Pengrowth Energy – dodged a bullet

Pengrowth Energy’s debentures (TSX: PGF.DB.B) will be redeemed on March 31, 2017 and the company has also announced it will be redeeming USD$300 million in senior debt (announced February 21, 2017).

I own the convertible debentures and will miss their presence once they mature. I’m probably one of the few people that invested in the company and actually made money.

They also announced their year-end results on February 28, 2017. The operations of the company are fairly simple to understand – they are losing a relatively small amount of cash in the existing oil price environment, which they assume is at WTIC US$55/barrel and a 0.74 CAD/USD rate. Management has made some good decision-making on their oil hedges, but they have now closed them (for cold hard cash) and are completely at the whim of the oil commodity markets.

If you take their 2017 guidance to heart, you will end up with $195 million in “funds flow through operations”, a non-GAAP metric that is a proxy for operating cash flow excluding the impact of financing expenses and remediation. The GAAP statements are a mess to read because of derivative accounting (for oil price hedges), exchange rate adjustments, and require some mental massaging to be read properly.

All things considered, the corporation is not in terrible shape.

This is, however, except for the debt maturities coming up which need refinancing.

The company did have a $1 billion credit facility at the end of 2016. It was untapped, probably because the credit facility has a covenant similar to the senior debt. I believe the original intention of management was to use the credit facility to pay off the senior debt as it became due.

The corporation pre-announced in Q2-2016 that if oil prices continued their relatively low level, that they would be potentially in breach of their covenants. What was new in the Q4 announcement was that they alleviated their senior debt (before working capital) to book capitalization ratio covenant, at the expense of amending the debt agreement to redeem senior debt in the event of asset sales and also to reduce the ceiling of their credit facility to $750 million.

There are three other covenants remaining that an investor needs to pay attention to. The most material of them is the senior debt before working capital to adjusted EBITDA ratio, which ended at 3.1 in 2016, but needs to be below 3.5.

Pengrowth, to its credit, walked investors through their covenant calculations (page 10 of their MD&A). Doing some pro-forma (after debt repayment in the end of March) analysis, we have about $1,250 million in debt for covenant purposes, which means adjusted EBITDA needs to be above roughly $360 million for them to clear the mark. They did $581.6 million adjusted EBITDA in fiscal 2016, which gives them a relatively healthy margin of error – even though guidance is taking their production down about 10% for the year despite $120 million in projected capital expenditures.

So as long as oil prices don’t crash, they’ll probably use the credit facility to pay off the remaining US$100 million in debt due in July 26, 2017. The next major maturity is CAD$15 million + US$265 million on August 21, 2018, and if nothing changes between now and then, they will use the credit facility to pay that off. At that point, they will have about CAD$500 million utilized in their facility, plus the (presumably negative) amount of cash flow they burn through operations in the next couple years.

If oil does slip, there is a point where they will get into covenant trouble.

They did note in the MD&A:

After the above debt repayments, Pengrowth anticipates it will remain in compliance with its covenants through the end of 2018. In order to comply with certain financial covenants in its senior unsecured notes and term credit facilities through 2017 and 2018, Pengrowth has run a scenario, that accesses the capital markets before the end of 2017, and includes an improvement in realizations for oil and natural gas.

They will probably tap the asset market to give them a higher degree of comfort. This is what Penn West did when they gave up their Saskatchewan operations to stabilize their balance sheet.

In retrospect, I think the company erred in not using shares to repay the convertible debentures – they probably should have bit the bullet and increased their margin of safety by cheaply equitizing the convertible debt. Now, management is basically gambling that oil will be going up in the next couple of years and are basically playing a waiting game.

How not to sell covered call options

Most retail investors use covered call options as a cash generation device. The algorithm generally goes like this: “I’m going to sell a call option at a strike price that I would have sold the shares at anyway – if the stock does not get up to the strike price, I would have held onto the shares, and if the stock goes above the strike I will be cashed out anyhow, so why not make a few pennies selling the call option?”

Unfortunately, such thinking is more damaging than not as investors are usually selling such options at an implied volatility that is lower than what the option should be priced at. Most of this is evident in illiquid option markets (such as the options that trade on most of Canadian issuers on the Montreal Exchange).

The reason selling low-priced covered calls is hurtful is because of the “lottery” aspect of stocks (statistically speaking, this is referred to as the “fat tails” of a price distribution curve) – stocks sometimes do not move in continuous prices, although these jumps do not occur frequently. For example, when selling a call option, you are giving up most of the takeover premium that you would potentially receive. Another example is jumps during quarterly earnings reports. The other significant disadvantage of using covered calls is giving up liquidity – in most retail cases, selling a covered call obligates one to hold the capital in the common shares until expiration, or unwinding the position (which requires paying a spread on less liquid options).

So when somebody is willing to sell you 8 weeks of time on a call option at a strike price that is about 5% away from the money for about 0.8% of the market value of the common shares, they’re probably letting things go for cheaper than they realize. This option is still likely to expire worthless, but the potential upside is far, far better than the price paid simply because it can rocket higher than the 0.8% of premium paid. So I spent a few bucks (far, far less than 1% of the portfolio) on hitting somebody’s low asking price.

