Equity – Page 50

Teekay Offshore – sad end to the story

There is always a risk in investing in companies that are incorporated in offshore domains. Teekay Offshore is a partnership incorporated in the Marshall Islands jurisdiction. Normally this doesn’t make much difference, but sometimes the geography of incorporation makes a huge difference – laws that apply in Canada and the USA may not necessarily apply to other jurisdictions.

I’ve written about Teekay Offshore (NYSE: TOO) before (a bunch of posts here), but today, Brookfield initiated a “take-under” offer, offering to buy back the 49% of the company they do not own. They already took control from Teekay corporation (who themselves were over-leveraged and needed the cash). TOO was trading at $1.16 last Friday, and the offer was at $1.05/unit.

The issue is that one has to read the legalese on the partnership units, and the cross-section with applicable Marshall Islands law to figure out what they can and can’t do to make this transaction occur.

Of particular note are the preferred shares, which on paper have very good yields. For instance, TOO.PR.E has an 8.875% coupon and is now trading at $16/share (par value is $25) which gives it nearly a 14% yield.

Looks like a good return on investment, eh? Brookfield will certainly continue to pay those preferred dividends since they will want to certainly make distributions with the common units when offshore drilling becomes profitable again, right?

Not so quick.

We are dealing with Marshall Islands law, where wild west type rules prevail.

What makes preferred investors think that the wholly-owned partnership won’t have their assets stripped away and the preferred unitholders stranded? In Canadian jurisdictions, this would be a constructive dissolution, but who wants to take their chances in the Marshall Islands, a territory with 53,000 residents?

No positions but watching the whole story unfold.

Examining the entrails of Kinder Morgan Canada

Kinder Morgan Canada (TSX: KML) was set up to be the publicly traded entity for Canadian assets of Kinder Morgan (NYSE: KMI). KML is 70% owned by KMI. The 30% remaining trades on the TSX and they are functionally economic participation units (i.e. Kinder Morgan has complete control).

KML’s flagship asset was the Trans-Mountain Pipeline, which was sold to the Federal government in 2018. The bulk of the proceeds was distributed to KML shareholders. Everybody knows about this story and it has been dissected to death (including myself), so I will not give it further press here.

What was lesser known is that KML had other operating assets in Canada that generated quite a large amount of cash. The operation is quite easy to analyze (which sadly means that the market has mostly picked up on a proper valuation). In Edmonton, they have a rail terminal and storage tanks (which facilitates operations of oil-by-rail). They have a small condensate pipeline going to the US border from Alberta (creating an odd situation where KML owns the Canadian side, while KMI owns the US side of the pipeline). Finally, they have a mineral concentrate terminal in North Vancouver and are also building a fuel storage facility.

These assets in 2019 are anticipated by management to generate $213 million in “adjusted” EBITDA, and roughly $109 million in distributable cash flow.

This will go down due to an existing contract in Edmonton that is currently being priced on favourable terms to KML. Starting April 2020, this will decrease by approximately $50 million EBITDA. Management claims this will be somewhat offset by future pricing increases. A reasonable guess would be a $170 million EBITDA run-rate absent of the revenues expected from the diesel storage business.

Other than that, the assets are sound and are likely to be in use for the foreseeable future.

So it was logical after the Trans Mountain Pipeline sale that the company investigate options as it was fairly obvious to either sell everything, or merge back into the KMI entity again.

They concluded in May 2019 that they will remain a stand-alone entity. This took the stock down from roughly $15/share to $12/share where it trades presently. KML has 116.3 million shares outstanding, and this gives them a market valuation of CAD$1.4 billion or roughly 8x adjusted EBITDA.

The company has a tiny amount of bank debt (nearly offset by the amount of cash on hand), but they do have CAD$550 million in low-yield preferred shares outstanding (TSX: KML.PR.A and KML.PR.C). These preferred shares were issued in anticipation of the construction of the Trans-Mountain Pipeline!

It obvious from my standpoint that KMI would want to get rid of its Canadian operations entirely, but they are not in a rush to do so – probably waiting for the federal election to see if a more oil-favourable government comes into office. The question remains how much they can obtain for the assets in this more favourable environment. In the meantime, they continue to generate cash and distribute CAD$106 million/year to their shareholders (common and preferred) in dividends.

KML at this point would appear to be a relatively low risk, low return type investment.

Rosetta Stone valuation question

I’ve been busy reading quarterly reports.

One flashback from the past (something I flipped around within a single calendar year, many years ago) was a software company called Rosetta Stone (NYSE: RST). They have over the past decade shifted and adapted to the subscription-based system, and also bet a good chunk of their cash on Lexia Learning, an English language training software.

