Investing

Comparables for q-copper

2010-01-03T01:49:00.001-06:00

As a quick sense check on the valuation of Q Copper (q-copper) I looked at some simple comparable data from other firms.

Reuters shows the price to book for the specialty mining and metals industry as 1.4. This is the industry within the basic materials sector that Q Copper will belong to.

Applying these values to the revised pro-forma net assets of 183.1M would yield 256M or $1.32 per share.

I have a concern that the book value of q-copper as presented in the prospectus does not reflect the basis that an ongoing copper company would show. This is because on acquisition you have the opportunity to adjust values on the balance sheet to reflect the acquisition cost. Therefore, adjusting the Q Copper pro-forma balance sheet to reflect the copper co Property Plant and Equipment along with the CopperCo capitalized exploration and development is more likely to provide an apples to apples comparison:

Adjusted Balance Sheet
Source	Adjustment	Amounts
Q Copper prospectus	net assets	$183,127,301
Q Copper prospectus	subtract property plant and equipment	-$53,391,638
Q Copper prospectus	minus capitalized exploration	-$100,238,563
CopperCo annual report	add property plant and equipment	$114,607,544
CopperCo annual report	add capitalized exploration	$23,351,576
CopperCo annual report	add capitalized development	$37,619,569
	Adjusted Net Assets	$205,075,789

Using the adjusted book value and the 1.4 P/B provides a price per share of $1.48. I had a concern that Q Copper had a lot more cash as a % of assets than an average speciality mining and metals company. However, that extra cash is all allocated to further exploration so it will end up becoming capitalized exploration or development expenditure. I would treat it differently if it were going to be returned to shareholders.

Finally I took the Reuters data for speciality mining and metals and looked at the median book value and then the median book value for those firms with earnings. There ratios were P/B of 1.47 and 2.125. (The original 1.4 that Reuters provided, and used above, is cap weighted which disadvantages smaller firms and includes firms with no earnings). Using the adjusted balance sheet would indicate a price per share of $1.56. Using the P/B for firms with earnings yields a price per share of $2.27 .

This is broadly comparable with fundamental valuation of between $1.41 and $2.08. It seems reasonable that Q Copper will trade up to around $1.50 and into the $2’s as the mine life is extended (less distributions).

Felix Resources – no better offers

2010-01-02T07:54:00.001-06:00

I discussed a merger arbitrage opportunity in Felix Resources. There was no counter offer and the deal went ahead for a 27% annualized profit. The interesting question is whether or not I got the probabilities correct.

James Moniter, previously of Soc Gen fame, wrote an excellent strategy piece on Process not outcomes: gambling, sport and investment! He discuss outcome bias, that is judging a decision differently based on the outcome. He cites multiple examples of where the quality of a decision is judged differently based on the outcome rather than the process used to derive that outcome. This is a serious misjudgement, the best performers in any field focus on the process not the outcome. He cites a great blackjack example. If you think hitting on 17 and get a 4 was a good decision then you are focusing on the outcome and not the process. It clearly is not a good decision.

I’m going to stick with my original Felix probabilities and conclude that I simply had a bad break. I assigned a 60% chance to a higher offer of some sort, a 10% chance of deal failure and 30% chance of the deal going ahead unmodified. That is in fact what happened. Of course the beauty of the opportunity was the positive expected value and I ended up with a positive outcome, just not as positive as expected.

q-copper IPO

2010-01-02T07:24:00.001-06:00

Cape Lambert Resources (CFE.ax) are selling their interests in a Queensland copper mine through an IPO. The prospectus can be found at http://www.qcopper.com.au/ .

The IPO was supposed to list on the ASX just before Christmas. However, one of the major investors failed to fund their allocation and the original plan fell through. CFE have released a supplemental prospectus and are continuing with the IPO but the listing will now occur in February.

One of the joys of investing in an IPO is the amount of detail presented in a prospectus. Including a valuation of the copper mine and various sensitivities.

The project, with the current copper prices and USD exchange rate, is worth a discounted 237M (using an 11% cost of equity which is higher than used in the prospectus). In addition q-copper will have 47M in cash. Adjusting for other assets and liabilities on the balance sheet I would call their net readily realisable asset value as 37M. That is 19M of liabilities offset by 47M of cash and $9M of property plant and equipment (the $9M is based on CFE’s initial carrying value not on q-copper’s initial balance sheet).

There is also likely near additional resources which would extend the mine life. There are research reports from before the CFE acquisition that identify that the mine likely has a longer life than the proven resources reflect. Furthermore the prospectus outlines these and the likelihood of finding them. The cash kept by q-copper has been allocated to further exploration. Assuming that the likely additional resources are proven then there is a discounted additional value of 175M less the $45M of cash to locate them.

There were originally going to be 225M shares outstanding. Since the original IPO fell through they have revised the offering to 194M shares.

Cash + proven copper project = $237M+$37M=$274M or $1.41 per share

Cash + proven copper project + mine life extension = $237M+$37M+$175M - $45M =$404M or $2.08 per share

There is execution risk as the copper mine needs to be restarted. The target is mid 2010. The analysis above assumes that the mine is not restarted until 2011. There is a new management team and the chance of delay or some other operational stuff up is high. There is a good chance that a delay or operational problem announcement will cause a share price drop. If you don’t get in at the IPO then waiting for such an announcement may be the second best chance to get in.

The offering is prices at $1 per share. $2.08 is not a fair price as the additional resources need to be proven, however $1.41 is too low. $1.70 or so would be my sell target as long as the additional resources have not been proven.

Asymmetric trading opportunity in Felix Resources (FLX.ax ax:flx)

2009-10-23T22:14:00.001-05:00

I have made some good risk arbitrage trades most recently on Corvette and Cape Lambert and before that on Dow and Rohm & Hass. There is an opportunity now in Felix resources.

Yanzhou Coal ( YZC ) have agreed to purchase Felix Resources. The Australian Foreign Investment Review Board was a major sticking point. That is now resolved with the conditional approval provided yesterday. Felix closed at $16.75 on Friday 23rd. The YZC offer price is $17.5. That is 4.5% in 2 months or 27% annualized. Though that isn’t the exciting opportunity.

The YZC bid for Felix was barely adequate when it was announced. On the basis of coal price and market moves since the August announcement the YZC offer is too low. I estimate that there is now a much better than 50% chance of a competing bid (or an increased offer from YHZ):

A DCF of Felix values it closer to $24-$30
YHZ have accepted onerous conditions from the FIRB
The market for M&A has reopened
There is some minor discontent about the deal within FLX shareholder ranks.

I suggested in this post on sniping Felix that a competing bid would wait until November. I also identified the potential alternate bidders for Felix in another post. BHP and Vale are obvious suitors. Xstrata was a no show at that time but things have improved for them since and they have an obvious advantage with their Ulan mine next to Moolarben.

The trade and the odds

Buy FLX at 16.75;

Case	Probability	Profit*	Timeline	Annualized Profit %
No Counter, deal goes ahead	30%	0.75	2 months	27%
Counter/ increased offer @ 19+	30%	2.25	3 months	54%
Counter @ 21+	30%	4.25	4 months	76%
Deal Fails	10%	6.00	24 months	18%

* including dividends

The probability adjusted profit is $2.78 over a probability adjusted period of 5 months for an annualized profit of 40%.

Short Term

If your timeframe is just a risk arbitrage on this position, then deal fails case becomes;

Case	Probability	Profit	Timeline	Annualized Profit %
Deal Fails	10%	-4	2 months	-143%

The probability adjusted profit is $1.78 over a probability adjusted period of 2.9 months for an annualized profit of 44%.

It’s not often that you get the opportunity to make a risk adjusted profit of 40%+ where your downside is limited by the cheapness of the assets.

Lynas Corporation (LYC LYC.AX)

2009-10-14T10:13:00.001-05:00

Lynas Corporation (LYC) is traded on the ASX. They are building a Rare Earths (RE) mine in Western Australia and a processing plant in Malaysia.

