Income from railway infrastructure services
We have developed a process to screen, review, select, purchase and monitor high yielding corporate bonds. Each week we screen thousands of corporate bond listings to find what we believe to currently be the best corporate bond for investors needing or seeking higher yields with the least amount of risk as possible relative to its projected return. The following is our review process showing why we believe this remarkable 8.25% bond with a short 3 1/2 year maturity passes the criteria for our clients.
Step 1 - Assessing the Yield Curve
As confidence continues to return to the market after the new year, we have observed the price of many higher yielding bonds starting to strengthen, which is resulting in declining yields. Along with these declining fixed income yields are heightened concerns for acquiring fixed income instruments that can outpace inflation without adding excessive risks. With five-year treasuries currently trading at about a 0.86 % yield and the (possibly flawed) CPI at 3.4%, this short term 8.25% bond appears to be able to make a stunning difference in performance as long as the underlying fundamentals of the issuer, which we will review the major elements of here in this article, support future income and principle payments.
Step 2 - A look at the issuer
Georgian Railway (GR) is a 100% state-owned limited liability company founded in 1992 after the transformation of the Transcaucasia Railway, and is an important part of the Euro-Asian Transportation Corridor that links Europe with Central Asia. It is a fully integrated railroad company that includes infrastructure ownership and all rail operations in Georgia (apart from subways or trams). GR operates 468 kilometers of main lines (100% electrified) from the Azerbaijan and Armenian borders to the Black Sea, but only 293 kilometers of double track lines. The total network owned and operated by GR is 1,326 kilometers and includes 114 stations.
GR operates the national railway system through three principal strategic business units: the freight unit, the passenger unit, and the infrastructure unit. Notable strengths for GR are its monopolistic position as a vertically integrated rail carrier for the Transport Corridor Europe-Caucasus-Asia, its superb operating margins despite difficult conditions during the past few years, and the "extremely high" likelihood of extraordinary government support from the Republic of Georgia in the event of financial stress.
Step 3 - We like companies that are profitable
For the year ending 2012, the freight and loss-making passenger unit accounted for about 95% and 4%, respectively, of GR's total revenue of GEL489 million ($292.8 million), which is more than a 20% increase over 2010's revenues. At the same time there was a reduction of operational expenses by 2.5 %, from 326 million GELS to 320 million GELS, resulting in the EBITDA margin increasing from 50.5% to 55.6%. The net profit increased from 101.5 million GELS ($60.8 million) in 2010 to 145 million GELS ($86.8 million) in 2011, showing a 43% year over year growth. In 2012 the company expects continued growth of profits.
Step 4 - Interest Coverage Ratios
Long term credit obligations of the company are limited to $250 million USD that is represented by this bond. Reviewing Georgian Rail's Q3 financials reveals that net financing costs, excluding a one time cancellation fee, were GEL14.039 million and earnings before taxes were GEL41.816. While 3x's coverage is less than we might normally like to see, in light of GR's state ownership and its highly monopolistic business model that provides the main distribution service for many of Georgia's prized industries, we believe it to be more than adequate to service the debt.
Step 5 - We like companies with lower debt to cash ratio
GR reported Q3 long term debt at GEL411.474 million ($246.4 million), which is primarily a result of this 9.875% debenture maturing 7/22/2015. Cash and short term investments were GEL199.246 million ($119.33 million), giving a very good cash to debt ration of almost 1:2. However, this ratio may decline as larger capital commitments relating to its Main Line Modernization and Tbilisi Bypass projects progress.
Step 6 - We like companies that have flexible balance sheets
Total equity for this 100% state-owned limited liability company is currently reported at GEL1,778,923 (about $1.065 billion USD), while long term debt is GEL411.474 million (about $246.4 million.) This would indicate a debt to equity ratio of about .23, which is quite low considering that much of this equity consists of such tangible assets as over 800 miles of rail lines, significant land holdings, rail stations, rail cars and locomotives. Given the importance and profitability of this monopolistic company to the Republic of Georgia, we agree with Standard & Poor's view of the "extremely high" likelihood of extraordinary government support from the Republic of Georgia in the event of financial stress. Considering further that the state also has the option to capitalize a portion of GR to fund additional rail service expansion, we consider GR to have extremely good balance sheet flexibility.
Step 7 - We like high yields
This U.S. dollar denominated Yankee bond issued by Georgian Rail has a face coupon of 9.875 and currently has a 8.25% yield to maturity. In contrast, similar maturity U.S. Treasuries are yielding about 0.5%. Although the credit ratings are widely different, we believe this large 7.75% spread between the yields is extremely high given the risks that we can identify.
Step 8 - Risks Considerations
Although GR has a monopolistic business with very high profit margins, they have significant capital expenditures programs which could weaken the company's financial profile. However, under terms of the bond GR is committed, at all times, to maintain a ratio of net financial debt to EBITDA of not more than 4x. Also worth noting is GR's key role in implementing Georgia's infrastructure development plan, which is one of the highest priorities for the current government. Being the largest employer and the largest tax payer in the country, GR is the major player in the domestic economy, and there are no expectations GR will be privatized over the medium term.
There is the potential for geopolitical instability in the Caucasus. The small network size exposes GR to a significant event risk, which has deepened due to tensions with its neighbor to the north. Russia dominates the recently updated documentation of 12 "Threats, Risks and Challenges to the National Security of Georgia." Listed as strategic partners are the Ukraine, Turkey and Azerbaijan.
We believe that these Georgian Railway bonds have similar to slightly higher risks, similar maturity and a much higher yield that the bonds reviewed in Seagate Technologies' (STX) 2016 Bond Provides Income From the Clouds and American Railcar's (ARII) 2014 Bond.
Summary and Conclusion
This is an exceptional yield, especially considering its short 3 ½ year maturity and strong governmental backing by the Republic of Georgia. Although Georgian Rail bonds are rated as B+/BB-, we believe they are a savvy risk offering a significantly higher yield from a company that has a good cash position, sound interest coverage, and a flexible balance sheet.
Ratings: B+/ BB-
Price: $ 106.75
Yield to Maturity: 7.50 %
Disclosure: Some Durig Capital clients may have a position in Georgian Railway bonds.