Teekay Offshore – sad end to the story

There is always a risk in investing in companies that are incorporated in offshore domains. Teekay Offshore is a partnership incorporated in the Marshall Islands jurisdiction. Normally this doesn’t make much difference, but sometimes the geography of incorporation makes a huge difference – laws that apply in Canada and the USA may not necessarily apply to other jurisdictions.

I’ve written about Teekay Offshore (NYSE: TOO) before (a bunch of posts here), but today, Brookfield initiated a “take-under” offer, offering to buy back the 49% of the company they do not own. They already took control from Teekay corporation (who themselves were over-leveraged and needed the cash). TOO was trading at $1.16 last Friday, and the offer was at $1.05/unit.

The issue is that one has to read the legalese on the partnership units, and the cross-section with applicable Marshall Islands law to figure out what they can and can’t do to make this transaction occur.

Of particular note are the preferred shares, which on paper have very good yields. For instance, TOO.PR.E has an 8.875% coupon and is now trading at $16/share (par value is $25) which gives it nearly a 14% yield.

Looks like a good return on investment, eh? Brookfield will certainly continue to pay those preferred dividends since they will want to certainly make distributions with the common units when offshore drilling becomes profitable again, right?

Not so quick.

We are dealing with Marshall Islands law, where wild west type rules prevail.

What makes preferred investors think that the wholly-owned partnership won’t have their assets stripped away and the preferred unitholders stranded? In Canadian jurisdictions, this would be a constructive dissolution, but who wants to take their chances in the Marshall Islands, a territory with 53,000 residents?

No positions but watching the whole story unfold.

Examining the entrails of Kinder Morgan Canada

Kinder Morgan Canada (TSX: KML) was set up to be the publicly traded entity for Canadian assets of Kinder Morgan (NYSE: KMI). KML is 70% owned by KMI. The 30% remaining trades on the TSX and they are functionally economic participation units (i.e. Kinder Morgan has complete control).

KML’s flagship asset was the Trans-Mountain Pipeline, which was sold to the Federal government in 2018. The bulk of the proceeds was distributed to KML shareholders. Everybody knows about this story and it has been dissected to death (including myself), so I will not give it further press here.

What was lesser known is that KML had other operating assets in Canada that generated quite a large amount of cash. The operation is quite easy to analyze (which sadly means that the market has mostly picked up on a proper valuation). In Edmonton, they have a rail terminal and storage tanks (which facilitates operations of oil-by-rail). They have a small condensate pipeline going to the US border from Alberta (creating an odd situation where KML owns the Canadian side, while KMI owns the US side of the pipeline). Finally, they have a mineral concentrate terminal in North Vancouver and are also building a fuel storage facility.

These assets in 2019 are anticipated by management to generate $213 million in “adjusted” EBITDA, and roughly $109 million in distributable cash flow.

This will go down due to an existing contract in Edmonton that is currently being priced on favourable terms to KML. Starting April 2020, this will decrease by approximately $50 million EBITDA. Management claims this will be somewhat offset by future pricing increases. A reasonable guess would be a $170 million EBITDA run-rate absent of the revenues expected from the diesel storage business.

Other than that, the assets are sound and are likely to be in use for the foreseeable future.

So it was logical after the Trans Mountain Pipeline sale that the company investigate options as it was fairly obvious to either sell everything, or merge back into the KMI entity again.

They concluded in May 2019 that they will remain a stand-alone entity. This took the stock down from roughly $15/share to $12/share where it trades presently. KML has 116.3 million shares outstanding, and this gives them a market valuation of CAD$1.4 billion or roughly 8x adjusted EBITDA.

The company has a tiny amount of bank debt (nearly offset by the amount of cash on hand), but they do have CAD$550 million in low-yield preferred shares outstanding (TSX: KML.PR.A and KML.PR.C). These preferred shares were issued in anticipation of the construction of the Trans-Mountain Pipeline!

It obvious from my standpoint that KMI would want to get rid of its Canadian operations entirely, but they are not in a rush to do so – probably waiting for the federal election to see if a more oil-favourable government comes into office. The question remains how much they can obtain for the assets in this more favourable environment. In the meantime, they continue to generate cash and distribute CAD$106 million/year to their shareholders (common and preferred) in dividends.

KML at this point would appear to be a relatively low risk, low return type investment.

Bank of Canada addresses Climate Change in their Financial System Review

It made a lot of headlines that the Bank of Canada listed climate change as one of their vulnerabilities in their 2019 Financial System Review.