Rare Earths have been capturing quite a lot of attention amongst early investors. A short introduction can be found at the following links:

Until recently they were going to sell slightly over 50% of themselves to the Chinese in exchange for equity and guaranteed loans. The Australian Foreign Investment Review Board (FIRB) rejected the application and the Chinese deal collapsed. Instead LYC have launched a massive capital raising, made much easier by Australia’s laws which allow rights issues and institutional sales without a prospectus. Large capital raising can go ahead in only a few hours.

The capital raising consists of:

$88M placement
$295 rights offering
$67M conditional placement

Based on 670M shares (inclusive of in the money options) outstanding before the offer they will add about 1bn shares.

Before tax based on:

$9.6 US per kg of RE sold, increasing by 5% per year
$7.45US per Kg of all in costs , increasing by 3% per year
Long term AUD/USD of 90c
10,500 tonnes in year one growing to 20,000 in year 6
Production commencing in 1 year
Cost of equity of 13.4%

LYC would be worth about 32c after the capital raising. To get to today’s price of 60c AUD you need to assume that RE price grow by 8% per year. 8% a year may not seem like much but that is $41 per kg in year 20. Alternatively you get to today’s price by taking the $14 all time high for LYC’s basket of RE’s and growing that by 3% per year for 20 years. Again, if that happens then you break even. Remember this is all before tax.

Lynas is planning to get to production without any debt having had bad experiences with debt financing up to now. While the value of the firm should not change based on the capital structure (Modigliani and Miller equivalence and all) the returns to equity would have been much higher with a mix of debt. While this is often true it’s worth noting in this case because the dilution from this capital raising is so substantial.

Buying into Lynas is a leveraged play on Rare Earths. If you think they are going to go up over 4 times in the next 20 years then you’ll break even!

You would have to have very bullish assumptions on RE prices to buy into Lynas at these prices.

Revised NGP Proposed Transaction with Eagle Rock (EROC)

2009-10-13T06:25:00.001-05:00

Natural Gas Partners (NGP) proposed a series of transactions with Eagle Rock Energy Partners (EROC), as detailed in this post. NGP have just submitted a revised term sheet to EROC.

The changes mentioned in EROC’s press release are:

$145M instead of $135M for Mineral Business
$4M less in fees to NGP and fee can be paid in units if the equity raising is less than 105M
Option on remaining GP units extended to 2012 from 2010

By redlining the two documents the following changes are also proposed:

Warrants only exercisable four times a year
If the public equity offering price is above $3.40 then EROC will issue up to $140M instead of $105M
Sale of the Mineral Assets will be effective on January 1^st, 2010. All profits from then until closing will accrue to NGP.
EROC can set up a data room and may market the mineral business. An alternate deal has 100 days and can be for all or part of the minerals business. It must be for more than $145M and must either close within 100 days or have no conditions.
They clarify that the transaction fee is only payable if the approvals are obtained
Proceeds can be used for hedge resets
NGP could terminate the agreement between the definitive agreement and the approval if the share price dropped below $2. This has been changed to $1.50.
EROC’s conflicts committee has a fiduciary out. That would allow them to accept another, superior, proposal if their fiduciary duty requires them to. NGP would get a $7M break fee. This out is only available until the Approval date.

All of these revised terms are more favourable to EROC though not substantially so. At best this may provide a few extra percent in value from $6.90 to $7.20 (versus $7.66 before the NGP EROC deal). The pricing of the equity offering is going to be much more important than the minutiae of the NGP EROC terms.

This revised term sheet indicates that a deal is very likely and the timeframe for realizing a good profit on EROC should be around 3 months. EROC closed at $4.57 so there is still a 58% gain if you see through the whole rights issuance (though we may not see all of that gain in 3 months).

Valuing Strathmore (STM STM.V) and progress on Bayswater (BAY.V) Deal

2009-10-06T20:36:00.001-05:00

As discussed in late August, Bayswater is trying to purchase Pine Tree-Reno Creek and the Wyoming properties from Strathmore Minerals (STM STM.V).

Bayswater just received a positive pre-feasibility study on the Reno Creek Uranium project. This study is for less than the 10% of Strathmore that BAY is purchasing.

The NPV of the Reno Creek project is US$164M using an 8% discount rate. Assuming that this is a reasonable average NPV for each remaining 10% of STM, it would value STM at 9x164 = $1,476M USD or $20USD a share.

I don’t think 8% is the correct discount rate for STM. Using a regression Beta from Reuters you get a cost of capital (it’s all equity) closer to 20%. That would make the NPV closer to $63M for Reno Creek and a total value for STM closer to $7.60 USD per share or $8 CAD. That is slightly higher than my liquidation value for Strathmore of $4-$7 CAD. Last night STM closed at $0.56 CAD.

Why is STM worth so little as a going concern versus an orderly selloff of their properties? The answer is their cost of capital. An established mining company could bring a much lower cost of capital to the project thereby capturing value closer to $20. Over time, as STM matures, their cost of capital will decrease and they will be able to capture more of the value that is currently discounted away.

This is yet another support for a valuation of STM in the $4 - $7 (or $8) CAD range today and an eventual value of close to $20, albeit with much higher than market risk.

Natural Gas Partners (NGP) proposed transactions with Eagle Rock (EROC)

2009-09-19T20:46:00.002-05:00

Natural Gas Partners (NGP) have proposed a series of transactions with Eagle Rock Energy Partners (EROC). These transactions involve:

A rights offering to current holders
An equity offering back stopped by NGP
Sale of EROC’s Minerals Business to NGP with the opportunity to sell to a higher bidder if one arrives
Repurchase by EROC of NGP’s Subordinated units, some General Partner Units and the attached Incentive Distribution Rights (IDRs)
An option to repurchase all of the General Partner (GP) Units
New Equity Incentives for Management
Restructuring of certain terms and conditions in the partnership agreement

Valuation

To analyse the proposed transactions we'll use the EROC Valuation from July this year as the base case. The other starting data we need is the end case of the proposed transactions; they can be divided into:

Changes to discount rates
Changes to cash flows
Changes to shares outstanding

The total debt repaid as a result of the transactions would be around 250M. That greatly improves the debt to equity ratio and reduces the 2010 discount rates from 17.5% to 11.6%. 2011 onwards discount rates move slightly from 12.2% to the revised 11.6%.

There are three impacts on cash flows:

The loss of the minerals business
The reduced interest expenses
The reduced cash losses from purchasing in the money hedges to avoid violating loan covenants

The minerals business produced $2.8M in profit in the six months ending June 30th 2009. Our base case is based on 2009 cash flows so annualizing that to $6M is consistent for comparison. The minerals business earned 31.8M in 2008 and nearly zero in 2007. EROC describes the 2008 results as a phenomenon as they reflect $17M of bonus payments “as a result of the regeneration phenomenon we received an initial royalty payment for 304 new wells”.

Interest expenses in the base case are $29M per year (they are in fact running slightly less than that now). Debt will be reduced by 31% which should lead to a straight line saving of $9M.

As described in the initial valuation of EROC, they manage their loan covenants by purchasing in the money hedges. As prices exceed these in the money hedges, EROC net loses money. This was not effectively modelled in the base case but was an inefficient use of cash and not doing this in the future is a benefit even if it’s not quantified.

The cash flow and discount rate changes look promising. Unfortunately they are offset by changes in shares outstanding.

The rights offering will add 19.6M shares
The equity offering will add 33.9M shares
The repurchase of half of the GP units will retire 400k shares
The subordinated units will not become active in 2022
Management will receive 8M shares as incentives

The net effect is about 117M shares from 56M today.

Cash flows are 49% of pre-transactions cash flows on a per share basis. With the reduced discount rate this values each unit based on a dividend discount model at $6.90 from $7.66 in the pre transactions base case.

Rights Offering

That’s not quite the end of the valuation. Current unit holders are offered the right to purchase .35 additional units for each unit they hold. They can purchase additional units for $2.50 and will receive a 2 year $6 warrant for each additional unit purchased.

