Tag Archives: income

Floating Rate Bond Funds: 7% Income And Appreciation Potential

Summary Floating Rate CEFs like JFR are currently yielding 7% with huge 13% discounts to net asset value. Exposure to energy is only 3% (and net asset value reflects current prices). Prices fell as investors pulled funds in anticipation of Fed rate hike, leaving little downside and potential upside as any increases are likely to be moderate and investors flee equities. Floating rate securities, like the Nuveen Floating Rate Income Fund (NYSE: JFR ) fund have served as a bond alternative in my portfolio. The fund typically invests in debt that has an adjustable feature, where the interest rate is based on a margin over LIBOR. These securities have yielded 6%-7% over the past year and can provide strong returns. JFR and its ilk are ‘Closed End funds’, which can trade at a premium or discount to the underlying assets. In recent months, discounts have widened, which may signal an opportunity. The underlying investments of funds like JFR are bond-like products that provide the benefits of (relatively) high yielding senior, secured bonds with protection against rising interest rates and inflation. As mentioned above, the protection is derived from a margin over a LIBOR floor (e.g. 30 day LIBOR plus 700 basis points). Every fund is different, but generally, +/- 90% of the investments are loans with B, BB or BBB credit quality. Source: Nuveen If you are intrigued by closed end floating rate funds, there are to choose from. The four highlighted funds, all with Morningstar rankings of 4 stars or better are certainly worth closer inspection. Source: Morningstar (M* is Morningstar) While there has been a modest amount of decline in asset values (bond prices decline as interest rates rise and interest rates have been rising in anticipation of the Fed increasing interest rates), the values of the funds have fallen much more than the underlying change in asset values. The increased drop is reflected in the current discount (in the above chart). As you can see, every fund listed has seen an increase in discount to net asset value of between 220 and 460 basis points. This is a huge manifestation of these securities falling out of favor. However, they create an opportunity for buyers. (click to enlarge) Source: Morningstar As the above chart shows, net asset values are similar to those in mid-December, but the discount has widened significantly (especially in the last few weeks). The catalyst for the widening of spreads was likely a sale of JFR (in the example) in anticipation of the Fed increasing rates. Please consider these points: Any Fed increase is already “baked into” the market. Most observers expect the Fed to either delay or be very cautious with respect to raising rates due to low inflation and the negative impact of a strong dollar on the U.S. economy (higher interest rates will likely to cause the U.S. Dollar to further appreciate, making exports less competitive). Current volatility in the stock markets may cause a subset of investors to look for alternate investments; the same supply/demand equation which has driven the current high discount can reverse. Risk is mitigated through company and industry diversification, with the top ten holdings of a fund typically representing less than 20% of the funds investable assets. Similarly, industry diversification is also maintained, with no one industry type receiving more than 20% of a fund’s investable assets. The below tables represents the top ten holdings and industry diversification of my favorite floating rate bank loan fund, JFR ( Nuveen Floating Rate Income Fund ) as of July 31, 2015. Top Ten Holdings of JFR (Source: Nuveen) Holdings by Industry of JFR (Source: Nuveen) Investment returns are commonly enhanced by leverage, typically between 25%-40%. In the case of JFR, leverage was 38.1% at July 31, 2015 (Source: Nuveen). Fees Because of the unique nature of bank loans, there really needs to be an element of human involvement in assessing the underlying securities. Therefore, these funds typically carry hefty management fees and expenses. Paying professional management is contrary to my investing style, but given the need to assess and monitor, I make an exception in the case of floating- rate senior bank loans. As an example, JFR fees are currently running at an annualized 2.05% (including leverage costs). A Discussion on Risk- Macro Nothing in life is without risk. The underlying assets of floating-rate senior bank loans, while offering first lien position in investment grade securities do default on occasion. According to a study by Moody’s Investors Service, the average annual default rate on senior floating-rate loans has historically (including the recent recession) been 3.4% (1996-2012). The same analysis highlights a 71.1% recovery rate on these same loans over the same period. Ignoring the time to recovery, the data suggest that an annual loss rate of 1.0% is to be expected (3.4% x 28.9% non-recovered) in an average year. Logically, the loss rate would tend to be less in times of economic expansion and greater in times of economic contraction or recession. A Discussion on Risk- Micro JFR’s energy holdings represent less than 3% (in dollars) of current holdings (as of Nuveen data analyzed August 21). Any declines in these bonds are already reflected in net asset value. Further, about 90% of JFR’s holdings trade for 