Pipelines and Inter-Pipeline

I’m not one to typically invest in pipelines. All of them are quite heavily levered, and in most cases, it is justifiable with the predictable streams of cash flows they generate. As a result, the equity is typically treated like a bond by most investors, plus you add a couple percent to make up for the ‘risk premium’.

In the Canadian retail space, there’s no better example of this than Enbridge, where investors blissfully clip their 74 cent a quarter dividend, with the promise by management that this will grow 10% a year indefinitely. The fact that there’s 65 billion in debt and 8 billion in preferred shares ahead doesn’t matter because of those high cash flows, so one can safely assume you will receive dividends forever. The current headline yield of 6.6% sure looks good and can only go up from here!

This might sound great, but investors of Kinder Morgan (NYSE: KMI) learned their lesson (2015) that some things can go wrong with this model and when corrections are required, shareholders take the hit and not the senior part of the capital structure. Taking equity risk on Enbridge in exchange for very limited capital appreciation upside is not my idea of a good investment, but I’ll digress.

Enbridge and other pipeline companies do have one virtue – because of intense political opposition, it becomes a lot more difficult to develop pipelines, especially in Canada. Thus, there is a huge element of advantage to incumbents. Even if you gave a competent oil major $30 billion, you wouldn’t be able to replicate Line 3 or Line 5 from scratch. Especially with Canada’s Bill C-69, there is really no point – TransCanada learned the tough way (even without C-69) that Energy East is a dead cause because of politics. The only real option these days are avoiding the federal scene entirely and going for intra-provincial pipeline infrastructure. An example of this is the Coastal Gaslink pipeline, connecting the northeastern BC gas formation to Kitimat, BC for LNG export. Even this has received heavy opposition of all sorts, but they were able to miraculously make agreements with all 30 elected First Nations councils and get the thumbs-up from the provincial NDP government (despite having a Green party coalition partner), which has been one of the big political surprises over the past couple years.

Which brings me to another pipeline company – Inter-Pipeline (TSX: IPL). What has been encumbering the company is the construction of their propane to polypropylene refining facility, which needless to say, is very expensive (all of this political talk of being able to refine your own production is completely uninformed about how expensive these facilities are and how much expertise they require to construct and operate – they don’t come up on their own like marijuana!). Their cost estimate of $3.5 billion is probably conservative and looking at the balance sheet, simply put, they have enough debt as it is without constructing this facility.

Now the media has caught wind that somebody wants to take them over, and somebody floated an unsolicited bid for $30 for the whole thing. Management rejected it, but this is starting to get the stock market interested. It’s an interesting valuation when considering that the enterprise value at IPL stock at $30 is 7 times the annualized revenues (1H-2019), while Enbridge’s is currently 3 times.

Appendix – Bill C-69

Here is a snippet of the new requirements that the environmental impact (now “impact assessment”) agency must consider:

Factors — impact assessment
22 (1) The impact assessment of a designated project, whether it is conducted by the Agency or a review panel, must take into account the following factors:
(a) the changes to the environment or to health, social or economic conditions and the positive and negative consequences of these changes that are likely to be caused by the carrying out of the designated project, including
(i) the effects of malfunctions or accidents that may occur in connection with the designated project,
(ii) any cumulative effects that are likely to result from the designated project in combination with other physical activities that have been or will be carried out, and
(iii) the result of any interaction between those effects;
(b) mitigation measures that are technically and economically feasible and that would mitigate any adverse effects of the designated project;
(c) the impact that the designated project may have on any Indigenous group and any adverse impact that the designated project may have on the rights of the Indigenous peoples of Canada recognized and affirmed by section 35 of the Constitution Act, 1982;
(d) the purpose of and need for the designated project;
(e) alternative means of carrying out the designated project that are technically and economically feasible, including through the use of best available technologies, and the effects of those means;
(f) any alternatives to the designated project that are technically and economically feasible and are directly related to the designated project;
(g) Indigenous knowledge provided with respect to the designated project;
(h) the extent to which the designated project contributes to sustainability;
(i) the extent to which the effects of the designated project hinder or contribute to the Government of Canada’s ability to meet its environmental obligations and its commitments in respect of climate change;
(j) any change to the designated project that may be caused by the environment;
(k) the requirements of the follow-up program in respect of the designated project;
(l) considerations related to Indigenous cultures raised with respect to the designated project;
(m) community knowledge provided with respect to the designated project;
(n) comments received from the public;
(o) comments from a jurisdiction that are received in the course of consultations conducted under section 21;
(p) any relevant assessment referred to in section 92, 93 or 95;
(q) any assessment of the effects of the designated project that is conducted by or on behalf of an Indigenous governing body and that is provided with respect to the designated project;
(r) any study or plan that is conducted or prepared by a jurisdiction — or an Indigenous governing body not referred to in paragraph (f) or (g) of the definition jurisdiction in section 2 — that is in respect of a region related to the designated project and that has been provided with respect to the project;
(s) the intersection of sex and gender with other identity factors; and
(t) any other matter relevant to the impact assessment that the Agency requires to be taken into account.

