Investing

iSOFT – Using John Paulson’s Merger Arbitrage Checklist

2011-06-09T03:19:00.002-05:00

I read John Paulson’s The “Risk” in Risk Arbitrage posted on gurufocus.com via Marketfolly. I filled it away and had the opportunity to use it recently in a merger arbitrage / risk arbitrage on iSOFT (ISF.AX). iSOFT is a medical software company based in Australia with substantial revenues from the UK. iSOFT are partners with Computer Sciences Corporation (CSC) in the NHS Program for IT (NHSPfIT) for the UK National Health Service. I used Paulson’s criteria to evaluate iSOFT and the results were quite positive. I was able to purchase iSOFT shares for 14.5c in mid May which will be about 10 weeks before receiving the cash from the deal for a 17% return. This isn’t a perfect deal but it’s pretty close and provides a good demonstration of using Paulson’s criteria. Finally I will run his criteria over a couple of other transactions for comparison.

I came across iSOFT a few years ago as I was reviewing the companies created by or associated with Allco. Allco were a large, leveraged financial services company with interests in property trusts, leveraged buyouts and other primarily financial transactions. In 2008 they went into administration (the Australian equivalent of Chapter 7 bankruptcy). I purchased some bonds in one of their child vehicles called the Allco HIT trust (see a Hug for AHUG) where I nearly made many times my money but ended up making a small loss. At times I also invested in Allco bonds and their Japanese property trust (RJT.ax). Another child company was Allco Equity Partners (AEP.AX) which changed their name to Oceanic Capital Partners (OCP.AX) after Allco went into administration. OCP owned publicly traded shares in iSOFT as well as convertible bonds. They also owned a security company and loan recovery company. They were selling for about half of their net asset value and I purchased a position in OCP. I intended to short the interest in iSOFT to substantially reduce the risk in m OCP holding. However that side of the transaction proved to be too difficult – it’s hard to short Australian shares (a story for another day). OCP have executed a few returns of capital and I’ve made a reasonable return in spite of iSOFT falling from around 90c to around 3c before the CSC takeover announcement. This is a good example of pulling the threads once you find an interesting opportunity and of investing in an opportunity with a wide margin of safety.

After the precipitous drop in iSOFT's performance and share price OCP took over chairmanship of the iSOFT board and were openly shopping it around. They made a deal with CSC for 17c per share. I rarely consider merger arbitrage opportunities because the margin of safety is often missing. In fact the opportunities often look more like picking up pennies in front of a steam roller. The last one I participated in was the Dow - Rohm and Haas opportunity in the midst's of the financial crisis (my error there was taking too small a position – though isn’t it always when the position works out!).

I took the opportunity with the announced iSOFT transaction to develop a merger arbitrage checklist and populated that list firstly with Paulson’s thoughts. He starts by dividing the risk to a merger arbitrage into Macro and Micro risks. For Macro risk you have little risk (risk of loss of capital) where the deal is cash, or stock where you can short the acquirer in proportion. Paulson then describes circumstances where the ratios are not fixed or are otherwise complicated. I’ve nominated cash deals as the best kind followed by ones with a fixed ratio that can be shorted. Finally on Macro risk it is worth noting that extreme market moves up or down can decrease the likelihood of a deal completing (he notes the 1998 shutdown of the high yield market and the internet bubble of examples each way. We all saw the recent financial crisis where the same occurred). The impact of market dislocations, up or down, is largely about portfolio construction. If your portfolio is neutral then a little market risk from a merger arbitrage position might be fine. If, however, your portfolio is already bullish then you may want to better protect the macro risk downside of this transaction (and of your whole portfolio). If a merger arbitrage position was the only one in your portfolio then you may consider some type of long call, long put strangle that were both substantially out of the money. Other Macro factors can impact a deal if it requires debt finance or the value of the merger is tightly coupled to commodity risks.

Paulson then goes on to Micro risks starting with earnings. The major risk here is that the target has a negative earnings surprise during the announcement-to-closure period. This can lead to the cancellation or renegotiation of the deal (if the agreement allows). Next is financing; cash transactions can come from cash already on the balance sheet of the acquirer or cash that they need to raise in capital markets. Once they need to go to capital markets you have all those macro risks come back into play. There is also a risk in a sudden decline in the earnings of the acquirer as their cost of capital would increase.

Paulson’s next discussion is around legal risks. You need to understand the specifics of the offer, if there are an corporate by-laws that impact the transaction and any litigation that either party is involved in. Another legal aspect is the merger agreement; it is a great representation of each parties’ commitment to the merger. Paulson describes the increasing degree of confidence that you draw from an agreement-in-principal all the way up to a definitive agreement. The degree of due-diligence, performance tests, material adverse changes, drop-dead dates, walk away provisions and regulatory hurdles all impact the likelihood of completion. Regulatory hurdles include anti-trust or speciality government watchdogs such as those that exist for national security, banking etc can kill a deal. Due diligence allows the acquirer to look over the company in detail; if this occurs post agreement then it allows the acquirer to exit the agreement if they find something they don’t like (or for practically any reason).

The Acquirer is the party purchasing the target. The amount of cash on their balance sheet, their capital structure and their deal history is very important. Is it possible that the acquirer is going to in turn receive a buyout offer? Be especially careful if you’re short the acquirer in a stock transaction and consider put options to hedge that risk. Fraud is a consideration but no different to the considerations in being long any stock.

There is then a discussion of return and how premium, taxes, the consideration (cash, stock or other) and timing effect your return. The summary is to consider the after tax return. In comparing multiple opportunities it’s also useful to calculate the annualized return by comparing the after tax return to the period in which it is earned. Be careful though not to call a 10% return in one month a 120% annualized return (excluding compounding) because you need 12 of them back to back for you to actually realize that 120%.

Paulson then presents a list of the types of opportunities to focus on and those to avoid:

Focus	Avoid
Definitive Agreements Strategic rationale Large acquirer No ﬁnancing condition No due diligence condition Solidly performing target Reasonable valuation Limited regulatory risk	Agreements in principle Deals subject to ﬁnancing Deals subject to due diligence Targets with poor earnings trends Targets with negative earnings Deals in cyclical industries Deals in highly regulated industries

Let’s compare iSOFT to the list:

Definitive Agreements – CSC and iSOFT have entered a definitive agreement that doesn’t have any clause allowing CSC to withdraw from the deal except in the most unlikely of circumstances (iSOFT default, iSOFT material litigation or iSOFT's customer contract termination and even then it has to have been omitted from the due diligence process) (+)
Strategic rationale – iSOFT are the software provider under NHSPfIT but CSC do the implementations. It makes lots of strategic sense form CSC to own the software as well as deploy it. CSC are quoted saying "Our decision to acquire iSOFT is independent of any specific transaction, client or contact. It's a strategic acquisition that's in line with our global expansion plans." (+)
Large acquirer – CSC are a USD 5.8Bn market cap company and this deal, including the assumption of debt and repayment of convertible securities, is worth around 500m. (+)
No ﬁnancing condition – there are no financing conditions and CSC has 1.84Bn in cash on their balance sheet (gross, not net, of debt) (+)
No due diligence condition – The due diligence was undertaken before the merger announcement (+)
Solidly performing target – iSOFT's performance has been poor. Two years ago the shares were around 90c. Their cost structure is far too high for their revenue streams and they have costs in the ever increasing Australian Dollar whereas substantial revenue from the falling British Pound. (-)
Reasonable valuation – iSOFT traded for 90c two years ago. It is a major player in clinical software and without CSC’s offer they may not have been able to pay off debt as it came due. It is likely that CSC have paid a distressed valuation for iSOFT. By the same token it was trading for 3.5c before the announcement so both sides are getting something of value. (+)
Limited regulatory risk – Though this was unlikely to receive regulatory scrutiny it has already passed the foreign investment regulatory review. (+)

