Equity – Page 57

Teekay Q1-2018: Still a leveraged mess

I won’t go into extensive detail over reading Teekay Corporation’s quarterly report (and daughter entities), but my summary is that the corporation and their daughters are still a leveraged mess.

The blood-letting at the Offshore (NYSE: TOO) subsidiary (no longer consolidated since Brookfield now formally is calling the shots) appears to be normalized, but management is on the verge of losing the Tankers subsidiary (NYSE: TNK). They just came to the realization that offering a dividend while trying to de-leverage the company is not so wise. The Tankers entity is bleeding cash with no recovery in sight. Shipping has been a miserable industry for half a decade now as overcapacity persists.

Teekay was trying to keep up the appearance of a minimal dividend since it was directly feeding into the cash flows of the parent (Teekay) entity, but the game is almost up – the only entity worth anything for Teekay is the LNG group (NYSE: TGP) which isn’t doing that badly – they are actually making money, but right now it is very slow in relation to the overall debt required to finance everything.

I wouldn’t be surprised if there was another debt crisis coming up for Teekay – why their January 2020 unsecured debt trades at around a 6.1% YTM is beyond me. I dumped out of their debt early this year (at 5 cents over par).

Teekay has value on its balance sheet as it does still own considerable equity interests in TOO, TGP and TNK, but operationally the only entity that will be feeding cash into it will be TGP, and immediate cash flows are going to be undoubtedly de-leveraging, especially as interest rates rise.

Another bullet shot in the heart of Canadian oil production – Kinder Morgan

Paying attention to Kinder Morgan’s (Parent: NYSE: KMI, daughter: TSX: KML) announcement that they’re stopping non-essential expenditures in relation to the Trans-Mountain pipeline (that goes roughly between Edmonton, Alberta to Burnaby, BC) expansion.

There’s a lot of political rumblings and a ton of public ignorance displayed, which usually is a good recipe for market reactions that lead to opportunity.

KMI owns 70% of KML. KML owns the assets relating to the Trans-Mountain pipeline. The assets currently pump about 300,000 barrels per day and very roughly, in 2017 produced $250 million in operating cash flow (allow me to ignore the very relevant capital expenditures in this post – they spent $618 million, the majority of which was on the Trans-Mountain expansion project – $445 million on pipelines and $173 million on terminals).

There are about 350 million shares outstanding in KML, so the most elementary analysis possible is that if KML decided to pack up shop and just keep the existing (and aging) infrastructure in place, they will generate about 65 cents of cash for shareholders – this is subtracting the amount given to preferred shareholders. Other than the preferred shares and pension liabilities, there are no other material amounts of debt or obligations on the balance sheet that is noteworthy for this analysis.

Obviously this amount would not be enough to sustain the existing stock price – currently CAD$18.44/share – the earnings yield would be around 3.5%, although this would be a very stable yield given that this is the only oil pipeline connecting the west coast of Canada to oil-rich Alberta. The expansion project is expected to bring in $900 million in EBITDA in the first 12 months of operations, plus spot volumes up to another $200 million. Since the project is expected to cost around $7 billion, a financing at 5% would still result in substantial after-tax cash flows.

A tripling of the pipeline capacity will, suffice to say, be extremely profitable for Kinder Morgan. Strategically speaking, the asset is the only oil-carrying pipeline from Alberta to Vancouver (good pipeline map resource here). Vancouver’s sole oil refinery is the Chevron facility, west of SFU. The nearest competitor is refined fuel product from Cherry Point, WA, which makes Vancouver extremely vulnerable to any slowdown/shutdowns in both oil capacity and refining capacity.