My comments: Good luck! Especially with the very quantifiable “intersection of sex and gender with other identity factors” criterion.

Gran Colombia Gold Notes – Part 2

Since gold is going crazy, I’ll just follow up from my previous post on Gran Colombia Gold’s senior secured notes (TSX: GCM.NT.U).

With gold at US$1,475/Oz, and assuming a call date on May 1, 2021, the notes at a purchase price of 104 will have a 13% YTM if gold continues at that price.

Unfortunately since the notes are amortized quarterly, it is very doubtful you can fully realize this, but as a buy-to-maturity investment, it gives you an equity-like return for a first-priority bond that is linked to a hot commodity. Only real risk is that the income you are being paid with is mostly derived from a single mine in Colombia – just hope for no earthquake in the next two years. Fortunately the only earthquakes presently are financial.

My notes were purchased near par and this one is looking like to be around a 15%er on debt. Not bad. Don’t think we will be seeing this again for a long time.

Book Review: The Outsiders – and outsized returns

The Outsiders: Eight unconventional CEOs and their radically rational blueprint for success – by William Thorndike.

I’ll recommend this book. Although it is becoming somewhat dated (copyright date was 2012), it gives the reader a 50,000 foot above the skies satellite view of some hand-picked CEOs that were able to strongly defeat the GE Jack Welch / S&P 500 record during multi-decade periods. They shared a single characteristic – they were able to allocate capital with discipline and ruthless efficiency. Operationally they were able to delegate to competent individuals and decentralization to the point of abdication was another theme.

If this book was written today and for Canadian CEOs, I would think Mark Leonard of Constellation Software (TSX: CSU) is an obvious candidate. He has delivered 42% compounded annual returns over the past decade, and 38% since going public in May of 2006 – notably still earning this return through the 2008-2009 economic crisis.

Reading (mostly written by) Mark Leonard’s Shareholder Q&A letters is fascinating insight on the company and how management thinks. It is indeed a shame that I never heard of this company until it was far, far too late. Sadly they are looking at future returns in the upper teens from their current size.

I have also taken great pleasure of reading Tyler’s compilation of quotations by TransForce’s (TSX: TFII) CEO Alain Bedard, which is a trucking and logistics company. TFII has performed at 22% compounded annually over the past decade, and about 13% since going public in October 2002 (in both cases dividend-adjusted). For a low margin business such as trucking, this is needless to say impressive.

There is a bit of retrospective bias in this book, however. Most individuals would probably regard Prem Watsa of Fairfax (TSX: FFH) as being a very good CEO, but his dividend-adjusted CAGR over the past decade has been 9%, and over the past 20 years has been 6%. Compare this with CEO Duncan Jackman of E-L Financial (TSX: ELF), which has been approx. 9% over both the past 10 and 20 year period. E-L Financial, in my opinion, is the least attention-seeking publicly traded corporation with a market cap of over a billion dollars.

For the sake of comparison, the TSX’s performance (dividends reinvested) over the past 10 years has been 6.6%. The main index (dividends not reinvested) over the past 17.7 years (which is how far the data goes back when they did a major change to the index) is 4.5% – adding in dividends would be another 3% or so. So a 9% CAGR performance is a slightly overperformance over the TSX, but posting returns into the teens and better is clear outperformance.

Macro / China

The currency depreciation war is active and alive (below is a chart of the US Dollar to Chinese RMB exchange rate, showing a 3% devaluation over the past couple days which is historically quite volatile for the currency):

We’re entering into a strange topsy-turvy financial world where things are going to stop making much sense at all. We already have that in Europe, where a lot of sovereign bonds are trading at negative yields (which is the definition of financial insanity).

Interest rate futures for the US federal reserve already show that the fed funds rate will slip down to about 1% – the December 2020 fed funds futures are a full percentage point below the present values. The Bank of Canada will likely be forced to match to some degree – I would look for the Bank of Canada to drop their rates correspondingly.

In terms of investment themes, always keep in mind TINA – There Is No Alternative – as safe bond yields get pushed into the low single digit yields, in order to make any returns at all, the risk frontier continues to get pushed further and further into the equity realm. Dips in equity valuations will eventually be bought as pensions and institutions need to seek returns that they are not going to be receiving from bond portfolios. Specifically, domestic industries (i.e. no China exposure) with cash flow pricing power will remain king.

The allure of leverage (why not when you can borrow so cheap?) will also be tempting.

Unfortunately, a lot of these companies (e.g. most utilities) already trade rich, but there’s a decent chance that the escape for safety will continue to push asset prices even higher.

Also, with medium-term interest rates declining, those 5-year rate reset preferred shares will also likely take a hit. There may be some interesting opportunities coming up in this space as shares get sold off.