Agreements in principle – No it’s definitive (+)
Deals subject to ﬁnancing – No (+)
Deals subject to due diligence – No, conducted before the agreement (+)
Targets with poor earnings trends – Yes, see above (-)
Targets with negative earnings – Yes, see above (-)
Deals in cyclical industries – No (+)
Deals in highly regulated industries – No (+)

Leading to a total of 12 positives and 3 negatives. It’s also worth noting that CSC have a long deal history and a reputation that they want to maintain in the market. When creating your own merger arbitrage checklist you should think about other factors that come into play in addition to those in Paulson’s list. I found a few more in his commentary such as deal history and have added a few that you would want in any company that you take a long position in such as a clean audit report.

By way of comparison I invested in another Allco related entity which I wrote about in AHUG a good value investment. That deal met only 6 positives and had 9 negatives. There were other potential upside surprises which made it more attractive. While it went ahead it was at a substantially reduced price leading to a loss. Running the “Dow – Rohm and Hass merger” over the list leads to 11 positives and 4 negatives (based on my recollection of the situation). That deal went through as originally envisioned.

With a limited sample, along with Paulson’s track record, it appears that this is a useful tool in analysing merger arbitrage opportunities.

Deliberate Practice – How to become an Expert

2011-04-16T06:22:00.002-05:00

This was cross posted on gurufocus.com

I’ve been reading Malcolm Gladwell’s Outliers. One of the key themes of the book is that experts in a field became experts through 10,000 hours of deliberate practice. There are numerous academic papers that support this view including The Role of Deliberate Practice in the Acquisition of Expert Performance.

[this article] explains expert performance as the end result of individuals' prolonged efforts to improve performance while negotiating motivational and external
constraints. ... Individual differences, even among elite performers, are closely related to assessed amounts of deliberate practice. Many
characteristics once believed to reflect innate talent are actually the result of intense practice extended for a minimum of 10 years…

For us the interesting question is what would deliberate practice look like for a value investor. Mark Sellers suggested some things that are not in his speech titled “So you want to be the next Warren Buffett? How’s Your Writing?”

Reading books and magazines – the law of diminishing returns applies once you have the core knowledge and at best this allows you to keep up
MBA, CFA or CPA – these teach you how to exactly match the market
Experience – if this were true then the best investors would be in their 70’s

and then he suggests 7 traits that make a great investor and that cannot be learned

Ability to buy stocks when others are panicking
Obsessive about playing the game and wanting to win – this often means a hard time maintaining personal relationships
Willingness to learn from past mistakes
Inherent sense of risk based on common sense
Confidence in their own convictions and stick with them even when faced with criticism – this also means no 2% positions, what’s the point
Ability to use both sides of your brain. It’s not enough to be able to do the math you need to be able to write and think of inventive ways to solve problems. You do need to be able to do the math!
The ability to live through volatility without changing your investment process

Now Mark believes that these traits are set in your early childhood and by the time you leave school it’s too late to change them. I suspect that Mark is mostly right. These are probably well developed by the time you leave school but with sufficient commitment you could practice your way to these behaviours. Of course the the question is would you commit to such a program if you didn’t already have some degree of these behaviours ingrained. If the value investing inoculation worked on you then you probably have what it takes to commit.

So what might deliberate practice for a value investor look like? Tony Schwartz in this HBR article distils the steps required to be an expert into these six steps:

Pursue what you love
Do the hardest work first
Practice intensely
Seek expert feedback, in intermittent doses
Take regular renewal breaks
Ritualize practice

Here are some ideas for deliberately practice towards become a value investing expert

Deliberate Practice	Not Deliberate Practice
Detailing how specific news items may impact your investments understanding if you should still hold those investments quantifying the impact on your valuation	Reading the newspaper
Valuing & evaluating Businesses Use annual reports to value companies Read annual reports for different companies in the same industry Evaluate the differences between companies in terms of their accounting, strategy, competitive advantages Summarize the results of the research	Reading Annual Reports
Engage the ideas in books Summarize books using mind mapping or similar tools. Apply the ideas presented Compare the ideas to your current ideas Test the ideas presented	Reading Investing Books
Engage the ideas and authors Summarize and file articles Comment on articles, engage the author in a discussion Compare the ideas to your current ideas Test the ideas presented	Reading Articles
Manage a portfolio Create and maintain a list of businesses and the prices that you would like to purchase them at (and if they hit your price then buy) Review the stocks in your portfolio and look for better opportunities (and if there are then sell / buy) Constantly evaluate if the situations has changed (and if it has then buy/ sell) If the price drops substantially where the situation is unchanged then purchase more Deliberately setting appropriate position sizes and evaluating performance in light of the chosen position size Constantly evaluate the overall portfolio and ensure that you have not accidentally made just 1 or 2 big bets (and adjust your portfolio if you have) Keep a log of why you bought and sold	Buying and selling shares
Writing your own research Write down your ideas along with the reasoning and encourage critical review Look back over your previous writings to see where you went wrong	Posting on message boards
Be a contrarian Buy stocks on the 52 week low list Sell when your stocks hit your estimate of fair value Develop systems that work for you to ensure that this happens (like Good-Till-Cancel limit orders) Keep a diary of trades and identify the market context at the time	Buying when the market is doing well or selling when it’s doing poorly

If you can engage in 20 hours of deliberate practice a week then you’re looking at about 10 years to become an expert. Over that time you would have read around 3,600 annual reports and evaluated around the same number of companies. You would have read 9,000 articles, reviewed 450 personal trading decisions and written around the same number of articles/ research pieces.

Finally the “Dan Plan” describes Dan McLaughlin’s efforts to go from no golf experience to a golf pro using deliberate practice. He’s at about 1,200 hours and so far has only practiced putting. He hasn’t played a single game of golf yet as playing a game isn’t deliberate practice. Buying and selling stocks is not going to make you an expert value investor. Doing the hard work, practicing your analysis skills intently and then critically reviewing your results just might!

Let me know your ideas for deliberate practice (or examples of not-deliberate practice) in the comments!