Valuing the right is easy. It’s 0.35 * (post transaction value - $2.50) = $1.54

Valuing the warrant is more complicated. One model would be .35 * (post transaction value – strike price) = $0.315. Unfortunately the warrant is only good for 2 years and therefore an option pricing model is probably more appropriate. Using the option inputs provided I’d value the warrant at 41c. As you only get .35 per current unit held then the warrant is worth $0.14.

New post transactions valuation - $6.90
Rights - $1.54
Warrant – $0.14
Total value - $8.58

This assumes:

EROC does not exercise the option for the other half of the GP units
The equity offering is conducted at $3.10. Every 10c increase in the price of this offering offers unit holders about the same 10c in unit value
All rights are exercised
Other assumptions per the original base case estimate

Other considerations

There are also some intangible benefits of the proposed deal:

If interest rates increase dramatically over the next year or two, EROC will be much better positioned to manage that
EROC will be better positioned to renegotiate their loan in 2012
Yield investors will be attracted back to the units
There is a short term catalyst for the stock

There are also some disadvantages:

EROC loses a low risk line of business with upside
The opportunity to assume the risk and reward of the debt pay down over the next 12-18 months is removed. The analysis presented here is based on values at the end of 2009. There is an extra 60% value to be captured in 2010/2011 if EROC makes it through that time period. That risk/ reward is captured in the discount rate.
These transactions will not be evaluated strictly on their benefit to unit holders, see conflicts of interest below.

The repurchase of the subordinated units and the IDRs for $35.5M is fair. The subordinated units will receive payouts from 2022 onwards. Discounting that back to today values the subordinated units at $40M. The IDRs appear close to worthless.

Restructuring

The transactions propose that future accruals of the minimum quarterly distribution cease. Current accruals may remain but they are a moot point once the subordinated units are redeemed.

Conflicts of interest

NGP have identified in their offer that these transactions pose a conflict of interests. The conflict will be put to the independent directors. Furthermore the most recent 10k outlines the responsibilities of those directors. While it’s well worth reading in full; you should note:

“Neither our partnership agreement nor any other agreement requires the NGP Investors to pursue a business strategy that favors us”
“Our partnership agreement limits our general partner’s fiduciary duties to holders of our common units and subordinated units.”
“We may issue additional units without limited partner approval, which would dilute ownership interests.”
“Our general partner is allowed to take into account the interests of parties other than us in resolving conflicts of interest”

Opportunity

It appears, on balance, that this is a fair transaction. It offers NGP a way to convert some long dated opportunities into shorter dated ones. It gives unit holders more short term upside while sacrificing a higher risk/ reward over the next few years. It also creates a catalyst as a result of the rights offering and the resumption of distributions. As valued today, these transactions moderately increase the value of EROC units to current holders.

Strathmore to Sell Pine Tree-Reno Creek, Wyoming, Uranium Project to Bayswater for US $30 Million (STM.V STM)

2009-08-24T23:30:00.001-05:00

Strathmore Minerals has agreed to sell Pine Tree-Reno Creek, Wyoming properties (Sale Properties) to Bayswater for $30M USD.

$30M USD is 43c CAD per share of STM. On August 18th STM closed at 43c CAD.

The sale properties are about 10% of Strathmore’s uranium or slightly less if you adjust for the reliability of the estimates. . It’s probably reasonable to assume that this deal values STM at about $4.5 CAD in the even of an orderly liquidation. I valued Strathmore in a prior post based on the Rio Kintyre sale at about $7.50 - $12 CAD based on an orderly liquidation. A lot has happened since July 2008 but $4 - $7 is still supported by this deal with Bayswater.

My original valuation of Strathmore as a going concern is in the teens. Again nothing has changed dramatically but that’s unlikely to be realized until they have some properties producing.

This is a sound deal for Strathmore. They are probably giving up a couple of dollars per share in the very long term for cash now. Not doing this deal could risk everything. There are some conditions that need to be met including Bayswater raising $36M. They have 4 months to close the deal. There is a small break fee of $250k which STM would have to pay if they accept a better offer or Bayswater will need to pay if they fail to close.

The problem is that Bayswater’s market cap is currently $17M CAD. It is unclear how they think they will be able to raise $36M. STM have a bit of a history of entering deals with companies that simply can’t pay. The same has happened with Great Bear & the Chord property.

The recent concerns about STM have been whether or not they have the cash to see through production.

“They continue to be able to sell equity in properties that they acquired for cash. Real properties with Real Uranium deposits, even if they can't raise equity or debt financing. “

Strathmore went through a dramatic decline from 2001 to 2003, reaching 6c. In 2005 it reached $5.18. In Strathmore Groundhog Day I outlined that STM would survive this crisis just like the last one. In the end when you have real assets you can always generate cash.

If this goes ahead it will be great for STM. If it doesn’t, then STM will need to find another source of cash which they are very likely to do successfully.

Sniping Felix (FLX FLX.ax)

2009-08-17T21:57:00.001-05:00

Anyone who has bid in an auction on ebay has learned that there are only a few winning strategies that participants use:

1. Bid low and early, in the hope that no one else will participate. You win the auction at the reserve price.

2. Bid very high immediately not in small increments. This frightens off competing bidders, especially if your bid is at or above a fair price for the item.

3. Snipe, which is waiting until the last second and making the smallest incremental bid to win the auction before the other party has time to counter.

These is a fourth strategy which generally doesn’t win:

4. Participate in the auction. That is bidding a little bit more than the last person at any time during the auction.

It’s pretty clear that Yanzhou is using strategy 1 (bid low and early) in their bid for Felix. Given the recent financial crisis it is unlikely that any competing bidder is going to have the stomach for strategy 2 (bid very high). That leaves an incompetent bidder using strategy 4 (participate) or a smart bidder using the one remaining strategy which is to try and snipe Felix.

Why does this matter? Because anyone expecting a counter offer should not expect it soon. Based on the published timeline, a counter offer can wait until November. There is additional benefit in waiting as the counter offer will be able to consider problems that the Foreign Investment Review Board (FIRB) has with the Yanzhou offer. Anyone looking to arbitrage a Felix buyout should wait for the excitement to die down. There is a good chance that you’ll be able to buy Felix at a lower price once the market believes that a counter offer isn’t coming. In fact, readers of this blog will know that a counter offer may yet arrive from a smart bidder.

I still expect a counter offer (>50% chance). The capital position of potential bidders is not great on the whole but this is counter balanced by the high ROI available from a counter bid. I don’t expect a counter offer in the next 4-8 weeks.

Felix Resources (FLX FLX.AX) Takeover – Counter Offers

2009-08-15T09:01:00.007-05:00

I have received a few emails and comments on Felix and the chances of a counter offer. In summary, a counter is likely.

There are three criteria that determine the chances of a counter:

Return on Investment of the deal based on the current price propose
Contract flexibility based on the contract signed with the initial party
Capability of alternate bidders to finance

Based on Yanzhou’s $18 offer they should see a 60% plus return in 2-3 years. This clearly support a counter offer. Furthermore there are parties that could create synergies from buying Felix, thereby creating an even greater return. At $24 there would still be a 20% return before synergies. If Xstrata were to bid then they could achieve substantially more than 20% because their Ulan mine is next door to Felix’s Moolarben mine. Examples of synergies would include shared transport infrastructure or marketing.

Next we consider the contract signed between Felix and Yanzhou. I was surprised by the small break fee of A$33M . While Felix directors are prevented from actively seeking another offer. They are allowed to negotiate and assist a potential acquirer once a superior offer is made. The contract appears quite supportive of an auction developing.

Finally the ability of other bidders to finance a bid comes into question. This is probably the biggest impediment to an alternate deal. It isn’t easy to get substantial debt or equity finance right now (unless you’re borrowing from the Chinese government). Xstrata recently did a large rights offering to reduce debt as did Rio Tinto, it therefore seems unlikely that they would bid. BHP, Vale, China Shenhua, Noble and Peabody have been identified as potential bidders. There have also been rumours that Canadian Teck Resources were looking for an Australian mine to diversify their coal sources.

