Most fixed income investors are well aware of the greatly increased difficulty of finding and acquiring yields that are high enough to provide the cash flow they need or desire without being accompanied by very significant and unacceptable risks, either in loss of principal or in long-term wealth losses related to inflation. Consequently, we dig deep into the far corners of the globe to search for the hidden gems that satisfies our client demand for both high yields and acceptable risk. This week, we again identify what may be the equivalent of a diamond in the rough for bond investors with short 52 month Yankee (U.S. dollar) bonds from Transportadora de Gas Del Sur S.A. (TGS), which are currently indicating an astonishing yield to maturity that's over 11.8%, and have added these high yield bonds to our Foreign and Global Fixed Income Portfolio.
Transportadora de Gas del Sur S.A.
We first reviewed Transportadora de Gas del Sur S.A. in 2011 and found very few professional articles detailing their products and services. After diving deeper into the details surrounding Transpotadora de Gas del Sur, a company intimately entangled in the highly regulated natural gas industry of Argentina, we believe this to be a largely misunderstood business that needs better and more detailed explanations to unlock a number of its hidden values. Transportadora de Gas del Sur (Gas Transporter of the South) is the largest natural gas extractor in Argentina. The company was established in 1992, after the privatization of Gas del Estado, the state owned company that maintained the pipelines. The company transports 60% of the total natural gas consumed in Argentina, and supplies distributors, electric generators and industries.
Before considering the specifics of its current business model, it bears noting that natural gas is considered to be one of the more environmentally friendly sources of guaranteed energy and it provides one of the lowest costs for electrical power generation. Therefore, natural gas power plants are projected as a top means of providing new guaranteed energy in the near future. In addition to this, TGS produces and commercializes Natural Gas Liquids (NGL), which includes such highly marketable products as ethane, propane, butane and natural gasoline. These NGL products that are actually Transportadora's primary source of revenues.
1) Liquids, 67% of Revenues
TSA's largest and fast growing business segment is an unregulated portion that converts natural gas to liquid gasoline and/or diesel. A majority of these sales go to world markets, where 90% of it is settled in US dollars. Liquid petroleum, which it exports, provides over 30% percent of total sales for the company. Thus, a major profit hub for Transportadora's overall business model involves acquiring low cost natural gas at the wellhead, converting it into liquids, and then selling it at spot prices to the rest of the world. Judging by the current (and growing) price spread of the two carbon based fuels, TGS should be able to keep robust margins and we believe this will continue to provide solid earnings for this business.
2) Gas Transportation, 26 % of Revenues
TGS pipelines (see map insert below) transport about 60% of all of Argentina's natural gas, and Argentina is currently recognized as the largest gas producer in South America. Argentina also uses natural gas for over 50% of its own energy needs. All of its "non-interruptibility" gas contracts with TGS are regulated and performed at a fixed rate, similar to a real estate rent, and consequently this portion of TGS revenues are not sensitive to the price the price of gas, volumes and other such factors. All guaranteed Gas (not-interruptible) clients pay connection fees that do not fluctuate with gas prices or actual usage. TGS provides a wholesale pipeline transportation business, primarily to reselling natural gas companies, as TGS is restricted from having their own retail gas business. TGS has one major pipeline competitor and does not foresee any new direct competitors, which puts it in the dominant and very desirable position of an oligopoly. Thus, the second major segment of TGS's business is relatively stable, as revenues are fairly immune to natural gas price fluctuations and should not be directly correlated to natural gas prices.
The Upside Potential for TGS
Argentina has a very large new gas discovery which, according to the US Energy Information Agency ((EIA)), gives Argentina a total of 774 trillion cubic feet (TCF) of technically recoverable shale gas resource. That's double the size of Canada's resource estimate, and is the world's third-largest assessment behind only the US and China. This is such a large discovery that YPF Sociedad Anonima (YPF) has plans to invest over $3 billion in 2013 to drill 132 shale oil and 14 shale gas wells. Many larger and smaller companies have been positioning themselves in Argentina's proven gas basins. For instance, the result of a recent deal for the largest US multinational oil and gas producer Exxon Mobil (XOM) is to nearly double its footprint to more than 310,000 net acres in the Neuquén Basin of Argentina. Another major US Multinational producer, Chevron Corporation (CVX), has increased development so much in the Neuquén Basin that Spain's Repsol, S.A. (OTCQX:REPYY) has threaten to sue any partner of YPF unless it recoups its losses in YPF.
The great interest in pointing out these large discoveries and production developments that are in or in close proximity to the Neuquén Basin is simply that this is where TGS already has a major pipeline for country wide distribution. TGS appears to be in a rather envious monopolistic position, having the largest established footprint in front of this hydrocarbon resource tidal wave.
We like companies that are profitable
Based on its 9 month reports (end of 3rd quarter) over the last 4 years, TGS shows good gains in its operating and net income. Most of this growth has come from the very profitable business of NGL conversion, which also explains TGS much stronger margins.