Seahawk (HAWK) – The Next Chapter “11”

2011-02-27T03:23:00.001-06:00

On February 11th, Seahawk Drilling (HAWK) announced that they were selling substantially all of their assets to Hercules Offshore (HERO). Since the announcement the share price has settled around the mid $4s for a 40% drop. The sale will be conducted through a Chapter 11 bankruptcy to separate the assets from some, unassociated, liabilities. This is a wonderful acquisition for HERO. It may be able to turn HERO’s terminal debt problem into a manageable debt problem. HAWK holders are likely, subject to the long, complex points below, to end up with shares in HERO thereby maintaining exposure to the sold assets. There is a reasonable chance that HAWK holders will end up with HERO shares at least to the value of HAWK’s shares pre-filing. There are some lower probability cases where HAWK holders end up with more than that (assuming HERO’s price is constant around $5) and cases where HAWK holders end up with just a dollar or two.

The treatment of a few key issues is going to define the payout:

Issue	Negative Outcome (<$2.50)	Most Likely Outcome ($5-$8)	Positive Outcome (>$8)
Seahawk’s requirement to cash collateralize the Pride letters of credit	$50M of the estate assets are held in trust to cash collateralize the Mexican tax Letters of credit until the dispute is resolved.	HAWK is relieved of this obligation through constructive fraudulent conveyance.	HAWK is relieved of this obligation through constructive fraudulent conveyance.
The treatment of intercompany claims	The worst case here is that the intercompany claims are all treated as unsecured claims. This would leave no money for equity as the intercompany claims dwarf the receipts from the sale. A related, poor outcome is that the intercompany claims rank equally with equity.	The intercompany claims do not result in actual claims.	The intercompany claims do not result in actual claims.
The treatment of tax sharing claims against Pride (and Pride against HAWK)	HAWK has to indemnify Pride for all losses incurred as a result of this sale causing Pride to lose the tax free status of the HAWK spinoff.	HAWK is relieved of this obligation through constructive fraudulent conveyance.	HAWK is relieved of this obligation through constructive fraudulent conveyance.
The treatment of other claims between Seahawk and Pride	HAWK has to pay Pride 16M of unsecured claims which reduces the payout to equity.	Pride and Hawk net out to zero.	HAWKs claims against PDE add $1-$2 to the payout to equity.
The outcome of change of control agreements with key staff (these being separate to severance agreements, the outcome of which are clearer in the code)	Though there is a headline number of $15M of unsecured claims to key staff this appears to be based on early 2010 equity prices. A worst case cash outcome appears to be an addition $4.5M with dilution of around 409k shares. This outcome appears contrary to law.	These are limited to 1 year of salary or around 1.6M plus a dilution of 409k shares	These are limited to 1 year of salary or around 1.6M plus a dilution of 409k shares
The outcome of a range of contingent claims such as insurance payouts	It's hard to provide a worst case here but a negative outcome guess is $5M	No idea but let's say these all net out	HAWK has claims including claims against BP for the impact from Macondo. There is some potential positive upside here. Guess is $5M
The overall quantity of claims	Aside from Pride and Blake the Trade claims are around $9M. The overall claims are unlikely to be much worse. Guess $13M. There is the possibility of the Hacienda trying to make a claim, though I can’t really see on what basis, research indicates that they would not be successful.	Aside from contingent and PDE claims : $9M	Aside from contingent and PDE claims: $9M
Bankruptcy, DIP and Transaction Costs	$12M	$7M	$6M
Price of HERO	HERO runs in to trouble with their debt refinancing and heads into liquidity problems. (52 week low = $2.05)	Uncertainty around HERO’s future persists and the stock remains around $5.	This acquisition provides a sufficient capital base for HERO to refinance at acceptable rates. (HERO P/B = Sector P/B = $8)

Most Likely does not mean that it is likely to occur, just out of all the outcomes it’s the most likely (consider 10 cases each with 9% chance except for the final case which has a 19% chance of occurring. That would be the most likely even though it has <20% chance of occurring).

Brief History

On August 4th 2009, Pride approved a plan to separate into two companies through the spinoff of Seahawk. The spinoff occurred on August 24th, 2009. There are four agreements that define the relationship between Pride and HAWK post spinoff. The Master Separation Agreement, The Transition Services Agreement , The The Tax Sharing Agreement and The Tax Support Agreement.

The combination of the downturn in the drilling market both due to the price of Natural Gas and the de-facto moratorium combined to exhaust Seahawk's liquidity. In November 2010 HAWK announced a process to explore strategic alternatives. Ultimately this process contacted over 100 parties with a view to mergers, acquirers and financial investors. HAWK was interested in an outright sale, sales of certain assets, debt and equity investments. HAWK received their first term sheet on 5th November 2010. Three more term sheets were submitted in late November as the process expanded. The initial term sheet was revised in mid-November but by late November they withdrew. HAWK negotiated with one of the three parties through mid-December 2010. In Mid December an LOI was executed and exclusive negotiations began. HAWK worked exclusively with this company until 21st January 2011. On 20th January HAWK received a substantially revised offer. HAWK rejected the revised offer and suggested that the offer needed to look like the offer in the LOI. On 21st January HAWK received another revised offer that was even worse and HAWK terminated the LOI with the company. Simmons and Company, who were handling the deal, then contacted bidders that had previously shown an interest, with updated data. HERO and one other responded. In February 2011 HAWK’s board entered an Asset Purchase Agreement (APA) with HERO after evaluating the other available offers.

HAWK currently have 7 of their 20 rigs working.

The executed APA contemplates the acquisition by Hercules of substantially all of HAWK’s assets and jackup rigs through a sale pursuant to section 363 of the Bankruptcy Code.

The APA includes the purchase of Rigs, Contracts, Equipment, Vehicles (including leased vehicles), All tangible assets, Accounts Receivable, Insurance Benefits arising from the business (but excluding certain claims), Cash, Prepaid Deposits and Expenses, Claims relating to the business, Permits, Photocopies of all records, warranties, all other assets not excluded.

The excluded assets include The proceeds from the sale, Rigs that are written off, Contracts & Permits that are explicitly excluded, Insurance benefits relating to the sold rigs, Original records, Third party property, Equity interests in subsidiaries, Bankruptcy Claims, Pride Claims, Warranties, leased real property, Software, Trademarks, Websites, Intangibles, Goodwill and other listed excluded assets.

HAWK have secured Debtor in Possession (DIP) financing of $35M of which they plan to draw $25m. Seahawk have received approval regarding the use of DIP proceeds to pay severance to employees terminated within 15 days following the Petition Date as well as incentive payments to non-insider employees under existing employee programs up to approximately $2.0 million in the aggregate.

The outstanding indebtedness under the Revolving Credit Facility is approximately $18.1 million. The Revolving Credit Facility has an initial facility amount of up to $36.0 million. The Revolving Credit Facility is secured by fifteen of HAWKs’ rigs and substantially all of the HAWKs’ other assets, including accounts receivable, spare parts and certain cash and equivalents. It’s important to note, in terms of the fraudulent conveyance discussion later, that 75% of HAWK’s assets could only secure a highly restrictive facility for 36M.

The aggregate consideration for the Purchased Assets is 22,321,425 shares of HERO plus $25,000,012 Cash , subject to certain adjustments. There is a $3M termination fee plus expenses in the event of a termination for reasons such as a better deal for HAWK.

