987 | ||
| Decrease in net assets from operations | (1,379,632 | ) | (1,088,342 | ) |
| Dividends paid from net investment income | (3,685,935 | ) | (3,685,935 | ) |
| Retained earnings - closing balance | 27,938,500 | 27,494,710 |
5 Related party transactions and balances
Management fees are paid quarterly to Deans Knight Capital Management Ltd. (the Investment Advisor), a corporation with certain common directors and officers of the Company, for services received in connection with the management of the investment portfolio and financial accounts, among other services provided. Management fees are computed quarterly at an annual rate of 1.5% of net asset value, adjusted for certain non-investment related assets. For the six-month period ended June 30, 2013, management fees (including applicable taxes) totalled $1,089,013 (June 30, 2012- $1,147,216). At June 30, 2013, $536,774 (December 31, 2012 - $589,251) was owed to the Investment Advisor, which was included in accounts payable and accrued liabilities in the statement of net assets, and is payable immediately.
A former director of the Company is a partner at a law firm that provides legal services to the Company. During the six-month period ended June 30, 2013, the Company incurred $175,830 (June 30, 2012 - $11,098) in legal services and disbursements received from this related party. At June 30, 2013, accounts payable and accrued liabilities include $103,000 (December 31, 2012 - $226) due to the law firm for legal fees and disbursements.
6 Net realized gains on investments sold and foreign currency contracts
The net realized (loss) gain on investments sold and foreign currency contracts for the six-month period ended June 30 was as follows:
| 2013 $ | 2012 $ | |||
| Proceeds from sale of investments | 20,273,556 | 11,055,277 | ||
| Investments at cost - Beginning of year | 117,207,284 | 125,475,983 | ||
| Add: Cost of investments purchased | 16,081,596 | 13,398,699 | ||
| 133,288,880 | 138,874,682 | |||
| Less: Investments at cost - End of year | (104,603,635 | ) | (128,269,140 | ) |
| Cost of investments sold | 28,685,245 | 10,605,542 | ||
| Net realized (loss) gain on investments sold | (8,411,689 | ) | 449,734 |
| Net realized (loss) gain on investments sold and foreign currency contracts consists of: | ||||
| 2013 $ | 2012 $ | |||
| Realized (loss) gain on investments sold | (7,052,919 | ) | 953,729 | |
| Realized loss on settlement of foreign currency contracts | (1,358,770 | ) | (503,995 | ) |
| (8,411,689 | ) | 449,734 | ||
7 Taxation
Uncertainty of deductibility of tax losses
Prior to the reorganization and change in business as discussed in note 1, the Company had generated significant tax losses and other tax attributes as a result of its prior businesses and research activities. The Company has recorded, as a tax asset, the full amount of the potential tax benefit of such items to the extent of its projected taxable income. There is no guarantee that the tax authorities will allow the Company to deduct some, or all, of the tax losses and other attributes.
In May 2013, the Company received and responded to a letter from the Canada Revenue Agency (CRA), advising the Company that it is under audit for the taxation years 2008 to 2012, being those that end after the recapitalization and reorganization of the Company. The Company believes the audit is a normal course audit and has provided the CRA with the information requested. The CRA has asserted no opinion on the Company's use of its tax attributes in the years under audit. After consultation with legal counsel, the Company remains of the view that such tax attributes were eligible for use by the Company.
Should the Company be denied the deductions, the recognized amount of the tax assets, as well as such amounts claimed to date, would be recorded as a charge to income. The total tax assets recognized and tax losses and other attributes claimed to date, which are subject to uncertainty, amount to $19,960,000 (December 31, 2012 - $21,154,044), representing $1.89 per common share at June 30, 2013 (December 31, 2012 - $2.01 per common share).
Future tax asset
Canadian GAAP requires a valuation allowance to be recognized against any future tax asset to the extent that it is more likely than not that the future income tax asset will not be realized. This is also the Company's stated accounting policy.
