Blessed by the Potato

I recently was pointed to Canadian Doomer’s site, where I saw this comment:

“Ontario Hydro is paying $0.80/kwh to those who sell them electricity on the MicroFIT program. But consumers are paying $0.05 to $0.10/kwh. This makes absolutely no sense, unless Ontario Hydro knows that they will soon be charging consumers MORE than $0.80/kwh. Look at your hydro bill and imagine it multiplied by 8.”

Well, no, it’s the price they have to pay to get solar off the ground. Very few people wanted to pay ~8x the price of grid power to buy their own solar panels, so the companies weren’t making panels, so the panels were expensive, etc… By offering enough money that PV would be profitable, it bootstrapped the industry, and broke the vicious cycle. The industry has already brought the price down by huge amounts (panels now cost half or a third of the price in just 3 years), and the government is going to cut microFIT any day now (they’ve already started dragging their feet with applications).

That lead CD to ask the follow-up question:

“Why does Ontario Hydro care so much about getting solar off the ground when they’re not making money on it?”

The short answer is that it’s because it’s the right thing to do.

The longer answer is to first up realize that Ontario Hydro is not an independent company: this isn’t Capital Power or Emera or Fortis offering money to install panels, it’s the government. And sometimes the government subsidizes things for social rather than strictly economic reasons.

Consider other breaks offered recently for green technologies:

The federal government was offering up to $2000 to buy a hybrid car, until just a year or two later, they changed their minds and took that incentive away. Many provincial governments (including Ontario) also offered rebates of several thousand dollars ($2k in Ontario) for hybrid cars (and similarly, no PST on bicycles). Those rebates by our government as well as others around the world — notably the US, which had various tax credits as well as other incentives to buy hybrids like free parking and HOV lane passes — were very helpful in getting this fuel-efficient technology off the ground. Hybrids are now reasonably mainstream, something like 4% of the overall passenger car market, and still growing quickly. However back 10 years ago, a hybrid was a very difficult sell: they were more expensive than a traditional car, there was a lot of uncertainty over how reliable they would end up being (a sentiment that still persists, even with over a decade of experience), how much they would cost to maintain… and all that was on the back of gas prices that were still measured in cents per litre. So those subsidies helped level the playing field until the cost of the cars and the price of gas brought us to where we are today, where $1.20/L looks cheap, and it seems stupid to buy anything other than a Prius. And while I tend to focus on how awesomely quiet my car is and the gas savings, the fact is that the gas savings is in part a side-effect of the hybrid’s original goal, which was to reduce pollution — an important social goal in an urban country.

So back to the solar subsidy: by guaranteeing a certain return on the panels, people became interested in purchasing them. The government could stand up and say that, for at least the next few years, there would be a certain level of demand for panels, which allowed panel manufacturers to go to their investors and raise money to build factories and invest in R&D to make more efficient and cheaper panel technologies, and basically got the whole ball rolling. Ontario and Germany really lead that area*, and factories really started churning out panels to meet the new demand, and to build capacity in the hopes that a certain superpower with a lot of desert would also decide to start subsidizing solar energy in the future (let’s call it “Nerizonda”). In just a few years we’ve gone from a world where you had to be an eco-nerd and know someone at NASA just to get a panel, to one where salesmen call up on a weekly basis to let you know how much the panels are on sale this week. Indeed, the build-up has been so rapid that now we’re facing a glut (exacerbated by Germany and other nations scaling back their subsidies for new projects now that they can declare victory), and panels can in some cases be had for below cost.

Now, the solar subsidy could have come in many forms: the government could have directly purchased the panels themselves, and installed them in parks or on government buildings, or even installed government-owned panels on private homes. They could have subsidized the purchase price directly. Instead, they chose this strange scheme that involved all the overhead of metering the panels, and making regular payments (or deducting from the power bill) for 20 years running. And that decision comes down to politics: the budget looks cleaner with a long-standing trickle of money for a program than it does with a big buy over just a few years, even if the total cost is the same. Furthermore, to give Dalton a little bit of credit for being political operators, there was going to be a big delay between starting the MicroFIT program and when the bulk of the payments would start rolling out the door, and in-between was another election. So for the 2011 election, hardly any microFIT payments would have shown up on the budget, and by the ~2016 elections, the program will have ended; off the radar either way.

