Enbridge Line 3 – Another setback

I do not have shares in Enbridge, but investors today (and probably tomorrow as the news came out mid-day and institutions will look at it overnight to digest the impact on valuation) will be feeling slightly less rich after today’s news that the Minnesota court of appeals deemed the environmental assessment concerning Line 3 to be inadequate.

The net result is that Line 3 will have their construction halted until Enbridge can file an appeal or an amended environmental assessment. This will also result in another round of legal battles with the 3Cs of regulation – committees, commissions and courts and my initial estimate would be at least half a year of delays. I could be wrong.

The reason for the delay is not terribly relevant from a financial standpoint, but the impact of it will be for both Enbridge (who will not be realizing increased cashflows from the increased volume that would be flowing through the pipes the second they are activated – not to mention the capital that has already been sunk into the project), but more importantly, land-locked Albertan/Saskatchewan oil producers that were seeing a light ahead of the tunnel after the presumptive second half of 2020 activation of Line 3.

At CAD$50/share, Enbridge was priced for perfection. Although Enbridge is mostly a cash flow story, an investor is paying a lot in advance in order to realize those cash flows – in addition to the requisite risks to pay back the debt, interest and preferred share dividends. Just wait until Line 3 or Line 5 experiences a spill, or some other adverse event which is currently not baked into the stock (or perhaps another adverse legal ruling that will stall it another couple years). Although the company in 2019 is expected to generate around $4.50/share in cash ($8.9 billion), the inherent growth that is available to Enbridge is a limiting factor – and as such, the accounting income P/E in the 20s (which takes into account depreciation) is unjustified. Coupled with large future capital expenditures, if there is any sort of credit situation that may occur in the future, equity owners will be taking a lot more price risk than the current potential for reward – which wasn’t going to be a stock price that much higher than CAD$50/share.

I would especially take issue with the common share dividend, which is currently $6 billion a year – while they can certainly afford to pay this at present (and management continues to escalate the dividend each year), it is not a financial perpetual motion machine – given the capital expenditure profile, this is currently being partially financed with debt.

There aren’t many free lunches in the stock market, including the pipelines. Companies like Inter Pipeline (TSX: IPL), which has less legal risk than Enbridge, are still at valuations that aren’t incorporating much risk to their future expected cashflows (albeit, in IPL’s case, it is a lot better today than it was a couple years ago where it was trading about 30% higher). It wouldn’t surprise me to see Enbridge follow a similar trajectory, but still maintain its equity dividend.

Students of history will want to pay attention to Kinder Morgan (NYSE: KMI), a supposedly safe and stable pipeline company in 2015:

I’ll leave it at that – pipeline companies are supposed to be stable for their cash generation capabilities, but financially it can be a completely different story.

More cash parking options

I’ve written a lot about some cash parking options – whether they are short-term bond ETFs, or short-duration target-maturity ETFs. Interactive Brokers currently gives out 111bps on Canadian cash, but there are higher yielding options with less risk.

I’ve discovered another vessel for cash parking: a high interest savings ETF (TSX: PSA), which simply invests in cash accounts held at credible financial institutions (National Bank, Scotia, Manulife, and some BC credit unions). They give out a net yield of about 2% (215bps minus 15bps expenses) with zero duration risk, and this is paid out monthly. There is a market maker which keeps transaction spreads to a penny at ample levels of liquidity.

Even VSB.TO (Vanguard’s short term bond ETF) has a YTM of 190bps and an MER of 10bps, plus you take the 2.6 year duration risk if interest rates change.

I’m surprised I haven’t encountered the zero-duration option (aside from cold hard cash) before.

I’ve recently sold out what used to be my largest position and I’ve once again found deployment of cash to be a pleasant, yet annoying problem. Future returns are likely to be muted by the levels of cash in the portfolio.

Inversion of the Canadian yield curve

Canadian government bond yields:

3-month: 1.63%
1-year: 1.68%
2-year: 1.55%
5-year: 1.48%
10-year: 1.59%

This would be one explanation why those 5-year rate reset preferred shares aren’t doing so good price-wise.

The 5-year yield also dropped under 1% between June 2015 to October 2016 – these were not happy times for rate resets.

The most obvious safety mechanism appears to be cash – but is one willing to endure the pain of taking a 2% pre-tax return?

Atlantic Power – selling a power plant

Atlantic Power (TSX: ATP) today announced they are selling their largest power producing plant (Manchief) on May 2022 for $45.2 million. In the meantime, Manchief will continue operating and contributing cash – in 2018, the cash generated from Manchief was 12.2 million (and indeed this number was somewhat lower than it could be given there was a turbine installation performed in 2018).

Manchief’s power purchase agreement expired on May 2022 and the primary customer of the electricity had an option to purchase which was exercisable on May 2020 or May 2021.

I’m guessing instead of stranding the asset (such as what happened in their San Diego operation, which was located on US Navy leased land which they could not further extend the agreement on), they decided to take the money and run. Clearly getting rid of an asset generating $12 million a year in cash for $45 million is not the best economics, but this is a part of dealing with a legacy business with power purchase agreements that were signed at much more favourable terms than what is available today.

Mansfield produced 300 MW of power, which makes it nearly a quarter of ATP’s net generating power (1,259 MW, not including the biomass plants that it will be acquiring).

In the meantime, the company continues to chip away at its debt and is on a relatively comfortable trajectory to doing this even as their legacy PPAs expire. In 2020 the next PPAs due to expire had a FY2018 EBITDA of 9.6 million (out of a total of 185.1 million for all projects) and distributed cash of 13.9 million (198.0 million). There are no PPA expirations in 2021.

Why the junk debt market is not dead yet – Alaris Royalty Corp convertible debt offering

Somehow the junk debt market is not dead yet – I see offerings like this (Alaris Royalty Corp. Announces A $100 Million Bought Deal Financing) – unsecured debt, 5-year term, 5.5% coupon, and 30% out-of-the-money conversion rate (noting that the underlying equity is already giving out a dividend at nearly a 9% yield at the closing price of the day the bought deal was announced).

Talk about a low return, high risk deal! That said, Alaris should be giving their underwriters (CIBC Capital Markets, National Bank Financial Inc., RBC Capital Markets and Scotiabank) full price for finding investors to actually buy this offering, let alone $100 million of it.

Just glossing through the preferred share markets, one can speculate on a better risk/return scenario. There are many examples I can give, but I will choose one at random. Believers in Brookfield Asset Management can pick up a preferred share series (e.g. TSX: BAM.PR.Z) and buy an easy 6% tax-preferred yield, with a reasonably decent potential for capital appreciation (it is trading well below par), and BAM’s underlying business provides significantly better inherent diversification, coupled with a much better credit profile.

Is the equity call option of Alaris’ unsecured convertible debenture worth it? Why not just buy the common instead and pick up a 9% dividend? I can’t see any realistic scenario where an investor would choose purchasing the unsecured debt instead of the equity – and if you think the underlying company was questionable, why invest in this at all?

No positions in any names mentioned, and most definitely not going to be in Alaris’ convertible debt at par!