As the Company's investments in debt securities are generating interest income, but are not expected to generate sufficient taxable income in order to fully utilize the available tax credits during the years of operations through to April 30, 2014, the Company has recorded a valuation allowance. The difference between the total value of these tax benefits less the valuation allowance, being $1,260,000 (December 31, 2012 - $2,390,000), is the amount of the future income tax asset that has been recorded by the Company in the statement of net assets. The valuation allowance is reviewed, based on updated projections of taxable income, and adjusted accordingly by a credit or charge to the statement of operations.
The tax effects of temporary differences and tax credits that give rise to significant components of the future income tax assets, at the statutory enacted rates when such benefits are expected to be realized, are as follows:
| June 30, 2013 $ | December 31, 2012 $ | |||
| Future tax assets | ||||
| Non-capital loss carry forward | 62,400 | - | ||
| Research and development expenditures | 4,533,250 | 4,533,250 | ||
| Investment tax credits | 5,322,750 | 5,322,750 | ||
| Share issuance costs | 313,440 | 313,440 | ||
| Total gross future tax assets | 10,231,840 | 10,169,440 | ||
| Valuation allowance | (8,971,840 | ) | (7,779,440 | ) |
| Net future tax asset | 1,260,000 | 2,390,000 |
| Future tax assets expected to be realized in: | ||
| 2013 $ | 2012 $ | |
| Less than 12 months | 1,260,000 | 1,930,000 |
| Greater than 12 months | - | 460,000 |
| Net future tax asset | 1,260,000 | 2,390,000 |
The tax balances and income tax expense recognized by the Company are based on management's interpretation of the tax laws. Due to the complexity inherent in tax interpretations, regulations and legislation, there are significant estimates required to compute income tax balances. It is possible that some or all of the Company's significant components of the future income tax assets may not be deductible for tax purposes and, accordingly, the amount of future income taxes and provision for income taxes recorded in the financial statements could change by a material amount.
In determining the amount of future income tax assets recognized, management assessed the projected taxable income of the Company. Inherent in all forward looking information is uncertainty and actual amounts could differ from these estimates and the difference could be material. In developing the projection, management has assumed full payment of all contractual interest that investments maturing prior to April 30, 2014 will be redeemed for par value, and that investments maturing after April 30, 2014 will be sold at their current value.
Tax pools available to offset future tax expense and payable
The operations of the Company and related tax interpretations, regulations and legislation are continually changing. As a result, significant estimates are required to compute income tax balances. As at June 30, 2013, the Company has accumulated scientific research and experimental development expenditures in the amount of $18,135,000 available for carry-forward indefinitely. The Company incurred non-capital losses in the six-months ended June 30, 2013, which will expire in 2033 and amount to $250,000. The Company also has accumulated approximately $7,097,000 of unclaimed federal investment tax credits, which expire as follows:
| Investment tax credits $ | |
| Year of expiry | |
| 2018 | 265,000 |
| 2019 | 990,000 |
| 2020 | 1,872,000 |
| 2021 | 2,483,000 |
| 2022 | 298,000 |
| 2023 | 187,000 |
| 2024 | 496,000 |
| 2025 | 506,000 |
| 7,097,000 |
Reconciliation of income tax expense
The reconciliation of income tax computed at the statutory tax rate to income tax expense at June 30, using a 25.75% statutory tax rate (2012 - 25.0%), is:
| 2013 $ | 2012 $ | |||
| (Decrease) in net assets from operations before tax | (249,632 | ) | (218,342 | ) |
| Statutory tax rate | 25.75 | % | 25 | % |
| Income tax expense at statutory rates | (64,280 | ) | (54,600 | ) |
| Non-capital loss carry forward | 64,280 | 54,600 | ||
| Reduction of future tax asset | 1,130,000 | 870,000 | ||
| Provision for future income tax | 1,130,000 | 870,000 |
8 Financial instruments
Fair value measurement
Financial instruments are classified in a hierarchy that prioritizes the inputs to fair value measurement. Each level is based on the transparency of the inputs used to measure the fair values of assets and liabilities. The three levels of the fair value hierarchy are:
Level 1 - inputs that reflect unadjusted quoted prices in active markets for identical assets or liabilities;
Level 2 - inputs that reflect other than quoted prices that are observable for the assets or liabilities either directly or indirectly;
Level 3 - inputs that are not based on observable market data.
