Teekay Offshore’s common units are not going anywhere

Reviewing Teekay Offshore’s financial results (NYSE: TOO), it strikes me as rather obvious that they have missed their initial early 2016 targets when they proposed a partial equitization (issuing common units, preferred units, and some refinancing) of their debt problems. They also borrowed $200 million from the Teekay parent entity (NYSE: TK).

In Q1-2016, they delivered a presentation with this chart:

In subsequent quarters, the company has generally not referred to progressing tracking to this projection, mainly because their debt to cash flow through vessel operations ratio has not met these targets. While the underlying entity is still making money, revenues are eroding through the expiration and renegotiation of various contracts, couple with some operational hiccups (Brazil) that is not helping matters any.

Putting a lot of the analysis away from this article, while in 2017 the future capital expenditure profile is going to be reduced (which would greatly assist with the distributable cash flows), the company doesn’t have a lot of leftover room for matters such as debt repayment and working on improving their leverage ratios in relation to cash generation ability. This leaves them with the option of continuing to dilute or depend on the parent entity for bridge financing. Indeed, one reason why I believe management thinks the company is still open for dilution is due to them employing a continuous equity offering program – they sold nearly 1.9 million units in the quarter at an average of US$5.17/unit. If they don’t think the company is worth US$5.17/unit, why should one pay more than that?

I don’t believe that they are a CCAA-equivalent risk in the current credit market (this is a key condition: “current” credit market), and I also believe that their preferred units will continue to pay distributions for the indefinite future, I don’t believe their common units will be outperforming absent a significant and sustained run-up in the oil commodity price. Note that there is a US$275 million issue of unsecured debt outstanding, maturing on July 30, 2019, which will present an interesting refinancing challenge. Right now those bonds are trading at around a 10% yield to maturity.

I have no positions in TOO (equity or debt), but do hold a position in the Teekay Parent’s debt (thesis here).

2016 Year-End Report

Portfolio Performance

My very unaudited portfolio performance in the fourth quarter of 2016, the three months ended December 31, 2016 is approximately +3.1%. The year-to-date performance for the year ended December 31, 2016 is approximately +53.6%.

Portfolio Percentages

At December 31, 2016:

48% common equities
27% preferred share equities
44% corporate debt
1% options
-20% cash and cash equivalents

USD exposure: 42%

Portfolio is valued in CAD (CAD/USD 0.7420);
Equities are valued at closing price;
Values include accrued corporate bond interest;
Corporate debt valued at last trade price.

Portfolio commentary

What an interesting year, both in the portfolio and in the overall investment climate. The climate back in February 2016 was with much more peril than it is now. Prices are now reflecting the decreased amount of peril, hence they are higher. Much higher.

The TSX composite also had a good year – about 20% with dividends invested. This was undoubtedly on the back of the recovery in the energy sector – most issuers are all up over this year-to-year.

From the previous quarter, several positions appreciated, I bailed out in one position entirely, and also also added to another position. All of my common equity that I hold are in companies that are trading under tangible book value and generating cash.

My preferred share portfolio is mostly unchanged. They are half rate-reset and half of them have a fixed rate. I did do some slight additions of one issuer that was very temporarily trading about 10% lower than its ambient price for no good reason, but this addition was slightly less than 1% of the portfolio (which is too bad, since I wanted whoever was selling it to continue hitting the bid – I was willing to go another 4% or so). I am generally content with my holdings in these categories, and I will also note that my preferred share holdings of Birchcliff Energy (both TSX: BIR.PR.A and BIR.PR.C) have remained quite close to a point where I would want to liquidate and head for greener pastures. I am demanding a price, however, that prices in the circumstance that they will continue to pay out dividends for a very long time (and indeed, given how their common shares have performed this year, I should have just bought them to begin the year instead of the preferred shares). If my price gets hit, great, if not, I will keep collecting the cash flows since my cost of capital is cheap.

I have six issuers of corporate debt that I hold. One will mature early in 2017 (Pengrowth Energy, PGF.DB.B) which will add a not-inconsiderable amount of cash back to the portfolio. I was happy to see my analysis come to fruition back in March 2016 on this issuer. The underlying company will do well if oil continues to rise in price, but at the US$45-50 range they will not do so well as they have a series of debt maturities coming up and refinancing will not be trivial, although they seem to have taken good steps to mitigate the issue with a royalty sale.

The rest of the debt portfolio (minus Pengrowth) has an average weighted term of 3.2 years. One of the features of investing in debt directly instead of through an ETF is that over time, your interest rate exposure decreases. I am concerned that interest rate risk will continue to rise, hence a decreasing term to maturity of the portfolio will mitigate that risk. As long as solvency is not an issue (i.e. bondholders get paid), it should present no problem if rates do rise. In addition, some of the debt is callable and while this will decrease the interest payout over time, it would give me the opportunity to redeploy capital.

