Petrobas, Parex Resources – Complexities of foreign jurisdiction hydrocarbon investing

On paper, the valuations of various international oil/gas producers look quite cheap.

One example is the state-owned enterprise of Petrobas (NYSE: PBR).

For the past 12 months, they generated about USD$37 billion in cash. Their current market cap is about USD$69 billion, and net debt is US$48 billion (total EV US$117 billion), so an EV/FCF of about 3.2x. Really cheap-looking!

Also, there is no denying that shareholders have received some capital back in the form of dividends:

For 2022 alone, this has totaled USD$4.13/share in dividends.

When dividends are this high in relation to the existing share price (US$10.54/share), it is instructive to look at the stock price unadjusted for dividends:

So let’s say you lucked out during the Covid low (March 2020) and bought your shares of PBR at US$5/share.

Today you would be sitting on a cumulative dividend of US$6.27/share.

Needless to say, this is a very healthy cash return on investment.

The question is – is this cash stream going to continue in the future?

Political considerations would have one believe otherwise. Jurisdictions all over the world, ranging from the United Kingdom, the EU, Colombia and the alike have either implemented or are calling for “windfall profit taxes” to be levied on hydrocarbon companies.

The history of Brazil and Petrobras I will not explore in this post, but needless to say, it is quite the story about how very profitable state-owned resource enterprises are, not shockingly, not optimized for shareholder returns.

The history of Mexico and Pemex is another one.

Venezuela and PDVSA.

Saudi Arabia and Aramco.

I can go on and on.

Finance and politics go hand in hand. When dealing with politically sensitive sectors such as hydrocarbons, political considerations must be in the investing toolbox.

In the case of Petrobras, “too difficult” is all I can come up with. I have no idea about the legislative framework and the relationships between the government and its state-owned agencies, nor do I have a way of assessing whether the new presidency will be able to substantively enact hostile actions to minority (let alone foreign) shareholders. In general, not even knowing the language of the land is enough of a disadvantage, let alone all of these other prevailing considerations.

Just like when investing in a company with a controlling stake, you always have to have a precise assumption of the intentions of the controlling stakeholder before diving in.

We fast forward to Parex Resources (TSX: PXT), which, just like Petrobras, on paper looks extremely cheap.

Its market cap is US$1.5 billion, and it has net cash of US$350 million, leaving it with an EV of about US$1.17 billion.

It generated free cash flow of US$275 million for the first 3 quarters of this year. Annualized, that is about US$370 million (not an appropriate extrapolation since Brent is down in Q4 from Q1-Q3 but we are doing a paper napkin valuation).

That is an EV/FCF ratio of about 3.2x. Just like Petrobras.

Looks cheap on paper, but going forward things are going to get much more expensive for the company. Colombia’s newly elected president has successfully put forward and passed a piece of legislation that is financially punitive. In addition to the general corporate tax rate increasing, there will be a 15% surcharge levied if Brent is above a certain threshold, and also royalties on oil and gas are no longer tax deductible.

This will do wonders for capital investment, let alone talks about banning further drilling.

Also not helping is the domestic situation allowing for blockades and the like against existing producing facilities (run this through Google Translator).

Parex will likely be best valued as a run-off facility. The question becomes whether it is worth it for them to propose a significant amount of capital expenditures to keep their facilities pumping at current levels or not, even if this can be achieved in a regulatory environment that makes Justin Trudeau look like oil and gas’ best friend.

I don’t know.

Parex has traditionally given a huge amount of shareholder returns via the share buyback route – they have maxed out their 10% NCIB in the past few years. Their new NCIB will renew around Christmas time, and that will likely give a bid to their stock. Trading-wise you might even be able to skim 10-20% riding the NCIB capital infusion. However, just because you take out 10% of your float every year for a few years doesn’t mean that your stock price will respond if your home government is taxing the majority of your future profits away. As most people know, when the government enacts a tax, it is a very rare day when they will take back the tax. Inevitably there will be a day where the commodity price environment reverses and we will never see a reverse “windfall recovery grant” given to such companies.

So despite it looking incredibly cheap on paper, I’m staying away. We’ve seen many cases in the past where the golden goose gets strangled. This might be the case and hence why these companies trade at 3.2x EV/FCF ratios.