It’s also important to note that there were several levels to the FIT program: for large commercial solar farms, the rate was less than half what an individual could get under the MicroFIT program. So from a “this is how much OPG expects power to cost in the future” point of view, that might be the upper-end figure to use. Why pay more for smaller systems? Several good reasons:

• In part as an experiment. People have been talking about distributed generation for years, and the government wanted some data on what that would actually look like. Which meant that you had to find some way to get people to put some kind of generator in their homes, and test out how well the load-balancing and monitoring systems worked. So getting solar out there in particular was a bit of a bonus on that front.
• In part to raise awareness. You can give money to a big corporation like Samsung to build a giant solar farm in the middle of nowhere, and accomplish your goal of bootstrapping the industry. But if you can get it on people’s homes they’ll see it every day, they’ll talk about it with their neighbours, and it’s also nice to pay your own citizens rather than a faceless corporation. From a political point of view, that also helps make it an issue you can focus on in an election if you want to.
• In part for long-term efficiency synergies. A giant centralized solar farm is a great way to quickly get solar power on the grid if that’s your only goal. But one of the beautiful things about solar is that its nicely correlated with peak air conditioner demand: just as the sun is beating on your house is also when your panels are at their maximum output. That benefit could potentially go away if Toronto is getting sun while the solar farm on Lake Huron is experiencing clouds. Though you need more inverters and monitors, you don’t need any transmission capacity to be built or maintained, since the generation is right at the site of demand. And on top of all that, you get the synergies that come with rooftop solar: the panel itself helps to shade a house and keeps it cooler than a typical asphalt shingle, further reducing peak power demand.
• In part for short-term inefficiencies. The fastest, most efficient way to get X number of panels installed and tied into the power grid is to go with a giant centralized solar farm: make braces and connect panels in assembly-line fashion in a consistent, controlled environment. You can even bulldoze any hills if you can’t find a naturally flat spot. But when you’re introducing a program in the middle of a recession, maybe you don’t necessarily want to be as efficient as possible, maybe you also want a little bit of economic stimulus for good measure: help create jobs for guys to crawl around roofs and take measurements and figure out where the bolts should go.

As for that central question of why? Well, because it’s a green, emission-free, renewable energy source. It has some side-benefits (correlated with air conditioner demand, cooling synergies), but also some negatives (inconsistent, extremely difficult to plan power loads with, expensive even after the cost reductions from recent investments). It has a good image, and getting to some single-digit percent of our power mix being wind and solar is something we can do a little chest-thumping over (never underestimate the importance of chest-thumping, it’s a trillion-dollar industry). Plus, innovations that are created for stationary solar may translate to other applications (space systems, remote self-sustainability).

* – I’m going from memory here folks, apologies if I forgot any other pioneers.

One of the great things about TD e-series index funds are their simplicity: with just four low-cost funds you can build a complete, diversified, passive portfolio. There are no sector or specialty funds to distract you, like there are in the ETF space.

That can also be seen as a downside though if you do want to get that exposure. Jeffery writes:

I’m interested in purchasing an index fund focused on the Emerging Markets. However TD Eseries does not offer anything targeted towards the Emerging Markets. After looking around, I found that the CIB519 mutual fund seems to be the best in terms of ratings from Morning Star and it seems to have been around for some time. The MER for this though is quite high, 1.36%.

First of all, I don’t really think it’s totally necessary to chase certain sectors if you’re going for a passive investing strategy. The whole point is to try to not make any unforced errors, as they say, or to try not to let your own (amateur) analysis interfere with a solid middle-of-the-road strategy. It’s also not really necessary in my opinion because you’ll still have some exposure to various sectors through the larger indexes: there’s lots of energy exposure in the Canadian index, and multinationals in all equity indexes will to some extent share in the upside from maturing developing economies. You’ll likely want to keep any “flavour” or “kicker” sector exposure small as well, and if it’s going to be a small part of your portfolio, will you really miss it that much if you just stick with the basics?