Upon the closing of the sale, the cash portion paid by Hercules shall be used to repay the outstanding principal amount of the debtor in possession financing, various working capital needs and accrued interest and fees due as of the closing date. The Hercules Shares, as the remainder of the consideration for the Sale, will be held in escrow and will be distributed to creditors and interest holders pursuant to a confirmed chapter 11 plan.

Need for Chapter 11

Outside of bankruptcy there is greater risk that a sale of substantially all of a companies assets will inherit some of the liabilities. Another benefit is that certain contracts can be cherry picked and there is certainty around the liabilities that do and do not attach to the sold assets. While they are excellent reasons for conducting the asset sale under Section 363 a Chapter 11 filing also permits the Debtor (HAWK) to challenge certain contracts, that they convince a court to deem as, a constructive fraudulent transfer.

Mexican Tax

Once such contract relates to HAWK’s liabilities for taxes to the Mexican government.

Pursuant to the Tax Support Agreement between Seahawk and Pride, entered into at the time of the Spin-Off, Pride has agreed to provide a guarantee or indemnity in favor of the issuer of any surety bonds or other collateral issued for the account of Seahawk or any of its subsidiaries in respect of the Mexican tax assessments for tax years 2001 through 2004 made prior to the Spin-Off Date, to the extent requested by Seahawk. The Mexican government previously assessed claims for taxes for the years 2001 through 2006 against certain non-Debtor (are not included in the the bankruptcy) subsidiaries of Seahawk.

Reviewing the most recent Pride 10K indicates that HAWK will attempt to have the tax support agreement set aside:

Risk Factors About Our Spin-Off of Seahawk Drilling
Seahawk’s pending bankruptcy proceeding may result in claims against us, the reduction or elimination of amounts owed to us by Seahawk, and termination of our rights to make indemnification claims against Seahawk …
In addition, the bankruptcy laws permit a debtor in bankruptcy, under certain circumstances, to challenge pre-bankruptcy payments or transfers of the debtor’s assets if the debtor received less than reasonably equivalent value while insolvent, or if the transfers were made with the actual intent to hinder, delay or defraud a creditor, or were made while insolvent on account of a pre-existing debt that has the effect of preferring the transferee over the debtor’s other creditors during the so-called preference period. Authorized representatives of the bankruptcy estate could seek to challenge transactions effected in connection with the spin-off under the bankruptcy laws.

In 2006, 2007 and 2009, Seahawk received tax assessments from the Mexican government related to the operations of certain of its subsidiaries. Pursuant to local statutory requirements, Seahawk has provided and may provide additional surety bonds, letters of credit, or other suitable collateral to contest these assessments. Pursuant to a tax support agreement between us and Seahawk, we agreed, at Seahawk’s request, to guarantee or indemnify the issuer …. On September 15, 2010, Seahawk requested that we provide credit support for four letters of credit … The amount of the request totalled approximately $48.4 million, … On October 28, 2010, we provided credit support ... Seahawk’s quarterly fee payment [A fee for the credit support] due on December 31, 2010 was not made, which had the effect of terminating our obligation to provide further credit support under the tax support agreement. Further, on February 9, 2011, we sent a notice to Seahawk requesting that they provide cash collateral for the credit support that we previously provided on their behalf, as provided under the terms of the agreement. In connection with its bankruptcy filing, Seahawk is seeking to terminate its reimbursement obligations under the tax support agreement.
If certain of Seahawk’s claims and requests were granted, the adverse effect on us could be material…

Even though the parties may not have had fraudulent intent, transfers and the obligation to transfer, could be deemed a constructive fraudulent transfer as defined in Section of the bankruptcy code:

§ 548. Fraudulent transfers and obligations
(a)(1) The trustee may avoid any transfer (including any transfer to or for the benefit of an insider under an employment contract) of an interest of the debtor in property, or any obligation … incurred by the debtor, that was made or incurred on or within 2 years before the date of the filing of the petition, if the debtor voluntarily or involuntarily—
(A) made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted; or
(B) (i) received less than a reasonably equivalent value in exchange for such transfer or obligation; and
(ii)
(I) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation;
(II) was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital;
(III) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured; or
(IV) made such transfer to or for the benefit of an insider, or incurred such obligation to or for the benefit of an insider, under an employment contract and not in the ordinary course of business.

For a transfer/ obligation to be fraudulent it must satisfy 548(a)(1)(B)(i) and one of 548(a)(1)(B)(ii) (I-IV).

At face value Seahawk received no value in exchange for the obligations under the tax support agreement. Tax Support Agreement Section 3.1 – Events of Default:"

Section 3.1   Events of Default.   If any of the following events (“Events of Default”) shall occur:
… (h)   Seahawk or any of its Designated Subsidiaries shall (i) voluntarily commence any proceeding or file any petition seeking liquidation, reorganization or other relief under any Federal, state or foreign bankruptcy, insolvency, receivership or similar law now or hereafter in effect, (ii) consent to the institution of, or fail to contest in a timely and appropriate manner, any proceeding or petition described in clause (f) of this Section 3.1, (iii) apply for or consent to the appointment of a receiver, trustee, custodian, sequestrator, conservator or similar official for Seahawk or any of its Designated Subsidiaries or for a substantial part of its assets, (iv) file an answer admitting the material allegations of a petition filed against it in any such proceeding, (v) make a general assignment for the benefit of creditors or (vi) take any action for the purpose of effecting any of the foregoing;…
Section 3.2   Events of Default Requiring Cash Collateralization.   If any of the following events shall occur:
(a)   any Event of Default described in clause (a), (b), (c)(ii), (c)(iii), (g), (h), (i) or (j) of Section 3.1 shall occur; …
and in case of any event described in Section 3.1(g) or (h), Seahawk shall forthwith, without any demand or the taking of any other action by Pride, cash collateralize the Aggregate Credit Support Exposure by paying to Pride immediately available funds in an amount equal to the then Aggregate Credit Support Exposure, which funds shall be deposited into the Cash Collateral Account.

Remember that HAWK is under no obligation with Pride to pay the Hacienda. The obligation to Pride is only around cash collateralizing the credit support account. The Hacienda is not going to call on the credit support at this time because the Mexican subsidiaries are not in default (they were deliberately excluded). So the situation is simply that Pride has provided credit support to HAWK so that HAWK could maintain the statutory credit to support an appeal for their tax assessments. Pride offered the support as part of the spinoff as it was contemplated at the time that HAWK may not be able to provide the credit support as a stand alone entity. Which would tend to prove that 548(a)(1)(B)(ii) (III) applied – intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured - i.e. HAWK would not be able to post the cash collateral because if they could post it then they wouldn’t have needed the Pride credit support.

Worst case HAWK has to cash collateralize the credit support account and 50M worth of cash/ HERO shares go into the credit support account until the Mexican tax issues are resolved which could be a very long time in the absence of a settlement. If the requirement to cash collateralize is set aside then Pride’s credit support stands. Pride doesn’t have an actual loss that they can claim against HAWK here because the Hacienda have not made a claim against the credit support. If the credit support was deemed to be a constructive fraudulent transfer then the credit support fees may also be set aside. It was foolish of Pride to not provide support to HAWK until August 2011.