2022 Edition: TSX Tax-Loss Selling List

The TSX has made quite a surge up this quarter, and year-to-date it is only down about 6%. That said, there are plenty of stocks deep in the red for the year. Some of them will have equity investors so underwater in them that unlocking capital losses will push prices even further down.

2022-11-21-TSXTaxLossSaleList (Excel version)
2022-11-21-TSXTaxLossSaleList (PDF version)

Attached is a spreadsheet that contains in rank-order, the year-to-date losers of the TSX, with an arbitrarily set market cap floor of $50 million and everything under 25% year-to-date.

There are some aberrations here and there that you will have to adjust for (dual class stocks, Dorel performing a massive special distribution, etc.) but for the most part there is a lot to go with here for research crusades.

I was floored by the number of companies on this list – 209 – and 81 stocks went down more than 50%.

There is a very obvious split between these companies. Most of the severe losers do not make money (and consequently do not give out dividends), while the second half of the list (between 44% and 25% losses for the year) approximately half the companies do exhibit a trailing 12 month positive EPS characteristic and more than half of them gave out dividends. Some of these companies are quite credible.

Screening these companies for value is an interesting exercise. The whole market environment from 12 months ago has completely transformed – specifically interest rates have gone from 0.25% to 3.75% with a very probable rise on December 7, technology companies have been completely murdered (witness the rise and fall of Shopify, down 73% for the year and no longer a top-10 component of the TSX Composite… they’re 11th) and instead of marijuana companies and gold mining companies being pervasively on this list, we have a much broader spectrum of sectors represented.

Some of the IPOs have exhibited extremely poor performance, especially in the software sector – for example, Vancouver companies Copperleaf (TSX: CPLF) and Thinkific (TSX: THNC) are down 83% for the year. Those option grants aren’t getting exercised in my lifetime. Both of these companies have a ton of cash on the balance sheet, have little debt, are losing money, but their market caps are still considerably above their book value. Will all of that software R&D (expensed and hence not on the asset side of the balance sheet) be realized in the form of profits sometime?

With this much breadth there are a few prospects I’ve been eyeing, but just like a tiger waiting in the bushes, there is a right time to pounce.

Anything on this list that catches your attention?

Slate Office REIT – or my brief attempt at becoming a corporate raider

Slate Office REIT (TSX: SOT.UN), as the name implies, is a REIT specializing in office properties. It is mostly Canadian, with properties in Saskatchewan and provinces eastwards, a couple buildings in Chicago and 23 properties in….. Ireland.

Clearly geographic concentration is not one of the focuses of this REIT.

In terms of their traded units, it has been fairly sleepy. If you take a 10-year chart and stick your fingers over the Covid portion, the units have meandered around $4-5 and have not really broken out of this range.

In terms of distributed capital, before Covid they got the distribution up to about 0.0625/month (75 cents a year). This was dropped after February 2019, to its current level of 40 cents a year. The characterization of distributions over the past couple years has been about half capital gains, half return of capital.

If you believe the MD&A, the so-called “Core FFO” is around 53 cents for the TTM.

IFRS book value is well above the current market price. Rounding to the nearest $100 million, on September 30, the stated property value is $1.8 billion and stated debt $1.1 billion.

The market value of the units is about $360 million.

This is about as mundane a REIT as it gets. The acquisition of the Ireland properties was really a departure from the previous inclinations.

A very well known businessman, George Armoyan (who runs TSX: CKI) owns, via his controlled corporation (G2S2), a sizeable stake in SOT, approximately 15-16%. They represent by far the largest unitholder group in Slate Office REIT, much more than Slate Asset Management (the effective controllers of SOT at this point in time) itself.

G2S2 created a website with an amusing name, Clean the Slate which you can check out (and which will likely be taken down after the proxy battle is over).

You can read their website to view their justifications on October 20 and 26. Putting a long story short, SOT has a management agreement which gives it an incentive to acquire properties that are not necessarily economic for minority unitholders. G2S2 claimed that SOT’s recent financing of a property using a new convertible debenture issue (TSX: SOT.DB.B) is very dilutive given the conversion price is well below book value.

G2S2 requisitioned a meeting to elect 4 trustees and remove 5 incumbents, which would give it control. Their purported aim is to converge SOT’s market value with book.