By looking at Felix as a percentage of the acquiring companies capital, looking at debt to market value of equity and analysing synergies it’s easy to establish who the most likely counter bids will come from.

Click on the table above to see detailed analysis and ranking of the potential acquirers
Based on the analysis in the table above:

BHP: Felix would be a minor addition to their portfolio. They could offer shares as well as cash which might be attractive for those with large capital gains. BHP has a tiny amount of debt (though they could do a deal for Felix using available cash without additional debt) and could capture synergies with it’s current businesses. BHP seems like the most capable and obvious choice.
Vale: Vale is not far behind BHP. ~~Vale own AMCI who in turn on 19.9% of Felix!~~ Felix would be a small but valuable addition to Vale’s portfolio. Vale is not highly levered and could easily afford to buy Felix with available cash or additional debt. ~~Given that Vale already own nearly 20% of Felix they seem like a high likely candidate for a counter offer.~~ (When I originally wrote this I incorrectly stated that AMCI was owned by Vale. Vale own AMCI Australia based in Brisbane not the AMCI that owns Felix. Vale still has the cash or debt capacity to buy Felix and Vale still has Australian operations that would provide synergies. However Vale is not as likely as when I thought the owned AMCI. Vale is still in the top 3. While you might expect Vale to be more interested in Metallurgical coal, in fact they already own Thermal coal operations in Australia, which is supportive of a bid.)
China Shenhua are nearly 6 times larger than Yanzhou. They are very conservatively levered and Felix would end up as a small part of their portfolio. Shenhua have a very low amount of debt and could very easily buy Felix through debt. Given that Yanzhou are already bidding it seems unlikely that Shenhua would become involved. Even if the bid was substantially higher, Yanzhou has the debt capacity. Shenhua are prospecting for coal in Australia but do not have any mining operations here.
Yanzhou is only the fourth most obvious candidate. At the offer price, Felix is 20% of their total capital so this is a substantial, company changing, acquisition for Yanzhou. They have effectively no debt so they can easily go to 20% debt to market value of equity. Even if Felix sells for more, Yanzhou have the debt capacity while remaining at a conservative debt to equity ratio.
Rio and Xstrata are not likely acquirers. They both conducted substantial rights offerings to lower their debt and are unlikely to lever up so quickly. Felix would be a neat addition to either portfolio but the finance doesn’t make sense.
Peabody is similar to Yanzhou in that Felix would become around 20% of the company. Peabody, however, already has debt at 33% of total capital. They would have some synergies but it seems unlikely that Peabody would be able to finance an offer.
Teck Resources is rumoured to be looking for an Australian mine to diversify their operations and to offer their customers a wider variety of loading locations. Felix would be 10% of capital for Teck so it would be a nice addition. Teck’s debt is already 75% of capital and they are unlikely to be able to make such a substantial purchase.
Noble is the smallest of the potential acquirers. Felix would be 45% of current capital. Noble has recently purchased Gloucester coal and it’s unlikely that Noble could manage to integrate two acquisition in such a short time. Given Noble’s current debt and size it’s also unlikely that they could finance a bid.

In closing, BHP and Vale are the obvious bidders if an auction develops. China Shenhua is not going to compete directly with Yanzhou. BHP and Vale could acquire a neat addition to their respective portfolios and achieve a high return on investment even at a substantially higher offer; both because of the attractiveness of Felix’s assets and because they would realize synergies with their existing businesses. ~~Vale already owns 20% of Felix so they won’t need to do substantial due diligence to put together an offer.~~

A counter offer is reasonably likely from a non-Chinese company with the capacity to finance. It’s unlikely that Yanzhou has made their final offer. Given the synergies on offer, the ability to pay with shares and the break fee it seems likely that a counter will cause another Australian mineral company to spurn their Chinese fiancé or at least make her increase the dowry.

Felix Resource ( FLX FLX.AX ) Yanzhou ( YZC ) Offer

2009-08-13T03:25:00.001-05:00

I have been writing about Felix Resource (FLX.AX AX:FLX) since late December 2005.

Felix was trading at $1.91 at the time of my first post in December 2005. At the time I valued Felix at around $10. Felix grew and the global energy market changed. My later valuations were around $24-$25.

Felix, today, announced the terms of a takeover proposal from Yanzhou Coal for about $18 (all amounts in AUD). Made up of $16.95 cash from Yanzhou, 5c worth of shares in a spinoff of their South Australian tenements and $1 worth of dividends.

There is a $33.3M break fee payable by Felix if any Felix director does not support the proposal, a competing proposal is accepted or there is a material breach. Yanzhou has to pay if it can’t secure financing or in the event of a material breach. This break up fee is pretty low and does not materially block another bid.

Felix directors are prevented from soliciting or encouraging other proposals, negotiating or discussing a proposal with 3rd parties and is not allowed to provide due diligence information to 3rd parties. However, if another proposal appears to be superior based on the statutory definition then directors can negotiate and share due diligence information.

The proposal has to be agreed by Felix shareholders and by 2/3rds of Yanzhou shareholders in addition to 14 other conditions including Yanzhou securing finance.

Yanzhou shareholders will be asked to approve the deal by mid-October, Felix will pay the first 50c dividend in late October. FLX shareholders will vote in early December and final consideration will be paid in late December.

Overall this is a barely adequate offer. Yanzhou are paying a small premium based on FLX recent closing price and are securing a good 75% plus upside over the next few years. Felix major shareholders are getting the opportunity to sell out together preventing the kind of debacle that happened with Macarthur Coal (where one shareholder sells a blocking stake).

Importantly the door is wide open for a serious better offer. There is plenty of time for one to materialize which gives FLX shareholders something of a floor. An offer nearer $24, would leave a reasonable 25% upside to the acquirer while paying a more reasonable price to current FLX holders.

Nickel Bull : Selling Mincor MCR (MCR.AX AU:MCR)

2009-08-03T09:17:00.002-05:00

I wrote about Nickel, Mincor and Panoramic resources here , here and here. I sold out of PAN a few months ago and have now closed out my Mincor position. In this post I estimated a long term price for Nickel (all in USD) of $7.75, Nickel was $5.18 at the time. Today Nickel traded as high as $8.53. To briefly reiterate the basis for the $7.75 estimate it is a blend of the 2000 – 2008 average and the marginal cost of production. Nickel can be replaced in Steel manufacturing by pig iron for prices of Nickel over $8.

My fair value estimate for Mincor is $2.27. Today it traded as high as $2.30 and I sold out. I placed the limit sell order ahead of time so I wouldn’t have to go through the difficult psychological process of selling a very successful position.

After such a big shock to the world economy it doesn’t make sense that Nickel would already have exceeded its 10 year average (the long term average is even lower at $5.60). While I can believe (as outlined here) that China and India have shifted the demand curve and that the supply curve has shifted; this ought to be captured in the 10 year average.

Nickel may double in the next month on its way to all time highs but it’s no longer a value investment, neither is Mincor.

Cape Lambert Iron Ore (CFE CFE.AX)

2009-08-02T04:30:00.008-05:00

Cape Lambert Iron Ore (CFE CFE.AX AU:CFE) owns a number of natural resource related projects either outright or through ownership of shares in other listed or unlisted companies. CFE are not miners but instead trade natural resource projects. They often develop a project to the point where it could be mined and then sell it. They buy or take a share in individual projects or small companies, develop the projects and then sell them on to larger companies.

