GFL Environmental Units

(Please note I wrote this a couple days ago when prices were different but didn’t get to hitting the ‘publish’ button until now)

GFL (TSX: GFL, also NYSE: GFL) is the fourth largest North American solid waste (garbage) collection companies, behind (Waste Management, WM; Republic Services, RSG; Waste Connections, WCN). GFL vomited out its IPO after a couple false starts in early March, just before the CoronaPanic really reared its ugliest days.

(GFL Prospectus from IPO)

If there is one guarantee on this planet, it is that waste collection will continue to be a viable business that can attract customers, and also be inflation-adjusted. There will be competitive cyclicalities that will cause margin compression, but the field also contains geographical barriers to entry that also will protect said margins, in addition to having captive customers (who the heck doesn’t produce waste?).

Financially, they have been operating as a roll-up operation; there is a lot of goodwill and intangibles on their balance sheet to reflect this history of acquisition (well beyond the equity line on the balance sheet). Patrick Dovigi is the founding CEO (from 2007) and retains a 3.7% economic stake and 27.7% voting stake in the company after the IPO – he’s also still very young – at the age of 40, he is still managing the empire.

At the beginning of March they went public at US$19/share, and the proceeds were primarily to reduce debt. They had a lot of it – about $7.7 billion, but this will be reduced to around $4.4 billion after the offering.

Financially, the operation makes money, especially when using the somewhat flawed EBITDA metric (approximately $800 million in 2019), but the “I” and “DA” amounts are significant – the company’s financial leverage was high, and garbage collection is intense on capital expenditures. They have been growing at such a large rate that they got overextended, and hence were forced to vomit this public offering out. They are going to enter a stage where they will become more efficient, and that should justify metrics that are closer to their counterparts (the companies listed in the first paragraph on this post).

(Prospectus for Tangible Equity Units)

They also sold “Tangible Equity Units” which trade as GFLU, which consist of 2.6316 shares of GFL plus US$8.5143 of a subordinated note. The units will be converted into shares on March 15, 2023 or earlier under some circumstances. The shares given will also be reduced to 2.193 if the shares of GFL trade above US$22.80, and it is a sliding scale between US$19 to US$22.80 (note that this represents US$50 of equity per unit). The subordinated note component has interest of 4%, and is amortized over a three year period with quarterly payments (consisting of roughly US$0.75/quarter per unit).

GFL currently trades at US$14/share and GFLU trades at US$41, or about a US$4.35/share above its immediate value and $17.51 if you assume full realization of US$50 of equity (which is currently worth US$36.84 at a US$14 equity price). Considering this as a hybrid instrument, you get a clean amount of upside for the first 36% of equity appreciation, and then this is effectively subject to a sold call option, until a further 20% appreciation from the US$19 par value.

An interesting hybrid instrument that I have taken a tiny stakes in, and no more.

Mid-stream oil and gas

Low oil prices hurt producers for obvious reasons.

They also are hurting the mid-stream, but this is for less obvious reasons – low prices means curtailment of capital expenditures, which typically mean lower volumes, which means less money for midstream producers. Volume is the dominant variable for the mid-stream, not prices.

The flip side of this equation is lower prices stimulates consumption, which means higher oil prices, which means higher capital expenditures… you get the picture. There is an equilibrium factor that depends on mutually dependent factors in order to “solve the equation”. In Excel, this would typically be a circular equation, but when applied in real life, the input variables are much more fuzzy, and thus it makes the output chaotic and difficult to predict where the true “landing spot” is (which never exists – it is always ever-moving).

The other clear factor is that when oil and gas companies are not making profits, there is an element of counterparty risk.

One broad-brushed way of investing in the US mid-stream sector is through the Alerian MLP ETF (AMLP) which got killed yesterday. The constituent companies are fairly stodgy oil and gas pipeline MLPs which give out most of their income in the form of distributions. Normally MLPs are very adversely taxed for Canadians, but the AMLP structure is a corporation. It distributes its income mostly in the form of a return on capital, but for tax purposes, it is equivalent to foreign income. However, in a registered account, this is a non-factor. At the low of $4.14/unit, it was trading at a yield of 18% and even when factoring in the inevitable decline of shale production in the USA, seems to be a reasonable risk-reward proposition as investors seek yield.

To a lesser degree, Canadians can also invest in Enbridge (TSX: ENB), TransCanada (TSX: TRP), Pembina (TSX: PPL), and for those interested in Albertan intra-provincial pipelines, Inter-Pipeline (TSX: IPL). However, the income to price disparity is not nearly as present as the American analogs (including Kinder Morgan, Williams, etc.).

Pembina, in particular, has gotten killed simply because it faces a risk that the Trans-Mountain pipeline is not going to be constructed, especially with the crash in oil prices and the general incompetency of our Trudeau-led federal government. The assets they picked up from the old Kinder Morgan Canada were quite good. Enbridge and TransCanada should also do well – the big loser going ahead will probably be the oil-by-rail trade – if production slows down, this volume will be the first to get scrapped, not the pipelines.

Constellation Software – valuation

There is no doubt that (TSX: CSU) is well-managed and the CEO’s instincts on return on investment from acquisitions is spot-on. Software has a “sticky” component where the cost to transition systems is so high that it creates a barrier to entry. With existing licensing regimes, it can create recurring revenues that can be increased over time (especially for institutional customers – much less price sensitive than consumers).

Glossing over the year-end results, this is what I see (from the cash flow statement) – note this is a really crude, paper-napkin styled analysis:

The balance sheet in relation is fairly neutral – they gave out $500 million in dividends in 2019 which impacted the cash balance, in addition to spending nearly $600 million on acquisitions. Despite this they still have about $100 million net cash on the balance sheet (and another roughly $250 million in lease obligations). Thus, I’ll ignore the balance sheet since this is obviously a cash flow valuated concern.

We use the $633 million number (the 2019 run-rate for free cash generation), divided by 21.2 million shares outstanding. This gives us about $30/share.

(An original post completely forgot about the fact that CSU reports in US dollars when their stock trades in CAD, so the numbers below have been corrected as appropriate, with some mild embarrassment for my own distraction as I was looking at the crude oil futures)

CSU’s last trade was at US$995 per share, which gives a 33 times valuation.

Let’s say they can grow earnings at 15% a year (ignore all the myriad forms of assumptions that would go into this), they will need about 3-4 years growth at that rate to get to a 20 times valuation with their stock price being constant.

That seems to be relatively expensive. Who knows, they might be able to grow faster than that.

CSU is good at what it does, but quality comes at a high price. The question is whether that price will get higher, either through growing the bottom line or a continued expansion of the price to cash (or earnings) ratio.

Making investment comparisons

This post is a little more abstract, but the thinking should be fairly easy to understand. The revolves around the concept of hurdle rates, and making comparisons to baseline investments.

I’ve been reviewing a bunch of companies that have balance sheets that have tangible (or nearly tangible) financial assets that when netted against their liabilities are trading below liquidation value. An example of this would be Input Capital (TSXV: INP) which Tyler has tweeted about, in addition to SM keeping me informed by email.

In the case of Input, taking their December 31, 2019 balance sheet as-is without mental adjustments, gives them a $1.24 book value. At a current market rate of 71 cents, that’s trading at a 43% below book discount. Assuming the asset side of the balance sheet doesn’t have more write-down surprises, the company on the income side still makes a modest amount of cash on their canola/mortgage streaming business, albeit at a rather high cost on administration (as a percentage of assets). If they decide to wind down, shareholders should be able to get out with a mild positive. Their mortgage portfolio will amortize and the board of directors can command management to fire themselves and call it a day.

So lets assume I have a chunk of cash, and I’m evaluating this option for the portfolio. To be clear, I’m not interested, and INP has very poor liquidity – typical trading volumes in a day is less than CAD$10,000. Piling onto our list of assumptions, let’s say liquidity is no concern.

The question is: What do I compare this to?

If I compare this to the simple risk-free cash amount (e.g. the brain-dead option is (TSX: PSA) which yields a net 2%), then yes, Input Capital looks fairly good by comparison. If INP materially winds up in 3 years and captures 90% of its present book value (conservatively assuming they lose a bit in the process of wind-down), that’s a 16% CAGR gainer. You’re effectively getting 14% net on the risk-free option – the risk of this not happening is what you’re getting this 14% spread for (such as the critical assumption on whether they choose to liquidate or not!).

However, things are not so easy in our multiverse of investment options.

For instance, you have other choices. Coming up with baseline options is vital for making comparisons. Other than the risk-free option (government bonds or for smaller scale amounts of money, PSA), there are surprisingly a lot of companies out there trading under book value that appear to be making money.

Perhaps the least glamorous, most boring, but relatively safe option is E-L Financial (TSX: ELF) which owns nearly all (99%+) of Empire Life, 37% of Algoma (TSX: ALC), and 24% of Economic Investment Trust (TSX: EVT). At the end of Q3, its book value (stripping the $300 million of preferred shares outstanding) was $1,421/share while its market value today on the TSX is $814, which is a 43% discount below book value, identical to INP’s discount today. ELF also from 2009 to 2018 compounded its book value by 9.7% annually, and clearly is a profitable entity.

So we compare two opposing options: INP and ELF – why in the world would you choose INP? The only reason would appear to be a chance of a quick and clean liquidation over the next few years, and that is measured against ELF earning 10% of book value over those three same years, and staying at a 43% below-book valuation. The only thing you don’t get with ELF is an interesting conversation at a cocktail party.

The baseline comparison of ELF compounding book value at 10% a year creates quite a hurdle for other below book value investments – the underlying mis-valuations must be very severe in order to warrant an investment in other vehicles. When scanning my portfolio, all of the common share investments have clear rationales for expected returns higher than this hurdle rate.

