Saturday, 12 November 2016

Thoughts on the week ended November 11, Fortis , Fairfax and Acasta Enterprises

This week was a tumultuous week for dividend investors, despite the Dow hitting a new all time high. Under the surface, there was a noticeable rotation out of income "proxies" like REIT's, consumer defensive, and utility stocks. I also noticed rotation out of high beta / tech favourites, like Google, Facebook, and Amazon.

Anything that had done exceptionally well this year due to yield or momentum chase got sold this week and anything that could potentially benefit from the Trump electorate (and by extension, anything that would benefit from higher rates, elimination of Obama-care, and continued deficit spending) got bought (banks, insurance, E&C contractors, etc.).

On the subject of this theme, let's look at Fortis. Long an institutional and retail dividend favourite, here's Fortis this week:

Now, a one week move doesn't really do justice to a long term trend, so here's Fortis over the last 10 years:

Putting things in perspective, this last week's performance looks like a blip. The problem I have with charts is that they only capture what has happened historically. To some extent, they offer clues as to what may happen going forward, but clues are not research, they are at best suggestions as to possible courses of price action through which experienced traders assign probabilities in order to make decisions. Whether those decisions ultimately lead to profits is a function of how good the trader is. In the case of the average investor, none of this should really matter, but I've digressed.

In order to really understand Fortis (or by extension, any regulated utility), I think it's important to understand how Fortis operates its business, and how management allocates capital in order to earn returns on invested capital.

Looking simply at Fortis as a "stalwart/dependable" dividend payer only tells a fraction of the story. The company's ability to pay dividends is a function of how well management allocates capital, and historically, management has allocated capital with a lot of help from accommodating capital markets.

First, a comment on return on invested capital. As noted in my previous post on Great Canadian Gaming, I have begun tabulating a database of incremental ROIC by companies I am interested in. I noticed something really interesting as I worked my way through the universe of investable Canadian companies, which I'll demonstrate by example below:

Here's Great Canadian Gaming again:

And here's Fortis:

As I've been comparing ROIC between companies with different capital structures, I noticed that ROIC for non utilities was significantly higher than ROIC for Fortis. Intuitively, this makes sense. Fortis has massive investments in PPE, which is fundamental to the company's ongoing operations. Put another way, one could make a reasonable prediction that investment in PPE on a similar scale will continue indefinitely. The company is committed to continuously maintain and/or upgrade its grids / capacity etc. in order to operate.

My estimated ROIC at 5% x a 150% reinvestment rate tells me that on balance, the company has capx in excess of operating cash flow. The difference between op cf and capx needs is funded by access to capital markets, either by virtue of issuing debt or equity.

For anyone interested, in order to estimate my reinvestment rate, I took average capx over the last 3 years, and divided this by average operating cash flow over the same period. For Fortis, capx / op cf worked out to in excess of 150% reinvestment, and this again, makes intuitive sense to me from the standpoint of understanding what a utility does. It constantly reinvests in capx over and above it's operating cash flows. My theoretical value compounding rate then becomes a function of ROIC x reinvestment rate. I think this result is synonymous with the empirical concept of estimating "g" in traditional DDM models. The dividend growth rate, "g" in conventional introductory finance is reinvestment x ROE, derived by virtue of solving for g in the formula, ROE = g  / (1-payout).

In my backwards (or forwards) way of thinking, I've substituted ROIC for ROE in order to solve for "g", where "g" is an estimate of a value compounding rate.

Obviously, "g" under either model isn't static, as required reinvestment changes over a company's life cycle.

My question here is, is a +150% reinvestment rate observation an outlier? By assuming reinvestment in excess of operating cash flows, I'm making a pretty significant generalization about the nature of utilities. There's an easy way to test this result, and that is to observe the ratio of capx to operating cash flow over time. Here's Fortis, courtesy of Morningstar:

Generally speaking, capx has exceeded operating cash flow every year since 2006, and the ratio of capx : op cash flow has ranged in scale from 2.15 : 1 to 1.1 to 1 over the last 10 years. Again, this is a general observation and intuitively, it makes sense as the company has needed to constantly upgrade PPE in order to upgrade and maintain its productive asset base in order transmit & deliver electricity &/or gas.