The following tables illustrate the classification of the Company's financial instruments within the fair value hierarchy:
| Financial assets at fair value - June 30, 2013 | ||||||
Level 1 $ | Level 2 $ | Level 3 $ | Total $ | |||
| Corporate debt | - | 85,709,064 | 12,268,652 | 97,977,716 | ||
| Convertible debentures | - | 3,562,115 | - | 3,562,115 | ||
| Equity | 8,354,240 | - | 390,619 | 8,744,859 | ||
| Royalty | - | - | 1,312,879 | 1,312,879 | ||
| Foreign currency contracts | - | (1,327,454 | ) | - | (1,327,454 | ) |
| 8,354,240 | 87,943,724 | 13,972,151 | 110,270,115 | |||
| Financial assets at fair value - December, 31 2012 | ||||||
Level 1 $ | Level 2 $ | Level 3 $ | Total $ | |||
| Corporate debt | - | 93,669,383 | 13,965,857 | 107,635,240 | ||
| Convertible debentures | - | 2,200,000 | - | 2,200,000 | ||
| Equity | 8,696,425 | - | 677,413 | 9,373,838 | ||
| Royalty | - | - | 1,238,770 | 1,238,770 | ||
| Other | - | (1,362,500 | ) | - | (1,362,500 | ) |
| Foreign currency contracts | - | (296,595 | ) | - | (296,595 | ) |
| 8,696,425 | 94,210,288 | 15,882,040 | 118,788,753 | |||
All investments remained at their respective levels within the fair value hierarchy during the six-month period.
The following table reconciles the Company's Level 3 fair value measurements:
| Fair value measurements of Level 3 inputs | |||||||||
| Corporate debt $ | Convertible debentures $ | Equities $ | Royalty $ | Total $ | |||||
| Balance - December 31, 2011 | 22,965,956 | 1,554,218 | 205,444 | - | 24,725,618 | ||||
| Purchases | 4,000,000 | - | - | 4,000,000 | |||||
| Sales | (13,081,762 | ) | (1,558,378 | ) | - | - | (14,640,140 | ) | |
| Unrealized appreciation included in net gain on investments | 81,663 | 4,160 | 471,969 | 1,238,770 | 1,796,562 | ||||
| Balance - December 31, 2012 | 13,965,857 | - | 677,413 | 1,238,770 | 15,882,040 | ||||
| Purchases | 982,991 | - | - | - | 982,991 | ||||
| Sales | (3,000,000 | ) | - | - | - | (3,000,000 | ) | ||
| Unrealized appreciation (depreciation) included in net gain on investments | 319,805 | - | (286,794 | ) | 74,109 | 107,110 | |||
| Balance - June 30, 2013 | 12,268,653 | - | 390,619 | 1,312,879 | 13,972,151 | ||||
Level 3 fair value measurements have predominantly been valued by considering data inputs such as the last price the security was traded at, most recent bid/ask information, prices of similar securities with available prices, and comparison of yields of comparable investments. Accordingly, in the absence of any reasonably possible alternative assumptions, and except as noted below, it is not practicable to provide a sensitivity analysis.
For certain Level 3 investments measured on a discounted cash flow basis the value is imputed through forecasted cash flows and discount rates. The following summarizes the affect a change in assumptions would have on total net assets at June 30, 2013:
| Increase by 5% | Decrease by 5% | |||
| Cash flow growth rate | 237,100 | (146,700 | ) | |
| Discount rate | (179,800 | ) | 374,000 |
Management of financial risks
In the normal course of business, the Company is exposed to various financial risks, including credit risk, liquidity risk and market risk (consisting of interest rate risk, currency risk and other price risk). The Company's overall risk management program seeks to minimize potentially adverse effects of these risks on the Company's financial performance by employing a professional, experienced portfolio advisor, monitoring daily the Company's positions and market events, diversifying the investment portfolio within the constraints of the investment guidelines and periodically using derivatives to hedge certain risk exposures. Further, the Company monitors the portfolio to ensure compliance with its investment strategy, investment guidelines and securities regulations.