Reports are in ARS pesos
(1 peso = aprox. $0.202)
Net Income before tax
Interest Coverage Ratios
TGS's total debt at the 9 month reporting period of 2012 totaled about 1.83 billion pesos ($390 million). Interest expense for this same period was about 124.2 million pesos ($26 million), so the operating income of 416.9 million pesos ($88.9 million) appears to be about 3.35 times its interest expenses.
We like companies with lower debt to cash ratio
Cash and cash equivalents at the end of Q3 2012 increased from 344.5 million to 647.6 million pesos ($138.1 million), improving TGS's debt to cash ratio to less than 3x's. Even after deducting the dividend reserve of 268.3 million pesos, it's debt to cash ratio would remain under 5x's. The Company is subject to certain restrictive covenants under its outstanding debt obligations which include, among others, some restrictions to incur new debt, dividend payments, the granting of guarantees, assets sales and transactions with related companies. Among these new debt restrictions are an earnings (EBITDA) to interest expense ratio greater than 2 to 1, and a debt to earnings equal to or less than 3.75 to 1.
We like companies that have sound balance sheets
Considering that all the financials of TGS are reported in Argentine pesos, which have devalued significantly over the last ten years, its equity value is difficult to assess. Over 51% of TGS stock is held by Compañía de Inversiones de Energía S.A. ("CIESA"), which we view as more restrictive on any possibilities for raising capital through additional stock offerings. However, all other basic aspects of its balance sheet remain very sound, and the total shareholder equity at the end of Q3 2012 was reported at 5.36 billion pesos ($1.14 billion.)
We like higher yields
This $500 million debt note (in US dollars) was issued by TGS in March of 2007 at the coupon rate of 7.875%, payable semi-annually. At the current deeply discounted price of about 86.75, it not only provides excellent cash flow from a high coupon rate, its average yield to maturity (in just over 4 years) is an astonishing 11.88%.
The default risk is Transportadora's ability to perform. Considering its historical and recent performance, its flexible balance sheet, its sound cash position, and the excellent cash flow that is projected to service its interest bearing debt, as outlined above, it is our opinion that the default risk for this short to medium term bond is minimal relative to its more favorable return potential.
The hardest risk by far for us to identify is the geopolitical risk. Since we first reviewed TGS, the Argentine Government accused YPF of insufficiently investing in and delaying the future development of the Neuquén Basin, and consequently nationalized the majority percentage (from Spain's Grupo Repsol) of YPF. In spite of this, the investing climate has evidently improved enough that Chevron (and a number of other companies) has increased its presence in Argentina. Furthermore, we find it increasingly difficult to understand many of the political changes within even in our own country, as it sometimes hard to fathom why the US Government appears to have significantly delayed (if not canceled) the approval of TransCanada Corp. (TRP)'s multi-billion dollar development of the Keystone pipeline. Therefore, speculation towards any future Argentine efforts to regulate natural gas or petroleum development might seem rather pretentious. With that said, it is our opinion that diversification into many other countries, locations and industries often serves to reduce overall portfolio risk. Our strategy is, as with other Yankee bonds, to focus on unique or required (and in this case somewhat monopolistic) services that can be seen as adding economic prosperity to the society it's associated with. Considering that Argentina's population is very dependent on natural gas for a major part of its basic cooking and heating functions and that natural gas accounts for 55% of Argentina's total energy consumption, we view TGS's natural gas pipelines and services as an essential part of the Argentinean society.
TGS is relatively small from a global perspective, and it may face increasing competition from substantially larger and better financed companies attempting to gain in massive natural gas expansion. However, it is by far still the largest pipeline company in Argentina and it's part of the Public Utilities sector, which includes competitive companies such as Enterprise Products Partners L.P. (EPD) and National Grid Transco, PLC (NGG).
TGS is directly affected by prices in natural gas both internationally and domestically, as well as by the exchange rate of the Argentine Peso. Further development of the Neuquén Basin and the greatly increased production that is forecast, combined with TGS's already embedded low cost pipe transportation hub, should help alleviate some of these uncertainties going forward.
We believe that these TGS bonds have similar risks and maturities to other high yielding Yankees bonds from Latin America such as Argentina Government 8% bonds, Venezuela's state-owned PDVSA (oil company) 11.4% bonds, or Mexican based Bio Pappel (OTCPK:CDURQ) 11.5 % bonds, which are selected from some of our previous reviews.
Summary and Conclusion
Given the dominant positioning of its pipelines and its highly profitability NGL operations, Transportadora de Gas del Sur appears to be very well situated as for the future as a key player within the Argentine economy. It has a fair cash position, excellent profit margins and 4 years of solid bottom line growth, and a healthy balance sheet even after incorporating its most recently announced dividend. Therefore, we think these short term TGS Yankee bonds offer an extremely high yield relative to the financial risks that we can identify, and we see them as a strong addition to our Latin America-South American portfolio.
Issuer: Transportadora de Gas del Sur S.A
Yield to Maturity: 11.89 %
Disclosure: Durig Capital and certain clients may have positions in TGS or TGS 2017 bonds.
Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports.