Equity – Page 16

Birchcliff Energy – hiding in plain sight

Sometimes an investment stares at you in the face and it is so obvious that it makes you wonder why others do not see it this way.

This is the case with Birchcliff Energy (TSX: BIR). Now that it has appreciated well beyond its Covid lows, I’ll write a little more about it in detail. I’ve been long shares of this (both common and preferred) for quite some time.

In 2022 it will produce about 79,000 boe/d equivalent (exit 2022 at approx. 82,000 boe/d), of which 80% of it is in the form of natural gas. All of this production is in the northwestern Alberta area, right up to the BC border.

Thus, the primary driver for this company is the state of the natural gas market. It has exposure to Dawn, Henry Hub and AECO.

Birchcliff is an unusual company in that they do not host quarterly conference calls. Instead, they issue information through large press releases and make it very easy to look at the assumptions. Although I have no problem sharpening my pencil and doing the leg works to do a proper pro-forma projection given various commodity price environments, Birchcliff expedites this process considerably.

There is some fine print to wade through, but the point is that BIR will generate $910 million in “excess free funds flow” (effectively cash flows after capex and projected dividend payments) with the average commodity prices as displayed in the release.

Notably, spot WTI and the spot Henry Hub price is well above their assumptions (US$114 and US$9.2 as I write this). Dawn typically tracks Henry Hub. Let’s ignore that spot is higher than modeled rates in the press release.

$910M of “excessive free funds” translates into $3.43/share.

At Wednesday’s closing price of $11.56, that is 3.4x or a yield of about 30%.

Normally companies are constrained with leverage and debt servicing. At the end of 2021, Birchcliff had $539 million in net debt (which includes BIR.PR.C) and another $50 million for the redemption of BIR.PR.A. The redemption of the preferred shares will result in a $6.8 million annualized savings on dividends (3 pennies a share, every bit counts!).

This will leave the company with a positive net cash amount of $270 million at the end of the year (the “Surplus”), unless they decide to blow some money on acquisitions and the like. Importantly, the math does not have to be adjusted for a leveraged return (indeed, it has to be corrected in the opposite direction).

The company will also be making enough money to eat through most of its tax shield ($1.9 billion at the end of 2021) and start paying income taxes in 2023, if the current price environment continues. Still, at US$88 oil, and US$5.50 Henry Hub for 2023 assumptions, the projection is for $535 million or about $2/share in free cash flow.

The stated policy on what to do with the cash surplus is to dividend it out beyond that which is to be used for strategic purposes. Management does not appear to be big on share repurchases other than to offset dilution that which has been issued from option plans (which is a real cash cost and will drag cash flows accordingly).

They will increase the dividend to $0.80/year in 2023, which is a $212 million outflow. This dividend can be maintained at price levels that are unlikely to be seen barring a great depression.

If they dividend the rest of their cash flows, when plugging in current commodity prices, they can give out far more than $0.80/year in dividends. It would be closer to around $2.80, or about $0.70 per quarter. Needless to say, if this is what they did, the market would find the yield (24%) tough to resist.

This is a very similar situation to Arch Resources (NYSE: ARCH), where the company will be giving out half of its free cash flow as a dividend and the other half to buy back shares. Considering its Q2 dividend will likely be around US$11/share, the obvious value of a share buyback is apparent. I wish Birchcliff would more actively consider it, at some cut-off threshold. For example, they can buy back shares until the price gets to a point where it is at 15% projected long-term free cash flows, a very conservative metric for a beneficial buyback. Right now that would imply that buying back below $15/share will clear that hurdle. At 12%, that number is about $19/share. There’s quite a way to go from current market prices.

None of this is a huge secret. It’s all in plain sight. It all relies on elevated commodity prices.

In a rising rate environment, cash flow talks – ARCH’s payout phase

“How much should I pay for the equity” is an easy question to ask, but computing all of the variables to come up with a range of prices is not so easy.

One of the components is the rate of interest. As interest rates rise, you want your cash flows today instead of tomorrow.

For instance, if your high tech company will give out a billion dollars in cash 10 years from today, the rate of interest has a significant effect on today’s capitalized value.

At 1% your billion dollars of cash 10 years out translates into $905 million.

However, at 3%, that same billion dollars turns into $744 million, or about an 18% difference from the above.

This is one reason why long term government debt has been decimated as of late. For instance, the TLT ETF (with an average term to maturity of 26 years) from the local peak at the beginning of December to present has rendered investors a 21% loss. The higher the long-term yield goes, the more damage that gets priced into the capital value. This is only mildly tempered by the 2.47% coupon and 3.01% yield to maturity – in other words, all things being equal, you would have to wait 7 years to recover the loss.