Fair value risk
The Company's investments are exposed to market price risk and this risk affects the fair value of the investments. All investments have an inherent risk of loss of capital. The maximum risk resulting from investments is determined by their fair value. The Company seeks to manage valuation risks by careful selection of fixed income investments prior to making an investment and by regular ongoing monitoring of the investment performance of the individual investee companies. Due to the predominantly fixed income nature of the investment portfolio, the Company has minimal direct price risk. A 10% change in the value of the Company's equity investments (excluding warrants) would have an $835,424 impact on net assets, on an after tax basis.
Credit risk
Credit risk is the risk that a counterparty to a financial instrument will fail to discharge an obligation or commitment that it has entered into with the Company.
All transactions executed by the Company in listed securities are settled/paid for upon delivery using approved brokers. The risk of this settlement not occurring is considered minimal, as delivery of securities sold is only made once the broker has received payment. Payment is made on a purchase once the securities have been received by the broker. The trade will fail if either party fails to meet its obligation. Since the Company invests in high-yield debt instruments and derivatives, this represents the main concentration of credit risk. The fair value of debt securities includes consideration of the creditworthiness of the debt issuer. The maximum credit exposure of these assets is represented by their carrying amounts. This maximum exposure may be offset to varying degrees in each investment, based on the collateral held, if any. Collateral may include such things as a general security agreement over all assets, or specific security over specific assets. It may also entitle the debt holder to take over the overall business through restructuring of the investment.
The Company's credit risk exposure by credit ratings on its investments is listed as follows:
| As a % of net assets | ||
| June 30, 2013 | December 31, 2012 | |
| Credit rating | ||
| BB+ | 4.3 | 4.4 |
| BB | 1.9 | 1.8 |
| BB- | - | 0.9 |
| B+ | 4.6 | 8.3 |
| B | 14.2 | 6.0 |
| B- | 11.2 | 10.6 |
| CCC+ | 20.8 | 30.3 |
| CCC | 6.1 | 3.1 |
| CCC- | - | 2.4 |
| Not rated* | 17.3 | 15.7 |
| 80.4 | 83.5 | |
* Unrated debt securities consist primarily of loans receivable.
Credit ratings are obtained from various credit rating agencies and sources. Where one or more rating is obtained for a security, the lowest rating has been used.
Credit risk associated with the Company's cash & cash equivalents is not considered significant, as they are held with Tier 1 Canadian Financial Institutions.
The Company's credit risk exposure by sector on its investments is as follows:
| As a % of net assets | ||
| June 30, 2013 | December 31, 2012 | |
| Sector | ||
| Consumer goods | 11.8 | 8.4 |
| Energy | 50.5 | 49.8 |
| Forestry | 3.5 | 6.2 |
| Industrial/manufacturing | - | 4.3 |
| Materials and metals | 10.2 | 13.7 |
| Services | 3.4 | 0.2 |
| Technology | 1.0 | 0.9 |
| 80.4 | 83.5 | |
Interest rate risk
Interest rate risk arises from the possibility that changes in interest rates will affect future cash flows or fair values of financial instruments.
The Company invests primarily in interest-bearing financial instruments. As such, the Company is exposed to the risk that the value of such financial instruments will fluctuate due to changes in the prevailing levels of market interest rates. The table below summarizes the Company's exposure to interest rate risk by term to maturity on its investments:
| Fair value | ||
| June 30, 2013 $ | December 31, 2012 $ | |
| Maturity | ||
| Less than 1 year | 4,865,200 | - |
| 1 - 3 years | 13,551,732 | 20,543,660 |
| 3 - 5 years | 58,157,188 | 46,527,959 |
| Greater than 5 years | 26,278,590 | 42,639,891 |
| 102,852,710 | 109,711,510 | |
As at June 30, 2013, if the prevailing interest rates had been raised or lowered by 1%, assuming a parallel shift in the yield curve, with all other factors remaining constant, net assets could possibly have decreased or increased, respectively, by approximately $3,600,000, or approximately 2.6% of net assets (December 31, 2012 - $4,000,000, or approximately 2.8% of net assets).