This got me interested.

After doing some review, I bought some of the convertible debentures of SOT.

There are three issues of debt.

SOT.DB matures on February 28, 2023. Coupon 5.25%. Convertible at $10.53 (not going to happen). Outstanding: 28.75 million.
SOT.DB.A matures on December 31, 2026. Coupon 5.5%. Convertible at $6.50. Outstanding: 75 million.
SOT.DB.B matures on December 31, 2027. Coupon 7.5%. Convertible at $5.50. Outstanding: $45 million. G2S2 also bought $7.1 million of this offering.

I attempted to get some of the .DB and .DB.B tranche, just a little bit. The bid-ask is reasonably narrow, but I have an aversion to hitting the ask unless if the situation really warranted it. I obtained a ‘starter’ position but could not accumulate more – the price is very narrowly traded. The trade ‘felt’ crowded.

After receiving a requisition for a meeting from G2S2 (October 27, 2022), I quickly glossed over the declaration of trust.

SOT had 21 days to reply to the requisition. This allows for some negotiation to occur.

Clearly such negotiations did not lead to much, as SOT announced on November 14 that they will hold simultaneously their special and annual general meeting on March 28, 2023. The cited excuse for the huge delay was:

The timing of the Meeting provides sufficient time for the Board to present information material to the unitholders of the REIT with respect to the items raised by the dissident unitholder, as well as information relevant to the previously announced review of strategic alternatives. The REIT intends to move up the timing of its Annual Meeting to combine it with the requisitioned Meeting, sparing unitholders the costs of the REIT hosting two separate meetings in quick succession.

Of course, I don’t believe any of this. This is a political battle and SOT is attempting to stack things as much in their favour as possible. Specifically they will want to dilute G2S2 to the extent possible, and also potentially extract as much value out of the asset base (even if they poison it) if Slate is going to lose it.

Clause 9.9 of the declaration of trust states:

For the purpose of determining the Unitholders who are entitled to receive notice of and vote at any meeting or any adjournment thereof or for the purpose of any other action, the Trustees may from time to time, without notice to the Unitholders, close the transfer books for such period, not exceeding 35 days, as the Trustees may determine; or without closing the transfer books the Trustees may fix a date not more than 60 days prior to the date of any meeting of the Unitholders or other action as a record date for the determination of Unitholders entitled to receive notice of and to vote at such meeting or any adjournment thereof or to be treated as Unitholders of record for purposes of such other action, and any Unitholder who was a Unitholder at the time so fixed shall be entitled to receive notice of and vote at such meeting or any adjournment thereof, even though he has since that date disposed of his Units, and no Unitholder becoming such after that date shall be entitled to receive notice of and vote at such meeting or any adjournment thereof or to be treated as a Unitholder of record for purposes of such other action. If, in the case of any meeting of Unitholders, no record date with respect to voting has been fixed by the Trustees, the record date for voting shall be 5:00 p.m. on the last business day before the meeting.

Putting a long story short, Slate can decide the voter base between 35 and 60 days before the meeting.

There will potentially be a couple actions taken between now and then, assuming no negotiated settlement.

One is that SOT will conduct a large secondary offering of units. The bought deal will be purchased by Slate-friendly entities.

Two is that SOT will take SOT.DB and post a notice of redemption and declare that the debentures will be converted for units rather than cash. The manner they can do this is described in the indenture (it is the VWAP of 20 trading days, ending 5 trading days before the redemption date). At current market price this will represent another 6.7 million units or so, minus the actual dilutive impact of the conversion notice itself.

I’ve been through the game of a stressed entity converting debentures for stock (Westernone) and it does not work well for both sides, the equity and debtholders.

I’ve also contemplated G2S2 converting its holding of SOT.DB.B into shares to bolster its vote.

Either scenario does not work well for minority unitholders or the convertible debenture holders.

Indeed, SOT.DB is trading at a YTM of 8.7%, SOT.DB.A is trading at 9.8% and SOT.DB.B is at 9.0%, the latter presumably because there is some equity value with the conversion price being relatively close to the trading unit price.

However, in a dilutive environment, that option value is going to fade.

In other words, I quickly came to the realization there is no way for a financial flea such as myself to “win”.

I dumped the debentures. Fortunately the small position was easily absorbed by the market.