The media subsequently went wild and instantly began to mis-characterize this as being a big vulnerability (headlines: “Climate change threatens ‘both the economy and the financial system,’ says Bank of Canada”, “Bank of Canada identifies climate change as important economic weak spot”, “Bank of Canada warns ‘fire sales’ of carbon-intensive assets could ‘destabilize’ financial system”, etc.)

I would suggest reading the actual passage as written by the Bank of Canada.

The move to a low-carbon economy involves complex structural adjustments, creating new opportunities as well as transition risk. Investor and consumer preferences are shifting toward lower-carbon sources and production processes, suggesting that the move to a low-carbon economy is underway. Transition costs will be felt most in carbon-intensive sectors, such as the oil and gas sector. If some fossil fuel reserves remain unexploited, assets in this sector may become stranded, losing much of their value. At the same time, other sectors such as green technology and alternative energy will likely benefit.

Climate change resolves into political risk for various companies, especially those in the fossil fuel industry – regulation under the guise of climate protection, which instead has the effect of increasing costs. In my opinion, it is not a risk that will cause the destabilization of the financial system.

I would rank the ability for climate change to cause a systemic financial disaster in the Canadian financial system to be on par with the risk of a moderately large asteroid hitting the planet and causing wide-scale disruption – both events would be “climate-related”, per se, and cause real disruption. The Bank of Canada might as well have included a discussion piece on the risk of an asteroid hitting the planet, perhaps directly on Ottawa.

So it leaves me to question the motivation of the Bank of Canada to include this in their report, and it is for the simple reason that they are playing politics and want warm and fuzzy attention for addressing climate change.

Typical research sweep

There are a few ways that stocks come across my desk. One is running some screens for issuers that fit my desired parameters (small to mid cap, low volume, among other characteristics). Sometimes I just randomly encounter companies that come up on various sector lists. Sometimes I just type in random ticker symbols and examine (seriously – try it). Another way is to go through 13F-HR filings of various fund managers I respect and try to examine some of their holdings.

Most popular fund managers realize that people like myself have parasitic tenancies in investment. Warren Buffett is a great example of this (think about Berkshire’s investment in Amazon).

One of the huge advantages of being a relatively small investor is that you can get in and out of positions without having to go through the pain of combating high frequency trading and the other chicanery of building or disposing of a position. As a result, smart managers do try to obfuscate this information to a degree, so 13F-HR filings are not the risk-free treasure trove of information one would initially suspect.

An example today is Scion (of Michael Burry fame) and their 13F-HR filing:

There are 14 positions to deal with, a most manageable number. Note that 13F-HR filings do not have to disclose short positions, nor do they have to disclose securities that are not included in a gigantic listing of 13F-HR disclosable securities, which mainly consist of USA-tradable securities (and foreign securities that trade on US exchanges).

So managers also have the option of trading securities that are not on this list to cover their tracks.

1. Alphabet – Why would I invest in Google? Pass.

2. Altaba – Same, too big. Pass.

3. Cleveland Cliffs – More interesting. Iron Ore producer. Canadian analogy is TSX:LIF which I kick myself today for not investing in early 2016 when it was on my radar and I gave it a thorough look. My knowledge of the iron ore industry is less than adequate, but the financials of Cliffs was less than inspiring in relation to its market value. They may have some competitive advantage by virtue of being the only regional game in town, coupled with Trump’s tariffs, which could bode well for it. But otherwise, don’t know enough to make a decision. Pass.

4. Corepoint Lodging – Hotel REITs are cyclical entities. When room rates rise, everybody and their grandmother seeks to build new hotels and they can be bought at $2-3 million a pop, in markets with relatively low barriers to entry. They are at a high point right now. The next recession will be wiping out a lot of equity value. Corepoint’s financials don’t show an entity making a ton of money on operations and are instead banking on land. Pass.

5. Disney – too big. Pass.

6. Facebook – I don’t even use Facebook. I’m a Luddite. Pass.

7. Five Point Holdings – Land developer, small scale, San Fran, LA and Orange county. Any business doing business in California has tolerance for a massive amount of self-abuse, which gives some incumbency protection. Not a terribly broken business, dual class structure. Relatively new entity, started trading 2017. Income statement showing very lumpy revenue streams. Huge non-controlling interest. Probably not worth further research, but can’t totally dismiss.

8. Gamestop – too many eyeballs on it. Pass.

9. Greensky – Another dual-share structure with a large non-controlling interest, dealing with payment processing and real-time lending solutions. Probably another pass.