Cape Lambert has quite a history;

In 2003 the precursor company to Cape Lambert (CFE), International Goldfields (IGL) merged with Hamill Resources. At that time they were focused on gold projects and were having some reasonable success with their enormous Mt Ida tenements and the Evanston project which came from Hamill.
In 2004 Mt Ida mining continued. The Baldock load is mentioned and should have be producing by 2005.
In 2005 exploration continued on Mt Ida, Evanstone and a copper-gold opportunity called Sacu in Romania. Mt Ida mining was put on care and maintenance to rework the mine plan in light of new resource discoveries including the Baldock load. IGL partnered with Cogema Group (a French mining company), they had the opportunity to earn in 51% of the project by spending 7.5M over the next 5 years. Evanstone exploration continued. The Sacu project continued exploration and IGL bought approximately 16% of NFX Gold in Canada.
In 2006 the company acquired the Cape Lambert Iron Ore mine through the purchase of Mt Ankatell with the expectation of a 12-18 month feasibility study. IGL issued about $33M in shares to fund the acquisition and for other exploration. The Cape Lambert Acquisition cost $20M. The company changed its name to Cape Lambert Iron Ore (CFE). CFE announced that the gold assets would be spun off into International Goldfields (IGC) and was IPO'd for proceeds of around $5M. CFE spun out the remaining shares but retains a royalty interest in IGC's assets. CFE also sold its interests in NFX and listed itself on the London AIM.
In 2007 extensive drilling of the Cape Lambert mine lead the company to expect a bankable feasibility study by Q3 2008. They produced interim mineral estimates for the mine indicating a 10-15Mtpa magnetite concentrate mine over 20 years. Some Chinese interest was explored but failed and CFE continued to pursue the prospects on their own. CFE also acquired additional acreage adjacent to the Cape Lambert tenement. The company agreed to sell 70% of the Cape Lambert project to a Mr Ding for US192M. Shareholders agreed and the deal was awaiting foreign investment board approval.
In 2008 the sale to Mr Ding did not proceed. However the project was sold for $400M (with 80M yet to be received based on receipt of licenses) to China Metallurgical Group (MCC). CFE kept their interests in the southern extension of the project. CFE then returned 100M to shareholders and acquired 30% of the Marampa Iron Ore project in Sierra Leone from African Minerals for about US45M. . CFE spun out various interests in other iron ore projects to CFE shareholders via Global Iron Ore.

Apparently there was some board reluctance to sell Cape Lambert at the time. The board wanted to spend another 10-15M to improve the resource. Apparently Tony Sage pushed hard to get the sale through as he believed they had reached the optimum cost benefit for further drilling. With hindsight it was a brilliant decision.

Since the 2008 annual report the company;

Cancelled their listing on AIM
Explored their Cape Lambert South tenement
Provided convertible loans to some small ASX exploration companies
Worked with MCC to secure licenses and in turn their $80M payment.
Acquired all the assets of CopperCo as the result of a liquidation of CopperCo due to default.

CopperCo was acquired by total payments of 129.7M made up of:

The secured debt for 72.7M (with 15M of that deferred until July 2009) from Macquarie Bank and LinQ Capital.
A $30M working capital facility during the administration.
$27M on completion of the sale.

Fortunately I was never a shareholder of CopperCo because their assets were sold at the absolute market bottom for a small fraction of their fair value based on normalized (not peak) commodity prices. The managers of CopperCo did the owners a great disservice by taking on a level of debt that put immense value at refinancing risk. All this is great news for holders of CFE (which incidentally doesn’t have any debt).

The material assets of CFE are shown in the table below. There are multiple sources for the value of the CopperCo assets. These valuations are generally not peak valuations and have been adjusted for my long term commodity price assumptions. I have validated some of these valuations where underlying data was available. For example CopperCo published cashflow expectations for the Lady Annie Project and if anything they support a higher value than other sources.

Sum of the parts valuation of CFE

CFE recently did a road show around Australia and released a presentation on the ASX. They disclosed that they are reviewing a potential trade sale of Lady Annie for around $150M . Hopefully they won’t proceed with such a sale. They revealed in their quarterly report that they have commenced a 2 year exploration program to expand the resource. CFE have a good (yet short) track record of adding value prior to sales and of selling once an appropriate (but not exhaustive) amount of value has been added. There is no reason that they can’t secure $200M for Lady Annie. My “Estimate” case assumes $150M for Lady Annie.

An article in Australia’s Paydirt has Tony Sage, the Executive Chairman stating that the company is going to try to sell their interest in Marampa for $400M US. I have no basis to value Marampa so I’ve assigned it the carrying value of $25M in my “Estimate” case (I’ve assigned $150M per the road show slides in the High case).

As mentioned above, there is 80M yet to be received from the sale of their name sake mine to MCC. I have assumed they will not meet the criteria to receive that payment in my “Estimate” case. The High case assumes they will receive the payment.

Finally there are some small equity investments that based on the road show disclosures I've valued at $7M.

Tony Sage, the Executive Director, has quite a storied history. Western Australian Police investigated Sage in relation to a vehicle that was later used in a crime, no charges were ever filed. He was supposed to have attended a soccer game with a criminal figure, though the newspaper that published the report later retracted it. Sage owns a Perth Soccer Club, night clubs and Fashion magazine Kurv. Sage has dealt extensively with Frank Timis, who hired Sage to work on Gabriel Resources many years ago. Timis is a controversial Romanian-Australian businessman who was arrested for Heroin dealing in his younger days. Sage is of the view that Frank needed to support his family. They have been friends for over 16 years. Ultimately Timis has made money for Sage and in turn for Sage’s shareholders. Timis was the seller of Marampa, through African Minerals. Sage has been criticized for the deal but time will tell how it works out. Most of Sage’s wealth is his equity in CFE so his interests appear to be well aligned with other share holders. Sage has developed a reasonable track record for proving the pundits wrong.

I don’t like the Marampa deal because the political risk in Sierra Leone (and in turn the increased discount rate for investment there) adds a factor that I don’t think CFE have sufficient experience dealing with. There have already been legal issues with the Marampa project. They may well get lucky and sell the deal to another company that will need to deal with the political risk; Chinese companies seem quite comfortable in Africa and Sage has been able to sell his projects on to Chinese companies. There were so many opportuities in natural resources earlier in the year that I am disappointed they didn’t forgo Africa and focus on more politically secure areas of the world. However, maybe that is what is causing such a dramatic under valuation in CFE shares.

Based on the sum of the parts valuation CFE is worth around 94c. Remeber this estimate assumes no residual from the MCC deal and no value to Marampa. Worst case it seems extremely unlikely that CFE is worth less than 39c. An article in the Mining Journal has Sage assert that CFE is worth at least 150% of its current market value of $150M. I would agree.

My average cost is about 32c. I am trying to buy more but I haven’t been willing to pay up after the recent rise. The combination of the recently completed road show, the resurgent broad market and a better appreciation of the Copper Co assets appear to be causing a revaluation of Cape Lambert. CFE most recently closed at 35.5c on the ASX for appreciation of nearly 175%. With no debt it is easy to make the case that Cape Lambert Iron Ore should hold a large sized position in your portfolio.

Eagle Rock Energy Partners (EROC)

2009-07-17T02:41:00.005-05:00

Eagle Rock Energy (EROC) is an oil and gas Master Limited Partnership (MLP). The partnership is ultimately run, managed and partially owned by Natural Gas Partners out of Texas. They operate an

Upstream - acquiring, developing and producing interests in oil and natural gas properties
Midstream - gathering, compressing, treating, processing and transporting and selling natural gas and natural gas liquids
Minerals - acquiring and managing fee mineral and royalty interests either directly or in partnership with others.

EROC is worth between 5 and 8 dollars and is currently trading for about 3.

Limited Partnerships
Owning a limited partnership is different to owning shares in a company. For example, as a limited partner you are responsible for paying taxes on the partnership earnings, regardless of whether or not you actually receive distributions (equivalent of dividends). MLPs are generally created to distribute most or all of their earnings to the limited partners. Therefore buyers of MLP units are generally seeking the high yields available.

Distributions
In April 2009 EROC announced that instead of a distribution of 41c (around 11% average yield in 2008) per unit received in 4Q 2008 that distributions would be cut to 2.5c. This was done to conserve cash to pay down debt over the next couple of years in recognition of the changed environment for debt. Eagle Rock has a nearly $1Bn credit line which had $837M drawn as of Q1 09.

