TGS - Transportadora de Gas del Sur

[peterHK]

Okay, bear with me on this one. This is actually a question/desire for feedback in the form of a pitch.

 

TGS is the largest extractor of natural gas, and largest operator of natural gas pipelines, in Argentina. Their revenue split is ~50/50, with almost half of the company's revenues coming from pipes, and almost half coming from extraction and processing (the remaining small portion, ~5% of sales, coming from a telecom company they own).

 

TGS's share price has been on an astounding run the last few years as 17 years of negotiation over tarrifs on their pipelines resulted in massive increases in revenue, and earnings. The tarrifs are playing catch up with a 1400%+ increase in wholesale prices, and increased 58% in April 2017, 78% in December 2017, and 50% in April 2018, and they haven't caught up yet, so I expect this will continue.

 

TGS earns 44% EBIT margins, 23% NET margins on an LTM basis after taking a $50 million currency loss (taking their FX gain and loss and netting them), and has no net debt on the balance sheet. Their return on capital is absurdly high at 30%+ despite no leverage (for comparison, North American pipes are leveraged 5x and earn 10%-12% ROIC's). If we ex out the currency loss, net margins are almost 29%.

 

The company's balance sheets have not historically been adjusted for hyperinflation (reason being the Argentinian government stopped calculating the wholesale price index, so they couldn't figure it out conclusively), so the balance sheet asset values are unadjusted despite massive inflation that has occurred in the country over the past few years. The effect is of course that they're earning inflated profits on uninflated asset values, so ROIC is going to look amazing. Net income will also be higher as D&A expense is lower. As of the past quarter, they've said they're going to start restating the balance sheet for inflation, so the effects will be interesting (I never thought I was going to use that part of CFA level 2!!) and a negative on the financials.

 

 

If we take assets on the balance sheet, and increase them by the amount of the tariffs (a compounded 303%) and increase D&A proportionately, then PP&E rises to $1.2bn gross, 784mn net, and D&A rises to ~$41mn (take current D&A as a % of assets, as they depreciate on a straight line basis, and multipy that % by the new gross PP&E).

 

After making those adjustments, EBIT falls by $27.3mn to $256.9mn or still a respectable 40% (TransCanada operates at ~37% currently, headed to 40%).

 

On adjusted capital of ~$1.3bn (debt and equity) they're earning $256.9mn of EBIT with a 30% tax rate, which gives you 13% ROIC's, which is much more normal for a pipeline operator.

 

Now, the obvious question is what about the currency.

 

They have $500 million of fixed rate debt denominated in USD at a 6.5% interest rate ($32.5mn of interest a year), and $291 million of construction obligations on new assets. They hold ~$344 million USD in cash and other financial assets, so those construction obligations are funded.

 

They also sell a portion of their refined product (ethane, butane etc) overseas, and those sales are denominated in USD. THis accounts for ~14% of sales, and I estimate (using the segment information for their production and commercialization segment) that comes at a 26% operating margin, so that's ~$32mn a year (using last 6 month annualized rate) in operating income, which is just enough to cover the interest, and on top of which there is another $250+ million in operating income, and effectively no additional debt.

 

Also recall that they have $344 million USD in reserves against $291 million in obligations over the next few years, so they have close to $50mn in excess USD cash, or almost 2 years of interest payments, if they choose to tap that reserve.

 

Thus, from a credit perspective, I think this is interesting. I don't have access to a bond quote as I write this, but I'd imagine the USD bonds have sold way off as the stock has.

 

From an equityholder's perspective, things are more complex.

 

This came across my radar on a screen that looks at 5 year historical average ROIC above 15%, leverage below 2 turns, and 5 year average revenue growth above 5%, all hallmarks of a very attractive business. The share price has exploded from ~$3 in 2015 to $13 today (down from a high of $23).

 

Part of me thinks this is a good business as a near-monopoly owning natural gas pipes (which are great assets to own) transporting 60% of Argentina's natural gas, that is in turn over half of the country's energy usage. It trades at 11.67x my adjusted EBIT with a pristine balance sheet, albeit in an economy that is a complete mess.

 

The other part of me says this may make a good short because as the company has to revalue the assets on the balance sheet, this goes from a company that screens as having 100% revenue growth, 44% EBIT margins, trading at 6x EBIT, and having ROIC's in the low 30's, to what I think it ACTUALLY is, which is a company that is growing maybe 5%, has 40% EBIT margins tops, ROIC's in the low to mid teens, and operates as a fixed asset provider in a country ravaged by inflation and very high interest rates.

 

Technically, they don't have to revalue things as Argentina has a law which states that hyperinflationary accounting doesn't apply (and hasn't since 2003), so one has to adjust everything looking at the country. It seems to me that people aren't doing that with TGS. No analysts ask these questions on the call, and management doesn't talk about it, so I don't know what adjustments consensus is really making here that they SHOULD BE if IFRS was actually applied here.