Teekay Corporation’s unsecured 8.5% debt maturing on January 15, 2020 has been behaving to thesis. Considering that the parent and daughter entities have been raising equity pursuant to a continuous equity offering, this can only be good for bondholders.

Currency-wise, the exchange rate differed a little bit – the CAD started the year at 72 cents, and closed the year at 74 cents, so this had a slightly negative impact on the portfolio performance.

Performance-wise, obviously this was a very good year for me. This seems to happen once every three years in generally market-positive years. I don’t have any specific insight why it happens when it does.

Finally, I will make a comment on the level of margin in the portfolio. It looks heavily leveraged at the moment (and historically this is quite high amounts of leverage for myself, who has been accustomed to holding significant amounts of cash in the past – up to half at times). Most of the margin is directly linked towards specific fixed income investments that have rather predictable cash outlay profiles. When considering the inexpensive (and tax deductible) financing provided, it makes a lot of financial sense to park idle capital into vehicles that can predictably give off stable streams of income and principal payments.

When looking strictly at the fixed (non-equity) component of the portfolio and offsetting it against the margin debt, the only conceivable scenario where there will be fast stress is if there is some sort of 6-sigma type event (such as a WMD (nuclear, chemical, biological) event in a major metropolitan center in the USA) that will fundamentally change variables. Despite the margin, there is quite a layer of safety embedded.

Reviewing the predictions of 2015

It is a time to look back at the predictions I made back in the 2015-year end report and see what I got right and what I didn’t.

1. Canadian Dollar, Canadian interest rates, Canadian Economy: Mixed bag. I was wrong on the trough on the Canadian dollar (I thought it would go to 65 cents), but I was right about the interest rates being fixed at 0.5%, and the general impact of natural resource extraction in Canada, although the late-year pipeline approvals from the federal government surprised me.

2. Crude Oil and natural gas: These were both a failed prediction. A lid was not kept on the price of crude, and natural gas, while performing better, was also considerably higher.

3. Canada Real Estate: Successful prediction, although BC enacting a foreign buyer transaction tax, coupled with the federal government’s change on mortgage financing is slowly putting a lid on credit conditions on this market.

4. Canada Federal Budget: Correct. The forecast deficit was higher than initial projections. Not a surprise considering the existing spend-everything government.

5. US Federal Reserve: Correct.

6. Next US President: Yes, I predicted Trump would win by a considerable margin. The definition of “considerable” can be debated, but a 304-227 margin, in presidential terms, is a very healthy victory. My prediction was 295-243.

Outlook

Similar to the Presidential election, 2016 was a unique year in that there were some very defined amounts of stress applied as a result of the oil and gas market reaching the trough of its leverage issues. Once this was done, there has been relatively little of opportunity in terms of reasonable risk/reward ratios. Most of my trades this year were done before April and the rest of it has served as a mild detriment to my own performance. Trading because one is bored and looking for thin value situations should only be limited to the smallest of percentages and thankfully I obeyed this rule.

I am projecting a rising price environment over the next couple months of the calendar year. My hunch is reliant on inflows of capital into the equity markets primarily as a result of past performance. While pension funds will have to execute on an equity-to-bond rebalancing, this will probably be offset by hordes of cash that will be dumped into robotic management (so called robo-investors).

Psychologically, it is one thing to invest in something and lose 20% of your capital. It hurts. It is even worse for an investor to have cash sitting in their bank account earning 1% (if that) and seeing the rest of the market rise 20%. Consider the vantage point of somebody prospectively wanting to buy real estate in the Vancouver area over the past decade (link to Teranet) – there was no decent time to not pull the trigger (until perhaps now).

I was fortunate enough to employ leverage at the best time possible, but it is time to harvest gains and bunker down a little.

Fiscal policy in Canada remains very deficit-driven. Politically-speaking, now that the Liberals have gotten their feet wet again in government, they will know that this year will be the year to enact the most publicly unpopular policies. They are also facing an issue of trying to raise money since they inherently have an inability to contain spending. An interesting document to scour is the report on tax expenditures (specifically this table), where you can be a finance minister and ask yourself what the best ways to net the government money would be. There already have been trial balloons floated on the taxation of health insurance plans for employers, and also an increase to the capital gains inclusion rate.