Covenants
Covenants are the rules which the company must stay in compliance with, to keep their loan (i.e. you violate a covenant then the bank can demand their money back).

There is a unique arrangement when it comes to covenants for the EROC lines. They effectively have two buckets that their total loan can be distributed against. One bucket is attached to the value of their upstream business. The size of the bucket is re-evaluated twice yearly and is based on the current value of the upstream business in turn based on commodity prices. As commodity prices rise the borrowing base rises and more of the loan can be allocated to this bucket. Conversely as commodity prices fall, the borrowing base falls and less of the loan is allocated to this bucket. This bucket has a very easy covenant that the company is well within so they want this bucket to be as big as possible.

The second bucket is for the rest of their loan. It is notionally attached to their midstream and minerals business. The size of this bucket is not recalculated. It simply contains all of their debt that isn't captured by the upstream bucket. The second bucket (the midstream & minerals bucket) has much tougher covenants. Therefore the company would like this to be as small as possible.

In March 2009 the upstream bucket borrowing base was $206M. In April it was resized to $135M. Effectively growing the size of the other bucket.

The upstream covenant is defined in EROC's credit agreement (available on EDGAR) as Consolidated EBITDA divided by Consolidated Interest Expense. This was 6.0 as compared to a minimum covenant of 2.0. This is the easy one.

The other covenant, on the midstream & minerals business, is defined as Total Funded Indebtedness divided by Adjusted Consolidated EBITDA. This was 4 in Q1 09 versus a maximum of 5. As the companies' EBITDA falls as a result of lower commodity prices then the denominator falls and the ratio rises. By late April it had risen to 4.4. There are only two ways to stay within this covenant. Decrease debt or increase EBITDA.

The company recognized that they were going to have an upcoming problem, if they didn't reduce debt, based on futures prices for natural gas and oil. In fact with their current hedges it was likely that they would violate this covenant by the end of 2009. They are safe earlier in 2009 because EBITDA is calculated on a rolling 12 month basis so they still received the benefit from 2008.

EROC determined that they would like the ratio to be closer to 3 to 3.5 which with Q1 2009 EBITDA is a reduction of around $260M - $340M. Q1 2009 EBITDA was helped by high hedges but hindered by lower volumes and very poor commodity prices. For the rest of 2009 they expect to make around 40-45M in adjusted EBITDA (their cash flow measure) which will allow them to pay off 75-100M in debt in 2009. Based on a simple model of their EBITDA versus debt it is unlikely that they will violate this covenant in 2009. The problem, at face value, is in 2010.

With current hedges assuming a drop in 2010 earnings commensurate with the drop in their hedge prices (2010 will be 77% of 2009) EROC will earn Adjusted EBITDA of 32-35M per quarter in 2010. This could cause a covenant violation depending on exactly where they end up in the range. The violation would likely occur in Q3 2010.

2011 futures prices are similar to EROC's 2010 hedges so there will not be a further drop off in 2011.

Covenant violations end up being a moot point because the bank covenants are based on EBITDA. Earnings before Interest, Tax, Depreciation and Amortization.

The money paid for EROC's hedges is amortized. Therefore in the EBITDA calculation it isn't counted. This allows EROC to purchase in the money hedges, realize the increased price received from the in the money hedges while ignoring the cost of purchase.

EROC entered just such a transaction in January 2009. They reset their 2009 hedges higher. The actually paid cash to buy higher hedges. In turn they will receive higher payments for their product. In the calculation of EBITDA, only the higher payments will be recorded. They said this was the purpose of the transaction on their conference call.

WHILE EROC HAS CASH OR CREDIT AVAILABLE TO PURCHASE IN THE MONEY HEDGES, THEY CAN PERMANENTLY AVOID VIOLATING BANK COVENANTS.

This may sound unbelievable but it is true. EROC need only reset some mid to late 2010 hedges higher and they will avoid violating their covenants. As this isn't a particularly good use of cash (at least not in the absence of bank covenants) they will wait until they see how 2009/ early 2010 is looking before they commit cash to resetting their hedges. It looks like $5m worth of in the money hedges would push them over the line.

In the worst case of a covenant violation, it's possible that EROC would end up having to pay higher interest expenses on an amended credit line rather than being forced into bankruptcy.

Valuation
There are some more unique features to EROC. Firstly the units are entitled to a minimum quarterly distribution (MQD). For every quarter that you don't receive the MQD the unit acquires an arrearage for that amount.

EROC has about 50M LP units and the manager of EROC, Natural Gas Partners, owns 20.7M subordinated units. These can convert into 20.7M LP units after all arrearages are cleared. Therefore the manager is highly incented to convert their subordinated units into a nearly 30% ownership of EROC worth around $90M. However, before they can realize that $90M+ they need to pay out all arrearages. This is achievable over a number of years.

Valuing EROC is based on discounting future dividends at EROC's cost of capital. Using 17.5% for 2009 & 2010 and then 12.2% as the discount rate. Along with distributions of 8c in '09 & '10 followed by $1.45 (the MQD) increased at 3% per year until year 20. Then from 20 to 25 decreasing at 10% per year. This leaves you with a value of $7.66.

A key assumption is the amount that EROC can pay in 2011 onwards. This model assumes that the 2010 cashflow (33M per quarter EBITDA/ 131 per year) is their sustainable level. That is $67 oil and $6.9 gas. As energy prices exceed these levels then EROC's value increases.

Expectations for 2009 EBITDA are about 170M based on $90 oil and $7.40 gas. If these are the 2011 reality then 2011 distribution could be around $1.75 leading to a value closer to $8.90.

EROC is currently trading at $3 and has been as low as $2.65. It's likely that you're offered 155% upside because the original holders of EROC have been selling. These holders wanted a high, consistent, yield. Those buying EROC now are value investors. Once certainty develops over the 2010 covenants, EROC is likely to trade higher.

Baupost's (Seth Klarman's) Latest Thoughts on Hedging Strategy

2009-05-14T19:56:00.002-05:00

I wrote about Baupost's (Seth Klarman's) Hedging Strategy based on his view in 1995-1997. In a recent speach he updated his thoughts on insurance (hedging).

"Do you overpay for insurance — or do you go uninsured?

Klarman: In terms of our firm, I tried so hard to learn
the lessons of 1998 in particular, which were: Don’t be
unprepared for something out of the blue that’s really bad.
To some extent, we were prepared this time. However,
you can never be prepared enough. We had a lot of macro
protection in terms of credit default protection on bonds
where we were just betting that credit spreads would widen.
That’s been incredibly helpful. But we’ve gotten really tired
of buying market puts, or anything like that, because they
inevitably are expensive and expire worthless.
So as an investor, you have terrible trade-offs. Do
you overpay for insurance — or do you go uninsured?
That’s just one of those dilemmas for which there are really
no perfect answers."
Outstanding Investor Digest March 17,2009

Baupost's (Seth Klarman's) Hedging Strategy

2009-05-10T18:54:00.002-05:00

Lots of blogs have been linking to Seth Klarman's Annual and mid year statements lodge with the SEC from early 96 to the end of 2001.

There hasn't been much analysis of the filings.

Put Option Strategy
I looked over four of his filings from Oct 95 - Apr 97. Over that period his put contracts ranged from 0.5% - 2% of assets. In the 0.5% case, I expect it's because the market ran away from him. It seems likely that his target is 1%-2% of assets.

In early 95 the majority of his puts were on the Russell 2000, by late 95 they focused on the S&P 500. By 96 they focused on the Nasdaq 100.

New positions appear to be placed at around 10%-15% below market. The days to expiry started off at about 305 in early 95 and had dropped to about 140 by late 96. This is easily explained by volatility. By late 96 he was buying Nasdaq 100 puts. In 6 months the Nasdaq 100 had risen by 16%. In such an environment you want to purchase puts with less duration as the value of duration declines as the market rises. This is offset by the discount you get for buying duration when rises are small but crosses over as the market moves away from your position.

