Blessed by the Potato

I’ve talked a lot in the past about Rogers from the customer’s point of view, so now I’ll flip that around and try to look at it as an investor, given the recent share price weakness.

In the past, I’ve never liked Rogers as an investment, without ever doing too much research: their P/E was always high, implying that investors expected a lot of growth, and I was always completely dumbfounded that the growth kept coming. Plus, you know, Blue Jays — how wise was that investment? Early on, as they were transitioning from being a cable company to a wireless company, I couldn’t believe how fast cell phone use grew, and how long it kept growing at those rates. Families were getting a cell phone for every member, a trend I was seeing with my own eyes and still not believing (I honestly thought it must just have been a Toronto thing, that surely not all Canadians could afford a cell phone). Rogers out-performed the TSX by a large margin for pretty much all of the last decade, and I kept thinking that it couldn’t continue.

I’ve still maintained my skeptical attitude towards these double-digit growth rates, despite being wrong for years running. I think I may finally be right, as if you add it up Bell, Telus, and Rogers now have between them 23 million wireless subscribers, against a population of 24 million between the ages of 10 and 65 (yes, surely some really young kids and older seniors will also have cell phones, but I have to believe that somewhere out there are a few people still without cells or who share within a family). Any future growth in net adds (above say 3-4%) will likely have to come at the expense of a competitor, and supposedly competition is heating up with the new wireless companies. I don’t know how much to fear margin compression with competition: the oligopoly of Bell, Rogers, and Telus have managed to “compete” without cutting into wireless profit margins for years, and maybe the new players will be in on the game too.

On the other hand, the markup for data services in Canada is one of the highest in the world, which leaves a lot of room for margin compression if any competition does take root, on top of any lost customer volumes as the market gets further fractionated. For comparison, the profit margin of Rogers and BCE is in the neighbourhood of 38%, but Verizon and AT&T are closer to 15%. So it’s definitely a concern, especially since Rogers doesn’t exactly have good brand loyalty.

The growth in upgrades to smartphones has been explosive, and adding data service to a wireless plan is a cash cow for a company like Rogers (smartphone customers spend ~2X as much per month). I don’t want to underestimate that, but at the same time, over a third of Rogers subscribers are already on smartphones. And competition is heating up there as Bell & Telus have only recently completed the network upgrades needed to seriously compete with Rogers for data customers (as well as getting access to the iPhone).

The cable TV part of the business is looking the weakest in my eyes: a small minority of people (like myself) have already cut off the cable, finding my TV watching needs can be met by DVD sets of my favourite shows, internet services, and over-the-air (which is all hi-def now, no need to go up like 3 packages to get the first few hi-def channels!). Fortunately, cable (TV, internet, home phone) is the smaller part of Rogers (wireless accounts for 68% of profit, cable about 30%, and TV just over half of that), and is still growing for the time being (though only 3.6% yoy in terms of revenue). Indeed, most of that growth is coming from the internet side: home phone is shrinking already, and TV was the only segment with net reductions of customers through 2009 (some came back in 2010, but I think that shows that there is weakness starting to form in the TV business). Internet should be pretty steady: hopefully UBB will go away, but they shouldn’t be getting much from that at the moment, as they’ve already driven the high-usage users off to the independents anyway. The next little while may be hairy though, as Bell & the CRTC’s UBB insanity gave the independents (and Netflix) a lot of free advertising.

There’s a touch more debt on the balance sheet than I’d like (and still growing, if slowly), and recently cash went towards share buybacks rather than debt repayments, but the maturity schedule looks well-managed.

In the end, I basically view Rogers as a utility: I don’t expect much if any growth, yet their services should have a well-supported demand with stable profits going forward (with no small amount of fear regarding competition). As such, I expect a utility-like P/E and dividend, and with the recent weakness it looks like that’s where it’s getting to. If I assume that earnings increase at about 2%/year (i.e.: about inflation, with any growth in customer base essentially offset by margin compression), and that book value is nil, I get a projected total return of about 9%/year here, using what I consider to be “fair” assumptions*. I’m not hugely thrilled with that for going out and picking something vs. just taking the market return in my indexed portfolio, but I am seriously thinking of investing in Rogers, in part for diversification (diworsification?) reasons, and in part for stupid reasons (I keep coming back to look at it, like my gut is telling me there’s something there, but that could just be because my gut likes beaten-up stocks).