Politically speaking, there are a set of huge competing interests at play:
– The federal Liberal government attempted to play a “middle ground” by supporting the pipeline, but they are dragging their feet on doing anything to getting it approved, and one can infer from Bill C-69 that the government intends to create so much regulatory uncertainty in the approval of any major national projects that they simply are not going to be built. Bill C-69 makes it impossible to know what conditions (and thus costs) it will take to approve projects requiring federal environmental assessment (soon to named “impact assessment”) approval. The Liberal government probably realizes at this point there is zero vote-getting ability for them to support the Trans-Mountain expansion, so they will only give lip service toward its approval – and lip service so they can avoid being seen as flip-flopping.
– The Alberta Government, led by NDP Premier Rachel Notley, has a huge economic interest in the pipeline. While inherently most of the people in her party are against pipelines in general, a lot of Alberta’s economy depends on the fortunes of the oil industry and if the NDP are going to have any chance of being re-elected, they need to galvanize the feelings of voters that they (and not UCP leader Jason Kenney) are best to fight Ottawa and British Columbia.
– The BC Government, led by NDP Premier John Horgan, is fighting on a side which inherently favours them. They attempted to enact some provincial regulatory reforms to make it more difficult for the pipeline to proceed, and they can do this because they have the support of their party and also the 3 Green Party MLAs that are strongly against the pipeline (the government is a narrow minority government that requires the support of the 3 Green Party MLAs in order to maintain supply). They have everything to gain by combating Alberta and Ottawa and only a modest amount to lose as not too many NDP supports would support the economic-creation aspects of pipeline construction. In addition, the majority of gains to be made if the pipeline expansion is completed is Albertan oil companies, so this does not favour BC. The BC Government will likely do anything it can to stall the project and will only yield way if required to do so by court judgement – that will be their “out” to explain to the public that they tried.

It appears pretty obvious to me that the current Nash Equilibrium is the pipeline expansion will be indefinitely stalled. It will probably take a Supreme Court ruling to unlock the situation and one is not forthcoming due to the Federal government intentionally deciding to not participating in a planned BC-Alberta reference case – lest the reference (info) definitively decide the matter (which works against the three governments’ existing interests).

Another bullet fired into the heart of Aimia

The Aimia (TSX: AIM) zombie keeps on moving but when the corpse will finally lie down and die is another good question.

Today, it was reported that Esso’s partnership with Aeroplan will terminate at the end of May 2018. Instead, the loyalty program partner that will be picked up is the Loblaws’ (TSX: L) optimum program.

One of the issues when valuating the fundamentals of businesses that have setbacks (and judging whether they can make comebacks or turnarounds) is to determine whether the blow they suffer was critical. In the case of Aeroplan, it was Air Canada and the threat of substitutions. Although Aeroplan/Aimia used to be a subsidiary of Air Canada, it was spun out for financial reasons and it is pretty clear that Air Canada knows that there are other alternatives available (such as doing it in-house). The psychology damage done when you lose your major business partner, coupled with the effect that your business depends on large volumes of customers trying to collect aeroplan miles for the purpose of flying, suggests that the subsequent network effect (or opposite thereof) will significantly devalue Aimia’s offerings. Another way of thinking about this is a negative economy of scale, but from a marketing perspective. Or what would happen if some other competitor to Ebay spontaneously stole 90% of auctions from EBay (we’re talking in the late 90’s/early 2000’s context, not the present day EBay).

The other buzz is that Air Canada is just negotiating for a better deal (since Aeroplan is set to expire in June 2020) but this is wishful thinking. Likewise, Aeroplan can’t just sign up any other airlines spontaneously since it takes quite a bit of time to link up with the electronic information systems of competitor airlines (there is potential they will sign up with a new discount airline brewing in Canada, but the volume of this business will be much, much less and Aeroplan will not be able to receive commercially acceptable terms like they had with Air Canada).

This all points to a huge value trap situation still with Aimia, as I’ve been trying to illustrate since the Air Canada/Aeroplan collapse.

Personally I have cashed out anything of value from my Aeroplan account. As an interm measure they will be (and I notice they have already) devalued their existing rewards to offset their deferred liability balance.

Genworth MI – Q4-2017: Capping off a very profitable year

Genworth MI (TSX: MIC) reported their 4th quarter results today. For those new here, I’ve been freely covering this company for ages. It is the stock in my portfolio I have held for the longest period of time (since 2012). It has sometimes been the highest concentration position in my portfolio, but it currently is not. Here are some notes:

1. The big headline-grabber should be the loss ratio. It is still exceptionally low (9%) – reflecting a relatively stable real estate climate. The average loss ratio for the fiscal year was 10%. This is at a record-low level.

Let me put some context to this. The loss ratio means that for every dollar of insurance the company recognizes revenues on (note this not the insurance they write in a given year although the two numbers are correlated), that the corporation books 10 cents on the dollar of expenses because they have to account for losses on insurance claims.

This means for every dollar the company recognizes, they retain 90 cents, before other expenses.

The expense ratio is 20%, which means it costs 20 cents on the dollar to administer the insurance (e.g. commissions paid to acquire the policies, the administration of claims, management, etc.).

So what is left over is 70 cents on the dollar.