Is this result problematic in its own? Probably not, but it makes sense for anyone interested in buying the stock simply because it pays a dividend to understand that in order for the company to continue paying dividends, it must a) be able to grow operating cash flows (subject to rate regulation constraints) and b) continue to have unrestricted access to accommodating capital markets in order to balance a) with indefinite capx constraints.

Here's a quick look at just how accommodating capital markets have been in terms of bridging the gap between operating cash flow and capx:

Roughly, the company has raised over $6B in either debt or equity issuances since 2011 in order to upgrade &/or maintain PPE and to make acquisitions. Not included in the above is the debt raised in order to acquire ITC Holdings this year, roughly $2B US.

So far, I've only discussed ROIC, but what about WACC? I think this is the missing component in understanding Fortis (or by extension, any regulated utility).

As I've calculated above, ROIC has averaged around 5% incrementally since 1996, and it appears that the value compounding proposition is a function of reinvestment driving growth. In reinvesting in excess of 100% of its operating cash flow, Fortis has been able to compound at 7.5% annually. So what about WACC?

From my readings along my investing journey thus far, a company can only create value over time if it earns an ROIC in excess of it's WACC. I find the concept of WACC tough to get my head around, simply because it's loaded with estimation. I am not in any way, shape or form, a finance maven, nor am I able to offer any expertise in terms of attempting to estimate beta, Rf, or the spread between Rm and Rf. The best I can offer is a point in time look at what WACC may (or may not be) today based on currently accepted parameters in the market.

Simply speaking, WACC is an estimation of weighted avg cost of capital, and my best (lazy) attempt to calculate Fortis' WACC is as follows:

% debt = $12.5B / ($12.5B + $10.3B) = 55%
% equity = (1 - 55%) = 45%

AT Cost of debt = (1-.28) x $293M x 2 / $12.5 = 3.4%

Cost of lazy equity:

The laziest estimation I can come up with is to simply use the incremental ROIC as the cost of equity. In this case, I use 5%.

The empirical estimation uses Capm as follows:

Re = Rf + Beta x (Rm - Rf)

For Rf, I'm going to borrow from Professor Aswath Damodaran and use a current point in time estimate of the North American risk free rate of 2%, and similarly, for the equity risk premium for Canada, I'm going to use Canada's equity risk premium of 6.25% (link here). Arguably, risk free rates are close to zero, but I don't feel comfortable modelling zero as this is a function of QE in my opinion and may not be sustainable over time.

For Beta I'm going to borrow from Professor Aswath Damodaran and use the beta for utilities as a group (currently) of .55 (link here)

Re = 2% + .55 x (6.25%) = 5.4%, pretty close to ROIC.

At 0%, Re = 0% + .55 x (8.25%) = 4.5%

My hybrid lazy WACC(2%) is therefore = 55% x 3.4% + 45% x 5% = 4.1%, and WACC(0%) is therefore = 55% x 3.4% + 45% x 4.5% = 3.9%

Now here's where analyzing Fortis gets really interesting. Recall my comment that a company can only create value over time if it earns an ROIC in excess of it's WACC.

Well, here's Fortis' spread based on Rf at 2%:

ROIC - WACC(2%) = 5% - 4.1% = .9% economic spread

And here's Fortis' spread based on Rf at 0%:

ROIC - WACC(0%) = 5% - 3.9% = 1.1% economic spread

One more piece of the puzzle. Given the above results, i.e., accepting that the economic spread is positive but just marginally equal to 1%, why has Fortis commanded a premium valuation over time?

Here's Fortis' multiple over time as compared to the S&P/TSX:

In every year with the exception of 2009, Fortis has traded at a premium multiple to the market. One possible explanation here is that because Fortis is essentially a regulated monopoly, it has been awarded a premium valuation by investors over time.

I personally think it's odd that investors would pay upwards of 20x earnings for a company with an economic spread between ROIC and WACC of 1%, but maybe the thinking here is that this 1% spread is sustainable and impenetrable by virtue of the company's monopoly status over time.

