Teekay Tankers Will Be Owned By Creditors for a While

• TNK stock has been down more ~50% year to date. It trades at less than 3x earnings and this has shareholders calling for buybacks.
• However, management is paying down debt instead. They have to do because of lower cash flows in 2016 and 2017, as well as demanding debt maturity schedule.

Back in December 2015, Teekay Tankers (TNK) announced a $900 million refinancing, including a term loan and a revolver that are both due in 2021. I thought the deal was bullish for the stock, since it cleared out near term maturities and allows TNK to buy back stocks.

This is not the case. That deal did push out a lot of near term maturities, but a substantial amount remains. In addition, the new term loan actually has an onerous principal payment schedule.

The $525 million term loan matures in 2021 but demands principal amortization of $31.94 million per quarter for the first few quarter and $24.845 million per quarter thereafter. This amounts to $99-106 million of principal payment per year.

What’s more, a sizeable chunk from old loans remains. The annual report has a maturity schedule pro forma for the refinance. Backing out the January 2016 loans, and assuming the debt payment made during 1Q16 was toward near term maturities, the current debt schedule would look like the below.

The big question is the $215 million due 2017. To put that in context, TNK only generated $167 million of cash flows from operations for the entire 2015, and that’s with peak tanker rates! So far in 2016 we are already seeing lower tanker rates and lower cash flows.

More headwinds are coming in 2017. Tanker supplies will come on line second half of 2016 and through 2017. So rates in 2017 will likely be lower. In-charters will expire so TNK will be operating with a lower number of vessels.

So forget about TNK paying off the entire $215 million out of cash flow from operations. It will struggle to even pay the ~$106 million term loan scheduled principal in a weaker market. It will certainly have to refinance the rest of 2017 maturities; failure to do so means another round of equity raise, or even bankruptcy.

To entice lenders for the 2017 refinancing, TNK will need to demonstrate credit worthiness and deleverage in the near term. This explains management’s focus on deleveraging, why the company has not repurchased any shares despite the ostensibly low P/E ratio, and why an equity offering is still on the table.

So creditors will get most of the cash flows for now. This is not to say avoid the stock, but investors should recognize the credit situation, and be willing to hang on for a couple years for their big pay day.

Advice for Investors

In this situation, demanding share buybacks is to demand a short term boost in the stock price while risking equity dilution or even bankruptcy down the line.

Instead of pushing for buybacks, big boy activist investors can provide the refinancing themselves. Just to toss some ideas around, with $250 million of 10% senior notes, weighted average cost of debt would still be under 5%.

Even after the 2017 maturity is addressed, TNK will still face a demanding term loan amortization. But by late 2017, it should have shown progress in deleveraging and tanker rates should have stabilized. Management can then refinance the January 2016 loan into another with easier principal payment schedule, and finally release free cash flows to shareholders.

There is also a lesson here. P/E ratios and free cash flow yield (free cash flow divided by market capitalization) are meaningless measures for companies loaded with debt. “Free cash flow” is not really “free” in terms of using it to reward shareholder, especially if there are near term maturities/obligations that can’t be funded from operation.

Beijing Enterprises Holdings - A Stub Trade

I first wrote about Beijing Enterprises Holdings (“BEHL”, 392.HK) last year here when the stock was trading around HKD$60. The stock is now at ~$39 HKD/share, a 36% drop. This is all despite very strong fundamentals. 2015 revenue and EPS were up 25% and 18%, respectively. 2016 results are also expected to be up double digits.

So why did the stock go down? First, it’s just a bad timing for a stock like BEHL. It’s China. It’s energy. Combine the two most hated features in this market and of course you get a lower multiple. The second reason is more concerning. There’s a risk of a tariff cut in the pipelines segment, perhaps coming in second half of 2016.

The stock is now ridiculously cheap. If you hedge out publicly traded subsidiaries Beijing Enterprises Water (371.HK) and China Gas (384.HK), that would leave you with the stub of natural gas segment, Yanjing Beer, and corporate (including waste treatment). This stub is trading at around 5x LTM earnings. Even in if you assume pipeline profits goes to 0, an extreme proposition, the stub is trading at <17x 2015 earnings.

Keep in mind natural gas usage is still set to grow in China over the next decade. LNG supplies coming online will push prices down, encourage adoption, and benefit distributors like BEHL. So I have gradually added to my positions in the past year. I suspect a tariff cut will actually be good for the stock, and that the stock will make a run after the bad news is flushed through.