Atlantic Power Q2-2019

This is a review of Atlantic Power’s second quarter, 2019.

My thesis statement on ATP a year ago was “Terrible industry, cheap stock” and little has strayed from that. The industry is still terrible (over-capacity, subsidies for wind/solar have drenched the market, etc.). However, with every passing quarter, Atlantic Power de-levers a bit and makes small financial decisions to the betterment of its shareholders.

For instance, in Q2-2018, they had US$778 million in debt, while in Q2-2019 that is now US$685 million (saving about 4.25% on interest expenses). Preferred share par value is from US$159 million to US$142 million. Shares outstanding went from 111,302,692 to 109,381,678.

Q2-2019 was better than expected due to weather – Curtis Palmer, a hydroelectric project in New York state, is projected to contribute $8.6 million in extra EBITDA. Negatives include the prolonging of the San Diego decommissioning (and costing a million more than previously guided), and other unexpected maintenance issues. Management guided that Curtis Palmer is 17% below average in the month of July, so clearly a caution that weather can be variable.

Atlantic Power has a very low capital expenditure profile, as maintenance is directly expended off the income statement (the accounting implication here is the “DA” in EBITDA is much more relevant because you are not artificially inflating reported cash flows with high capital expenditures – effectively EBITDA is a proxy for free cash flow). For the first six months of the year, they generated $68 million in operating cash flow.

The storm clouds on the horizon involve the expiration of their power purchase agreements PPAs. Manchief, currently producing $7.7 million in EBITDA in 1H-2019, will expire on May 2022, and afterwards will be sold for $45 million. The market did not receive it very well as it represented nearly a quarter of the company’s power generating capacity (incorrectly extrapolating that the rest of it will be sold at the same rate). The company’s hydroelectric projects are much more likely to claim a higher multiple to EBITDA.

The reduction of capacity and expiration of PPAs are somewhat offset by the purchase of biomass facilities which appear to be purchased at 20%+ EBITDA levels.

As the debt continues to be whittled away at (noting that the company’s tax shield is considerable – $587 million in operating loss carryforwards as of the end of December 2018), eventually the market will realize there is a lot more value to Atlantic Power than what it is presently trading for. If by some miracle the power generation market recovers, there will be even further value to the equity. Looking at a three year stock chart is like watching a heart EKG but fundamentally, the corporation is in much better shape today than it was 3 years ago. Eventually the graph will “hockey stick”, but in the meantime, this is one to purchase and forget.

Conference call notes

Sean Steuart, TD Securities Equity Research – Research Analyst

Few questions. Wondering if you can give some context on deal flow. Are the best opportunities you are seeing limited still to biomass or are there other technologies that, I guess, state your preference for out-of-favor cigar butt-type investments?

James J. Moore, Atlantic Power Corporation – CEO, President & Director

Yes. So biomass, I would say, is the main focus of what we’re looking at now because they’re unglamorous, they’re not popular. A lot of them have had difficult start-ups and difficult operating-wise. Our internal expertise on biomass allows us to kind of roll that out as we try to integrate new plans. So we’re becoming quite a large biomass operator with the acquisitions we’re going from 4 to 8.

I think in the past, we’ve said — look, we were asked this question over the last 4 or 5 years, we’re paying off debt, but we’re going to be very focused on intrinsic value per share. We’re going to be very disciplined. So it took us 5 years before we ended up making some acquisitions.

And then what we did, we moved with some speed and scale. So I think that’s the way we’re always going to approach this. So today in terms of the deal flow, we are looking at biomass plants. We also picked up half of the hydro plant. It’s all about price to value for us, and a sector may be unpopular and then something happens.

Back in 2015, we sold off. I think it was 5 wind plants for what I estimated, my own look at it, around 14x what would be normalized as cash available for distribution. And within 6 months, with the yield cost coming apart, I thought we might be able to buy those at attractive prices. We might be able to buy wind at 15%.

And so we’re going to be very disciplined as evidenced by the fact that over 5 years, we paid down a $1 billion of debt, we cut 60% of our overhead, we didn’t do any external acquisitions for 5 years while we were buying in shares and buying prefs, but when we saw opportunity and when we thought were attractive returns, we jumped on it. It’s getting interesting now. I mean power and commodities, the difficulty with them is they’re commodity-priced and they’re capital-intensive and they’re volatile. But for a value investor, that creates an interesting opportunity set for us. So we come in every day and this — the market tells us what return we can expect if we buy in our own shares or buy prefs what the cash return on that will be.

And then, from time to time, we’ll see something in the external markets and — we didn’t go out and buy 5 plants in the last year because we had cash burning a hole in our pocket. We bought 5 plants because we thought the economics for the various plants we bought were compelling. So we’re continuing to do that, and we are seeing some interesting deal flow, some interesting disruption in the market. There is nothing imminent other than the next 2 biomass plants that are going to close very soon. But that’s the game plan we’ll say on in the next few years.