Today I examined them and read the financial statements of their last quarterly update without looking at their stock price, and see that the underlying operation still is not generating cash and they are struggling to keep their high margin revenues (namely – there is quite a bit of competition in the language learning space and also the barriers to compete in this market are not that high).

There are two salient accounting points to this firm that is relevant in the analysis – the product is sold in advance, which means that the company can collect the cash today but recognizes the revenues over the course of the term of the software license.

As a trivial example, if I write software and then sell it to you to use for two years for a hundred dollars, I would today show 100 dollars of cash on my balance sheet and 100 dollars of deferred revenue (50 current, 50 long-term). In the subsequent two years, I would book 50 dollars of revenue and reduce the deferred revenue amount accordingly – I do not receive any more cash.

Likewise, RST has $146 million in deferred revenues on their books which will be ‘guaranteed’ revenues over the next couple years. This is cash that is already collected, which means the valuation depends on how much future cash they can collect – the revenue figure is a lagging indicator.

In Q1-2018 to Q1-2019, deferred revenue climbed up from $140 to $146 million, which is a reasonable sign for the company. But hardly a rocket launch.

The other item that is worth pointing out is that RST capitalizes some of their “internal use software” expense – instead of expensing it out to R&D, they pack it on the balance sheet. This is expected to be around $20 million of expenses for the year, which is not a trivial amount – the way the company “masks” this is to focus on the operating cash flow figure, which does not include this inconvenient “internal use software” expense.

Certainly the projections from Q1-2018 to Q1-2019 and the year-end 2019 projection show a slow positive trajectory – EBITDA is up and the cash burn is slowing down to nearly nothing – and presumably more deferred revenues will show on the balance sheet. The entity is debt-free, has a bit of cash on the balance sheet (roughly $28 million now, projected $38 at the end of the year).

How much would this be worth? Let’s say 1.5 times sales – which is already generous given the competitive nature of their particular software market.

Then I looked at the stock price. Oops.

What the heck happened that warrants such a valuation?

I shook my head and moved on.

Whether it is marijuana or language learning software, there is a lot of capital being thrown into companies in industries that have relatively few competitive barriers. Is this just because the low interest rate environment has left nothing to throw capital into?

Asset stripping in inter-corporate relationships

Whenever researching companies that have control over other corporations, it is quite important to pay attention to signs of agreements between both entities that are to the benefit of one or another. Today’s example is fairly textbook.

This news release from Dream Asset Management (TSX: DRM) hit my mail feed this morning:

TORONTO, April 23, 2019 (GLOBE NEWSWIRE) — Dream Unlimited Corp. (TSX: DRM) (TSX:DRM.PR.A) (“Dream”) announced today that Dream Asset Management Corporation (“DAM”) has agreed with Dream Hard Asset Alternatives Trust (the “Trust”) and Dream Alternatives Master LP (“Master LP”) that until December 31, 2020 the management fees payable to DAM pursuant to the management agreement of the Trust will be satisfied in units of the Trust (“Units”) valued at the recently reported net asset value per Unit of $8.74 for purposes of determining the number of Units to be issued, subject to the receipt of required regulatory approvals and unitholder approval at the upcoming meeting of unitholders of the Trust to be held on June 17, 2019. DAM has agreed to accept Units in satisfaction of the management fees in order to increase its ownership stake in the Trust and to preserve the business’s cash to support the cash distributions by the Trust while the Trust seeks to increase the market value of the Units by offering to purchase Units. As of the close of business on April 22, 2019, DAM and its joint actors own 13,386,072 Units representing approximately 18.6% of the issued and outstanding Units.

Notably, Dream Unlimited and Dream Hard Asset Alternatives (TSX: DRA.UN) are run by the same management team. When skimming through the financials of DRA, the bulk of their portfolio consists of various real estate ventures ($118 million), equity-accounted for investments in the real estate sector ($133 million), commercial/development lending ($144 million), income properties ($224 million, notably shared with two other related Dream entities), a solar and wind power asset ($130 million), and finally some cash ($47 million). On the liability side, they have $195 million in loans outstanding, most of it ($123 million) mortgage loans.

Book value is $592 million. Trust units outstanding are 72.6 million, so the NAV at the end of December 2018 is $8.15/share. (I know the above release cited a $8.74 NAV – this is reconciled on page 2 of the MD&A but it is not terribly relevant to this post).

The trust reported $8.3 million in operating income, plus another $3.3 million in interest income, for a total of $11.6 million before taxes (note as a non-REIT trust they would pay a tax on income distributions, but since those distributions are mostly return of capital at this point the taxation is entirely within the consolidated portions of their asset portfolio – a great future CPA taxation topic I would be more than happy to write about!). At their stated distribution rate of 40 cents per unit, they would require $29 million a year to pay this.