After commissions, the ordeal yielded me a profit of just over a hundred dollars and ended my brief episode of becoming a corporate raider.

I’m going to give Tyler a shout-out here for delving into this as well. His conclusion is somewhat different than mine (perhaps there is some value in SOT.DB.B), and his insight is well worth reading.

But for me, I’m just a spectator now.

A few miscellaneous observations

The quarterly earnings cycle is behind us. Here are some quick notes:

1. There is a lot more stress in the exchange-traded debenture market. Many more companies (ones which had dubious histories to start with) are trading well below par value. I’ve also noticed a lack of new issues over the past six months (compared to the previous 12 months) and issues that are approaching imminent maturity are not getting rolled over – clearly unsecured credit in this domain is tightening. There’s a few entities on the list which clearly are on the “anytime expect the CCAA announcement” list.

Despite this increasing stress in the exchange traded debenture space, when carefully examining the list, I do not find anything too compelling at present.

2. Commodity-land is no longer a one-way trade, or perhaps “costs matter”. I look at companies like Pipestone Energy (TSX: PIPE) and how they got hammered 20% after their quarterly release. Also many gold mining companies are having huge struggles with keeping capital costs under control. Even majors like Teck are having over-runs on their developments, but this especially affects junior companies that have significantly less pools of financial resources to work with (e.g. Copper Mountain).

3. This is why smaller capitalization commodity companies are disproportionately risky at this point in the market cycle – we are well beyond the point where throwing money at the entire space will yield returns. As a result, larger, established players are likely the sweet spot on the efficient frontier for capital and I am positioned accordingly. I note that Cenovus (TSX: CVE) appears to have a very well regulated capital return policy, namely that I noticed that they suspended their share buybacks above CAD$25/share. The cash they do not spend on the buyback will get dumped to shareholders in the form of a variable dividend. While they did not explicitly state that CAD$25 is their price threshold, it is very apparent to me their buyback is price-sensitive. This is great capital management as most managements I see, when they perform share buybacks, are price insensitive!

4. Last week on Thursday, the Nasdaq had a huge up-day, going up about 7.3% for the day. The amount of negative sentiment baked into the market over the past couple months has been extreme, and it should be noted that upward volatility in bear markets can be extreme. This is quite common – the process is almost ecological in nature to flush out negative sentiment in the market – stress gets added on to put buyers and short sellers and their conviction is tested. Simply put, when the sentiment supports one side of a trade, it creates a vacuum on the other side and when there is a trigger point, it is like the water coming out of a dam that has burst and last Thursday resembled one of these days. In the short-term it will look like that the markets are recovering and we are entering into some sort of trading range, but always keep in mind that the overall monetary policy environment is not supportive and continues to be like a vice that tightens harder and harder on asset values – and demands a relatively higher return on capital.

I suspect we are nowhere close to being finished to this liquidity purge and hence remain very cautiously positioned. My previous posting about how to survive a high interest rate environment is still salient.

Ritchie Bros – how to destroy shareholder value

Ritchie Bros (TSX: RBA) has carved out a monopoly-like niche with regards to their construction equipment auction business. As a result, they’ve received a premium valuation. Indeed, in early November their 2023 estimated P/E was around the 33 level, which puts them well beyond my own investing horizon.

However, last Monday they announced they will be spending US$7.3 billion, with about US$2.3 billion in cash ($1.3 billion in cash and $1 billion in the assumption of debt) to take over IAA, an automobile auction company. The market speaks for what I perceive to be the value of this acquisition:

The excuse given by management is one of accessing other markets, geographical diversification, “synergies”, etc.

You’re exchanging 100% of a monopoly-like business for a 59% residual interest in one, and a 41% interest in a company operating in a market that is very competitive. (NYSE: KAR) is an example of a competitor, but there are many others.

You’re purchasing a company that is inevitably at the peak of the historical earnings cycle, while the press release claims a 13.6x “adjusted EBITDA” transaction value on the trailing 12 months.

You’re leveraging a balance sheet which currently is mildly leveraged (net debt of roughly $200 million if you exclude restricted cash) and injecting $2.3 billion dollars of debt (which will suck out another $150 million or so a year in financing expenses).

Needless to say this acquisition is awful if you’re an RBA shareholder.