Tax Sharing (losses incurred by Pride due to the loss of tax free status from the spinoff)

Similarly HAWK is responsible for covering any and all Taxes that arise from certain actions. Under the terms of the Tax Sharing Agreement:

“in the event that the Spin-Off and/or certain related transactions were to fail to qualify for tax-free treatment, Seahawk would generally be responsible for 50% of the tax resulting from such failure. However, if the Spin-Off and/or certain related transactions were to fail to qualify for tax-free treatment because of certain actions or failures to act by Seahawk or by Pride, the party taking or failing to take such actions would be responsible for all of the tax resulting from such failure. “

The Asset Purchase Agreement with HERO is a restricted action. In the Tax Support Agreement SECTION 8:

Restriction on Certain Actions of Pride and Seahawk
8.1 General Restrictions. Following the Effective Time, Seahawk shall not, and shall cause the members of the Seahawk Group not to, take any action that, or fail to take any action the failure of which, (i) would be inconsistent with the Internal Distribution qualifying, or preclude the Internal Distribution from qualifying, as a tax-free transaction …
8.3 Certain Seahawk Actions Following the Effective Time. … during the two-year period following the Effective Time, Seahawk shall not take, nor enter into a binding agreement to take, any of the following actions: (i) sell all or substantially all of the assets … (iii) transfer all or substantially all of the assets that constitute the Seahawk Business as of the Effective Time …

in each case, without first obtaining and delivering to Pride at Seahawk’s own expense a Supplemental Tax Opinion with respect to such action, or a suitable form of financial security issued by a Permitted Financial Institution, in such form and on such terms as Pride may reasonably direct, and of a sufficient amount which Pride may determine in its sole discretion to cover any and all Taxes that may arise as a result of taking such action.

This appears to be a similarly unreasonable obligation and HAWK may try to have it set aside. Pride notes in their 10k:

If certain internal restructuring transactions and the spin-off of our mat-supported jackup rig business are determined to be taxable for U.S. federal income tax purposes, we and our stockholders that are subject to U.S. federal income tax could incur significant U.S. federal income tax liabilities.
Certain internal restructuring transactions were undertaken in preparation for the spin-off of our mat-supported jackup rig business in 2009. These transactions are complex and could cause us to incur significant tax liabilities. We received a ruling from the Internal Revenue Service that these transactions and the spin-off qualified for favorable tax treatment. … If any of these are incorrect or not otherwise satisfied, then we and our stockholders may not be able to rely on the ruling … and could be subject to significant tax liabilities … if the spin-off should become taxable … including as a result of significant changes in stock ownership after the spin-off or the proposed purchase of Seahawk’s assets in its pending bankruptcy proceeding.

Intercompany Claims

There are $387.6M in intercompany claims noted in HAWKs’ filings offset by intercompany Receivables of $194M. The majority are owed to Central American Drilling and Peninsula Drilling, HAWK subsidiaries that are not included in the Chapter 11 filing. There is insufficient detail to determine the nature of the intercompany claims. To the extent that the wholly owned, non bankrupt subsidiaries, do not assert a claim then there is no issue.

Employee Contracts

Normally in a bankruptcy severance is paid out at no more than 1 years salary.

§ 502. Allowance of claims or interests
(a) A claim or interest, proof of which is filed under section 501 of this title, is deemed allowed, unless a party in interest, including a creditor of a general partner in a partnership that is a debtor in a case under chapter 7 of this title, objects.
(b) Except as provided in subsections (e)(2), (f), (g), (h) and (i) of this section, if such objection to a claim is made, the court, after notice and a hearing, shall determine the amount of such claim in lawful currency of the United States as of the date of the filing of the petition, and shall allow such claim in such amount, except to the extent that—…
(7) if such claim is the claim of an employee for damages resulting from the termination of an employment contract, such claim exceeds--
(A) the compensation provided by such contract, without acceleration, for one year following the earlier of--
(i) the date of the filing of the petition; or
(ii) the date on which the employer directed the employee to terminate, or such employee terminated, performance under such contract; plus
(B) any unpaid compensation due under such contract, without acceleration, on the earlier of such dates;

Based on 2009 Numbers that is 1.64M.

Randall D. Stilley	$ 649,038
William C. Hoffman	$ 138,462
Steven A. Manz	$ 311,538
Alejandro Cestero	$ 295,962
Oscar A. German	$ 249,231
Total	$ 1,644,231

Though the claims for cash are probably limited as above there are also change of control provisions that impact options and restricted stock units. For key employees, options are supposed to be modified to provide at least three additional years outstanding and restricted stock units are to be paid in full after a change of control. Assuming complete dilution from these terms an extra 643k shares would be issued. The HAWK 10K indicates the options strike price is around $25. The 409k restricted stock units will likely be issued. The “Notice of proposed interim DIP Financing budget” notes approximately $15m of “payments for change of control agreements”. The Def14-A issued around March 31, 2010 notes around $15m in total compensation for key employees in the event of a change of control. I think this is the basis for the number in the “budget”. In fact, the options component is worth zero, the restricted stock were valued at $22.54 in the proxy filing and the cash compensation will be reduced through the bankruptcy (which based on the table above would be adjusted to $650k for Stilley down from 2.5M in the proxy). Making similar adjustments for all the key employees sets the cash liabilities at around $1.65M and dilution of around 409k shares.

It’s worth noting that Stilley is not doing particularly well from a Chapter 11 filing and most of the value he is going to receive will be as a result of returns to equity. Alignment is always good!

Trade Creditors, Pride Claims (and Counterclaims)

There are around $25.7M worth of trade creditors. HAWK has stated that they plan to pay them in full except for Pride; $16.7M of this is owed to Pride:

Risk Factors About Our Spin-Off of Seahawk Drilling …

In August 2009, we completed the spin-off of Seahawk, which holds the assets and liabilities that were associated with our mat-supported jackup rig business. In February 2011, Seahawk and several of its affiliates filed for protection under Chapter 11 of the Bankruptcy Code. In the bankruptcy filings, we were listed as Seahawk’s largest unsecured creditor with a contingent, disputed, and unliquidated claim in the amount of approximately $16 million. The debt was listed as a trade payable, subject to setoff. … Prior to the commencement of the bankruptcy, Seahawk indicated an intention to seek, among other things, (i) to reject its outstanding contracts with us, thereby replacing Seahawk’s future performance obligations under the contracts with general unsecured claims in the bankruptcy, (ii) to seek a judicial determination or estimation of all of our claims against Seahawk, including indemnity claims and contract damage claims, and (iii) to set off claims Seahawk alleges it is owed for spin-off transition and other matters against all amounts currently payable from Seahawk to us in respect of transition services and rig management services, and to seek to recover any positive balance after such netting.

…As of December 31, 2010, we had a receivable from Seahawk of $16.0 million, net of allowance, which is included in “Other current assets,” pursuant to a transition services agreement and management agreements for the operation of the Pride Wisconsin and the Pride Tennessee in connection with the spin-off.

I have assumed in the “good case” valuation that claims for an against Pride nets out to zero though in the best case it could provide a larger, positive amount. From an equity perspective it doesn’t much matter if the Pride claims are obligations or general unsecured claims as they both rate ahead of equity. The interesting parts are the judicial determination of totals owing and the recovery of a positive balance!