99 or more, which given bid-ask spreads mean the vast majority of JFR’s bonds are doing fine and trading for par (even after price drops due to rate concerns). Foreign holdings represent about 14% of total investments; however these bonds tend to be denominated in, and pay interest in, dollars. Potential Performance in Today’s Stable-to-Rising Rate Environment In addition to a monthly payment, which currently is an annualized 7%, there is the prospect of appreciation (on the closed end funds) as discounts decline from today’s 12%-13% to a more moderate 5%-7% or even a more normalized 3%-4%. Further, according to a study by Vanguard, the performance of floating-rate products during a period of rising rates outperforms the bond market by 4.3% (see an excellent discussion from Vanguard on floating-rate bond funds). Summary Floating-rate securities offer an opportunity to capture income, with appreciation potential and modest risk compared to bonds. The floating rate feature of the securities provides protection in the event interest rates do rise materially which the yield and opportunity to close the discount-to-net asset value provides income and appreciation potential. Disclosure: I am/we are long JFR. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Just Energy Is In Hot Water

Summary Just Energy is an energy reseller. The business model has many questionable elements. Several factors could cause the earnings to decline in FY2016. Just Energy (NYSE: JE ) is a Canadian retailer of energy across select regions in North America and the UK. The company has a long rap sheet of customer complaints, fraud charges, and consumer watchdog warnings. Investors have bid the stock up in recent weeks on a swing to profitability in the first quarter. That profit is based on a one-time item. Beneath the surface, Just Energy is a company with lengthy legal concerns, a declining customer base, and an inherently flawed business model. Flawed Business Model One of my favorite financial quotes is from famed investor Jim Chanos. “A business model that relies on deceiving customers is an inherently flawed model.” No sentence more accurately describes Just Energy. The services offer no value to consumers. In fact, one study found that the average JE customer pays more for their utility service than those who pay for their utilities through a traditional utility provider. If your business model is built on saving customers money by switching them to your service, shouldn’t your service actually be less expensive? It appears that in 98% of cases , it is not. According to a lawsuit in Illinois, “there is no reasonable person who could market this product by suggesting that a customer would ‘save’ money.” The lawsuit also noted that “almost all of [Just Energy’s] plans have cost customers far in excess of what [utilities charge].” This could partially explain the aggressive sales practices. If your services cannot deliver as promised, why not just bend the truth? The company’s profits rely on selling long-term contracts to customers at rates higher than can be achieved in the marketplace. Essentially, the company locks customers into 5-year contracts and hopes that energy rates decline. The only way it makes a profit is by overcharging customers. Again, a business model marketed as a less expensive alternative to utilities that can only make a profit when it is, in fact, more expensive, is deceptive and fundamentally flawed. Legal Concerns There is a litany of formal complaints filed against the company, so many in fact that it has had to change its name and buy new brands in an apparent attempt to hide the past misdeeds. Among the most notable concerns are lawsuits brought by the Attorneys General of Illinois, Massachusetts, Ohio and New York. Complaints filed by the Canadian Energy Board and consumer watchdog groups have also caused reason for concern given the repeated allegations of misconduct. The company has an almost unheard of F rating by the Better Business Bureau . The BBB cited “a large volume and pattern of complaints concerning misleading sales practices.” (click to enlarge) Source: Internet review websites Just Energy could arguably have received more complaints per customer than any other publicly listed company in North America. The Illinois Attorneys General lawsuit found that the company received about 30,000 complaints annually in the state of Illinois alone. So what caused so many formal complaints against the firm? As most lawsuits describe, the company’s sales team goes door-to-door soliciting homeowners to purchase energy contracts. It also utilizes telemarketers in its sales process. The fraud complaints stem from thousands of sales reps purposely lying about rates, and in some cases, signing up customers without their permission. Source: News articles The unbelievably poor compliance at JE is a cause for future concern, as the practices are systemic of the organization and do not seem to have been curtailed. In fact, they are getting worse. In July 2015, Just Energy partnered with an alleged pyramid scheme to distribute its products. Lyoness is a MLM firm with a long history of pyramid scheme accusations. Think Herbalife (NYSE: HLF ), but worse. If the company’s former sales team was so inadequately trained that hundreds had to be laid off after defrauding clients, why would the distributors for a company under numerous fraud investigations be any