Liquidity risk
As the Company is a publicly traded, closed-end investment company with a fixed number of common shares outstanding, unlike an open-ended mutual fund, it is not exposed to the liquidity risk associated with daily cash redemptions of securities.
Investments in fixed income investments may not be able to be liquidated quickly at an amount close to their fair value to respond to specific events such as deterioration in the creditworthiness of any particular issuer. Fixed income investments purchased by the Company may be subject to resale restrictions such as hold periods. The resulting values for fixed income investments may differ from values that would be realized had a ready market existed.
The Company actively reviews its investment portfolio, and the fixed income market, to assess liquidity risk on its holdings.
Currency risk
Currency risk is the risk that the value of a financial instrument will fluctuate due to changes in foreign exchange rates. The Company invests a portion of its assets in securities that are denominated in a currency other than the Canadian dollar, which represents the functional currency of the Company. Consequently, the Company is exposed to currency risk as the value of the portfolio securities denominated in currencies other than the Canadian dollar will vary due to changes in foreign currency exchange rates.
The Company enters into foreign currency contracts with financial institutions to hedge the value of foreign currency denominated investments. The fair value of these contracts is reflected in investments. Gains or losses arising from these contracts offset the gains or losses from translation of the underlying investments. The unrealized gains or losses are reflected in unrealized appreciation/depreciation on foreign currency contracts on the statement of operations. The potential impact to net assets of a 5% change in foreign currency rates against the Canadian dollar, assuming all other variables remain constant, would be $132,000 (December 31, 2012 - $16,000).
9 Capital management
The capital of the Company is divided into voting and non-voting common shares, each having an unlimited authorized amount. The number of voting and non-voting shares outstanding and changes thereto, are outlined in note 3.
The Company manages its capital in accordance with the Company's investment objectives. The Company's investment objectives are to: (i) maximize the total return for common shareholders, consisting of dividend income and capital appreciation; and (ii) provide shareholders with monthly dividends targeted to payout a minimum of 75% of net investment income annually. Net investment income, in reference to the Company's dividend payments to shareholders, excludes any realized and unrealized capital gains and losses from debt securities in the portfolio and any income or loss not derived from debt securities in the portfolio. The Company commenced its dividend payments on June 30, 2009, making monthly payments of $0.0583 per voting and non-voting common share, or $614,322. During the six month period ended June 30, 2013, the Company made dividend payments of $3,685,935 (June 30, 2012 - $3,685,935).
The Company is committed to continue paying a monthly dividend of $0.0583 per voting and non-voting common share for the three months ending September 30, 2013, totalling $1,842,966 (note 11).
10 Comparison of net asset value per share and net assets per share
In accordance with Section 3.6(1) of National Instrument 81-106, the Company's net asset value per share, the net assets per share calculated in accordance with Canadian GAAP for financial reporting purposes, and an explanation of the differences between such amounts, are required disclosures in the notes to the financial statements. For investments that are traded in an active market, Canadian GAAP requires that bid prices be used in the fair value of instruments, rather than the use of the last traded price, as currently used for the purpose of determining net asset value. This change accounts for the difference between the net asset value and the net assets.
| June 30, 2013 $ | December 31, 2012 $ | |||
| Net asset value per share | 13.08 | 13.58 | ||
| Canadian GAAP adjustments | (0.06 | ) | (0.08 | ) |
| Net assets per share | 13.02 | 13.50 |
11 Subsequent events
On July 4, 2013, the Company announced a monthly dividend of $614,322, or $0.0583 per common share, payable on each of July 31, 2013, August 30, 2013 and September 30, 2013.
Contact Information:
Craig Langdon
Chief Executive Officer and Director
(604)669-0212
Deans Knight Income Corporation
Mark Myles
Chief Financial Officer
(604)669-0212
www.dkincomecorp.com