That said, what if you do still want to get more specific than the e-series lets you? Well, there are a few ways to go. One is what Jeffery has already found: use a higher-cost mutual fund to get the exposure, and just pay the MER.

If you’re not going to be making many transactions though, a better route would be to look at using an exchange traded fund (ETF) for that exposure, and that’s part of the beauty of using TD Waterhouse for your e-series account over TDMF. If you have $50,000 or more in assets at TD, it’ll be $10/trade, $29/trade otherwise. You don’t want to make frequent transactions for small amounts when you have to pay commissions for each trade, but if you’re just looking for a small bit of flair, that’s fine. You can pay the commission once, and not be too strict about your rebalancing — will it really matter if your emerging market or energy or whatever ETF goes from 4% to 6% of your portfolio (or 4% to 2%)?

The math on the expenses is pretty simple: you’ll have a commission for every transaction, plus the MER of the fund itself. So for example if Jeffery wanted to buy the iShares emerging markets ETF XEM and was investing $3000 in it, and paying $10 in commissions to buy, $10 to sell, and planned on holding for 5 years (without further rebalancing over that time), the overall expense would be: $20/3000 = 66.7 bp/5 years = 13.3 bp per year for transactions, plus the 79 bp of the fund itself, for a total expense of 92.3 bp (or 0.923% if you prefer). That’s a better option than the mutual fund he found, but not by a whole lot — some of these specialty funds are expensive even as ETFs. If he planned on investing a little bit over time rather than a lump-sum up front, then it would make more sense to go with the mutual fund; if he had more to invest, or an even longer time horizon, then the ETF may look more attractive. There are of course lots of ETFs out there by providers like iShares, BMO, and Claymore in Canada, as well as some available on US exchanges by Vanguard. Speaking of which, the Vanguard emerging markets ETF, VWO, has a MER of just 0.22%, but then you have to pay to get your Canadian dollars converted into US ones to buy it on a US stock exchange, which can cost ~1.5% each way at TD (there are some cheaper alternatives, like using a “gambit”, but those generally require larger sums to be worthwhile). For longer timelines, VWO is probably the way to go.

So I don’t think it’s necessary to add emerging market exposure to your portfolio, and if you have less than $50k to invest the slice emerging markets would represent (assuming you’re aiming for something in the ballpark of market weight, ~5-10%) it’s probably not going to be meaningful enough to worry about anyway; you can just stick with the basic e-series. If you have more than $50k, then you’ll get the $10 commissions, and the ETF route is probably the best one to take.

Jeffery also had this detail to add:

I noticed an offer for PCF customers where if they open an investment account through them, they offer a discount of 0.10% off of the MER for any Index fund from CIBC. Which means that the MER would be lowered to 1.26% if I bought it through a PCF account.

I’m all for saving money, but 0.1% off is not a very big savings — if you have $2000 to invest in this particular side pocket, that’s $2/year. $2 isn’t nothing, but I’d be tempted just to pay it rather than deal with the hassle of opening another mutual fund account. And if you have more than $2-3000, then the better option is to use an ETF through Waterhouse.

This is perhaps one of the weakest sections of the book, since it largely tells you to just back-of-the-envelope it if you’re young, and to go visit a planner or read a dedicated planning book if you’re older. But it does give you a feel for the writing style, and if you like this, hey, you’re gonna love the book.

Putting together a plan is important: the plan will shape your investing/saving activities, so having a plan is obviously a must, but putting one together yourself (even if only very approximately) is also important because there are so many bad planners out there (mostly salescritters posing as advisors). If you rely on their plan you may be setting yourself up for disappointment, so it’s important to at least know if they can get you in the ballpark before you go to a “planner”.

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Planning

It’s important to come up with a plan to guide your financial life. There are many factors to consider, including:

• how much you should save
• your return on investment
• how much you’ll need to spend per year in retirement
• your timelines (how long you have to save/invest, how long you have to support yourself after)
• other goals
• tax issues

For each be sure to consider a range: what if returns were 4%? 5%, 6%, 7%, 8%? Be sure to be realistic, as it does no good to come up with a plan that won’t even come close to a realistic return (as easy as retirement saving looks with a 20%/year return, it’s not realistic).