Predictions about how the Canadian government’s Budget 2017 tax proposals with my confidence factors:

1. (50%) Flow-through share deductions will be eliminated.
2. (75%) Employee stock option deduction will have a full, instead of half inclusion rate, OR the amount will be capped to some nominal amount (e.g. CAD$50k allowed or something).
3. (40%) Taxation of capital gains on principal residences is going to have some restrictions (time, or value) placed.
4. (75%) Partial inclusion of capital gains will rise. Using the year 2000 model, Canadians should consider crystallizing gains in early 2017 before the budget. The only question is whether this will apply to individuals or corporations, or whether there will be a limited dollar value applied to this condition.
5. (90%) I do NOT believe the non-tax exemption for private and public health plans will be scrapped. This would be a political nightmare for the government compared to the rather esoteric notions on the items.
6. (50%) The GST will rise (probably to 7%, but this prediction will be judged a success if it is simply raised at all).
7. (50%) Corporate income taxes, on large corporations, will rise.

Fiscally speaking, I see another CAD$25-40 billion deficit year coming ahead, with the low end only coming to fruition if they raise the GST. The budgetary projections will show a slow return to surplus, but in actuality I will be writing here in January 2018 and the same forecast will occur.

Switching to Canada’s largest trading partner: the election of Donald Trump everybody has been trying to figure out the impact, but until January 20 comes rolling around, it is all imagined at the moment. If he is able to execute on even half of his economic policies, it would suggest that the best analogy to be applied is what happened when Ronald Regan was elected – although the initial starting conditions between Jimmy Carter today are vastly different – unemployment in the USA is at record lows and the economy, despite everything the existing administration has tried, is not in bad condition.

The power of hope is something that is not easily captured in forward-looking economic statistics, but the messaging of the Trump administration (which has still yet to officially take power) is that domestic US concerns will “trump” all others, especially with respect to employment.

That said, I shudder to think about the application of the business acumen of Trump’s administration versus Canada’s government (think about the trade minister crying after the EU agreement broke off) and the simple fact that Canada is in a very poor negotiating position in relation to the USA.

It is clear that Canada will not be able to negotiate a favourable deal on softwood lumber, nor will it be able to with automobiles, energy, or anything else for that matter simply because our country’s primary export had been real estate, which will soon be evaporating. Also by pre-emptively stating that we are willing to renegotiate NAFTA after Trump got elected has to be one of the top damaging statements to make in 2016 (and there was a lot coming from the government in this category, thinking about the completely incompetent Minister of Democratic Reform). Once the counter-party knows that you’re willing to negotiate, you’re in deep trouble.

The net result of this is that the USA is going to obtain much higher benefits out of NAFTA than Canada in historical context. Once the USA also reduces their corporate tax rate, one of the only advantages that Canada has will evaporate and you can be pretty sure that capital that was previously slated for deployment here will be heading down south. This clearly will have a negative effect on the Canadian dollar.

The only predictable event that would save us is the re-emergence of high energy pricing, but this event would not be of the existing government’s actions – it would be by pure luck.

About 80% of Canada’s oil production comes from Alberta and the provincial government is as hostile to fossil fuels as it gets and will only be replaced in 2019 by a government very likely to be lead by Jason Kenney. So while this is still at least a couple years away, investors are not going to be putting anything but maintenance money into the Alberta oilpatch even if the federal government gets its act together.

Our economic malaise is amplified by the case that our second largest export (energy) is hampered by the inability to actually get the product to market – alternatives (such as crude by rail) costs a lot more than pipeline.

Outlook – broader markets

As it relates to the market, however, most of the price appreciation seems to be baked in. When scanning the equity markets and the preferred share markets and debt markets, most of everything appears to be trading at relatively lofty valuations. There is little out there that appears to be trading with distress, which typically means that one will only get market-sized gains as opposed to making extraordinary gains.

I face the confusing notion that even if I am able to appreciate my portfolio by 10% in 2017, that it results in a drop in overall performance! I manage my portfolio for absolute returns, so I do not take this into consideration. If I have to sit the year out mostly in cash because I don’t see good opportunities, I will. Ideally, however, short-duration bonds with likely payouts fit the bill for idle cash, but those have been difficult to find at acceptable risk-reward ratios.

Just like how Costco is a great corporation, their stock is another story. The US economy will likely be roaring in 2017, but will this result in stock market success? Has it already been priced in after the November election of Trump? It is difficult to say. I am not very good with macroscopic forecasts of stock markets, and can only concentrate on the microscopic – and I don’t see a lot of stocks out there trading at 52-week lows which leads me to think a lot has been priced in already, but think there is going to be plenty of cash inflows for “follow-alongs” that felt like they missed the party.

Scanning the Canadian corporate debenture market, just as an example, leads me to precisely zero leads. It is a great time for issuers to be issuing debt.