Covered calls do have their usage in portfolios, but they typically are constrained to high volatility situations when the action to sell calls seems to be a difficult decision.

Who’s short on Genworth MI?

Genworth MI has 57.2% of its shares outstanding held by Genworth Financial (NYSE: GNW). This leaves approximately 39.3 million shares outstanding in the public float. Q4-2016 in the following annotated chart refers to the quarterly earnings report at the end of February 7, 2017:

On January 31, 2017 there was a reported short position of 2,844,353 shares and on February 15, 2017 that position increased to 3,188,297. This is a 343,944 share increase in short interest since their earnings report (which means that somebody is taking on a position to profit from their presumed downfall).

Borrow rates on MIC are relatively modest, at around 2.75%.

That said, when the price increases and short interest rises it will raise volatility – is the entity with deeper pockets the one that is accumulating shares and driving up the price, or are they the ones that are selling shares and applying downward pressure on the price? It is impossible to say without the benefit of retrospect, but if either party exhausts its funds or changes the pace that they are accumulating or distributing, it will result in higher price volatility. Imagine if those 3.2 million shares that are shorted decide that it is time to cover their position. Could there be a short squeeze? Share volume has been higher than normal lately which suggests that there is interest in both sides of this price battle to see who breaks first. Right now, clearly the winning side is the one accumulating shares and slowly raising the bid – I noticed the same price trend post-Presidential election, where the algorithm was simply “accumulate shares at whatever rate that it is sold to you and raise the bid by a nickel each trading hour until you hit some sell pressure”.

Technical analysis these days is simply about guessing the competing algorithms at work and who has the most money behind them – almost no institutions use non-algorithmic trading anymore as such manual trading leaks information like a sieve which increases frictional costs (you’ll get front-runned).

Teekay Offshore’s common units are not going anywhere

Reviewing Teekay Offshore’s financial results (NYSE: TOO), it strikes me as rather obvious that they have missed their initial early 2016 targets when they proposed a partial equitization (issuing common units, preferred units, and some refinancing) of their debt problems. They also borrowed $200 million from the Teekay parent entity (NYSE: TK).

In Q1-2016, they delivered a presentation with this chart:

In subsequent quarters, the company has generally not referred to progressing tracking to this projection, mainly because their debt to cash flow through vessel operations ratio has not met these targets. While the underlying entity is still making money, revenues are eroding through the expiration and renegotiation of various contracts, couple with some operational hiccups (Brazil) that is not helping matters any.

Putting a lot of the analysis away from this article, while in 2017 the future capital expenditure profile is going to be reduced (which would greatly assist with the distributable cash flows), the company doesn’t have a lot of leftover room for matters such as debt repayment and working on improving their leverage ratios in relation to cash generation ability. This leaves them with the option of continuing to dilute or depend on the parent entity for bridge financing. Indeed, one reason why I believe management thinks the company is still open for dilution is due to them employing a continuous equity offering program – they sold nearly 1.9 million units in the quarter at an average of US$5.17/unit. If they don’t think the company is worth US$5.17/unit, why should one pay more than that?

I don’t believe that they are a CCAA-equivalent risk in the current credit market (this is a key condition: “current” credit market), and I also believe that their preferred units will continue to pay distributions for the indefinite future, I don’t believe their common units will be outperforming absent a significant and sustained run-up in the oil commodity price. Note that there is a US$275 million issue of unsecured debt outstanding, maturing on July 30, 2019, which will present an interesting refinancing challenge. Right now those bonds are trading at around a 10% yield to maturity.

I have no positions in TOO (equity or debt), but do hold a position in the Teekay Parent’s debt (thesis here).

Pengrowth Energy Debentures – cash or CCAA

A quick research note. Pengrowth Energy debentures (TSX: PGF.DB.B), something I have written in depth about in the past as being one of the easiest risk/reward ratios in the entire Canadian debt market, has reached the “point of no return” with regards to its redemption. They are to be redeemed on March 31, 2017 for cash (and an extra half year of accrued interest at 6.25% annually). For the company to exercise its option to redeem them for shares (of 95% of TSX VWAP), they needed to give 40 to 60 days of notice from the redemption date.

(Update, February 21, 2017: Pengrowth announced they will be redeeming the debentures on maturity at March 31st. Also on their senior debt covenants, it looks like somebody is trying to steal the company… they might be forced into making an equity offering.)

My math says that the next market opening, February 20, 2017, will be 39 days before March 31st.

Barring some sort of mis-interpretation of the legalese, this means that the company must redeem this debt (CAD$126.6 million) for cash. The alternative is CCAA, which I do not deem is likely considering Seymour Schulich would likely have something to say about that particular option (he controls 109 million shares or 19.9% of the company at present). There is no longer any time to negotiate an extension with debenture holders.

This debenture issue was acquired as a result of the NAL acquisition back in 2012. It was originally CAD$150 million but they company repurchased some at a considerable discount to market earlier this year.

Pengrowth is in the middle of a silent negotiation with their senior creditors as they are in covenant troubles. Their senior creditors will no doubt be unhappy with the fact that some company cash is going towards a junior creditor.

Sadly I have no good candidates for re-investment at this time. Suggestions appreciated.