The summary is that they are holding onto a lot of private assets and while they can likely be liquidated in the medium term (especially the real estate holdings), in the short term they are distributing more cash than they are able to generate without selling such assets. They are not in a desperate situation and have the luxury of time to optimize matters.

Likely due to the controlled ownership situation, coupled with the illiquidity of their underlying portfolio, they are trading at a discount. Before today’s announcement they were trading at $7.20/unit, so they were about 11% under the GAAP book value, and around 18% using management’s revised NAV estimate.

At the same day, DRA announced:

As part of its strategic plan announced on February 20, 2019 to enhance unitholder value, management and the Board confirm that the units of the Trust are an attractive investment opportunity and are committed to deploy up to $100 million towards its unit buyback program (representing just under 20% of current market capitalization). Providing further clarity on the execution and timing of the unit buyback program, the Trust now intends to make three offers to unitholders in accordance with applicable securities laws, the first of which is expected to be made on or about July 15, 2019 for approximately 4 million units at an offer price of $8.00 per unit and two subsequent offers will be made in 2020 for $30 to $35 million of units at prices of at least $8.25 and $8.50, respectively, for a total buyback of $100 million of units prior to the end of 2020. These buybacks compare to the closing price of the units on the TSX of $7.17, as of April 18, 2019. The exact number of units that the Trust offers to purchase and the timing of such purchases will be determined by the Trust at the time of launching such offers subject to the receipt of the expected proceeds from capital recycling and the trustees’ obligation to act in the best interests of unitholders. The Trust has been advised that Dream Asset Management Corporation, the Trust’s asset manager and an 18.6% unitholder does not intend to tender any units to such offers.

In this release is a non-binding promise to initiate a partial tender at prices above current market value.

DRM’s entitlement in 2018 was $13.6 million. By opting to receive units at $8.74 compared to today’s market value (currently $7.70/unit), assuming prices, the management fee, and NAV remains constant, DRM has opted to graciously donate about $1.6 million to the unitholders of DRA. While this is not a gigantic amount of capital in relation to the sizes of the entity, it does give a hint as to where management is prioritizing the reception of its capital allocation.

This is another example of how a related party transaction is a red-flag show stopper with regards to an equity investment prospect. Dream Unlimited is relatively cheap in theory, but to invest in it you have to completely in for the ride with regards to the whims of management (the control character is Michael Cooper). This has not prevented me in the past, however, from investing in what used to be the best and nearly risk-free 7% eligible dividend in the form of (TSX: DRM.PR.A), but sadly the market has gotten smart about it and management should be calling it when they wish to realize the quickest 9.2% pre-tax use of capital.

Hat tip to Tyler on Twitter for this one. I had intended to write about this when it hit my inbox, but I saw that he wrote about it first.

Investment companies, agency, and Difference Capital / MOGO Merger

Most corporations that specialize in maintaining equity portfolios typically trade less than their component parts, simply due to the control issue. Shareholders generally have little control or say on when the company can reach their purported net asset values. Management usually has an incentive to not sell off their companies so they can collect salaries and/or benefits and/or power that comes with control.

As a result, it is a very relevant consideration before investing in such vehicles that the incentives of management are in line with your incentives (presumably as a minority shareholder). Some managements do care about their overall shareholder base (Berkshire presently I would judge to be part of this category, although they are much more of an operating company than most think), while most generally regard minority holders as an annoyance to be mitigated. It is rare where minority shareholder groups will organize to a point where a credible proxy fight can be contested, but such contests are expensive and usually the bias is toward incumbent management. A good example of a failed proxy fight was the contest for Aberdeen International (TSX: AAB) in early 2015 (a very brief legal summary is here).

Aberdeen was a notable case where it was trading far below its net asset value and the share structure did not have super-voting shares. The dissident group failed to accumulate enough support and shares to overthrow the board. Aberdeen at that time was trading at 15 cents a share and the book value was roughly 40 cents. Today they are down to a market value of 5 cents per share.

There are plenty of other cases to examine with these types of companies. Dundee Corporation (TSX: DC.A) is a conglomerate with consolidated and non-consolidated investments and has been trading below book value for a considerable period of time. In their last annual report, I highlight the salient page which shows that their operating entities are not doing too well:

Dundee is a dual class structure, with the founding family controlling the entity via super-voting shares. In order to resolve a situation with a redeemable preferred share issuance (which I have written about in the past) they also notably diluted their shareholders – issuing about 42 million shares to go from 61 million to approximately 103 million shares outstanding effectively – at a conversion price of $2/share. After this conversion, the parent company will hold no material debts and management will have a lot more time to be able to figure out how to transform the operating businesses into profitable entities. Presumably until this happens, Dundee will be trading under book value.

