Husky Energy (OTCPK:HUSKF)(TSE:HSE) is the recipient of a recent takeover offer from Cenovus Energy (NYSE:CVE). Both firms are oil and gas producers based in Calgary, Canada, and both produce primarily heavier grades of oil. Husky is more diversified, as aside from its oil sands operations, it has conventional heavy oil, offshore oil in Eastern Canada, offshore production in Asia, and refineries in Canada and the US. Cenovus is primarily oil sands operations, with some deep basin natural gas/liquids and US refining assets. There is a significant strategic rationale for the merger, and Husky’s refining assets will help to provide a natural hedge for Cenovus’ oil sands production. There will also be significant cost savings, and in the deal announcement, they estimated an incremental $1.2 billion in improved free cash flow from operating and capital cost savings.

This piece will focus on Husky’s outstanding preferred shares issued on the Toronto Stock Exchange. Because both companies report in Canadian dollars, and the shares primarily trade in CAD, all figures are in that currency unless otherwise noted. They have a number of outstanding preferred issues, and the release linked above notes that they expect these to remain outstanding after the deal closes. The holders will need to vote to exchange their preferred shares for new preferred shares issued by the merged company (which will be called Cenovus). If that vote fails, the existing preferred shares will remain outstanding, and Husky will become a wholly owned subsidiary of Cenovus. I think the vote is likely to pass, as the preferred shareholders will gain senior status on the entire company’s equity stack after the merger.

I also think it is likely that the merger will improve the price of these preferred shares simply because of the larger scale of the combined entity.

Source: Investor Presentation on the Deal

Because preferred shares are somewhat of a retail phenomenon in Canada, the perception of the company’s size and the industry it’s in are important factors. While Husky’s preferred shares are rated as PFD-3 (high) by DBRS, they trade at higher yields than many Canadian preferred shares with lower ratings, even after an ~10% gain in the preferred shares since the announcement. As just a couple of examples, AltaGas (OTCPK:ATGFF)[TSX:ALA] has preferred shares trading with lower yields than Husky, and it is rated PFD-3 (low). Fortis (NYSE:FTS) and Enbridge (NYSE:ENB) preferred shares have the same rating and trade at much lower yields. Even Capital Power preferred shares trade at a higher valuation than Husky, despite its lower PFD-3 (low) credit rating and the fact that most of its business is coal fired generation in Alberta, which is facing a mandated government shutdown in just a few years!

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So, I’m not too terribly worried about the fact that DBRS has said they will likely be downgrading Husky by one level as a result of the deal. That would result in a preferred share rating of PFD-3 for the new preferred shares. The rating action makes sense, as it is essentially the ratings agency averaging the existing Husky and Cenovus credit ratings. The diversity of earnings and the quality of assets the combined entity will have should provide a significant backing to the preferred shares. 2020 metrics are likely to be poor, because of the period of time where oil prices were very low (and briefly negative). However, the recovery in oil prices, and the combination with Cenovus’ extremely low cost assets should allow them to cover their fixed charges even at very low oil prices.

The key assets of Cenovus are their two large in-situ oil sands projects, where they inject steam into the ground to melt the heavy oil, then pump it out. The firm’s Christina Lake project has the best ratio of steam to oil in the industry, and their Foster Creek project is also top quartile. These projects have somewhat of a natural moat – if the oil price in Western Canada declines enough, other projects producing a great deal of oil will shut in before these have to. And the Government of Alberta is also helping out, by ending the apportionment of oil production in the province. Cenovus had been buying quota from other producers to allow it to fully produce its top-tier assets, and so they will save that expense now that they apportionment system is over.

While the credit rating will be lower initially, I think the company’s preferred shares are actually better covered after the merger than they were before. RBC had a $378 MM estimate for Husky’s 2021 free cash flow (after capex/interest costs), which was a reasonable margin of safety on their fixed charges. Cenovus, which is bigger, had a $1.166 billion estimate for their 2021 free cash flow from RBC. But the firm’s estimate of 2021 synergies from the deal is $1.2 billion in operating and capital cost savings. Even if they don’t achieve the entire synergies, that is a meaningful improvement to their cash flow position. As they start to generate those savings and show them in their results, the preferred share dividends will be perceived as more secure, so there is a potential upside catalyst here after the close of the deal as well.

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Security Selection

The individual preferred shares of Husky are all equally ranked, and all pay a cumulative dividend that is senior to that paid on the common stock. Thus, from a credit point of view, they are all equal. Thus, the decision between them is entirely based on the terms of the individual issues. I’ve included a table below with the relevant information, as there are a number of outstanding issues.

Ticker Current Yield Reset Spread (basis points) Reset Benchmark Price Yield After Reset Yield After Reset if Rates Rise 1% Reset Date
HSE.PR.A 9.25% 173 Government of Canada 5-year $6.50 8.00% 11.8% Mar 31, 2021
HSE.PR.B 7.64% 173 Government of Canada 3 month $6.53 7.01% 10.8% Mar 31, 2021
HSE.PR.C 9.39% 313 Government of Canada 5-year $12.49 6.97% 9.0% Dec 31, 2024
HSE.PR.E 9.07% 357 Government of Canada 5-year $12.66 7.74% 9.7% Mar 31, 2025
HSE.PR.G 8.45% 352 Government of Canada 5-year $11.64 8.31% 10.5% Jun 30, 2025

Source: Excerpted from Author’s Database

All of the issues except for one reset based on the Government of Canada’s five-year bond rate, which is currently 0.35%. That is obviously extremely low, which, when combined with the significant decline in the oil market, has resulted in significant losses for these issues, all of which have a $25 face value. The current yield column is the one that investors often over-weight in their analysis of preferred shares, but I believe for rate reset preferred shares that the yield after reset is a more important benchmark. Simply because the amount of time the return is governed by the reset will exceed that governed by the current yield. In the case of Husky, the five-year resets all have current yields in a tight range – 8.45% to 9.25%.

However, their yields after reset diverge quite a bit. The least attractive yield after reset is the HSE.PR.C, which at current benchmark rates would reset under 7%. While the reset there is over 4 years away, the extra yield after reset on the HSE.PR.A and HSE.PR.G, both of which yield over 8% after reset, seems worth the lower current yield to me. Personally, my position is in HSE.PR.A – the current yield is the second highest at 9.25%, so there is very little yield lost in the near term. It resets in March, to a current estimate of 8.0%, which is still attractive. It also has the most leverage to any eventual increase in rates, as shown by the second last column. That shows how the after-reset yield of each security would change if benchmark rates rose by 1%. HSE.PR.A has the lowest price of the 5-year linked shares, so it has the most leverage to interest rates (either rising or falling).

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That said, I’ve had the position for a while, and at present prices, I think HSE.PR.E and HSE.PR.G are probably comparably good value. Those taking a larger position may want to diversify between the different issues to reduce the amount of money that is linked to interest rates at any one time.

Conclusion

While the merger of Husky with Cenovus will likely lower Husky’s credit rating, the extra heft and diversification that is offered probably makes the combined company a more attractive preferred share investment. I also think Cenovus’ low cost oil sands assets make the oil price that will be required for the shares to be money good a lower number, which is important for any commodity linked business, but especially one where the primary product has as volatile a price as oil. Their target for $1.2 billion in synergies and stated commitment to debt paydown and an investment grade credit rating are also key factors for me. The current Cenovus leadership has been laser-focused on debt paydown, and I expect that to continue, which would make these more secure. Aside from their significant current and after-reset yields, I think there is a possibility for capital gains on these if they trade to a valuation in line with other similar rated names.

Disclosure: I am/we are long HSE.PR.A. 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.



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