10. JD – Do I have any expertise on Japanese online retailing? Nope. Pass.

11. PetIQ – This one is interesting. A lot of money has been lost on the retail side of animal care, but this company deals with the branding and distribution of foods and veterinary care products. Financials are not a complete disaster, but they are in an expansion phase and need capital to do this. The income statement is very low margin and the industry is competitive to the point where they’d need to be the lowest cost producer on the virtue of localized economies of scale – this has been tried before in many instances. Worth further research, but skeptical. Also they announced a major acquisition a couple weeks ago, which usually means huge integration pains for at least a year to come.

12. Sportsman Warehouse Holdings – What’s amazing is how this company can still continue to make money. Lots of money to be made on the equity side if you predict they can keep their gross profits at the levels they are at and keep a cap on their SG&A expenses. Will Amazon/Walmart kill them? Not my cup of tea to analyze, but the stock is trading low enough that there is a compelling case to be made if you have an inclination that they are not doomed to Circuit City-type retail oblivion.

13. Tailored Brands – Otherwise known as the old Men’s Warehouse. Unlike most other clothing companies, Amazon doesn’t really compete very well in the suits category. They had a gigantic amount of debt to work with, but they are still chipping away at it. Valuation is actually not that bad, all things considered! I did look at them many, many, many years ago, so I do have some familiarity with the company.

14. Western Digital – Too big, but a respected hard drive manufacturer. Pass.

So after this screen, I found a few prospects to do further due diligence on.

Fair value adjustments and some quirky accounting rules

I am pretty convinced that the purpose of a lot of IFRS edicts is to make financial statements unreadable. The introduction of IFRS 16 adds two lines to most companies’ balance sheets and while mildly annoying (mentally one has to make a provision for lease-heavy companies that the amortization of the lease asset/liability is akin to a lease payment and make sure not to perform apples-to-oranges comparisons when looking at EBITDAs), the biggest pain has to be IFRS’ tenancies to use mark-to-market fair value adjustments whenever such data is available.

As an example, I am going through Gran Colombia Gold’s (TSX: GCM) last quarterly statement and the income statement is getting to the point where it is almost unreadable.

For example, under “Other income (expense)”, the entire $4.591 million under “Loss on Financial Instruments” consists of fair value adjustments. For an untrained eye these would seem quite relevant in that one would perceive the company is ‘paying’ more in financial expenses than is actually the case. From an analytical perspective, these fair value adjustments are irrelevant.

I’ll break down this even further, which is covered by the rules of IFRS 9.

$2.569 million of the $4.591 million consists of a mark-to-market adjustment on the fair value of warrants the company has outstanding.

When the company issued the warrants in conjunction with a notes offering, they issued 12.151 million warrants which were publicly listed on the TSX (TSX: GCM.WT.B). The warrants are convertible at CAD$2.21/share.

Let’s step back and remember the following law of accounting:

Assets = Liabilities + Equity

In a sane world, these warrants should reflect equity (the warrants in no circumstances can ever reflect a drain on the assets of the company). However, in our brave new IFRS world, they are a liability because they represent value that has not been set at a fixed price by the company. GCM reports in US currency, so therefore the warrant liability in Canadian dollars is a floating obligation and thus needs to be re-valued every quarter!

Once the door was open to expensing stock options, the logical progression is that any issuance of like instruments (such as warrants) need the same treatment.

Since the warrants are publicly traded, the fair value of the liability can be recorded using the market price. This needs to be updated quarterly.

The warrants at the end of December 31, 2018 were worth $13.8 million. On March 31, 2019 they were worth $16.4 million. Therefore, the company “lost” $2.6 million and this has to be reported on the income statement as a financial expense.

This expense, in no manner, reflects an actual cash expense. Nor does this expense affect the valuation of the company in any respect. This “expense” does not impact the taxes the company has to pay.

What it does, however, is really skew any ratios that may need to be calculated. For example, if you have an excessively high non-cash expense due to a fair value adjustment, it would serve to understate your net income, or make your apparent tax rate higher than it actually is.

Perhaps this is why most people do not read financial statements anymore – they’re becoming more and more difficult to read.

However, opportunity exists in complexity – if computer programs that are designed to screen for fundamentals do not factor in irrelevant expenses such as these fair value adjustments, companies that appear to be losing money on the income statement could be undervalued by the market as standard stock screens will report them as less profitable than they actually are. I’ll leave it at that.