* – don’t let my excel-fu instill a sense of false precision, I could see a future of anywhere from just the 4-5% dividend to 11%/year, and that’s just using some “fair” assumptions — admittedly, lower than the bottom range of “consensus” but not very conservative. Pessimistic ones about competition can make things look much worse: assuming profit margins go down to an American ~15%, then RCI would be over-valued by about a factor of two.

Thesis progress was once again abysmal this week. In fact, yesterday featured negative progress as I got into a discussion with my supervisor about some previous prose that I may now have to rewrite… Can’t wait to be finished this thing. Weight was down: only one pound, so it could just be measurement error, but at least it wasn’t up again!

Patrick of A Loonie Saved has finally put a post up, discussing the P/E-10, which right now is suggesting that the market is over-valued, in contrast to my earlier ambivalence. In the comments, Patrick links to another blog by Saj Karsan that suggests the P/E-10 may be skewed a bit by a large number of share buybacks over the years, and by the effect of two recessions (the -10 part of P/E-10 is supposed to give an idea of P/E over a full business cycle, but the last 10 years catches two bottoms instead of just one).

Harper once again shows he’s a class act.

Now even Paul Krugman is very worried about a Canadian housing bubble. The Economist has an article titled “Bricks and Slaughter”. “An even bigger reason to beware of property is the amount of debt it involves. Most people do not borrow to buy shares and bonds, and if they do, the degree of leverage usually hovers around half the value of the investment. Moreover, when stock prices fall, borrowers can usually get their loan-to-value ratios back into balance by selling some of the shares. By contrast, in many pre-crisis housing markets buyers routinely took on loans worth 90% or more of the value of the property. Most had no way of bringing down their debt short of selling the whole house.”

Michael James has some very sensible advice on looking beyond the next 5 years in the eternal fixed vs variable debate.

There have been a couple good reports on the fox domestication program in Siberia (watching that Nova episode was the source of the current tagline in the masthead: “50 years ago, Soviet scientists set out to…” “That’s how all the best stories start.”), but I haven’t tracked them down on the web to link to them. Here’s National Geographic, Nova Science Now, and Nova: Dogs Decoded.

Wired has a nice article up on why trivial decisions can sometimes seem hard when there’s an abundance of choice. I seem to recall another article from a few years ago on choice paralysis in investing, and that company pension plans were much better utilized when fewer options were presented.

I was feeling a bit down as my thesis progress has been so slow, and what has progressed has seemed to be won at such a high cost. So I took the Sad Panda meme image and made it my avatar on various social networking sites, but then realized it wasn’t sad enough for the PhD thesis woes. So I made it even sadder by turning it greyscale and adding a watercolour painting effect:

Since I don’t know who to credit for the original image, I can’t presume to claim any rights on the derivative, so have at it.

The pipelines have long been a core part of my portfolio: with nearly no income, I pay no income tax, so the tax treatment of the distributions never affected me, allowing for a bit of tax arbitrage (for most investors, outside of a taxable account, the yield on a pipeline would have been less after-tax than an eligible dividend, so their yields were high). They’re stable, long-term businesses, with very acceptable returns (esp. given the, IMHO, low risk involved). For full disclosure, I own both Fort Chicago (now Veresen) and Inter Pipeline, and have for years. So when Wayfare was looking for a safe investment in the midst of the chaos of 2008/2009, we turned towards pipelines, and settled on Enbridge Income Fund. After roughly doubling, she was wondering if it was perhaps wise to sell it (or sell half and invest in something else). Here’s a few of the things I looked at when making that decision:

First of, it’s important to recognize that pipelines are not exactly growth industries: it’s a capital-intensive business, and it’s hard to build out some fraction of a pipeline per year. So I don’t generally plan on much, if any, growth, which may be a little pessimistic (if nothing else, the transport tariffs may increase with inflation, and they do have other business lines, and hook up new producers to the pipeline over time in small segments).