The last entity I will point out is Difference Capital (TSX: DCF). They were notable with having “Dragon’s Den” titan Michael Wekerle being their original CEO and lead investor and they invested in a whole smattering of private placements and various business ventures.

This didn’t quite work out for them for the majority of their history. In 2018, they able to focus on monetization of their portfolio in order to mostly pay off a convertible debenture. The remaining part was financed with a 12% secured loan which was partly paid for by insider money. In their year-end of 2018, they held a net asset value of $7.20/share on their financial statements and this was contrasted with a $3 share price (indeed, shortly after the new year, they executed on an asset disposal that spiked their share price up to $4) – hardly a risk for insiders to take when they were first in line on security and taking a nearly guaranteed 12% return – the shareholders are the ones effectively paying for this.

The final monetization of their company was announced on April 15th – however, it was to another company called MOGO Finance Technology (TSX: MOGO) which is chaired by Wekerle and 22.4% of MOGO is already owned by DCF.

DCF is nearly majority controlled by Wekerle (47% via a holding company that he wholly owns). Thus, a DCF shareholder has to ask whether their interests are aligned with his.

The agency issue is whether DCF minority shareholders benefited from the MOGO transaction. The obvious answer, when looking at the financial situation, is no. It reminds me of what Elon Musk did when he merged SolarCity and Telsa together – SolarCity was about to financially fail, but Musk wanted to fold it into Tesla to avoid the negative attention that such a failure would cause, with Telsa shareholders picking up the bill to deal with the entrails of that transaction.

Instead, this transaction was likely to give MOGO some financial breathing space as they were effectively buying the residential value of DCF’s private equity portfolio and more importantly, cash.

MOGO is bleeding significantly serious amounts of money:

The cash shortfall is significant. Operationally, MOGO is not in terrible shape – they reported an operating income loss of $4 million in 2018. The real deficit in MOGO is the cost of their capital. They have $75 million outstanding on a credit facility, $42 million in non-public debentures (ranging from 10% to 18% interest), and $15 million in 10% convertible debentures (TSX: MOGO.DB). When reading the fine print on the credit facility, the following is the key paragraph (note the underlined):

On September 25, 2017, the Company finalized a new senior secured credit facility of up to $40 million (“Credit Facility – Other” and, together with the Credit Facility – Liquid), which was used to repay and replace Mogo’s previous $30 million entered into on February 24, 2014 (“Credit Facility – ST”). This transaction resulted in the extinguishment of the Credit Facility – ST. On December 18, 2018, the Company increased the borrowing limit on the Credit Facility – Other from $40 million to $50 million. The facility bears interest at a variable rate of LIBOR plus 12.50% (with a LIBOR floor of 2.00%) up to the first $40 million of borrowing, a decrease from the variable rate of LIBOR plus 13.00% (with a LIBOR floor of 2.00%) under the Credit Facility – ST. The incremental portion of facility borrowings above $40 million bears interest at a variable rate of LIBOR plus 11.00% (with a LIBOR floor of 2.00%). Consistent with the previous facility, there is a 0.33% fee on the available but undrawn portion of the $50 million facility. The Credit Facility – Other matures on July 2, 2020, compared to the maturity date of July 2, 2018 under the previous facility. The amount drawn on the new facility as at December 31, 2018 was $44.3 million (December 31, 2017 – $28.8 million) with unamortized deferred financing costs of $0.2 million (December 31, 2017 – $0.2 million) netted against the amount owing.

You’re not going to get rich borrowing money at LIBOR plus 12.5%! Indeed, as a percentage of revenues, interest expenses are 28% – they will never show a profit at that level of interest bite.

Hence the presumed justification for the merger with DCF – Michael Wekerle has invested significant resources into MOGO. MOGO is borrowing money at exorbitant rates and DCF will add some assets to MOGO’s balance sheet, which can eventually be liquidated for desperately needed cash.

Does this in any way benefit non-controlling shareholders of DCF? Not at all. This explains why DCF traded down after the transaction and MOGO traded up.

Currently, MOGO has a market capitalization of $80 million (this is after it received a good 15% rise after the DCF announcement). Will they be able to find cheaper financing? Most of their debt matures in 2020.

But either way – this is yet another example of making sure to check the motivations of controlling shareholders before you jump on board – you might find they will make decisions that will have little to do with adding value to the stock and instead use the entity for other strategic purposes.