Equity – Page 13

Teck’s coal spinoff (Elk Valley Resources)

Many smart people have already written about this, and many smart people have traded this. I won’t repeat their analysis.

The key point was this line in the conference call:

Concurrent with the separation, we announced agreements with two of our steelmaking coal joint venture partners and major customers to exchange their minority interest in the Elkview and Greenhills operations or interest in EVR. Notably, Nippon Steels $1 billion cash investment implies an $11.5 billion enterprise value for our steelmaking coal assets.

Given the amount of cash the EVR spinoff is producing at current met coal prices, the EV that they gave the equity stake to is low, which is probably why they got the minority shareholders to subscribe to EVR.

I surmised in my previous post:

What you also do to complete the financial wizardry is that you load the coal operation with debt, say around $10 billion. Give it to the parent company as a dividend, or perhaps give it to shareholders as a dividend in addition to the spun-off equity and the projected return on equity will skyrocket (until the met coal commodity price goes into the tank, just like what happened two seconds after Teck closed on the Fording Coal acquisition before the economic crisis).

It turned out my $10 billion dollar figure was nearly correct, but in the form of a 60% royalty on the first $7 billion of cash, coupled with $4 billion in 6.5% mandatorily redeemable preferred shares. Instead of doing a straight debt deal, this all just goes into Teck’s bank account.

The length of the payout period depends on met coal pricing being sufficiently high – something that I don’t think can be depended on for the majority of the rest of the decade.

Quite frankly, I think they screwed it up and hence the market reaction.

Since Teck is likely to make huge positive cash flows coming forward with their copper operations, they did not need to do a cash grab on the coal operation. If the spinoff was a simple one, I think much more market value would have been assigned to the joint entities.

Also, not being given enough attention is the give-away to the Class A shareholders. This is a very rare situation where you have a dual class structure and the voting shares get a huge payoff. (Looking at Rogers’ stock here!). I will be voting against this arrangement.

Refinery explosions

Oil refineries are incredibly complex pieces of machinery.

I’ve read the technical report at the now-Cenovus, formerly Husky Superior refinery that occurred in 2018 (this was before Cenovus took over Husky).

If you ever want to get a sense of appreciation at the technological marvel of oil refining, you should read this report.

This refinery is currently being rebuilt and should become operational again sometime this year.

Cenovus has had bad luck with their refineries. About a month after they signed a deal to acquire the remaining 50% of their Toledo refinery (the other 50% is owned by BP and the refinery is operated by BP), the refinery blew up on September 20, 2022 which resulted in the death of two workers. Thankfully for Cenovus, it was before the deal actually closed, and one would presume that the acquisition contact would require the refinery to be in a non-blown up state before the deal closes.

The preliminary report, released on October 31, 2022, indicates that a release of flammable materials from a specific drum was the origin of the fire.

These investigations take a lot of time and I do not think the repair job will be a speedy process either. It is too bad for Cenovus, as refinery spreads are sky-high at the moment and considering the lack of capacity expansion on downstream operations, will likely be this way for some time.

Canaccord – Going Private?

Canaccord (TSX: CF) put forward a management-led buyout proposal of the company at CAD$11.25/share. The total price is expected to be $1.127 billion, which also includes a consortium of people, including management, of 21.3% of the company.

The balance sheet of CF is not the cleanest:

The significant amount of minority interest stems from the roughly 2/3rds ownership CF has in its UK and Australia subsidiaries (which are consolidated on the statements) – and 55% of the Goodwill stems from these divisions.

I remember looking at CF last year (when it was still around $8/share) and decided against it given where I thought the economic climate was going (2021 was a banner year for public offerings, while subsequent to this things are going to be quite dry, relatively speaking). This doom-and-gloom did appear to be baked into the stock price, but as to what degree, I could not say. Dividend investors would have been happy considering they have found a new appreciation for giving out their cash flow to shareholders.

There are a lot of companies that have “covid characteristics”, whereby one has to look back to 2019 results of being more representative of a baseline performance. 2020 to 2022 are abberations for many companies.

In 2019 (backing out dividends), CF was trading at around $5-6/share. Even after adjusting for inflation, an $8/share price seems to have embedded in a reasonable amount of risk. It was not ridiculously under-valued.

However, the special committee to review this CAD$11.25 deal is not thrilled:

The Special Committee and the Management Group engaged in prior discussions concerning a proposal from the Management Group regarding a potential Board-supported transaction to be executed by way of a plan of arrangement. The Special Committee advised the Management Group that it was not prepared to support an offer of $11.25 per common share based on the preliminary financial analyses conducted by RBC. To date, engagement between the Special Committee and the Management Group has not resulted in an agreement on a value per common share that the Special Committee could support and recommend to shareholders.

…

Importantly, the Special Committee has not agreed to recommend that shareholders accept the Proposed Offer.

One danger of investing in smaller-capped companies is that on occasion you will have management try to low-ball an acquisition of the rest of the company. Jimmy Pattison’s firm tried to take out the minority stake in Canfor (TSX: CFP) which nearly succeeded. I still remember being resentful when Cervus Equipment got taken out by management. Almost anything with the name “Brookfield” in it is susceptible to this phenomena. There are plenty of other stories out there. The danger of having these management-lead buyouts increases in proportion to the smallness of the company and the proportion of ownership of management.

As a final point, my last ownership in CF has been through its preferred shares many years ago – which I have long since sold. In early 2016 they were yielding double-digits and were too tempting to not purchase (indeed, they were a steal at the time). However, preferred shareholders get no preferred treatment as a result of this management buyout – the CF.PR.A shares traded up today, but basically at the asking price of a very high bid-ask spread. CF.PR.C traded down! The shares reset in September and June of 2026, respectively, and with current yields of 7.09% and 8.31%. If you believe that 5-year interest rates will remain at around 3.25% around the middle of 2026, the reset rate goes up considerably.

Reviewing major index sector performances in 2022

Not surprisingly, energy had a banner year in both Canadian and US indexes.

TSX:

The big two losers were health care (think: marijuana companies and biotechs dropping from grace), and information technology (think: Shopify and practically every technology IPO). Real estate was the third worst with a -24.3% performance (office REITs, in particular, were slammed more than the other sectors).

S&P 500:

The forward P/E on the S&P 500 of 16.8 still appears to be quite a rich valuation (5.95%) over the risk-free rate of interest (the one-year US treasury bond yields 4.7% at present).

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.