The converse is true for entities that will give out cash today instead of tomorrow.

Arch Resources reported their first quarter results today. There is a lot of details to digest, but the obvious headline is the declaration of a $8.11/share dividend, which is the result of their capital allocation policy to give out half of their free cash flow in dividends, while retaining the other half for other general purposes.

With the price of coal, both metallurgical and thermal, being sky-high as a result of a huge confluence of events (chronic under-investment, ESG, Russia/Ukraine, Australia/China, and overall demand for steel production), Arch and other coal producers that are still able to produce (this is the key – they need to have functional mines and not promises to build them) are making a fortune in free cash flow.

This quarter alone, operating cash flow minus capex was $271 million. This number was smaller than it otherwise would have been due to logistical constraints on the railway that serves the company.

In Q2, this number will be increasing because they will be able to further restore rail capacity, coupled with the average realized price to likely be higher.

My rough estimate for Q2’s dividend will be about $11.60/share, but this depends on certain variables being achieved. Barring a complete and total collapse of the commodity market, it will be around that figure.

However, to be “conservative”, let’s use the previous number – $8.11/share. Multiple this by four times and you get $32.44/share annualized. At Monday’s closing price of $131.32, that represents a yield of 24.7%.

Realize that the dividend represents half of the free cash flow available to the company before a reclamation (asset retirement obligation) reserve.

Obviously the stock market is going to find a 24.7% annualized yield to be very difficult to resist, no matter how vilified the sector of the company is. Pension funds, with both broad exposure in an equity market that is down about 12% year to date and a long bond market that is down 16%, have gotten murdered this year. They need an avenue for returns. The temptation is going to be too much for them to avoid.

Not surprisingly the stock market has decided it was too much to resist and Arch is up about 20% as I write this post. The yield at the implied $32.44/year dividend is now down to 20%.

The question is how much temptation there will continue to be going forward. Will yields compress to 18%? 15%? 10%? This really depends on how desperate the market is for a return, coupled with their impression on how durable the coal market is.

At the current pricing of coal, however, Arch will pay back its entire enterprise value to investors (either through dividends or share buybacks) in a couple years. Needless to say, this beats Microsoft equity which has a total return of 4%, based off of analyst estimates on their upcoming fiscal year ended June 2023.

Going back to my original topic of interest rates and cash flows – in a rising rate environment, present cash flows talk bigger than the promise of cash in the future. Arch (and other fossil fuel companies) is going to be a demonstration why.

A happy problem is to decide how to re-invest the cash flows. Internally for Arch, after building up a sufficient cash reserve, they will likely engage in some sort of equity buyback which will further juice up the stock price. So they are already making part of the decision for you with their cash flow, although there is a diminishing returns aspect to this decision (inevitably they will buy back too many shares at too high a price, like they did in 2019). It doesn’t mean that you have to re-invest your dividend into them – indeed, it would probably be a better time than to be stockpiling the cash for stormier days.

Atlantic Power – after the buyout

It’s always interesting to see what happens to companies after they get bought out. It makes you wonder whether the price you are receiving is well-deserved or not.

In the case of Atlantic Power, they were bought out for approximately US$270 million plus the assumption of debt (not a trivial amount, roughly US$560 million).

I was just doing some checking up and noticed that Innergex bought the Curtis Palmer hydroelectric project. They paid US$318 million, which implies an EBITDA multiple of about 7.5x.

This was the gem of Atlantic Power.

I also notice they inked a deal with New Jersey to decommission their only coal plant (a 40% economic interest) at Chambers effective May 2022, where they would have received a capitalized value of the remaining power purchase agreement. This PPA was set to expire in 2024. I’m not sure exactly how much the payout was, but I would estimate it would have been around US$80-90 million.

This leaves 19 projects remaining, consisting of biomass, natural gas and hydro generators.

Atlantic Power was a very interesting company to analyze, and run by top-grade management that I would follow in a heartbeat if they decided to manage another public company.

The MEG Energy Takeover Sweepstakes

Following up on my article “When will Cenovus or CNQ buy out MEG Energy?”

Things have evolved since Husky Energy tried to take out MEG Energy at $11/share back in October 2018:

At the time of the Husky offer, WTI oil was at US$75/barrel, MEG had 297 million shares outstanding (today they are at 307 million), and they had $3.2 billion net debt (today they are sitting at under $2.6 billion). Annual production in 2018 was 87.7 kboe/d, while in 2022 it will be around 95-96 kboe/d.