From this pool of money, the two big expenses left to be paid is interest on debt and income taxes. $24 million was booked for interest expenses (about 3.5 cents) and $188 million (28 cents) was booked for the year in income taxes.

However, (this is where readers of Warren Buffet’s annual reports will know this on the back of their heads), Genworth MI has the benefit of float, which is the 6 billion in assets they have to invest before they pay out claims. As a function of premiums recognized (revenues), Genworth MI made 39 cents on the dollar with their investment portfolio.

So when you do the math, the company recognized $676 million in revenues, and recorded a bottom-line amount of $528 million, or 78 cents on the dollar of net profitability.

I want anybody to tell me any other company on this planet earning 78% net margins, after interest, depreciation/amortization, and taxes.

When people are paying their mortgages, this is a wildly profitable industry to be in.

This breaks when people start defaulting on mortgages, causing a collapse in real estate pricing due to forced liquidations, and then soon mortgage insurance providers will be hard-pressed to pay banks that will be knocking on the door. So far, this scenario has not happened. A rising real estate price environment means that even when people default on their mortgages, when they occur, such defaults are not severe from a mortgage insurance perspective – even when there is fraudulent underwriting (see: Home Capital Group).

The Canadian government is most unlikely to change this insurance scheme, because the 100% government-owned crown corporation, CMHC, is also raking it in – their volume is roughly double of what Genworth MI does. Why interrupt the gravy train when this crown corporation is delivering huge amounts of cash to the government in the form of mortgage insurance fees?

2. Premiums written on transactional insurance was up slightly from Q4-2016 – mainly due to the increase in mortgage insurance rates from last year, offset by decreased volume due to mortgage rule changes. Portfolio insurance is down significantly, but this was expected due to regulatory changes. My take on this is that it appears that the dollar amount of insurance written has stabilized. There is slightly less concentration in Ontario/BC than the rest of the country:

3. The interest rate swap they took to the tune of $3.5 billion notional value 3-5 years out continues to pay off – fair value of $131 million at Q4-2017 vs. $120 million in Q3-2017. This was a very, very smart move on interest rates.

4. In terms of balance sheet management, the only changes to the portfolio has been a slight shift away from corporate debt, in favour of collateralized loan obligations and an increase in corporate preferred shares (5-year rate resets). Fair value has increased to $6.45 billion from $6.34 billion.

5. It is still not entirely clear what the impact of the China Oceanwide merger with Genworth Financial (NYSE: GNW) will be – or even whether this merger can be consummated at all. Reading Genworth Financial’s 8-K, a huge stumbling block is “The delay in the review process is due to the difference in opinion of the fair market value for Genworth Life and Annuity Insurance Company (GLAIC)” which is a huge stumbling block (this subsidiary of Genworth Financial is saddled with liabilities concerning the long-term care insurance pricing disaster). One potential scenario has always involved Genworth Financial completely selling off their holdings of their Australian and Canadian mortgage insurance subsidiaries.

Genworth Financial is also looking at a secured bond transaction to finance their upcoming 2018 bond maturity – although they have the cash at the holding company level to pay it off, it will leave them constrained.

6. Minimum capital test level is at 168% with the target being 160-165%. Management has a history of either executing a share buyback or giving out a special dividend with the excess capital. Their history has typically been quite prudent and only buying when the stock is at a substantial discount to book value – which it is not presently. I would believe they will be holding tight and figuring out what to do with the excess capital later. Diluted book value is $43.13, while the common stock closed today at $41.49.

(February 7, 2018: Listening to the conference call, I believe management will let the MCT go substantially higher than 165% during 2018 – I no longer believe a share buyback or extraordinary dividend will be in the works in 2018).

(April 9, 2018: My February 7, 2018 note was obviously wrong – the company bought back 1.2 million shares in March at around $41/share).

The company remains in what I consider to be my fair value range at present.

Bombardier vs. Boeing

Just like most (but not all) of the financial community, I was not expecting the USA trade panel to vote 4-0 in favour of Bombardier.

The immediate implication here is that Boeing, by its actions, has pushed Bombardier into Airbus’ arms, and Airbus is obviously more capitalized and equipped to handle Boeing. By forcing the trade issue, they’ve allowed Airbus to take control of a superior product, which Airbus has a strategic interest in proliferating.

Suffice to say, Bombardier’s stock price is up today, but more relevant for myself, I will be holding onto their preferred shares.