Are 1-2% of assets enough to hedge? Yes. In late 95 the fund had $89M in assets. Assuming 20% was in cash then 72M is exposed to market moves. Let's assume that Seth is buying insurance against a substantial move of 30% or more and that the loss on the invested portion will only be 20%. This is reasonable as value investments generally outperform on the downside (even though they didn't necessarily in the current bear market). The portfolio would have lost $14M and the hedge was worth 11M. In 96 losses would have been around 16M and the hedges worth 21M. As noted previously, the Nasdaq 100 puts got away from him and only offered about $6M in protection from a $20M loss.

Based on a 30% drop, the average upside of the put portfolio was about 17 times for each period (using the annual cost of options with < 1 year to go).

When volatility is at historically normal levels, using 1%-2% of your portfolio can provide a reasonable hedge against substantial market drops. Such an approach will reduce the volatility of your returns and provide cash to buy when others are selling. Klarman doesn't seem to be mechanical about his option buying but broadly stays within bounds of 1-2% of assets, a strike 10%-15% below market and a duration of about a year under normal (average) market conditions.

Demystifying PPIP (or Felix Salmon mystifying PPIP)

2009-04-29T19:18:00.003-05:00

Felix Salmon writing for Reuters talks about a meeting with Mohamed El-Erian of PIMCO fame...

"On the subject of PPIP, though, I did ask El-Erian about how much value there is in clipping tails. If the government promises to absorb all losses beyond the first 15 cents on the dollar, how much does that raise the amount of money you’re willing to pay for any given asset? I was trying, in effect, to come at a value for the FDIC guarantee in the PPIP plan, but I didn’t get very far.

The answer, you see, is basically “it depends”. Every asset has a different probability distribution, and if you think that there’s a good chance the asset is actually worth 90, the tail-clipping at 85 is much more valuable than if you think the asset in reality is more likely to be worth 110. In short, it’s a long and laborious process of looking at every asset individually determining a probability distribution, and doing some math on it. How many good credit analysts are out there and capable of doing that kind of analysis? I think it’s not nearly enough, but El-Erian is a bit more bullish on that front: he thinks that if you create the right incentives, people will start to work this stuff out."

I've reproduced these paragraphs because Felix and El-Arian have taken something quite well known, put options, and made them sound mystical requiring some special kind of analysis. It doesn't! It requires the use of option pricing. The tail-clipping is simply a put sold by the government. That is why it's worth more the closer the intrinsic value is to your purchase price. Your purchase price minus 15% is the put's strike price. A put is obviously worth more the closer it is to being in the money.

The long laborious process of looking at every asset and determining its probability distribution translates to looking up historic volatility as an input to the options pricing model. In the absence of such data you could use a bottom up variance based on similar assets.

So putting this together, how does the government guarantee work. You believe a bond portfolio is worth 50c. You might bid 35c for the portfolio. Now if the government gives you a put 15% below your strike price you'll bid more because that put has value. Say the put is worth 4c. In that case you can bid 37c and you're still ahead by 2c.

The inputs to price the put are the strike price (15% below your purchase price), the current value (your estimate of intrinsic value), the volatility (calculated either bottom up or from trading data) and the time to expiry (however long the government guarantee runs for).

Opti Canada (OPC.to) - It's all in the risk

2009-04-20T20:50:00.003-05:00

I wrote about Opti in November '08 here. Since then they have made some major changes to their capital structure. They sold 30% of their project equity to Nexen, their partner, for cash. This generated just enough cash to survive. If the whole company was purchased on the same terms, then there would be enough money to redeem the bonds at 80c on the dollar. Equity would be worthless.

The worry now, after the recapitalization, is whether or not they can meet their new covenants. It's relatively easy to analyse OPC's cash flows and it seems quite likely that they will meet the covenant in Q3 09. Failure to meet the covenant is not necessarily a death sentence. They can simply not draw against the revolving loan (in which case the covenants don't matter) or they could negotiate temporary relief. My analysis shows they will have about 100M drawn on the revolver by Q3, though they could manage this to a lower number. The covenant is the ratio of the drawn down revolver amount (first lien debt) to EBITDA with a maximum ratio of 2.5 to 1. The price of oil isn't terribly important due to OPTI's hedges. I have assumed a flat $45 for the year.

On this basis EBITDA will be around $44m annualized which provides a debt ceiling of around $110M. The January '10 quarter looks to be more of a problem. I expect annualized EBITDA of nearly 56M which provides a ceiling of $140m but I expect debt to be drawn down by about 146M. Again they can probably manage away $6m but it's quite tight. From Q2 2010 I expect OPTI to be well within this covenant.

The next interesting problem is their ability to participate in future phases of development. They expect 6 phases, with the current phase being phase 1. I don't expect they will be able to participate in phases 2 or 3 without substantial, additional financing. I have assumed they will not be able to secure such financing.

Assuming:

No participation in phases 2 or 3
Substantial repayment of debt, starting in 2011
WTI of $60 in 2010 rising to $75 by 2013 and then rising by inflation
A high risk period cost of equity of 22.6%
A low risk period cost of equity of 10%
A 30% discount based on chance of a B3 bond defaulting over the high risk period (if the bond defaults then equity is worthless)

Then OPC is worth about $2.31. It has traded as low as .61c but is currently trading at $1.82. There is probably a small option value in their right to participate in future phases (if oil is trading at $200 then they will be able to secure funding for the earlier phases). This is not reflected in my valuation; $2.31 is a conservative floor.

The fair value estimate is based on considerable risk. As they de-risk their business their value will increase substantially. At a fixed 10% discount rate (all the other assumptions remain constant except the 30% discount) OPC is worth $7.30.

Nickel Stocks DCF (MCR.AX Mincor Panormaic Resources PAN.AX)

2009-04-20T20:29:00.002-05:00

In January I completed discounted cash flow estimates for PAN and MCR. They are both up substantially since then. My fair value estimate for MCR is $2.27 and PAN $2.38.

In comaprison to the blended analyst estimates I have a higher value for Mincor and a lower value for Panoramic.

The model assumes a Nickel price of $7 by 2011 rising by inflation and a constant .65c AUD to USD exchange rate.

From today's price MCR (.96) has 137% upside and PAN (1.58) has 50%.

Nickel Stock Updates, Mincor, Panoramic (MCR MCR.AX PAN PAN.AX)

2009-01-29T20:44:00.005-06:00

QUARTERLY RESULTS
Mincor and Panoramic Resources have just released their quarterly reports. Unfortunately, in Australia, quarterly reports do not have detailed financial data. However, there is a lot of good information. I've updated a number of metrics on both PAN and MCR since my last posts (prior PAN post, prior MCR post).

FINANCIAL METRICS
My buy price was loosely based on cash and cash equivalent backing net of liabilities. Roughly what Ben Graham called a net net or what Marty Whitman would call readily ascertainable net asset value.

In the case of Mincor this number has held quite steady at .52c per share down from .58c per share in the prior quarter. I don't believe that there is a particular trend downwards in these numbers. In the case of PAN, however, we are down to around .59c from .90c in early November; this is also the number used in my prior post.

The key financial metrics are presented in the table below. You may have to click on it to see all the figures.

VALUE AND TARGET PRICES
It's interesting to note that MCR has higher leverage to the price of Nickel but unfortunately also to the AUDUSD. Unfortunate, because I think the AUD will strengthen. MCR reports net working capital, PAN only reports net cash and receivables so I've estimated payables.

Since my prior posts I've also developed a long term Nickel price target. At US$7.75, It's lower than the one mentioned in my prior posts on PAN and MCR. I've gone back over analyst's reports from the prior 6 months and used that number to aggregate fair values.

I've then developed a blended fair value and compared the current price to it along with net current assets and book value.