The unsecured creditors committee has been formed and comprises the Pride, Offshore Towing and Dooley Tackaberry. If there were other major creditors it’s reasonable to assume that they would have revealed themselves.

Other Contingent Claims

There is a long list (90) of outstanding litigation matters against HAWK, many relating to personal injury and a few to asbestos. Some of these have been inherited from Pride and may be set aside. The company does not attempt to identify the amounts owing under these claims. There are claims against BP, East Cameron Partners, Blake international and Pride (as noted above) which are listed under contingent assets. The last HAWK 10Q notes:

We are routinely involved in litigation, claims and disputes incidental to our business, which at times involve claims for significant monetary amounts, some of which would not be covered by insurance. In the opinion of management, none of the existing litigation will have a material adverse effect on our financial position, results of operations or cash flows. However, a substantial settlement payment or judgment in excess of our recorded accruals could have a material adverse effect on our financial position, results of operations or cash flows.

Which is the basis for assuming a net position of zero.

Equity Committee

An Official Committee of Equity Holders has been formed comprising MHR Fund Management, Seadrill Americas, Hayman Capital, HSBC Distressed Opportunities Fund and The Keffi Group. Seahawk made a limited objection noting that they were still responsible to act for the equity and requesting that the Equity committee have a limited scope. The order granted by the judge does not limit the equity committees scope. The main areas of disagreement will likely be around key employee contracts. Aside from that, management and equity holders are quite well aligned.

Value of HERO

I haven’t taken the time to do a valuation of HERO. With an improvement in drilling and this terrific deal a price to tangible book equal to that for the sector seems achievable for a price of $8. Their large debt load provides substantial leverage to an improvement in the shallow drilling situation. It also provides leverage to the downside. As noted in the conclusion an increase in HERO to $8 makes it extremely likely that HAWK equity holders will do better than the pre-petition price and possibly a lot better.

Conclusion

Good case, claims senior to equity consume around $35m and 10m of that is met from HERO shares. The rest of the HERO shares are distributed to HAWK holders to the value of around $8 at today’s price for HERO. A bad outcome would require payment to Pride of their trade debt along with cash collateralizing the letters of credit. This leaves around $2.50 for equity holders plus an interest in the eventual outcome of the Mexican tax dispute. An increase in the price of HERO to around $8 substantially improves both cases to around $13.50 for the good case and $8.10 for the poor case. Handicapping the outcomes is difficult. Based on binary outcomes of $2.50 or $8.00 the market is handicapping around a 45% chance of the better outcome. I’d estimate a higher chance than that though I wouldn’t be a buyer or a seller at $5.

2011-01-30T01:35:00.002-06:00

I'm going to be in Las Vegas from 3rd Feb to the 10th and then in LA on the 11th (Friday) and 12th (Saturday) of February. If any US readers would like to catch up to have a chat about value investing or specific ideas then please send me an email or leave a comment.

Eagle Rock (EROC), Kerrisdale and Investment Timelines

2011-01-15T22:12:00.004-06:00

I sold out the last of my EROC position in the last few days. I first wrote about EROC in mid July 2009 - Eagle Rock Energy Partners (EROC). I first pegged the value between $7.66 and $8.90 when EROC was trading around $3. In late July 2010 I posted an updated Valuation of Eagle Rock Energy (EROC) post transactions. This pegged a reasonable valuation, based on a weighted average of managements estimates contained in SEC filings, at $9. As EROC is now at around $9.40 I’ve closed all my positions in the stock and warrants.

When EROC was trading at $3 there was a forced seller and a belief that they could violate bank covenants. The forced sellers had purchased EROC for yield and the distribution had been cut to 2.5c per quarter. In reality the bank covenants could not be violated as the company had control over their hedges which provided a backdoor mechanism to remain in compliance. EROC subsequently announced a series of transactions to affect a recapitalization. There was a lot of controversy over the transactions. Kerrisdale Capital launched a site fair-eroc.com to vote down the proposal. Kerrisdale do good work and I bet they have a terrific run rate. However, this time they got it at least partially wrong. Kerrisdale outline their concerns at fair-eroc.com;

“So what remains? In our view, NGP is essentially canceling (sic) its subordinated units in exchange for $29mm (plus associated rights/warrants if they receive the fee in shares). These subordinated units are not worth $29mm+. With $1.65+ of arrearages ahead of them, the subordinated units will be underwater for 5+ years. We at Kerrisdale believe they are worth very little.”

In fact they were worth around $40M. I contacted Kerrisdale about their methodology for calculating the value. They had not calculated a value for those units but held a belief that the value was so far in the future that the uncertainty would wipe out all the value (sounds like an option doesn't it!). I calculated an undiscounted cashflow of nearly 400M and a discounted value of $40m. EROC was paying $35.5M for them. Kerrisdale did manage to bring about some minor changes in the plan and I appreciate their efforts to put management on notice.

As a result of the initial offer I valued EROC at $8.58 which was then updated by a few percent after the revised transaction was announced.

In Kerrisdale’s 8/10/10 post on their activism efforts (login required) they note

“In the end, however, unitholders voted in favor of the plan. We’re not exactly sure why – the restructuring was clearly less than ideal, and we’re confident that NGP would have sweetened the offer if holders had rejected the initial proposal.”

The answer may lie in Behavioural finance. There is a famous experiment called the Ultimatum Game in which two volunteers participate. “The first player proposes how to divide the sum between the two players, and the second player can either accept or reject this proposal. If the second player rejects, neither player receives anything. If the second player accepts, the money is split according to the proposal. The game is played only once so that reciprocation is not an issue”. In many cultures a 50/50 split is offered and an offer below 20% is usually rejected. The most economically rational decision is to keep $19 and offer $1. The 2nd volunteer is still $1 better off but a 19/1 split is usually rejected. In this case NGP developed a proposal that offered value far from 50/50 but probably at around the 80/20 line (80 to NGP of course!). The reality was that EROC holders were offered incremental value, just substantially less than the value to NGP. Kerrisdale may well be right that NGP would have come back with a better offer but the offer on the table was accretive to shareholders.

At $9.39 there are a number of risks to EROC. Natural gas prices, interest rates, refinancing and capital investment risk. There are lots of ways EROC could be worth less than $9.40 and far fewer ways that it could be worth substantially more.

Finally, as this seems to have turned into the Seahawk (HAWK) blog it’s interesting to note the EROC timeline with a Seahawk overlay. The Seahawk closing prices are shifted to match my initial purchase of both HAWK and EROC.

If HAWK takes as long to play out as EROC then there are still 15 months to go. I have no particular insight that this is an appropriate timeline. However, if your timeline is substantially less than 1-3 years then you are unlikely to see this play out before you (have to) close your position.

