Value Destruction at TransCanada

There are far worse offenders than TransCanada, but value destruction by management is rampant in many cyclical and/or commodity industries, and natural gas is one which has a particularly high rate of occurrence. There are many natural gas firms, particularly those that focus on upstream operations, which compensate officers at least partially on the growth of both production and reserves as opposed to value creation.

There are gas producers which are destroying shareholder value at a much faster pace than TransCanada, which is a midstream pipeline and storage operator of both oil and gas, but it is more difficult to measure for producers given that they at least have the potential for significant improvement in earnings if prices revert to historical averages. TransCanada on the other hand, is not exposed to commodity prices near as much and generates revenues from contractual rates based on costs plus a small rate of return, which depends on volume transported. Despite historically low gas prices, gas volume produced industry-wide continues to increase and so TransCanada is much more of a utility given that its infrastructure will be used throughout cycles in spite of lower prices. Given that its results will not fluctuate to the same degree as upstream producers based on pricing, it is easier to determine the efficacy of management in allocating shareholder funds in the short-run.

From 2014 to 2018, TransCanada has increased total invested capital from $47b to $76b (all figures in CAD), net income from $1.84b to $3.15b, and NOPAT from $2.6 to $3.6b. That’s a 62% increase in capital and 72% increase in net income, with a 38% increase in NOPAT. This is a $29b increase in capital for a $1b increase in NOPAT, so as of right now that additional capital invested has only brought a 3.4% return. Over this time, the firm has only generated a total of $12.6b in NOPAT and $4b in net income. Of note is that the firm in its reports estimates its maintenance capital expenditures and distributable cash flows net of growth investment-they say in 2017 their estimate of owners earnings was $3.6b, which is right on the money of a NOPAT estimate using a 20% tax rate (a generous tax rate).

With a pretty constant 5% ROIC, and paying out over $1.5b a year in dividends (about 150% of total earnings for about $6b in total dividends in the four years), the firm has grown capital by 13% a year over this time, meaning it has gathered all of this additional capital from elsewhere- both debt and share issuances. The total amount gathered from outside debt and equity investors would be equal to the total increase in capital, subtracted by the firm’s earnings, plus dividends paid out. With a $29b increase in capital, and the firm having earned only $4b and paid out $6b, $31b was taken from outside investors. Of this $31b, $19b came from debt-holders and $12b from share issuances.

So for a $1b increase in NOPAT, the firm has had to take on an additional $19b in debt which will need to be paid back along with interest, and they also diluted shareholders by increasing the share count by about 28%. An investor would have to be capitalizing those earnings at a very low single digit rate for those to be worthwhile expenditures by TransCanada’s management. The dividend yield is currently at 5% which excites dividend-seekers, but it is maintained by increasing debt and shares outstanding. Further, with a 5% ROIC along with interest charges on debt, the firm is decreasing in value to its owners with every additional dollar invested into operations, assuming owners expect a rate of return higher than 5% less interest. As long as dividends and earnings keep increasing, most investors will likely overlook this inconvenient fact, but I believe it is a common and significant mistake.

There are many examples of firms in which earnings are increasing but which aren’t increasing in value to shareholders as debt increases in a disproportionate manner. More than a few pharmaceutical companies in the recent past have increased earnings rapidly through debt-fueled acquisitions and have been rewarded in the short-term with higher share prices despite destroying value along the way and the artificial growth inevitably dissipates. Although earnings in such cases have increased, eventual future debt repayments have either reduced future free cash flows to equity or haven’t grown them at a reasonable rate of return. The future change in net debt is often mistakenly excluded from valuation, meaning earnings increases in most cases are applauded by investors regardless of the increase in debt. The primary issue is the fact that more and more capital is being put into a company generating excruciatingly marginal returns.

This wasn’t necessarily meant to be an indictment or analysis of TransCanada’s operations, I just wanted to use the numbers as a real example to show what I believe is value destruction. However, when you quickly factor in that TransCanada’s rates are regulated with a cap on its ROE, I believe it is highly unlikely that this $29b in additional capital was well-invested for owners. Apparently, management plans on reducing debt in future years and bringing new infrastructure to capacity which may improve things, but as it currently transports 25% of North America’s gas, and with recently reduced rates, and with industry gas supply at historic highs, I would be surprised if enough additional volume came about to prove me incorrect.

This discussion also highlights what can go wrong using surface-level metrics. TransCanada has a P/E of 17 and dividend yield of 5%, which doesn’t sound terrible if you are just investing for a stable income from a utility-type company. When you add the debt to its current market cap of $50b however, the enterprise value is $97b which is a better idea of the true price of the firm, for an EV/NOPAT of around 27. Again, the dividend yield is basically meaningless knowing that it comes from dilution to owners and from new debt- who cares if management is paying you a 5% yield when your business is taking on debt or inviting more owners to pay that cash to you. They’re frankly just moving the cash from the hands of other investors to your hands and your business will eventually have to pay those investors off with the cash it generates. Despite the EV ratio being more explanative than the P/E, it isn’t a valuation, so you would have to ask yourself whether the firm will in a reasonable period of time generate sufficient cash flows to allow for good returns for owners in the long-run. I think the answer is very likely not.