better? According to an Australian regulator, Lyoness’ distributors “lie about every aspect of the business they are promoting.” These people will now be the face of Just Energy. Cue the forthcoming onslaught of Attorneys General investigations that are likely to emerge. Declining Customer Base While the company has largely weathered the past concerns, that luck seems to be eroding. As customers are coming out of their five-year contracts, they do not seem to be re-enrolling. Additionally, the company is failing to find new customers. Perhaps the years of negative reviews, multiple fraud investigations, and bad press coverage have dissuaded customers from trying out the company’s service. Or perhaps they can just do math and do not want to pay more for a service they already receive. For the first time in years, the company had a net loss of customers in the most recent quarter. Additionally, the number of new customers was the lowest since 2012. In red below, we can see that new customers are down 31% from Q1 2015 and down 15% from Q1 2014. The company is not growing the customer base enough to offset those leaving the business. (click to enlarge) Source: Investor presentation (with Q1 info added by author) How This Will Impact Earnings With a clear downward trend developing, investors should prepare for a future decline in sales. The average Just Energy contract is 3.5 years. The decline in new customers is not directly felt on the income statement just yet. As customers leave (about 1.15 million per year), the inability to replace those customers will cause revenues to decline. For the first time in years, JE is losing more customers than it is gaining. Customers leaving today locked into a temporarily low point in natural gas prices, thus new customers that replace the customers being lost are “higher margin.” While management has spun this as a positive, in reality it is a massive headwind. As noted, the average customer contract is 3.5 years. In early 2012 (exactly 3 ½ years ago), natural gas prices bottomed at nearly $2. So yes, the customers leaving are being replaced by new customers with higher margins, but it is short lived. In the coming quarters, as more customers leave, the new customers will be lower margin than those customers lost. Source: NASDAQ The next two years are going to be a massive headwind as the company loses customers that signed up under much higher natural gas prices than today’s prices. Recognizing this impact, the company began diversifying the portfolio over the past several years. In 2009, debts were zero. Today, debts are in excess of C$677 million. The decision to buy electricity suppliers has cost the company in a time when profits and margins are going to begin eroding. Impact On The Stock Predicting JE’s EPS is a challenge. The company often swings between massive losses and equally massive profits. Over the past three years, the company has posted net profits from C$602 to losses of C$579. With customer attrition likely to increase over the next year, it will be virtually impossible to produce a net income. While Q1 saw an EPS of C$0.67, that figure was due to asset sales. That is not a long-term means of growth. Had the company not sold off a unit for C$505 million, it would have posted a loss for the quarter. For FY2016, expect a significant loss (unless JE continues selling off assets). While management is correct that margins are improving, that effect will fade in Q2 and reverse in Q3. New customers will begin to constrain margins beginning in November. That is because 42 months ago (3.5 years) natural gas prices fell to levels below current levels. That lasted from December 2011 to June 2012. Every customer who signed up after June 2012 is a higher-margin customer than the ones the company is acquiring today. JE requires volatile gas prices for profits. In 2015, natural gas has been flat. In order to turn a profit, gas prices would need to drop. At $2.7 today, that seems unlikely. With all of this in mind, the company could post continuing revenue growth, but will still report losses. Management does not provide earnings or revenue outlook, instead it only focuses on EBITDA outlook. For FY2016, the company expects C$193-C$203 million in EBITDA. The excessive focus on EBITDA is alarming from an investor’s standpoint. Multiple forensic accounting firms have highlighted red flags in relation to how JE calculates its EBITDA. Additionally, it is always alarming when a company with no tangible cost structure (JE does not own any hard assets) only points to EBITDA. In 2015, the company generated sales of C$831 per RCE (residential customer equivalents). This is the non-GAAP figure used to calculate the number of customers. The actual number of customers is around two million. The C$831 per RCE is higher in 2015 because margins are increasing. As margins decline (as I have suggested will be the case in the second half of FY2016), the revenue per RCE should normalize to figures from previous years. About ⅓ of Just Energy’s customers leave each year. In past years that decline was offset by adding more customers, creating a net gain. That trend reversed in Q1. If the rate of decline experienced in Q1 continues throughout FY2016, total RCE will decline to 4,390,000. Using the C$831 figure (which I feel is very generous), total revenue for the year will come to C$3.6b, a 7.7% decline from 2015. RCE Sales per RCE Sales (in millions) Q1 4,609,000 C$202.4 C$933 Q2 4,535,000 C$202.4 C$918 Q3 4,462,000 C$202.4 C$903 Q4 4,390,000 C$202.4 C$889 Total – – C$3,643 Source: 10-Q The exact nature of any declines are subject to a number of factors including the timing of margin contraction, the severity of the contraction and the ability of the company to aggressively increase marketing to obtain new customers. All of these factors could impact the above calculation. At the end of the day, things do not look good for Just Energy. It is hard to imagine how the company will grow EBITDA by 5.5% (as it predicts) when the business is facing declining customer growth, increasing attrition and declining margins for 2016. Long term, there are too many headwinds to keep this electricity and natural gas reseller from being an attractive investment. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

IFRS Vs US GAAP In Utility Analysis And The UIL Merger

Summary Iberdrola USA filed an S-4 with the SEC related to its acquisition of UIL. Previously IUSA financials were based on IFRS, but the S-4 used US GAAP. This creates a unique opportunity to examine how accounting standards impact utility results. Accounting issues appear to make a noticeable difference when comparing US and international utility companies. IUSA Income under US GAAP was $20M lower than under IFRS; don’t be surprised if guidance for the combined company is eventually lowered. Iberdrola USA’s ( IUSA ) purchase of UIL Holdings (NYSE: UIL ) was announced back in February. The parties have been progressing through the various requirements to complete the merger, and they are still on track to complete it by the end of the year. IUSA financials were previously done under IFRS , because they were a fully owned subsidiary of Spanish utility Iberdrola S.A. (OTCPK: IBDSF ) After the completion of the merger, the combined company will be publicly traded on the NYSE, and will be required to provide financials under US GAAP. The recently filed S-4 IUSA restated their 2014 financials using US GAAP , providing a unique opportunity for investors to see how accounting standards impact utility results. This article provides a side to side comparison of the two financial statements under the two standards. This information should be particularly useful when comparing American utilities to those elsewhere in the world. These issues should also be in investors minds when comparing utility ETFs like (NYSEARCA: XLU ) that are US focused to ones with a bigger international component, like (NYSEARCA: JXI ). Balance Sheet Assets The first thing that jumps out when reviewing IUSA’s assets on the balance sheet is that the two methods come up with different values for cash. Now you would think cash is cash, but somehow the accountants have come up with a way to make it different, with US GAAP showing $18M more in cash than IFRS. Another noticeable difference between the two methods is that no deferred tax assets show up in the US GAAP books. These assets have not disappeared, but they have just been netted against the deferred tax liabilities on the other side of the balance sheet. The US GAAP books show almost $900M more in total assets than the IFRS books, but since the deferred tax assets have just been moved to offset the liabilities, the “real” difference between the two methods is closer to $3.3B. The biggest driver of this difference is regulatory assets. IFRS actually does not allow companies to put regulatory assets or liabilities on the balance sheet, but US GAAP does. This is really a big deal for utilities, which have constant dealings with regulatory authorities. While regulators do sometimes change their minds, if a state public service commission says that a utility can collect $100M from customers to cover certain costs, it is very likely the utility can expect to get that money. IUSA has almost $2.5B in current and non-current regulatory assets. These represent promises from regulators that IUSA should expect to receive. These promises will be an asset that helps support the business going forward, and should be recognized on the balance sheet. Balance Sheet Equity and Liabilities (click to enlarge) IUSA’s equity under US GAAP was $1.9B higher than under IFRS. A big reason for higher equity was from regulatory assets and liabilities. There are almost $1.4B of current and non-current regulatory liabilities which partially offset the $2.5B of regulatory assets discussed earlier. Another driver for the increased equity is a decrease in environmental remediation costs and in asset retirement obligations. These items were included in the “other provisions” line under IFRS. Note 18 of the IFRS books shows an $845M liability between these two items, while it is only $518M in US GAAP. IFRS requires the use of the mid-point of a range of estimates if no best estimate is available. US GAAP uses the low end of the range. So it seems likely that IUSA is at risk to higher environmental costs than are shown in the latest balance sheet. Deferred income also contributed to the change in equity, with US GAAP showing a $300M smaller liability than IFRS. Another area that is important to understand with IUSA is the special financing they have used for their wind projects. Under IFRS these are “Capital Instruments with Debt-Like Characteristics” and have a balance of $344M. US GAAP calls them “tax equity financing arrangements”, and has a current balance of $124M, and