Select Harvests and the Almond Boom and Bust

SHV is the second largest almond producer in Australia, behind the well diversified Olam. SHV is the only pure play almond stock I know of. The company is vertically integrated - it owns almond orchards, not just processing plants - and sells both domestically as well as export.

Almond prices have crashed over the past few months and SHV’s stock price went the same direction. Earnings will probably be way down this year.

A bullish story for Australian producers emerges once you look past the recent boom and bust of almond prices. Global demand for almonds continues to increase over time, driven by health trends. California supplies the majority of the world’s almonds, but it faces structural difficulties from drought and water shortage. Australia is the second largest producer and is in position to take more market share. Australian producers also have geographic advantage in terms of being closer to key growth markets of India and China.

I think almond prices are probably at or near a trough. The current price of $2.3/lb in California is already near break even. According to this presentation (see slide 43), growers need $2.15/lb to break even and $2.5/lb to insure a minimal profit. Longer term, stabilizing California supplies should put a floor on global prices.

Select Harvest will enjoy a natural production ramp in a few years (think like ~2019) as trees age and reach production sweet spots. Between higher normalized price and higher production, I can see earnings stabilizing.

The risk is California productivity. Yield per acre have consistently went up over the past decade. It is conceivable that Californian farmers can find a way to cut down water usage while keeping up production, so supply may actually not be constrained for years.

To be conservative I assume prices of USD 2.25-2.75/lb and fully ramped production of 19,000 tons. This would correspond to earnings of A$0.2 to 0.5 per share for SHV. The stock had a nice run during my research and it is now at A$5.4-5.5/share. I’m waiting for a pull back toward $5 or below to pull the trigger.

Virtus Health

Business and Industry Overview

Virtus Health Ltd (“Virtus”, “VRT”) is a steady dividend grower I found while scanning through Australian stocks.

Virtus operates In Vitro Fertilization (IVF) clinics. Fertility specialists contract with Virtus to use the clinics for IVF and related operations and get a split of the revenue. When a couple gets an IVF at Virtus, they pay the bill initially but gets heavy reimbursement from the federal government (Medicare and EMSN) as well as Private insurance if they have it. As a result, Virtus’ revenue is AUD 10,000-14,000 per IVF cycle but typical out-of-pocket costs for each patient is 1/3-1/2 of the total price.

The Australian assisted reproductive services (ARS) industry is concentrated. The top 3 players Virtus, Monash IVF, and Genea owns over 70% market share and are all privately owned. ARS are mostly provided by private clinics as there are virtually no public sector fertility clinics in Australia. Virtus is the biggest of the three with ~1/3 market share. At the local level VRT is even stronger since it is number one or number two in its geographies.

Why I Like It

There's lots to like about the industry and specifically Virtus. You have a product that is naturally price inelastic (we’re talking about babies here), good market structure, and very long growth runway due to demographics.

The industry structure is a big attraction for me as new entrants will have difficulty recruiting fertility specialists. This is the key to market share gains. But there are only some 300 odds fertility specialists in Australia and they are typically under contract with the big three.

Australia’s low birth rates provide Virtus a long growth runway. Those data were cited extensively in IPO prospectuses so I won’t recite them here.

Acquisitions have been sensible and generally at below 10x earnings. As a result return on incremental capital is solid low-mid teens. Management has been good about returning excess cash in the form of dividends.

My plan to make money with this stock is buy and hold, let the company accrete value over time and receive dividends in the interim. That should give 5-15% IRR over the next few years, maybe even decades.

Risks and Mitigants

What might change my mind? If the key risks turn out worse than expected: government funding risk, lower price competition, and alternative technologies.

By “funding risk” I mean risk that government will reduce reimbursement for IVF, or reduce subsidies for private insurance. Despite the chaos in Australian politics I have actually gotten comfortable here. First, unlike other benefits that add to expenses for the government, an IVF actually creates a future tax payer. 

Second, in the extreme and unlikely case where funding is removed and patients pay 100% out of pocket you're talking about AUD 10,000-14,000 per IVF cycle, a lot of couples would still pay. Keep in mind Australia is one of the wealthiest countries on Earth and typical clients are women in their late 30’s, who tend to be well educated and have sound financial positions (which is often why they delayed starting a family in the first place)

Competition is a bigger worry. Primary Health is in the market with low end $500 or even $0 out of pocket services. There has been some impact on Virtus' lower price, less service clinic but management indicates their full service IVF is still going strong. Industry IVF cycle growth have been higher than normal since Primary Health’s entry, so it would seem that they enlarged the pie by drawing in new customer segments. 

Primary only has two IVF clinics so far and I think scaling up and signing up doctors will be tough. I don’t see why doctors would leave a high priced practice for a low end one.