I’m afraid I don’t have much insight other than that when in this state, raising cash and being patient for opportunities is the order of the day. I intend on de-leveraging and doing just that. I might have to wait an extended period of time until stress is visible in the marketplace.

Currency-wise, while I usually don’t have any grand prognostications and as a result, I tend to keep a balance of CAD and USD in the portfolio, I’m generally of the belief that the US dollar is going to continue to strengthen. This will continue to keep a lid on commodities.

Outlook – Portfolio in 2017

If absolutely everything works in 2017, the gains should be in the low teens. It is more probable that it will be a mid-single digit percentage year for me. My research pipeline is relatively thin at the moment (not a good sign for gains). Keeping my past 11 year record of 17% right now is a pipe dream.

Predictions for 2017:

1. The 1st half of the year will contain the high water mark for the S&P 500, Nasdaq and TSX. (The TSX’s high water mark was on the last trading day of the year!).
2. The Bank of Canada will not raise the short-term interest rate (0.5%), UNLESS if the 10-year bond yield rises above 2.5% (right now it is 1.72%).
3. The Canadian dollar will depreciate below 70 cents USD at some point during the year.
4a. Kevin O’Leary becomes the next leader of the Conservative Party of Canada, first-ballot victory with around 60% of the vote.
4b. He will speak better Fran├žais better than the media expects (think about Facebook’s Zuckerberg speaking Mandarin).
5. The 2017 Budgetary proposals as written above (I’ll consider this prediction successful if at least 4/7 occur).
6. Spot WTIC pricing will spend the majority of its time around the USD$50-65 price band.
7. If China experiences something akin to Japan’s early 1990-type economic malaise, there will be significant ripple-down effects on Vancouver real-estate (let’s define this as a Teranet average of less than 220).
8. The US federal reserve will raise interest rates once to 1%, but will relax the interest re-investment policy on their balance sheet assets during the year and retain a tightening bias.
9. “Canada Recession” will register a Google Trends search index rating of higher than 10 sometime in 2017. This is basically a prediction that by year-end that it should be fairly evident that we are close or going into recession.
10. Minister of Democratic Reform Maryam Monsef will get shuffled out of her portfolio (in addition to others from theirs) during 2017. There will be some “face-saving” measure applied for the justification (e.g. she suffered an injury, or something to explain it other than her performance).
11. In the May 2017 BC election, the BC NDP win 20 seats or less (down from the 35 they currently hold). I note polling now has them neck-and-neck with the governing BC Liberals.
12. There will be at least one volatility spike (VIX index) that will take it above 30 as a result of some geopolitical (not economic) event.
13. (Added January 2, 2017) Canopy Growth Corp (TSX: CGC) trades below CAD$9.14/share (2016 year-end closing price) at 2017 year-end (background info).

Portfolio - Year-End 2016 - Historical Performance

Performance and TSX Composite is measured in CAD$; S&P 500 is measured in US$. Total returns indices are with dividends reinvested at time of receipt.
YearDivestor PortfolioS&P 500 (Price Return)S&P 500
(Total Return)
TSX Comp. (Price Return)TSX Comp.
(Total Return)
11 Years (CAGR):+17.2%+5.5%+7.7%+2.8%+5.8%
2006+3.0%+13.6%+15.6%+14.5%+17.3%
2007+11.7%+3.5%+5.5%+7.2%+9.8%
2008-9.2%-38.5%-36.6%-35.0%-33.0%
2009+104.2%+23.5%+25.9%+30.7%+35.1%
2010+28.0%+12.8%+14.8%+14.5%+17.6%
2011-13.4%+0.0%+2.1%-11.1%-8.7%
2012+2.0%+13.4%+15.9%+4.0%+7.2%
2013+52.9%+29.6%+32.2%+9.6%+13.0%
2014-7.7%+11.4%+13.5%+7.4%+10.6%
2015+9.8%-0.7%+1.3%-11.1%-8.3%
2016+53.6%+9.5%+12.0%+17.5%+20.4%

Re-examining Teekay Corp

Back in April 2016 I stated I invested in the unsecured corporate debt (January 2020) of Teekay Corp (NYSE: TK). Yields have compressed considerably since then:

tk-bonds

Part of this is due to a $100 million equity offering that was purchased by certain insiders, including the 37.7% holder Resolute Investments, Ltd. They paid US$8.32 for their shares which are trading at a market value of about $7.15 as I write this.