There’s a whole profession of financial planners out there with their own professional designation (CFP) with a host of detailed, complicated software tools that can account for different investment returns, inflation, taxes, etc. When you get closer to retirement (within a decade or two) then it may very well be worth paying a visit to one to draw up a detailed plan. But if you’re younger (20’s and 30’s) then the uncertainty of the future is so great that the details probably aren’t all that important: you can get close enough by yourself with a few minutes of careful thought and a spreadsheet.

Just try to save as much as you can get away with early on and you’ll set yourself up to be in fine shape by the time you’re ready to have a professional look at your situation.

Your investments are just one part of the overall plan, but the part that is really the focus of this book…

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That’s exactly how it appears in the book. Now one of the objectives of the book was to keep things brief, and cover a lot of important topics. Here I’ve got a chance to perhaps reflect and expand and maybe even edit myself a bit. Recently Netbug asked “what should be in a plan?” So to make a convenient list:

1. How much you should save.
• Take the time to go through the exercise from both ends: starting from where do I want to end up, how much do I need to save to get there? And also starting from my current budget, how much can I save?
• Remember that your savings rate likely won’t be the same through your whole life, and you can include that in your plan, though also remember that the more you do early on, the more effective those savings will be.
• Don’t forget to stock that emergency fund!
2. Your return on investment.
• You’ll want to plan for several scenarios. Remember that you have basically no control over your investment returns.
• Be realistic. Saving for a lavish retirement seems easy if you assume you’ll make 25%/year on your money, but 2.5% after inflation and taxes might be more realistic.
• Also consider at this point your asset allocation and risk tolerance. If you have a low risk tolerance, you’ll likely also need to allow for a low return on investment.
• Remember to use real returns, or to otherwise factor in inflation.
3. How much you’ll need to spend per year in retirement.
• A good starting point is how much you spend now (go back to that budget you made in step 1).
• Don’t forget occasional big ticket items, like new cars, vacations, etc.
4. Your timelines (how long you have to save/invest, how long you have to support yourself after).
5. Other goals.
• Saving up to go back to school, buy a car, a house, or whatever? These should also be part of your plan.
• Do you want to die broke, or try to live off just the returns, leaving behind a large estate for your kids or charity?
6. Tax issues.
• Don’t forget to account for tax burdens when projecting out over the years. Also, where is it best to put your savings? TFSA vs RRSP, one spouse’s account vs the other?
• But also don’t worry too much about taxes — they’re another level of complication, and they can’t be entirely avoided or deferred. Many people make bad investing and life decisions attempting to minimize taxes paid.

As for determining what to plan for each of those items, I’ll say that like many things in life, it’s a balancing act. You want to save enough that you’ll be supported in retirement, but not scrimp so much that you sacrifice your quality of life today. Though a hint: very few people hit retirement and say “oh darn, I saved too much!”

You’ll have very little control over many of the factors in your plan, and not much clarity over exact figures on the ones you can. Early on, like in your 20’s and 30’s, don’t worry too much about it: it’s more important to have the outline of a plan and to just get started than it is to have a binder of projections and precise scenarios prepared. As you get closer to retirement, you’ll want a more detailed plan, so in your 50’s it may be worth moving on from ballparking with a napkin and Excel to paying a planner. In fact, why not make a visit to a fee-only planner a 50th birthday gift for your friends and family?

And of course, sticking to a plan is important (more important than getting that plan perfect), and this flowchart by CPFB is relevant.

Introduction

Poseidon is a spin-off of Open Range Energy (ONR). PSN leases modular above-ground fluid holding tanks to oil and gas companies for fraccing fluid handling and storage. Their literature indicates several benefits of their approach over traditional methods such as excavating and lining a pit or using multiple tankers. These benefits include cost, full-year access (lighter truck loads for road bans, and no need to dig in the winter), and more efficient heating of frac fluid pools (a simple matter of surface area, combined with insulation).

PSN has exhibited incredible exponential growth over its short history, rapidly outgrowing its parent O&G company. There are many unanswered questions about its business, in large part because it is so new, but also in part because past financials of Open Range Energy were not restated to segregate the Poseidon tank rental business from the O&G business. It looks good, but is it too good to be true?