Purchasing Power Parity Valuation for the Australian Dollar 2011

2011-01-08T23:11:00.001-06:00

I first wrote about the Australian Dollar PPP in October 2008. The AUDUSD had fallen to .62 on it’s way to .61 a couple of days later and was 40% undervalued (all over/under valuation is compared to USD). The crux of the October 08 post was to invest in AUD assets at that time because there was a substantial headwind in other currencies if your base is in AUD. Similarly in other currencies you had the chance to be buoyed by AUD appreciation. The work was based on the Economist Big Mac index. There is substantial research that a few simple metrics often out perform larger models and Purchasing Power Parity (PPP), the idea that representative goods should trade at similar prices world wide, makes sense. There was a belief in Australia, in late 2008, that the AUD was going to keep falling. I had dinner around Christmas in 2008 and discussed this with an IT company CEO and a senior manager at an international oil company. They both thought an appreciation of the AUD was quite unlikely; they were wrong and PPP was right.

Where are we now

John Hempton of Bronte Capital, a blog I strongly recommend, has noted “And early is wrong. At least if you are an Australian and you took your cash offshore at 80c or less to the USD.”. Today the AUDUSD is 1.0 with a high of 1.03 reached recently.

The October 2008 list of major countries who’s currencies were more undervalued than Australia’s was;

South Africa
Malaysia
Hong Kong
Philippines
Thailand
Indonesia
China

Now It’s somewhat larger!

30-50% under

Hong Kong
China
Malaysia
Thailand
Philippines
Russia
Indonesia
Taiwan

0-30% under

Mexico
South Africa
Poland
South Korea
Singapore
Hungary
Chile
Argentina Czech rep
Britain
Peru

0-13% over

Turkey
New Zealand
Japan
Canada

The Australian Dollar is now 16% overvalued compared to the 40% undervaluation in October 2008. Hong Kong and China are still nearly 50% undervalued. The Euro, Canadian Dollar and the Australian Dollar are all 10-20% overvalued with the Yen at around purchasing power parity.

An Insurance Trade

The Australian dollar has an excellent track record of falling to greatly undervalued levels in times of crisis. This is very supportive of insurance trades from current AUDUSD levels. The table below shows the AUD P&L for shorting a hypothetical US index in USD where your record currency is AUD. The trade is

Short Index
Receive USD Cash
Buy back index
Convert USD Profit or Loss in to AUD

AUDUSD	Index=100	Index=50	Index=150
1	0	50	-50
.6	0	83.33	-83.33
1.4	0	35.71	-35.71

In the case where global markets fall and the AUD falls your gains are magnified. In the case where the AUD keeps rising and the US market keeps rising the losses are diminished. The risk in this trade is where a very country specific event happens to Australia causing the AUDUSD to fall and the US market still has a substantial rise. In that case your losses are magnified. Of all the cases, this one is relatively unlikely and as an insurance trade there is potential for the losses to be offset by your gains. I'm not proposing this is a great outright trade, only that it’s great insurance with a free kicker that grows when you most need it.

Hong Kong Dollar

Jim Grant has an excellent discussion of opportunities in Asian currencies and especially ways to profit from an eventual rise in the HKD, in his free summer break Vacation Delectation from August 2010, under the heading “Three-dollar tale”.

“In preview we expect the Singapore dollar to appreciate and the Hong Kong dollar to appreciate-or, just possibly, to depreciate. Holding a certain kind of currency option, one would be paid in either case”.

“Or taking an agnostic view you could buy a strangle with strikes set 10% out of the money on either side,…, two years out for 33 basis points”.

Jim has done a better job than I ever could describing the situation and the trade he proposes has an excellent risk reward. I favour a substantial appreciation of the HKD over time but as both Jim Rogers and Jim Grant point out, the short term direction, on revaluation, could go anywhere. I wrote about REIT investments in Singapore and Hong Kong in July 2008. I made some investments and the subsequent drop in the AUD diminished the losses. Prosperity REIT was trading at HKD 1.5 in July 2008 when I wrote about it or .20 AUD (AUDHKD 7.50). By January 5th 2009 it was trading at 97c or 18c AUD (AUDHKD 5.50). The loss in HKD was 35%, in AUD only 10%. It closed today at 1.79 HKD and has paid 5 dividends totalling .30 since for a total return of 40% in HKD – not bad for a REIT (current AUDHKD is 7.74 so the AUD returns are 35% or 15% annualized). Receiving 15% a year while you wait for a revaluation isn’t bad but Jim’s trade is $0.33 to make $40 best case, if PPP is reached within 2 years!

Portfolios with AUD (CAD or EUR) base currency

This is a sound time to investing in USD assets and an excellent time to invest in HKD denominated assets. Cheap assets, of course, as always! With the HKD you get all the insurance benefits of a USD investment and the potential upside of a currency revaluation. It’s also a good time to re-orient portfolios out of your home country because the headwinds have moved there. This applies to the Australian Dollar, Canadian dollar and to a lesser extent the Euro.

Seahawk (HAWK) Strategic Alternatives

2010-11-10T18:21:00.000-06:00

Seahawk announced earlier this month that they had engaged Simmons & Company International to explore strategic alternatives. “These alternatives could include, but are not limited to, transactions involving a sale of assets, a recapitalization, or a sale or merger of Seahawk.” While there could be many options I want to lay out a proposed capital raising that would raise $54m, be fair to current holders that did not participate and provide current holders with the exclusive right to participate.

The scheme would allocate 5 options and 1 ordinary share for $10.19 to each subscription right. Current holders would be offered this on the basis of .45 subscription rights for each current share. The subscription rights would be tradeable as would the options once issued. The scheme would allow oversubscriptions from current holders in proportion to their subscription rights. If the maximum amount of $54m was not raised then the offer could be extended to non-current holders.

The options would have a strike price of current $20 which would be $17.21 after the capital raising and a 5 year expiry. The share price should not fluctuate immediately after the capital raising because the shares would have been issued at the current price. The new market cap would be 175M (current market cap plus new cash) and there would be 17.2M shares outstanding up from 11.9 today.

The returns from participation are shown below. Note that the “no participation” case does not reflect your ability to sell the rights which will increase your returns (potentially up to $4.50 per right). The participation case does not include the time value of the options which should also increase the participation returns (at-the-money with 3 years remaining would have a time value of $1.40 per option).

Old Price	New Price	No Capital Raising	No Participation & no sale of rights	Participation & exercise of options (not sale)
$ 10.18	$ 10.19	0%	0%	0%
$ 20.00	$ 17.21	96%	69%	69%
$ 25.00	$ 18.59	146%	82%	129%
$ 30.00	$ 19.96	195%	96%	189%

$54M would provide about 7 quarters of liquidity at $7M burn per quarter or 5 quarters as $10m. It is quite unlikely that the Q3 experience is going to continue for the next 5 quarters.

Though it’s not very important now, the cash raised from exercising options could be restricted for: repurchasing stock at a discount to book value, repurchasing options at a discount to intrinsic value or a return of capital to shareholders.

Let’s work through the current $20 and current $25 cases.

$20

The market cap indicated by $20 pre-raising is 241M. We add the 54m raised to get 296m. No options would be exercised so there are 17.2M shares outstanding for a share price of $17.21. That would be a 69% upside from current prices after the raising instead of the 96% you would have had in the absence of a raising. Bear in mind that those participants in the capital raising would have at-the-money options which should have some substantial time value (depending on when this occurs).