Longer term tail risks is that an alternative technology emerging to replace IVF. Also if IVF success rates (currently ~25-30% for women in late 30's) improve then people would need less service.

Why Virtus and Not Monash IVF; Catalysts

I prefer Virtus because Monash has business concentration risk with 1/3 of IVF cycle from 5 doctors. It also hasn't really been exposed to competition from Primary Health, which only recently opened a clinic in Melbourne. Yes, Monash IVF does have higher margins mostly due lower employee benefits, but Virtus is not a provider of low cost commodity services and in fact there's something positive to be said about paying your employees well.

“Self-help” earning opportunities are available in the next year or so. The company’s Singapore operations can swing from loss to profit (management indicated this can happen in a couple quarters). One of the Ireland Clinics had some temporary staffing issues in FY1H16 which has been addressed. VRT can also benefit from general ramp up of new facilities and younger doctors as they grow their reputation and attract new clients.

Australian budget comes out in May and we will have more color on the government funding risk then. The technicals are not great - the stock is coming upon a resistance zone at $7.0-7.25. But I’m inclined to ignore that and hold even if it gets there.

I have a 2-3% position right now with average cost basis of $6.56. Virtus trades at 15-16x forward earnings. Accounting earnings tracks cash flows well and leverage is moderate at 2-2.5x EBITDA.

NexPoint Residential Trust Passes My Stress Test, Has Room to Improve

NexPoint Residential Trust (NXRT) is a dividend growth play. They own and operate apartment buildings in the south. I view NXRT as having both defensiveness and optionality.

Defensiveness comes from the fact that NexPoint invest in Class B apartments, which are actually more defensive than high end Class A’s because tenants live there not out luxury, but of necessity. Growth optionality comes from their strategy of buying apartments that they can rehabilitate, which then allow them to raise the rent.

The company's geographic exposure is below. In this article I want think through a stress case on NXRT, then some of the more qualitative factors.

Defining the Stress Case

Rental vacancies for the South Region, where NXRT operates, peaked around 13.5% during the great recession of 2007-2009. There are large local variations though. Spot checking MSA level data on some of NXRT’s cities I get the following rental vacancies (using 1Q to 4Q 2009 as proxy):

• Atlanta: 14.6% - 18.4%
• Charlotte: 10.9% -14.6%
• Dallas: 9.9%-14.2%
• Nashville: 5.7%-10.9%
• Orlando: 18.2%-28.1%

How about rental prices? According to Axiometrics, class B rent growth went negative for about 7 quarters from 4Q2008 to 1Q2010. Importantly, rent never declined more than 10% before it rebounded.





So I think a reasonable stress case for NXRT would be 85% occupancy and 10% rent cut from current levels. Since we’re modeling stressful times, I assume they cut down a little on G&A expenses and shut off all capital expenditures, which is not good but understandable.

In this stress scenario NXRT can still get to ~$16mm of funds from operations (FFO) which, along with cash on hand, should let them maintain current dividend of $17.5mm per year. Realistically, if they get to that point I would expect a dividend cut, but the point is even in stress scenarios NXRT will generate enough cash to have options.

The credit and liquidity picture looks fine. They are highly leveraged but no big maturities until 2020+.

Quality of Apartments - Need to Get Better

I googled around Nexpoint's properties for ratings, and ended up settling on www.apartmentratings.com since this is the one site I know of that has all NXRT’s properties. Since people tend to write reviews only when they have negative things to say, the key is to see how NXRT's properties stack up relative to their peers. For example, if an NXRT apartment in Dallas has 20% of reviewers recommending it, while the average apartment in Dallas gets has 60% its reviewers recommending it, then the NXRT property probably have some room to improve.

In the table below I listed out NXRT’s properties. The four columns on the right (highlighted in green) shows 1) number of reviews, 2) percentage of reviewers that recommend that particular apartment, 3) average percentage of “recommends” for apartments in that city, 4) difference between NXRT’s property versus city average.

This is not pretty. Nexpoint’s properties in Texas generally get much worse reviews than city averages. Some of their Florida properties get excellent reviews. In general though, this is a picture of lower quality versus peers.

I understand NXRT’s strategy is buy apartments and rehab them, so arguably it’s the migration of ratings that matters, not ratings at a snapshot in time. Unfortunately, NXRT do not have any rating improvement data. The only related data are improving occupancies and higher rents – which are functions of not just quality, but also overall industry demand.

On the positive side, clearly they have lots of room and options for improvement.