Overview

PSN has positioned itself to be a small/mid-cap high dividend-paying oil services company (the tank rental business). It has set the initial dividend as a monthly $0.09/share, or $1.08/year, which at today’s price of $11 represents a yield of 9.8%. They project that they will be able to cover that yield from operating EBITDA for full-year 2012, with further growth to come. Growth has been phenomenal, starting from nothing at the beginning of 2010 to $20M in revenue in Q3-2011, with 170 tanks at that point, and a current build rate of ~1 tank/day.

It requires very little in the way of capital, and offers extreme margins and returns (90% operating margin, ~70% RoIC). The company has applied for Canadian and US patents on its tanks, and a provisional Canadian patent has been granted.

Several important questions have not been answered, however:

1. How is their technology reviewed by 3rd-party professionals?
2. What is the long-term market share they can expect to hold? Long-term margin?
3. With such a lucrative business, why is no one else doing it?
4. What is the lifetime of a tank, on average? [Update: investor relations says over 10 years, expecting up to 20]
5. Why do they pay a dividend?
6. Why did they split the company, rather than using PSN’s cash flow to fund ONR’s O&G development, or selling the PSN division to a yield-hungry pension fund?

PSN has negligible book value, so an investment would be predicated on the long-term ability of the business to generate cash (i.e., to pay the dividend).

Financials

Growth: Started with $1.6M of tank rental revenue for Q1+Q2+Q3 of 2010, up to $41M in Q1+Q2+Q3 2011, with over half of that in Q3-2011 alone. 2011 guidance is $55M EBITDA, and $130M for 2012. Growth rate is simply out of this world. The dividends would work out to about $80M in 2012, leaving a projected $50M for capital expenditures from cash flow.

PSN has a $75M credit facility, with $25M drawn, leaving $50M available for capital expenditures (in addition to retained earnings).

Between debt already arranged and cash flow, PSN should be able to spend $100M on new tanks in 2012. Their manufacturing allows for approx. 1 tank to be built per day.

Note that PSN has only ever reported EBITDA figures. No numbers are available for depreciation.

How much does a tank cost?

This is not explicitly stated, however the ballpark would be $350-750k/tank. The release for PSN’s split indicated that PSN had 170 tanks at Sept 30, 2011, and had $60M in assets (substantially all of the assets are anticipated to be tanks). Looking at the capital expenditure statement of consolidated Open Range, capital spending for 2010 + 9 mos 2011 was $127M, over which time they built 170 tanks (and also presumably spent some of the capital budget for the O&G business), so the worst-case is $750k/tank. Closer to $400k/tank is probably most accurate.

Tank Inventory

170 tanks at Sept 30, 2011. 2012 is projected to open with 240 tanks. At $400k/tank, they could build 250 tanks with the available cash and debt lines; at $350k/tank, they could build 285 tanks in 2012. Either way, that is not the maximum output of 365+ tanks we could expect given the current manufacturing run-rate. Which leads to my biggest question:

Why are they paying a dividend?

Dividend-payers are all the rage right now, and indeed PSN only came to my attention because it was a prospective dividend-payer, but why as a shareholder would you ever want to take a dividend when you can reinvest in a business that’s doubling every year and boasting the kind of margins and RoC that PSN offers? Yes, they could still max out their production with additional borrowing, but why? The answer may be related to the next few questions.

What is the long-term outlook and fleet size?

I have no basis for attempting to estimate the long-term margin they will be able to achieve. Competition will almost certainly arrive: so far they have first-mover advantage (the answer to “why isn’t everyone in this business” is likely because it came out of nowhere just 2 years ago), but that won’t last forever. They have a patent, but I have not had a chance to see it for myself, and even then, some non-infringing copy-cat attempts will likely be made.

For fleet size, I ballparked a final fleet size in the 400-500 tank range, which would represent getting tanks associated with something like 10-20% of the fraccing rigs in North America, and with 4-5 tanks per rig required (though the tanks set up quickly, it’s likely that each will be needed at a site for longer than a fraccing rig in order to process the fluids). Again, just ballpark estimations. At the current rate of production, PSN would hit that before the end of 2012, and that (I’m sure more out of coincidence than anything) would mesh up with the capital budget I outlined above. If that is the case, then that may explain why they can pay a dividend: the growth plateau is close.