There are parts that are hard to analyze, and hard to talk about analyzing. The companies often have other businesses (e.g., Fort Chicago/Veresen has both power generation and NGL extraction businesses). Some of these may be commodity-price sensitive, but I think I can safely say that generally most of the income from the pipelines is independent of what natural gas/oil does. The contracts vary (this is one of the hard parts to research), but are often take-or-pay, which means that the pipeline gets paid even if the producer gets shut down for some reason and doesn’t use the capacity. The pipeline itself may have different characteristics (e.g.: Inter Pipeline is all up in the oil sands, so it has a bit more growth as it hooks up the growing extractors in that region to its system). Enbridge and Veresen split the main Alliance pipeline that stretches across half the continent, but Enbridge has been more active in trying to grow in Saskatchewan. The corporate structure shouldn’t matter, but I find it much easier to read Fort Chicago/Veresen’s statements than I do Enbridge, since firstly the Enbridge name applies to several different companies (Enbridge Inc., Enbridge Energy Partners, Enbridge Income Fund) which have various relationships, and secondly because even just Enbridge Income Fund itself has various subsidiaries and holding company structures. Figuring out how to value these differences is a bit of a challenge to me.

Nonetheless, the first thing I look for is yield: after all, unless there is an expectation for growth somewhere, the yield is going to be where most of the return comes from in the pipelines. ENF right now yields about 6.1%, vs. it’s brother VSN at 7.6%.

Yield however is fairly meaningless if there isn’t cash flow* to back it up, so I next look there: what’s the payout ratio? The payout ratio represents the size of the distribution vs. the amount of cash or earnings the company is making: for an income trust (now just a high yielding corporation), I expect a high payout ratio, but one that still leaves room for growth, debt repayment, margin of error, etc. It’s pretty subjective and depends on the industry, but for REITs and pipelines, I look for a roughly 80% payout — much higher, and I start worrying about a future cut in the yield (or at least no/low growth); a lower payout may indicate a forthcoming increase to the distribution. For the payout ratio, I tend to look to cash flow rather than net earnings due to the very high depreciation line item that’s usually found — this tends to make the P/E ratio look crazy for pipelines (and other trusts/REITs). I have gone through the statements myself at some point in the distant past to get a handle on cash flow, and how it meshes up with net earnings, but lately I’ve been lazy and have just been accepting what the statements say at face value, or what the broker report has down for cash flow. For the latest quarter, ENF reported $100M of cash available for distribution [full year], and paid out $84M in distributions [full year], for an 84% payout ratio. VSN will report their full year results tomorrow I believe, but for the last 9 months had $134M of cash flow, compared to $107M in distributions [9 mos], for an 80% payout ratio. Due to the income trust conversion, these companies will have to pay income taxes going forward (but on net income, and it will also make the distributions eligible dividends), so I would expect the payout ratios to be squeezed for a few years.

What’s the debt look like? One big question will be the total amount of it, which is usually easily found (ENF: $1.1B, VSN: $1.7B), and that can be compared to earnings or cashflow/EBITA to look at debt coverage. Those measures are very sector-dependent: I’d be running for the hills if a restaurant had debt of 10X cashflow, but it seems appropriate for a pipeline. The various maturities can be important, as was brutally learned by Priszm and H&R — if credit conditions tighten, it can sometimes be difficult to “roll” the debt, so ideally the debt maturing in each year should be within a range where at least a large part of it could be paid off from earnings (with suspended distributions) if it came to it. ENF has this chart on page 17 of the Q4 report, I haven’t found it for VSN, but will likely be in the full annual report. That debt actually gets paid off can be important, depending on your view of leverage, but I think it is important for long-life assets to have the debt paid off before the asset is fully depreciated, and that is indeed how the debt is structured for the Alliance pipeline. VSN’s debt situation is a little more opaque as they paid down some long-term debt related to the pipeline, but then issued more debt in recent years for other acquisitions and capital spending. Anyway, both companies look very similar from a debt perspective (which should be expected).

For growth, I think ENF might have the edge over VSN due to its Saskatchewan system of pipelines. Otherwise they’re very similar, each owning part of the same Alliance pipeline (which makes up the majority of their businesses) and even sharing some power generation assets.

So at the end of the day, I looked at these two and couldn’t figure out why ENF had run up so much (119% for ENF vs 81% for VSN since March 2009) and was now yielding so much less than VSN (6.1 vs 7.6%), and that’s how we came to decide that Wayfare should sell ENF.

* – also called AFFO – adjusted funds from operations.

The legislation to make the TTC an essential service is in the pipeline, and may well be in force by the end of the month, when the contract again comes up for negotiation. It is a delicate issue, but one I’ve supported for a while.

I don’t want to be too indelicate on the matter, and there are several intertwining issues.