Valuation

For valuation I have always struggled to determining an appropriate amount of “maintenance capital expenditure” to deduct from FFO. This gets a bit hazy as some of the natural decays of the building might be offset by regular maintenance and repair expenses, which are already charged through the income statement. (The IR person I spoke to argues that it’s all accounted for in the income statement, so there’s no need for a separate maintenance capex deduction. But I think that’s a bit aggressive since repairs are expensed, but you still get one-off replacements like roofing/tiles which are not).

I ended up using an extremely rough proxy. Maintenance capex from fellow apartment REITS UDR and Post Properties are stated at $1150-1250 per unit. For NXRT that works out to ~16mm of maintenance capex. The company currently has about $34mm of FFO (which mirrors cash flow from operations excluding working capital); deducting $16mm maintenance capex would leave $18mm of free cash flow, which is almost 100% used toward paying dividends.

Since free cash flow mirrors dividend payments, this also means FCF yield = dividend yield = ~6.2% at the current price of $13.2 per share.

I would give this idea a B. It has enough defensiveness and growth optionality, but the apartment reviews are something to monitor. That NXRT is externally managed is another ding. I have a small amount of NXRT in my IRA account.

Omega Protein: Low Expectations and Activist Presence

Omega Protein ("OME") catches fish then processes them into fish meal and fish oils. It has two segments, Animal Nutrition and Human Nutrition, corresponding to the use of its products. Profit mostly came from the former while the latter is currently losing money.

In the Animal Nutrition segment, fish meal and fish oils are used as feed in aquaculture, swine, and pet food industries. Aquaculture customers have become more important in recent years. I expect this tailwind to remain the next few years as the Atlantic salmon producers increase capital expenditure and production.

Catalysts

Earning expectations through 2017E are now reasonable and beatable. Valuation is undemanding at 11x forward PE.

Wynnefield Capital is trying to get OME to dump the money losing Human Nutrition segment. The company has been conducting a strategic review and is scheduled to announce a decision in a couple quarters. The activist wants to nominate their own directors, further putting pressure on the company.

For now I see the activist stuff as bonus. Given the valuation, the key is to make sure earnings are not going to fall off a cliff.

The Core Animal Nutrition Segment

After the latest earnings OME stock took a hit and earnings estimates have been cut, so there’s already some de-risking here.

Currently sell-side expects 10% and ~6.7% EPS gains for 2016 and 2017, respectively. Much of the growth can be fulfilled by just 2015 revenue getting pulled into 2016. 4Q15 was weak on revenue but productions sold forward were up some 20% yoy. Given the big jump in inventory, Omega should be able to fill these orders. Here are details on the forward contract from the 10K.

“As of December 31, 2015, Omega Protein has sold forward on a contract basis approximately 72,000 short tons (1 short ton = 2,000 pounds) of fish meal and 10,000 metric tons (1 metric ton = 2,204.6 pounds) of fish oil for 2016, contingent on 2016 production and product availability… As a basis of comparison, as of December 31, 2014, Omega Protein had sold forward on a contract basis approximately 54,000 short tons of fish meal and 14,000 metric tons of fish oil for 2015.”

Pricing has marched steadily upward the past few years. Management says the 1H2016 forward sales are generally at or slightly below 2015 levels. Global productions of fish meal and fish oil have been depressed the past few years, providing some support for pricing.

Cost per unit is driven by production volume (93% R-squared the past 5 years), which itself is catch volume multiplied by yield percentage. As the company explains it, yield is basically luck.

o The “total yield,” or the percentage of fish meal, fish oil and fish solubles products derived from the menhaden fish has fluctuated over the years and from month to month due to natural conditions relating to fish biology over which Omega Protein has no control “
o The Company believes that fish oil yields are influenced by multiple factors, including but not limited to, fish diet, weather, water temperature and nutrient content, fish population and age of fish, but such possible relationships and inter-relationships are not generally well understood.”

It sounds awful that a key driver should be left to chance, but that’s actually positive in this case because yield has been well below average (see chart below), so mean reversion would lead to higher yields.

Fish catch volumes are in line with historical norm. Combining a stable fish catch volume with better yield percentage should mean improved production, so cost per unit could improve over the next few years. The company is also investing $18mm on equipment to increase productivity.

Margins should hold up given these unit price and cost outlooks. Add in 15-20% increase in volumes, I can certainly see big revenue and earnings bump from Animal Nutrition segment in 2016.

If they ditch or fix that money losing Human Nutrition segment then earnings have further upside.