a non-current balance of $277M. These are very complicated instruments where investors contribute money to IUSA’s wind projects, and are paid back with cash and tax benefits. At first these investors may receive the majority of a project’s returns, but over time the majority shifts back to IUSA. There is also an interest component to these payments, but how much of the payment should be allocated to interest vs. repayment of principal, or another category is difficult to determine. This difficulty is likely part of the reason there is a current liability for this category under US GAAP, but there is only a noncurrent liability under IFRS. It is interesting to see that US GAAP seems to think that they are a bigger liability than IFRS, though both methods say they should not be considered “true” debt. However, while it may not be “true” debt under either method, it is still similar and it is significant. When thinking about IUSA’s debt and interest ratios these values should be considered in the calculation, but most people likely ignore. Statement of Cash Flows (click to enlarge) The statement of cash flows shows the total change in cash during the year to be the same under both methods. However, some of the cash was categorized differently. As many people know, followers of IFRS have the option to run interest expense through the financing instead of operations, but that was not one of the differences in this instance. One of the big items to stand out is capital expenditures. These are $155M lower under US GAAP, which makes up the majority of the difference under investing activities. It is likely that some of this is differences in how major maintenance spending is capitalized. IUSA also has some investments that were proportionally consolidated on a 50% basis under IFRS, while they received equity method treatment under US GAAP. It is possible CAPEX at the proportionally consolidated subsidiary disappeared using the equity method in US GAAP. Under operations, depreciation and amortization was almost $100M higher under IFRS. This would likely be consistent with the CAPEX numbers discussed in the investments section. If more expenses were capitalized it would make IFRS PP&E higher (and it was $300M higher on the balance sheet), and therefore depreciation would be higher as well. Regulatory assets and liabilities also played a big role in cash flow from operations. Under financing, the “Changes in borrowings from affiliates” line item disappears under US GAAP. It seems likely that some of this was netted against “repayment of long-term debt and related interest” under US GAAP, but this would seem to be important information that investors would want to know about. Another item of note is that the Aeolus debt and the tax equity financing are basically the same thing, but there is a slight difference in the value recorded. This slight difference is probably reasonable considering the difference discussed earlier on the balance sheet. Income Statement (click to enlarge) IUSA’s net income was $22M lower in 2014 under US GAAP than under IFRS. This seems consistent with what we’ve seen on the other financial statements. Moving spending from capital to expenses would lower income. Including regulatory assets in the financials would lower income as well. Under IFRS, the cash recovery of these regulatory assets would likely go to income, while under US GAAP the incoming cash would match up against a decrease in the regulatory asset account. Implications for UIL/IUSA Merger Assuming the merger is completed, this analysis implies that there is a risk that the new company will reduce its combined guidance. According to last month’s S-4 filing, the IUSA forecast used in evaluating the merger was based on the IFRS $446M of net income in 2014. With the biases discussed in this article, it seems like IUSA’s starting point was actually too high, and it makes sense that these biases would have continued in their forecasts. It might be appropriate to reduce the combined 2016 forecast of $700-730M to $680-710M based on these factors. When analyzing the new entity with other metrics, like EBITDA, this accounting review shows that there are a lot of uncertainties created by their tax equity financing arrangements. How much of the payments to these other entities should count as interest and how much as a reduction of the outstanding balance? Should these be considered debt? If the accounting standards cannot agree on how this should be handled, how can investors be consistent when they are comparing different companies on these metrics? While there are no clear answers to these questions, investors cannot forget these issues when analyzing the company. Implications of Analysis of International Utilities This article also shows that the different accounting methods can create significantly different results, with IUSA having a 5% reduction in earnings under US GAAP. Investors should think about this when comparing US utilities to those elsewhere around the world. The different treatment of CAPEX, and especially regulatory assets, would seem to create a bias that would increase international utilities earnings vs. the US. Obviously each case is different, and there are potential factors that could move results the other direction, but this example should be a wakeup call to US investors considering international utilities. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.