This is pure speculation on my part, but part of me believes that the most logical explanation for this:

Can only be due to this:

As yields have generally plummeted over time, the logical beneficiaries are levered entities such as utilities, because in theory, as yields move down, WACC moves down (assuming some part of the existing capital structure is floating), and the spread between ROIC and WACC increases. Now, a 1% spread ain't much, but a movement in spreads from .5% to 1%, x leverage, well, intuitively, this is a recipe for higher valuations.

Now here's where things get interesting, and to close off on Fortis, I'm going to use an excerpt from Professor Aswath Damodaran's blog from last week (link here):

"That is not to say that I am sanguine about low interest rates. The low growth and low inflation that these numbers signal are having their effect on companies. Real investment has declined, cash flows to investors (in dividends and buybacks) have increased and cash balances have surged. The increase in debt at companies will not only increase default risk but make these companies more sensitive to macro economic shifts, with more distress and default coming in the next downturn. Finally, to the extent that central banks send signals about the future, the desperation that is being signaled by their policies does not evoke much confidence in them."

Could the recent spike in yields (globally) be the start of spread compression impacting utilities? If so, there could be a lot more pain in store for Fortis and the like.

Onto Fairfax

I'm not sure if anyone has had time to digest the news this week reporting that Fairfax has removed 50% of it's equity hedge book. Here's a link to the news release courtesy of the Globe and Mail.

I find this a fascinating about face, especially considered Mr. Watsa's bearish stance since 2010! By my estimation, he's run an almost 100% hedge book on his common stock portfolio for almost 7 years now, and during one of the most ridiculously volatile weeks in recent history (the Dow has rallied close to 2000 points since the Tuesday night post election lows), Watsa reports taking off 50% of the hedge book?  How is this not capitulation on a massive scale?

I did some quick and dirty math using the reported #'s from the 12/31/15 annual report.

Here's an excerpt on the hedge book:

By my read, he added another $1B in notional shorts during the first few weeks of 2016 (talk about painful).

Here's note 24 from the 2015 annual report:

Prior to the news release, he was short 112% of the fair value of the equity holdings, so assuming $6.7B at the end of 2015 + whatever return his equity holdings have generated YTD during 2016 (let’s use SPY and assume 7% YTD), he’d have been short $6.7Bx 1.07 x 112% = $8B notional?

The majority of the weighting was in individual equity and Russell 2000 swaps.  He must have gone into the market this week and covered  a combination of $4B notional total return swaps and individual shorts on a +2,000 point move against?

Utterly fascinating. Now that the last big bear has thrown in the towel, the market can really crash.

Onto Acasta Enterprises

This is a little known Canadian SPAC (blank cheque company) run by Mr. Anthony Melman, previously second in command at Onex. Acasta went public last year and raised close to $250M. I've owned units in the accounts I manage since the IPO, and my educated guess was that Mr. Melman (and the who's who of the executive team) would end up doing something exceptionally interesting in the future. I've pretty much ignored the units as they've done nothing since I bought them. I figured that owning units is akin to owning a call option with limited downside (if no strategic acquisition is done within a certain time frame, the units will get redeemed at close to par, and if a strategic acquisition is done, well, enjoy the ride).

Well, this week Acasta announced two strategic acquisitions and a new direction for the company. Basically, my read is that Acasta is going to be run like a mini Onex.

Here's an interesting excerpt from the news release concerning the acquired businesses and new direction, link here:

The units didn't do much this week, they only ended up around $.10 (some poor schmuck paid $11.80 on the open after the halt trade) but what drew me to the release was the estimated post closing NAV estimate and the stated price hurdle increase of up to $13-$15. There are lock up provisions in the release stipulating that the shares must reach $12 before founder shares can be sold, and the founders are taking on a significant amount of remuneration in the form of shares. Hopefully, this means that management are all aligned with creating value over time.

One last interesting tidbit: there are warrants outstanding with an exercise price of $11.50 and a 5 year life post approved strategic acquisition. These came alive this week, and I bought some, despite the stock only trading marginally above par.

I ran a simulation as follows using 50% expected volatility, a 5 year time to expiry, and a strike price of $11.50. Here are the results with stock price at $10:

Here are the results with stock price at $13:

It will be interesting to see how this all unfolds.

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