Downside and Conclusion

This is simply a crappy business. There’s little competitive advantage or moat. The fish processing business is growth constrained – harvest volumes are capped by quotas and fish in the sea which is gradually deteriorating. The company can make it up with higher prices but price is constrained by substitutes (fish farms can use vegetable based protein instead of fish based, even though the latter is considered higher quality). The company has little control over key drivers of production, as yield is basically luck of the ocean.

Management has not done well. The company takes impairment and “non-recurring loss” almost every year. In recent years the company has ramped up capital expenditure. Acquisitions have been questionable.

The unattractiveness of the business are mitigated by the fact that stock trades at ~11x PE – hey you get what you pay for. Throw in low expectations through 2017E and some activist presence, I’m inclined to roll the dice on this one.

When Does it Make Sense to Adjust for Amortization of Intangible Assets?

Buffet’s 2015 annual report contained his usual warning about amortization charges.

“… serious investors should understand the disparate nature of intangible assets. Some truly deplete in value over time, while others in no way lose value. For software, as a big example, amortization charges are very real expenses. Conversely, the concept of recording charges against other intangibles, such as customer relationships, arises from purchase-accounting rules and clearly does not reflect economic reality

Buffet goes on to say about 20% of Berkshire’s amortization charges are “real”, therefore adding back about 80% of amortization charges in his non-GAAP presentations.

For a lot of companies, non-GAAP earnings routinely doubles that of the GAAP version after adjusting for amortization of intangibles and stock-based compensation. Clearly these are no trivial matter. Since Buffett already criticized the latter, here I want to focus on the former.

Most Intangible Amortizations are Real Expenses

If the key question is, as Buffett suggested, whether the intangible asset depletes over time, then I would say most of them do. They are called “finite-lived intangibles” for a reason. Software and patents are fairly obvious - they deplete due to technological obsolescence and legal expirations, respectively. But even customer relationships and brands depletes overtime. 

Buffett cited customer relationship as an intangible asset that does not deplete. But I would argue even that decays overtime as your customers change (they move out of your geography, retire, move to another company…etc.) and competitors try to steal your customers. Brand value decays as well. If you literally buy out the Coca-Cola brand for a gazillion dollars and then subsequently spend zero on marketing, advertising, or promotional budgets while Pepsi continues their efforts, I believe even Coke would gradually lose “mind share” and its revenue will slowly decay overtime.

Criteria for Adding Back Amortization Charges

So when is it ok to add back amortization of intangibles? I think the real question is not whether something depletes – they pretty much all do. What really matters are 1) whether the company is spending to replace or maintain that earning power and 2) whether that cost is already accounted for.

Due to the quirks of accounting, intangible assets are capitalized when they are acquired. But the costs to internally replace that earning power (think R&D, advertising expense, marketing expense, and so on) are usually expensed. This means they already flow through the income statement, as opposed to getting capitalized on the balance sheet then amortized later.

Go back to the Coke example. Let’s say you buy out the Coke brand, and now you got a massive intangible asset and lots of amortization expenses. But instead of letting it rust, you actively incur expenses on sales/marketing/advertising to maintain or increase that brand value. Since these costs are already reflected in the income statement, not adding back amortization expense would be double counting.

Compare this to depreciation of hard assets. Since ongoing cost of maintenance would be capitalized and not expensed in the income statement, an accurate earning measure would either treat depreciation as a real expense, or add it back but subtract an estimate of maintenance capex.

The Verdict

To conclude, adding back amortization of intangibles makes sense. Not because they are not “real expenses”, but because the cost of replacing that intangible asset is likely already reflected in the income statement and you don’t want to double count. It is “likely”, but not always, because the appropriate treatment would differ company by company, and asset by asset. There’s no one size fits all answer.

Berkshire Hathaway is unlikely to skimp on spending to maintain its earning power, so Buffett’s adding back 80% of their intangible amortization seems sensible.

On the other hand, if a company’s core business model is acquisition of intangibles (say patents for drugs), yet does nothing to maintain or replace its decay (no R&D capability in house), then adding back amortization would be voodoo math.



Notes:

1) Whether a number is “correct” will depend on how it’s used. So if you add back amortization to earning or free cash flows per share, then apply a low multiple to account for the gradual depletion of earning power, then I have no problem with that. But more often than not people add back amortization of intangibles to come up with EPS or FCF/share, then apply 15-20x or even higher valuation multiple – therefore implying the earning stream is perpetual.

2) Intangibles have to be judged on a case by case basis because the same thing could be expensed or capitalized depend on situation (as this article explains, it depends on whether the intangible is acquired versus internally generated, and “identifiable” vs “unidentifiable”)