Teekay also significantly rectified a capital funding gap in their Teekay Offshore (NYSE: TOO) daughter entity with the issuance of preferred shares, conversion of preferred shares to common units, and other generally dilutive measures to their common unitholders. This will also involve TK with a higher ownership of TOO and the solving of TOO’s liquidity issue will serve to be positive to the payment of TK debt.

The last few trades of TK debt going on today (volume of roughly $400k par value) has been around 90 cents on the dollar, corresponding to a yield to maturity of about 12%.

What I expect to happen is the market will continue to normalize and ideally then we will see yields compress to result in above-par prices. In the meantime I get paid interest income. This is a reasonably heavy portfolio weighting.

Teekay Corporation – Debt

Over the past couple months I have accumulated a substantial position in Teekay Corporation’s (NYSE: TK) unsecured debt, maturing January 15, 2020. The coupon is 8.5% and is paid semi-annually. I am expecting this debt to be paid out at or above par value well before the maturity date. The yield to maturity at my cost I will be receiving for this investment will be north of 20% (and obviously this number goes up if there is an earlier redemption).

tk

I was really looking into the common shares and was asleep at the switch for these, especially around the US$7-8 level a month ago. Everything told me to pull the trigger on the commons as well, and this mistake of non-performance cost me a few percentage points of portfolio performance considering that the common shares are 50% above where I was considering to purchase them. This would have not been a trivial purchase – my weight at cost would have been between 5-10%.

However, offsetting this inaction was that I also bought common shares (technically, they are limited partnership units) of Teekay Offshore (NYSE: TOO) in mid-February. There is a very good case that these units will be selling at US$15-20 by the end of 2017, in addition to giving out generous distributions that will most likely increase in 2018 and beyond.

The short story with Teekay Corporation debt is that they control three daughter entities (Teekay Offshore, Tankers, and LNG). They own minority stakes in all three (roughly 30% for eachUpdate on April 26, 2016: I will be more specific. They have a 26% economic interest and 54% voting right in Teekay Tankers, a 35% limited partner interest in Teekay Offshore, and 31% limited partnership interest in Teekay LNG), but own controlling interests via general partner rights and in the case of Tankers, a dual-class share structure. There are also incentive distribution rights for Offshore and LNG (both of which are nowhere close to being achieved by virtue of distributions being completely slashed and burned at the end of 2015). If there was a liquidation, Teekay would be able to cover the debt with a (painful) sale of their daughter entities.

Teekay Corporation itself is controlled – with a 39% equity stake by Resolute Investments, Ltd. (Latest SC 13D filing here shows they accumulated more shares in December 2015, timed a little early.) They have a gigantic incentive to see this debt get paid off as now do I!

The mis-pricing of the common shares and debt of the issuers in question revolve around a classic financing trap (similar to Kinder Morgan’s crisis a few months ago). The material difference that the market appears to have forgotten about is that Teekay Offshore (and thus Teekay Corporation’s) business is less reliant on the price of crude oil than most other oil and gas entities. The material financial item is that Teekay Offshore faces a significant cash bridge in 2016 and 2017, but it is very probable they will be able to plug the gap and after this they will be “home-free” with a gigantic amount of free cash flow in 2018 and beyond – some of this will go to reduce leverage, but the rest of it is going to be sent into unitholder distributions assuming the capital markets will allow for an easy refinancing of Teekay Offshore’s 2019 unsecured debt.

At US$3/share, Teekay Offshore was an easy speculative purchase. Even at present prices of US$7/share, they are still a very good value even though they do have large amounts of debt (still trading at 16% yield to maturity, but this will not last long).

The absolute debt of Teekay Corporation is not too burdensome in relation to their assets, and one can make an easy guess that given a bit of cash flow through their daughter entities, they will be in a much better position in a couple years to refinance than they are at present. They did manage to get another US$200 million of this 2020 debt off at a mild discount in mid-November 2015, which was crucial to bridging some cash requirements in 2016 and 2017. The US$593 million face value of unsecured debt maturing January 2020 is the majority of the corporation’s debt (noting the last US$200 million sold is not fungible with the present $393 million until a bureaucratic process to exchange them with original notes) – I’d expect sometime in 2017 to 2018 this debt will be trading above par value.

The debt can be redeemed anytime at the price of the sum of the present values of the remaining scheduled payments of principal and interest, discounted to the redemption date on a semi-annual basis, at the treasury yield plus 50 basis points, plus accrued and unpaid interest to the redemption date.

This is a very complex entity to analyze as there is a parent and three daughter units to go through (and realizing that Teekay Corporation’s consolidated statements are useless to read without dissecting the daughter entities – this took a lot of time to perform properly). I believe I’ve cherry-picked the best of it and have found a happy place to park some US currency. I still think it is trading at a very good value if you care to tag along.