By all accounts MEG is in better shape today than it was 3 years ago. Will it be CVE or CNQ to first offer a stock swap for a 30-40% premium over the current price?

The big hidden asset not readily visible comes from the following two paragraphs on MEG’s financial statements:

With WTI at US$70/barrel, it will take a very, very long time to dig through these tax pools. Simply put, $5.1 billion in non-capital losses represents an additional $1.2 billion of taxes that can be bought off in an acquisition. With the way things are going, Cenovus will be able to eat through their tax shield mid-decade (they also inherited a tax shield from the Husky acquisition), and CNQ’s tax shield is virtually exhausted at this point (they did acquire some with their announced acquisition of Storm Resources on November 9th, but this will go quickly as Storm had about half a billion in operating loss and exploration credits).

Either way, this tax pool is a ‘hidden’ asset and will bridge the differential between the current market value and a takeover premium. Since valuations in the oil patch are still incredibly depressed (enterprise value to projected free cash flows are still in the upper single digits across the board), a stock swap makes the most sense.

Operationally this is the most likely course of action – without a major capital influx, MEG is constrained to around 100kboe/d of production and things will be pretty much static for them after this point. The only difference at this point is whether Western Canadian Select valuations rise (having Trans-Mountain knocked out for two weeks did not help matters any) and what the final negotiated value will be. The acquiring entity will be able to integrate MEG’s operations to theirs quite readily and shed a bunch of G&A after they pay out the golden parachutes.

Needless to say, I’ve had shares of this at earlier prices.

Q4 IPO – typical SaaS issue

This analysis is not too deep, but I note that the IPO of Q4 Inc. (TSX: QFOR) had a tepid reception by the market – the IPO price was CAD$12 and the stock traded mildly under this after opening.

Q4’s primary function is to provide an investor relations portal for companies. It’s a distinct market and from what I can tell, the software does add value by offloading various functions that corporate secretaries would have to handle themselves (such as virtual AGM processing).

From the prospectus, we have:

As at June 30, 2021, approximately 50% of the companies that comprise the Standard and Poor’s 500 Index (“S&P 500”), 63% of the companies that comprise the Dow Jones Industrial Average (“DOW30”) and 48% of the companies that comprise the Russell 1000 Index (“Russell 1000”) are Q4 customers, and these numbers and their associated revenues continue to grow quickly

This is a reasonable sample – half of the Russell 1000 use this software.

Indeed, on June 30, 2021, there were 2,505 customers of this software. For the first half of the year, the average revenue per account was US$18k.

The IPO valuation is CAD$510 million on a fully diluted basis. The balance sheet is relatively clean, and they’re looking to raise CAD$100 million for the next ramp-up. The reason for this is despite them obtaining a credible variety of customers, they still have not been profitable.

This is a pretty good example in my books as a software-as-a-service that is scale limited and does not deserve a typical SaaS valuation.

There are two general issues here. Scale and competition.

On scale, how many publicly traded companies are there in North America?

The TSX and TSXV combined have about 3,300 listed companies. The NYSE has 2,300, Nasdaq about 3,700. Then the next tier, CSE is about 720, and OTCBB/Pink Sheets (which also covers international tiers and is quite redundant). I’m ignoring international (a logical audience would also be Australian and UK companies). Let’s ignore OTCBB and international for now and just focus on the first few – we have 10,000 listed companies as the target market.

They’ve already penetrated a quarter of this market. On a logistic curve, they are probably well past the half-way point on the y-axis in growth.

However, let’s say they manage to obtain 100% of their potential client base (a huge and unrealistic and wildly optimistic assumption). That’s a US$180 million revenue stream, a good chunk of money. But that’s the best case scenario short of offering parallel software packages to boost per-customer revenues.

The SG&A and marketing expenses of a software provider are not to be underestimated, let alone R&D expenses. They are material. One would think they will scale down, but it never quite ends up working that way.

Finally, there is competition – the cost of a company to switch to another provider. In the IR space, one would surmise it would be easier to transition than some other mission-critical software applications where discontinuity means death to a business. For US$18k/package, it is a trivial expense for many corporations. This works in favour of Q4, but as they try to raise the per-customer spend, it will most definitely attract competition of some type.

For these simple reasons, Q4 is a company I am not too interested in at this valuation. They have a good niche, but just because your company is in the SaaS domain does not mean you deserve Constellation Software valuations (currently 8 times sales). Good on Q4, however, for raising CAD$100 million. I think they hit the market at precisely the right time.