Category: Equity

The CN Rail Cash Machine

CN Rail reported their Q3-2010 result; it indicates they have recovered well from the economic crisis.

Although CN’s equity price is relatively high in terms of the cash they are able to deliver to shareholders (most notably they are spending about $300M/year above the rate they are amortizing), there are worse places to put “stable” cash – the equity trades more like a bond. This is another example of when people talk about “asset classes” that you cannot just put a blanket on “Canadian equity” and consider every share of every corporation to have the same risk/reward characteristic.

In terms of the actual numbers, the business was able to generate about $2.78 per share of free cash flow over the past 9 months. Annualized, this is about $3.71 in free cash, on top of a $67 equity price justifies the “relatively high” remark with respect to valuation.

Despite the high price (which is very near all-time highs), it is likely that CN’s total return over the next 10 years will outperform the equivalent Canadian 10-year bond, which yields 2.74%. The railways (CN and CP Rail) will likely be successful cash generating entities as long as Canada and the USA remain politically stable, and also are a benefactor of high energy prices – freight rail competes very well against trucking when it comes to goods movement.

Unlike most utilities, all railways have one very valuable piece of paper which is impossible to obtain – the right of way in major urban centres. If you were to give somebody $100 billion from scratch and got them to construct a railway, there is no way you could transform that capital into an income-bearing instrument that would yield better than the government bond. One of those reasons is property acquisition and track right of way – something Warren Buffet was thinking about when he bought out Burlington Northern. The only way you’d be able to get any sort of reasonable return is just to buy the railway outright, but even then the government could step in, citing “national interests”.

A relatively quick trade

I am now slowly unwinding my trade in Davis + Henderson Income Fund (TSX: DHF.UN). If the units go higher by approximately 5%, I will be exiting the entire position compared to the partial sale of my position as of this writing.

While I do not have concerns about the stability of their distributions (especially as they will be reduced 35% or to $1.20/share after they convert to a corporation), I do have concerns about the ability of management to grow the company’s free cash flow from existing levels. They have been pursuing a strategy of growing revenues and income through acquisition, which is generally a risky method compared to growing organically. So far, it has worked for them. The question is whether it will continue to doing so – which is never a given.

This company is not unique at all in the income trust sector to being bidded up. All sorts of income-bearing securities are becoming very expensive.

Although DHF will pay 5.85% a year (at 20.50 per share) in eligible dividends in 2011 when they convert to a corporation, I do not think this cash stream is worth paying the current price for given other investment opportunities – none of which give yields.

What I find interesting is it is likely retail investors that will be focusing on the 5.85% yield instead of looking at the underlying business and asking what they are purchasing. I am not complaining – I am taking this opportunity to take some more of my portfolio off the table and holding yet even more cash for future deployment.

The net gain is approximately 25% above cost basis; not factoring in the few distributions that occurred between the purchase price and the disposition, not bad considering that the upside is more limited than the downside.

What to do when your shares rise

Long-time readers should be able to see this chart and know what security I am talking about, but I have purposefully omitted the name and ticker and price scale just to illustrate. The security in question is quite “yieldly” so it is susceptible to the huge increase in demand we are seeing for income-bearing securities.

Here is a 3-year chart:

Here is a 6-month chart:

Finally, here is a 1-day chart (approximately up 7% for the day):

There is seemingly no fundamental news involved, which makes me suspect this was purely technical trading occurring. The volume was not excessively high compared to average volume.

Question – do you sell the spike? Do you get greedy and see what happens the next week?

Fundamentally speaking, the security involved is priced slightly above my fair value range. It already consists of a relatively large fraction of my portfolio, so choosing to lighten up is the obvious answer. I can’t help but think, however, that by getting “greedy” that I can get an extra 10-20% out of this that I would otherwise have not received by using a more fundamental trading method. By scaling out of your positions slowly, exiting piece by piece as the price goes higher, you can participate in some upside, but continue to reduce your risk as the price continues to rise.

2010 capital gains are starting to be a big concern for me tax-wise, but fortunately there are some units of this security in my RRSP that I can start off with on a tax-free basis.

Encana – cutting back capital expenditures

Encana (TSX: ECA) is a very large natural gas producer. In their recent quarter, they announced they will be cutting back capital expenditures and reduced expectations due to lower natural gas prices. Hydraulic fracturing is saturating the marketplace, leading to reduced prices. This is well known by the marketplace, and as such, Encana’s stock was only down by 3% today on the news.

The two charts will explain the story, one is of Encana’s stock price, and the other is the spot rate for natural gas, and one will see the correlation:

One can easily see the connection. Encana is a type of company that will not have its equity double in value in a short period of time, but it does represent a fairly good store of value in terms of the vast reserves it can control (especially reserves in politically stable climates such as Canada). It also represents a fairly good proxy for the price of natural gas.

One of the worst ways to play an increase in natural gas, however, is through the Natural Gas ETF (NYSE: UNG) which I have written about before. I will let the chart do the speaking here:

Whistler-Blackcomb going public

Whistler-Blackcomb, owned by Intrawest, filed to go public on the TSX. The salient numerical details, such as the total amount of the offering (rumoured to be $300 million) and pricing of the company’s stock remains to be seen.

Intrawest used to be public, but was taken private in 2006 and is now owned by Fortress Investment Group.

Although I have not completely read the document (and won’t until the issue has a price), of note is that the public entity will hold 75% of the Whistler-Blackcomb partnership (page 128); the corporation will have an additional $261 million in debt taken out; and the entity will generally have historically made about $50-60 million in income from 2007, 2008 and 2009. Note that because the corporation has a 75% interest in the partnership, that some accounting rules will kick in and subtract the 25% minority interest, so the net income figure will be lower.

This offering is being touted in the media as an income play, which is likely why the company is going public right now – to get out while the premium paid for income-bearing securities is red hot.

I have a paper napkin valuation which will likely be lower than what the actual selling price will be. I also think there are a whole host of risks that this venture are correlated to – including the resort real estate business, and BC tourism in general. I believe the company is using the elevated 2010 numbers from the Winter Olympics to tout their equity, which will be a mistake for investors to depend on. The 9 months ended 2010 show a $52 million income year, compared to $58 million the year before. Note the last quarter of the year is a money-loser.