By all of these metrics Mincor is the better buy. It has almost the same upside leverage, is much closer to net asset backing, has higher leverage to the Nickel price and is at a larger discount to book value. Mincor has managed their net current assets better than Panoramic and have a lower cash cost. Mincor seems like a slam dunk buy at .58c and a sell at $1.79. Panoramic would be a buy at .59c and a sell at $2.60 (though it would have 4 times upside from .59c). I also worry that PAN may be in a downtrend in terms of net current assets.

Barron's Roundtable on Stealth Gas (GASS)

2009-01-26T18:01:00.005-06:00

The quote below is from the Barron's 2009 Roundtable. Scott Black from Delphi talks about StealthGas (GASS). I have marked the offending portion in bold. He claims that their ships are worth $335M net of debt.

Aggresively they may be worth $30M as scrap and that's NOT net of debt. They have about 80k light displacement tons and each ton sells for between $205-$250USD in the scrap market.

This may or may not be a good buy but it's not "an asset play"!

__________________________________________________________

Barron's 2009 Roundtable:

"Black: My last pick is an asset play, atypical for Delphi. ROE is only 10%, but the stock, StealthGas, is cheap. The company owns tankers that transport liquefied petroleum gas, or LPG. It's based in Athens. The stock is 4.73, there are 22.3 million fully diluted shares, and a market cap of $105 million. It pays a 75-cent dividend, for a 15.8% yield, but they may not continue to pay it. Some shareholders think they should buy back shares or knock down debt instead

Schafer: What's the book value?

Black: Book is $14.23 a share and there is no goodwill, so price-to-book is 0.33. For 2008 I figure they earned $1.35 to $1.40 a share on revenue of $112 million. The company already has contracted for 67% of its voyage days for 2009 and 34% for 2010.

Schafer: How much stock does management own?

Black: About 6.5 million shares out of 22 million. The company has 39 boats. Day rates should come down a bit, to $7,000 from about $7,600. They get $21,000-$22,000 a day on three of their product carriers, so total 2009 revenue could be $124 million. Operating expenses will go up. We assume a 5% increase, to $5,760. They have $241 million of debt. Subtract about $94 million in expenses from $124 million in revenue, and you get estimated earnings of $30 million, or $1.35 a share. Street estimates are $1.42 to $1.45. Analysts have a higher revenue estimate. The stock sells for 3.5 times my earnings.

StealthGas specializes in short-haul, or feeder, boats. They come into a harbor in, say, Singapore or Thailand or the North Sea and offload their cargo. Four customers account for 60% of revenue: Shell, Statoil, Petredec and Vitol. Many contracts are for three or four years. The company's net debt-to-equity ratio is 0.71 to 1. Management says it has access to credit. Borrowing is done ship by ship.

Gabelli: What does a new ship cost?

Black: A new LPG tanker is about $18 million, and a product carrier is about $57 million. The fleet is only 10.8 years old. On a scrap-value basis the LPGs are worth about $500 million and the product tankers, $60 million. That's $560 million, less net debt of $225 million, for a total of $335 million or $15.09 a share, conservatively. After this year StealthGas will be cash-flow positive because it has finished building its fleet. That's it for me."

Fair Value for Crude Oil

2009-01-26T06:43:00.003-06:00

A follow up to yesterday's post on incremental costs of various commodities. The chart below is from CIBC StrategEcon January 23, 2009 it shows that crude has rarely traded below the marginal cost of production and has always rapidly bounced back. Looking at the graph, it would seem to show that crude has traded about 25% above the marginal cost of production since the early 80's. CIBC claims that $90 a barrel is the marginal cost "for production from a new Canadian integrated oil sands mining and upgrading facility these days". That would indicate a price of about $112 as fair value for crude.

Commodity Prices

2009-01-24T20:43:00.007-06:00

I've been looking at long term commodity prices to develop an average price to use in valuation. Here are some long term averages for LME Nickel (click for larger image).

Here are averages for Australian Thermal Coal, Copper and Crude Oil (simple average of three spot prices; Dated Brent, West Texas Intermediate, and the Dubai Fateh).

There are lots of implications. These prices were higher than I expected for oil, lower than I expected for Nickel and about right for copper and coal.

It's worth mentioning the corresponding spot prices as of January 23rd (USD):

Nickel - 5.18
Copper - 1.47
Oil (sample average as above Brent, WTI & Dubai Fateh) - 46.17
Australian Thermal Coal - $81.46

An equally important metric is the marginal cost of production (USD unless noted).

Oil US offshore - $69.75, Average Western Hemisphere - $47.63
Copper Marginal Cost - $1.8
Australian Thermal Coal (based on Credit Suisse research) - $70-$80 AUD, $80 USD to meet project hurdle rates
Nickel Marginal Cost - $6.8

Putting it all together:

Nickel and Copper look to be the most undervalued against their average range and spot prices
Crude oil is much lower than the marginal cost of production but is within it's long term average range.
Australian coal is well above the long term average and fractionally above the marginal cost of production.

Looking at long term averages assumes that supply and demand are relatively constant over long periods of time. It is worth considering that China and India may have permanently increased the demand for these commodities at a given price. It is also worth considering that decades of underinvestment, depleting resources, political instability and environmental laws have shifted the supply curve such that there is now a lower supply at a given price.

I do believe that this is what's happened BUT most importantly I'm not investing on that basis. The key here is to invest in commodity companies that are valued based on commodities priced at or below the marginal cost of production and long term average prices.

When to sell

Given that buying is relatively easy, how do we decide when to sell. I'm going to choose price points for Nickel, Crude, Coal and Copper.

NICKEL
Nickel - $7.75 USD. Nickel can be replaced in Stainless Steel manufacturing by Nickel Pig Iron at about $8 USD for Nickel. The $7.75 is the 2000-2008 average. This is the number based on long term economics that draws the line between investment and speculation. I would expect to sell most of my Nickel stocks once they become priced based on $7.75 Nickel.

OIL
Oil - $85 USD. I need to keep an eye on the marginal cost of production and depletion rates. This article puts current marginal cost at closer to $85-90USD based on Goldman Sachs. I'm going to place my initial long term oil price at $85USD and I'll continue to monitor the situation. I would expect to sell some oil exposure once my oil stocks become based on that long term price.

COAL
Coal - $80 USD. Based on Credit Suisse's research, Thermal coal at $80USD and Coking coal $90USD (which is Russia's marginal cost versus Australia's at $100AUD) are good price points. Based on energy equivalence thermal coal would sell for around $130USD with oil at $85 USD. Thermal coal is very tightly tied to long term oil prices and energy demand. I will watch changes in oil prices and energy demand closely but I would expect to be reducing my coal exposure once long term thermal prices of $80USD are factored into coal equity prices.

COPPER
Copper - $1.80. I don't own any copper equities but it would seem that any companies reflecting $1.47 or worse copper would be a great buy right now. Once equities reflect $1.80 copper, it will be time to reduce positions.

Felix Buyout (Change of Control FLX FLX.ax)

2009-01-24T18:13:00.003-06:00

The answer to what's going to happen with a buyout of Felix Resources is containted in an interview with Citigroup’s China analyst Huang Yiping.

"Number one is they certainly don’t want the Chinese companies to go out and invest prematurely. There was a concern last year, for instance, if the Chinese want to go invest overseas whether or not these investors understand the cycles of the market and there was a lot of discussion whether we have the international experiences for making a judgement on the current situation. "

"What they really want to avoid was making an investment where the asset price dropped significantly the next day. These kind of incidents already caused a lot of political pressure on investors as well as the government and so they're trying to discourage it a bit when people are not sure where is the bottom and so that's I think the first thing. They're probably trying to discourage investing over the near term a bit."

The Chinese government is going to make Chinese companies wait until there is a confirmed bottom before making any investments. As silly and un-Buffett like as that sounds, I'm sure it's the thinking of BHP etc as well.

This pretty much guarantees no transaction until FLX is trading above $14 or so for a number of months.

That's fine, I can wait.