Wednesday, 30 September 2015

Transcanada and Margin of Safety

I’ve been reading Seth Klarman’s book Margin of Safety.  His bio is here.

I'm about 1/2 way through the book. If anyone's interested in reading it, it can be found via easy google search.  I'm not going to post a link. 

If my understanding of Klarman’s approach is correct, balance sheet first.  p/l second.  Dividend yield = irrelevant.  Dividend yield is like a shiny dangling carrot to equity just before the titanic hits the iceberg.

As my thought process has evolved, I’ve begun thinking only in terms of margin of safety. 

I looked at transcanada.  I’m attaching a very simple analysis of TRP’s ratios over time (all amounts taken from gurufocus, and all in USD’s)

Interest expense-704-635-614-684-714-777-795-1,016-823-966-754-969-986-926-991-1,028
Int coverage1.642.
Current debt55355157000001,0052,1842,2553,0272,7323,2012,6463,6983,907
Total debt8,0877,4417,1617,7888,6609,10210,42815,20216,32519,30921,69221,03322,40624,22024,61425,306
Effective interest8.71%8.53%8.57%8.78%8.24%8.54%7.62%6.68%5.04%5.00%3.48%4.61%4.40%3.82%4.03%4.06%
Less: capx-534-312-384-298-391-649-1,363-1,647-2,540-5,139-4,996-3,197-2,621-4,193-3,078-3,132
Free cash flow5963378471,1531,0059884361,184-239-2,302-1,938683986-740459272
Less: dividends-352-327-350-447-511-504-535-545-582-786-748-1,120-1,430-1,430-1,402-1,391
Sensitivity at:5%6%7%8%
Interest expense-1,265-1,518-1,771-2,024
Int coverage2.632.191.881.64
Less: dividends-1,391-1,391-1,391-1,391

A few things jump out:

  • Interest coverage appears to have improved since 2000.  It’s gone from 1.64x to 3.24x.  A first level thinker would be happy about this.  He/she would feel comfortable that the interest coverage improvement suggests an improvement in safety to equity.  A higher level thinker would look at the effective interest expense (Interest expense / debt) over the last 15 years.  It’s come down from almost 9% to 4%.  I would hazard a guess that this is indicative of decreasing cost of borrowing in the market due to injection of liquidity since 2009.  A higher level thinker would sensitivity test the impact of higher cost of funds on the debt at cost of funds between 5% and 8%.
  • Free cash flow is terrible.  This is a function of capx.  Since 2000 (15 years), FCF has totalled $3.7B, vs. CF from operations of $38B.  This business hardly generates any free cash flow due to constant reinvestment in capx.  The whole business model is predicated on building capx.  While it may look great at cost of funds  = 4%, equity needs to ignore 4% and worry about 8% cost of funds and the impact on future capx funding.
  • Free cash flow less dividends is a black hole.  They continue to pay dividends by issuing more shares.  Share count has increased from 475m to 709m since 2000.  It’s basically doubled.  In 2015, they will have to make up about $1.1B of dividend deficiency by either borrowing or issuing more shares.
  • I have attempted to sensitivity test higher cost of funds, and I’ve roughly calculated that interest coverage gets back to 1.64x at 8%, and free cash flow less dividends jumps to -$1.8B from $1.1B.

My thoughts?  There is no margin of safety in equity.  Better to buy the debt at $.50 on the $1 (or less), at least you’ll be covered by the pipeline assets if they go bankrupt.

TRP has a number of different bond issues, you can see them at morningstar here

The majority of the maturities seem to be spread out between 2034 and (gulp) 2067.  They've floated $2B of 4.625% and 6.2% bonds maturing between 2034 and 2037.  Let's call the average coupon 5.4%.  They've floated another $2.025B of 4.6%, 5% and 7.25% bonds maturing between 2038 and 2045. Let's call average coupon 5.6%. They've locked long term cost of funding in at between 5.4% and 5.6%.  The equity yields 5% currently.  Adding the two together, I get an approximate discount rate of at least 10% (if I were equity, I'd want more than just a 5% yield in order to compensate me for the leverage and riskiness of the cash flows).  Let's choose 12%.

I'm going to value the dividend as a perpetuity.  I'm assuming equity holds this for the dividend only. 

Div of $1.60 / .12 = $13.33 vs. $31.02

Just my two cents and I’m probably over-simplifying.

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