 

Thoughts?

 

 

 

[petec]

My thoughts

 

1) primary determinant of your return is going to be whether Macri gets re-elected next year and the normalisation of tariffs continues (he is why it’s happening).

 

2) while your maths around revaluing the balance sheet is interesting, very few investors in Argentina will trust accounting ROICs (or will fail to adjust those ROICs for inflation, which is currently 40%). I’d be surprised, therefore, if lower net income comes as a surprise.

 

3) value it on cash flows.

 

4) The dollar bond trades at 90 for an 8.7% YTM. Quite nice for a net cash pipeline!

 

[peterHK]

My thoughts

 

1) primary determinant of your return is going to be whether Macri gets re-elected next year and the normalisation of tariffs continues (he is why it’s happening).

 

2) while your maths around revaluing the balance sheet is interesting, very few investors in Argentina will trust accounting ROICs (or will fail to adjust those ROICs for inflation, which is currently 40%). I’d be surprised, therefore, if lower net income comes as a surprise.

 

3) value it on cash flows.

 

4) The dollar bond trades at 90 for an 8.7% YTM. Quite nice for a net cash pipeline!

 

Agreen on Macri, I personally think he may not, but I hate handicapping politics in these scenarios.

 

If we adjust D&A, free cash gets a boost as maintenance capex will be in nominal dollars, so from that perspective its a benefit. So, good point to value it on cash flows.

 

They're $291mn USD on capex to build pipe into a new gas field. Management has said 15% IRR target, though I don't have a lot of trust in them so really who knows.

 

LTM FCFE using adjusted D&A is ~$100mn ($175 of adjusted CFO less $73.9mn of capex, most of which is maintenance). So at a $2.925bn market cap, that's a 3.4% FCFE yield vs. something like TRP and ENB at closer to 10%.

 

The fact this screens so expensive on the cash flow statement, but so cheap on the income statement makes me wonder which investors are really using. I think that it should trade at a higher FCFE yield given the risks involved, personally.

 

 

 

 

 

 

 

[Guest Schwab711]

Isn't the dollar bond yielding so much because of the currency risk? The USD reserves are great but the currency mismatch is probably why the stock/debt are so cheap. I'm guessing the market is expecting them to need more USD going forward.

[petec]

If we adjust D&A, free cash gets a boost.

 

[petec]

If we adjust D&A, free cash gets a boost.

 

No it doesn't. D&A is a noncash figure so it doesn't affect FCF.

 

I would be very surprised, given the bear market bordering on panic in Argentina, if this thing is expensive on any metric including FCF after maintenance capital (which is how I would value it). Bear in mind after the devaluation, capex has gotten more expensive in pesos but revenues haven't yet. They will catch up as the fx rate impacts inflation (which then impacts tariffs).

[peterHK]

If we adjust D&A, free cash gets a boost.

 

No it doesn't. D&A is a noncash figure so it doesn't affect FCF.

 

I would be very surprised, given the bear market bordering on panic in Argentina, if this thing is expensive on any metric including FCF after maintenance capital (which is how I would value it). Bear in mind after the devaluation, capex has gotten more expensive in pesos but revenues haven't yet. They will catch up as the fx rate impacts inflation (which then impacts tariffs).

 

Higher D&A results in a lower pre-tax income, lower tax expenses, and you then add it back after tax. The result is higher FCF due to lower taxes. Non-cash expenses that can lower taxable income, but leave cash flow unchanged are beneficial.

 

They're currently running on MCX, they've barely invested anything in growth, so you can effectively take capex off the cash flow statement. Remember that assets are hugely undervalued, so as a % of book value, MCX looks very high, but it's not really.

[petec]

Are you sure that the tax accounting is going to change? Often the tax authorities apply one set of accounting rules and the auditors another. If the company is considering changing its accounts for reporting purposes, that doesn’t necessarily mean the tax accounting is changing (and they have no control over that).

[peterHK]

Are you sure that the tax accounting is going to change? Often the tax authorities apply one set of accounting rules and the auditors another. If the company is considering changing its accounts for reporting purposes, that doesn’t necessarily mean the tax accounting is changing (and they have no control over that).

 

Might be true, I don't know. I do know that the government doesn't accept hyperinflationary accounting, so they are unlikely to change their accounting for tax purposes or reporting purposes.

 

My point is that the accounting here doesn't reflect the actual economics of the assets or the business, leading to inflated metrics all over the place.

 

 

________________________-

 

On the USD bonds, yes they trade at a high yield because of the mismatch in currencies, but I think they're well covered from a credit standpoint. Unless there are capital controls which would render the ARS pnl hard to transfer into USD, they do earn USD profits I estimate cover the interest (between interest on cash balances and the pnl from extraction/commercialization business.)