The first is the unique situation of the TTC itself: many people in Toronto rely on the TTC to get around. Not just for commuting, but getting to doctors’ appointments, picking up groceries, and just living their lives. Because transit in Toronto is decent, people don’t have cars: most new condo buildings don’t even have parking spaces for 1 car/unit; some famously have none. Likewise, we don’t have the taxi fleet, road infrastructure, or parking spaces to fully deal with the spill-over from a transit strike: the city shuts down. With some notice, the worst of it can be dealt with, at least temporarily: people can shift their hours to spread out rush-hour, businesses can arrange to work with skeleton staff and get people to telecommute, individuals can arrange car-pools, and people can restock the fridge. Of course, last time around, the union promised to provide notice, and then walked off at midnight, stranding people in a disgusting display of selfishness and greed. That kind of thing can’t be allowed to happen again: if the union can’t be trusted at its word to provide notice — or even to use something less than the nuclear option, like reducing service to holiday hours — then essential service legislation may be the only way left to keep Toronto moving, and to give people the confidence they need in the TTC to leave their cars at home.

With the chaos in Wisconsin, a parallel was almost immediately drawn:

“The leaders were also quick to equate Ontario with Wisconsin, where tens of thousands of workers have protested a proposed crackdown on public-sector unions.

In Ontario’s case, however, the legislation is not about saving money – declaring the TTC an essential service is widely expected to cost the city more in the long run. Ontario Labour Minister Charles Sousa stressed that the legislation is expressly designed for the unique and critical role Canada’s largest transit system plays in the lives of Torontonians.”

And that is a different issue. Even though I suppose you could label me as anti-union (I’ll try to clarify that below), from all accounts it looks like the republicans of Wisconsin have lost their minds. They’re not just trying to readjust the balance of power, or to get some much-needed concessions from an obstinate, entitled union (indeed, it appears as though the unions are willing to work with the state to try to balance the budget), but rather to annihilate collective bargaining all-together. And that’s going too far.

I’ve written about the power of unions before, and how in particular with government (garbage collection, TTC, etc.), the balance of power is out of whack: the unions hold too much. But removing the right to organize entirely isn’t the answer. Essential service regulation for some may be the key, especially where sudden strikes can lead to hardships. Other striking restrictions may be called for, such as some minimum standard of service during a job action (e.g., at least once-a-month garbage collection).

Part of where I stop seeing eye-to-eye with government unions is in their monopoly nature: just as corporate monopolies can lead to abuses, the same can happen on the labour side. I don’t want to take away anyone’s right to get together and collectively bargain, but why, once a union is formed, is that then the only option? If a union wants to walk off the job rather than negotiate, why can’t the government then try to negotiate with someone else to do the job? Why does it take a special exemption for someone who disagrees with the union to get a job, and even then, she still has to have union dues deducted from her pay (though in this case, they won’t go to the union)?

The balance-of-power just isn’t quite right at the moment. I don’t think radical reform a la Wisconsin is in order, but something along the lines essential service regulation does a lot to re-level the playing field. It’s just not fair that tax-payer funded workers are better off than many of the tax-payers themselves. Pay increases can’t increase faster than the rate of inflation indefinitely; and stuff like this burns too:

“The Ontario Liberals, trying to trim a nearly $19 billion budget deficit, raised the hackles of local unions when they announced in the 2010 budget that they would seek a two-year wage freeze on about one million public sector employees. However, apparently to avoid a labour showdown, the government failed to introduce legislation to back up the plan. Non-unionized salaries were frozen immediately. That means many unionized public sector workers have been getting pay hikes while their nonunionized counterparts doing the same work, often in the same location, have not. The Ontario Hospitals Association has been particularly vehement about these inequities.”

Mere hours after a strike deadline, the University of Western Ontario Faculty Association negotiated a settlement worth 1.5 per cent for each of four years.

That one in particular stings because grad students haven’t had an increase to their stipends in over a decade… but that’s a rant for another time. There’s a clear union/non-union imbalance there, and I don’t think the answer is “well, join a union” since there also looks to be a power imbalance between the government and the unions (an inability to extract even a minor concession like a wage freeze in the midst of a recession).

Anyway, I’m glad to see the TTC’s essential role recognized in the law, and hope that a more proper balance of power with other government unions is found. It could come from other legal changes, but it could also come just from the union leaders wising up to the fact that a strike, especially a public-sector one, is a severe undertaking, and not a biannual street party. Note though that I’m mostly only talking about government unions: the private sector does have a bit more of a balance (private companies can legitimately threaten to close down plants/offshore, simply fold up shop, or reason that a strike also hurts the union if it leads to the competition eating their lunch).