When you compare to real bottom of the trash barrel options like Aberdeen International (TSX: AAB) which are trading 85% below book value, why would you want to put investment capital into a sub-$100 million market capitalization entity when there is a perfectly viable option that is clearly a legitimate firm, and has a very good track record of building its balance sheet? (For those financial historians out there, many years ago Aberdeen was subject to a bruising proxy fight where an activist tried to take over the board for the purpose of realizing book value, but the management was successful at fighting it and then proceeded to fritter away the company into what it is today – a 3.5 cent per share stock – shareholders got what they deserved!).

As a final note, the presence of fixed income options that appear to give off very high low-risk returns tends to make such comparative decisions really difficult. For example, Gran Colombia Gold’s notes (TSX: GCM.NT.U) are linked to the price of gold and give out more yield when above US$1,250/Oz. Given the seniority of the notes (they were secured by the company’s primary mining operation), even at the baseline gold price, the notes represented a very low-risk 8.25% coupon. At current gold prices, the coupon effectively rises to around 15%. It is difficult to compete against such investments, except in this specific instance they must be capped as a reasonable fraction of the portfolio (if the mine had an implosion, explosion, earthquake, etc., then there would be trouble). The opportunity is now gone since the notes are now in a redemption process and the remaining principal value will be whittled away with quarterly redemptions at par values below market trading prices, and the rest of it will likely get called off after April 30, 2021 (at 104.13 of par).

I won’t even get into comparisons with the preferred share market, where there are plenty of viable options with little risk that will yield eligible dividend yields roughly in the 6% range that would require an economic catastrophe of huge magnitude before they stopped paying out. The ebbs and gyrations of the underlying business itself is almost irrelevant to most of these preferred share issuers (e.g. Brookfield preferreds will likely pay dividends in your lifetime and mine). People, however, do get confused on the “stopped paying out” part of preferred shares vs. them losing market value – the preferred share trading today at 6% might look good to leverage up money at 2.2%, but if those preferred shares start trading at 7% or 8%, you might be the unwilling recipient of a margin call or the margin calls of others.

To conclude, just because an investment looks good on an absolute basis doesn’t mean the research stops there before hitting the buy button – making comparative measurements is just as important. Nothing precludes one from buying into both options; after all, if there is no correlation between the two investments and your success rate is 70%, you’ll hit your target on at least one investment half of the time.

Yellow Pages Q4-2019: Dividends re-instated

(Past post on Yellow Pages – November 2019)

Yellow Pages (TSX: Y) reported Q4-2019 results today and it featured the first balance sheet since its 2012 recapitalization where it did not have any senior secured debt. This was eliminated at the beginning of December.

The quarter also featured a shade under $30 million in free cash generation, or a shade above $1/share. The most impressive aspect of the business is that cash flows through operating activities actually increased year-to-year despite revenues dropping from $577 to $403 million. It pays to focus on profitable business and management has had an insane laser focus on cost containment. I have not seen anything like it in my entire investing history.

A business cannot last very long if revenues drop 30% a year, and if they can stem this challenge, which I believe they will, the stock will be going much higher than the $11.70 it closed at yesterday.

The only debt remaining is a $107 million issue of convertible debentures (TSX: YPG.DB) which will be redeemed at the earliest possible moment at par, on May 31, 2021. If they redeem earlier they pay a 10% pre-payment fee, which makes no sense to do it currently. The conversion price is $19.04, and if they start making a significant impact on their revenue decline while keeping 38-40% EBITDA margins, it will likely be the holders that decide to convert into shares when the redemption is announced.

Finally, because the shackles of the senior secure debt are finally off, management has the flexibility of engaging in capital allocation decisions involving dividends and share buybacks. I was expecting some sort of equity buyback decision (there is a considerable incentive to seeing a higher stock price both from an insider perspective but also equitizing the convertible debenture), but instead, management announced they will pay 11 cent quarterly dividends in Q2-2020. This works out to a 3.8% yield on the $11.70 closing price.

A dividend also creates some interesting implications for how the stock trades. Once again, it will be on the radar of Canadian income ETFs. My suspicion is that Yellow Pages will continue to receive an uptick of activity as passive vehicles slowly get back into the stock. If the market capitalization gets even higher, it will start getting into the liquidity range of even more ETFs. This is yet another example of how momentum is a valid market strategy – passive vehicles often weight their investments by relative market capitalization, and when that goes up, you have to buy more without caring about the price…

My own model and fair value assessment of this stock suggest it should go higher. So far they have generated cash better than my initial estimates when I got into the stock in the first place.

Who would have ever thought – Yellow Pages started as an income trust and was a ‘stable’ producer of distributions. I bet few people thought in 2011 (when they slashed dividends to zero) that they’d ever see this day.

Disclosure – presently, this is my largest holding.