60% of the current tanks are already leased through to the end of 2012. Some multi-year contracts in place as well. This suggests that demand is still moderately strong.

What is the lifetime of a tank?

The depreciation for PSN has not been broken out in a segregated filing. One quick estimate would be 10 years: somewhat similar to other machinery/autos that are used year-round outdoors with steel components [update: investor relations indicates this is a good guess].

Valuation Scenarios

Let’s attempt then to value PSN under several scenarios.

Assume 2012 goes as forecast by management and ballparked above. Then for 2013 they would have 450 tanks and be in the long-term plateau of company size. Presently, they earn EBITDA of $400k/tank/year. Assume the bank line is fully drawn at $75M with a 5% interest rate, so interest expense is $3.75M/year.

Scenario #1: margins remain lucrative, tanks continue to earn EBITDA of $400k/tank/year, tanks last 10 years.

Scenario #2: margins remain mostly lucrative, but fall a bit, tanks earn EBITDA of $300k/tank/year, tanks last 10 years.

Scenario #3: margins tighten by half, tanks earn EBITDA of $200k/tank/year, tanks last 10 years.

Note that these are all varying degrees of conservative scenarios, there are others (e.g., continued exponential growth through 2013) that offer more upside.

While scenario #1 is reasonably conservative in terms of final market share (with the information currently available), it is not conservative with respect to revenue and margins. The more conservative scenarios in #2 and #3 indicate that the company should be able to pay the dividend in the short term (even in #3, dividend would be covered by EBITDA, though for long-term sustainability, it should be covered by normalized cash EPS).

Risks

There are many sources of risk. Some may give early warning signs allowing one to exit a position, whereas others are unavoidable and must be priced in and accepted. For PSN, these are the risks I’m most concerned with:

• Environmental. The tanks have a short service history (<2 years), and the fleet is expanding extremely rapidly. This means that there must be a lot of newly-trained personnel dealing with these tanks. A leak or full breach of a tank that leads to a spill, especially early in this company’s history, could lead to a total loss from liability damages and damage to reputation. This is a low-probability high-cost type risk.
• Competition. The business has such incredible margins that competitors will be flocking to this space. It is unclear if the patent PSN holds will be enough to protect them, or if the patent will be granted in the US at all.

Conclusion

Unfortunately I can’t come to a firm conclusion about PSN. It looks like a lucrative opportunity with lots of upside if everything goes well (growth, margins). Note that when I tried to estimate some value I tried to stay at least somewhat conservative. There is a whole lot of upside beyond that if everything goes right (high final market share, continuing high margins, etc). However, I’m very skeptical of the company’s ability to maintain that level of return or growth for very long. Given how attractive reinvestment in PSN looks, the fact that management has chosen to pay a dividend, and a high payout at that, should be taken as a signal that the end of the growth curve is near, with a plateau likely to be found in mid-late 2012/early 2013.

Many unanswered questions remain, however a 10+% yield — which would be supported under several reasonably conservative scenarios — may adequately compensate one for taking a position, with the outside chance at truly spectacular returns if the growth rate and pricing power can be maintained for several more years at the current level.

Disclosure: I’m currently long PSN, with what I consider to be a “speculative position” weighting (in English: I like it, but not enough to bet the farm, so it’s only ~2% of the portfolio).

A bit of a strange article in the Globe says that: “Mr. Cowen believes that overcoming stagnation will require an increase in the social status of scientists relative to other professions, so that our best and brightest will not prefer law or finance or view university science and math as a prerequisite for careers in medicine or dentistry.” I don’t think the social status of scientists is the problem, unless that’s code for “paying them better and revamping the career path.”

Now, I could probably get behind a “science tax” but I don’t think it has a snowball’s chance in hell in the real world. Heck, it would probably be counter-productive, and lead to public outrage against science.

So aside from paying them better, what do you think could be done to “raise the social status” of scientists?