$25

This case is more complicated because we assume that all options have been exercised (worst case) and the cash is held on the balance sheet. We start with a 356m market cap (current price * 2.5 + cash from raising) and add 459M from option exercise for a market cap of 815M. There are now 44M shares outstanding for a price per share of $18.59. That’s an 82% return for those who did not participate in the capital raising (and did not sell their rights). For those that participated they would make $8.40 from their original shares, $3.78 from their new shares and $3.10 from the options from a total investment of 10.19 (current price) plus 4.58 (.45 * 10.19) for a return of 129%.

So why would you want to participate at $10.19 for 1 ordinary unit and 5 options. Each option is worth around 90c (using an option pricing calculator that includes the impact of dilution) or $4.50 in total for a value of $14.50 per $10 subscription. If you sold the options after issue you would expect to have paid $5.50 for each ordinary share.

This model trades off upside (for those that don’t participate) for a much more certain, lower return; while providing an immediate return for the sold rights (potentially as much as $4.50 per right).

I don’t propose that this is the optimal model but it shows how a capital raising could be structured to be fair, provide substantial upside to those interested in an eventual return to normality and provide the liquidity that HAWK needs right now. Compared to a takeover which would truncate your upside, an underwritten share issue which would greatly dilute your upside or even a discounted rights issue which would reduce the returns to non-participants at all price points (old $20 would return only 30% instead of 69% under this model). It also provides a reasonable baseline to compare future proposals. I’m not suggesting the company should proceed with this model, simply that such a model exists and the challenge for HAWK should be to produce a superior one

Q3 2010 HAWK Conference Call

2010-11-10T00:03:00.001-06:00

Management have continued to innovatively cut costs, sell spare parts and broadly behave in a shareholder friendly manner. There are lots of potential upside surprises and not too many ways things could get worse than Q3.

I’m surprised at how much money they’ve spent on the Seahawk 3000 but from a liquidity point of view it makes sense.

The Mexican tax issues continue with no clarity as to the eventual outcome, though HAWK continues to insist that they don’t expect a payout.

The Strategic review was triggered by a deterioration in management expectations since July. There is going to be a liquidity problem in the first half of 2011 and they want to explore alternatives now. They had previously “hoped” to be cash flow neutral by the end of 2010. I never shared management’s optimism though the review creates additional potential upside surprises (albeit with the potential to lock in a smaller, definite, upside such as a sale in the mid-teens)

Below are my notes from the call organized by topic.

Upcoming work

Seahawk 3000 on contract by 1st week December 55-60k per day for 6 months.
They think could have 8-9 rigs working by the end of the year.
6 rigs under contract, 3 idle, 11 cold stack not including the Seahawk 3000
“Customers haven't been able to drill in 2010. Could you see a bonanza next year to catch up?”
- That depends on permits. If he could see how many permits issue next year then would know drilling activity. If get back to normal you would think it wouldn't take long to get back to fully utilized rigs.
US Nat Gas prices have been weak with increased drilling on land. Workovers and re-entry drilling should create increased shallow water demand if permits were issued in a timely fashion. As permitting process improves they expect demand to improve regardless of gas prices. Especially the plugging and abandonment of wells.
PEMEX will issue tenders for 20 jackups starting in 2011 in addition to 4 short term. 10 for incremental rigs and will likely relax the 10 year age restrictions. Some of these will likely come from us GOM. PEMEX may not require matt supported rigs but Seahawk should still benefit from the supply / demand environment.
“Randy are you seeing opportunities throughout the world for matt rigs outside GOM?”
- Not a whole lot. There could be some opportunities but they'll be in the same place. East coast India needs a matt rig. For the most part by the time you factor the mobilization costs it's hard to be competitive.

Idle Iron

3500 wells and 650 platforms. Should lead to additional demand over next 3 years.
Applies to wells out of service for 5 years. If there are platforms with no producing wells then the platforms have to be decommissioned along with the pipelines.
From Oct 20th Operators had 120 days to submit plans to BOEM. 3 years to complete the work. P&A work over and above normal and platform decommissioning.
“How can this be done with 44 rigs given around 4k wells and platforms?”
- Typical P&A job is 1wk - 10 days.
- Platform may or may not use a rig can use a lift boat.
“Are any recent contracts for P&A?”
- P&A is still in the future.
- Probably 2Q next year at the earliest.
- 2Q & 3Q most active due to weather.
- The work will be planned out over the 3 years. Actual decommissioning only during 6 months but P&A all year.
“Is the cost of P&A same as drilling a well?”
- No, some P&A few hundred thousand to 1M. Per day cost is the same.
“3500 wells need to be plugged, over 3 years. 1200 wells per year. 7-10 days to do the work. 1 rig could do 35 wells in a year. Is that correct?”
- 10 days on outside. Figure on 7 days. Could probably do 52 per year.
- Until they see the plans they won't know how many will require rigs and how many won't require rigs.
- There are other ways, temporary plugs can be done with wireline units. Permanent plug require rigs. Once the plans are submitted they'll know the real demand for the rigs. Much clearer picture early next year.
(HERO talked about the incremental demand for their liftboats from this work on their call)

Costs & liquidity

Only 1 idle rig is fully crewed the others are not
“What is the contingency on the 2505?”
- Contingent on award of drilling contract. Not awarded until early Feb at the latest.
“Are you looking to stack 1-2 more rigs?”
- The idle rigs are not crewed so it's not so much of an issue.
“Are you seeing some reasonable pricing gains?”
- Some modest gains or at least holding their own.
- On P&A potential, are operators starting to move? Right now operators are submitting plans. Won't get plans in until early next year. Then 3 years from then.
In 3rd Q sold some surplus equipment for 900k and received gain on sale of 750k.
4Q rig utilization is unpredictable expect 3-7 rigs, operating costs excluding SG&A, Depreciation and Repair costs : 23-25M including $2M of shore based expense.
“Prepaid expenses and accrued current liabilities, what are the major components?” -
- Prepaids - some of the usual stuff, insurance etc. Any of this one time - no it's ordinary. Not unusual.
- On the accrued expenses and liabilities- some of the repair work on Seahawk 3000, rest of that is ordinary stuff. How much of 46 is repair work, 7m.
Impairment analysis, no reason for additional write-downs unless they sell more rigs for less than book.
Repair of Seahawk 3000 $7m in Q4.
Operating costs 22-26k per day of working rigs.
Cold stack 2k-3.5k per day per rig as a result of cluster stacking scheme.
4Q SG&A $8m-$9m (similar) 2.4M non cash stock comp.
HAWK balance sheet currently has 41.4M cash , net work 11.4M
14.5M payable to pride. Will not pay pride until resolve counter claims.
Drew down $11.5M revolving credit for Seahawk 3000.
Actual cash burn $18m.
Forecast $25M cash burn for 4Q includes $15M paid out for Seahawk 3000. Cash burn assuming current run rates on the current contracts.

Permits and overall industry

Across the GOM 31 contracted rigs of 44 marketed fleet. Only 27 working due to permit delays.
13 new well permits since April 20th. Not optimistic that they’ll get to 15 per month until mid to end next year.
“What is the permitting process like now?”
- Has improved somewhat.
- Normally picks up in 4Q.
- BOEM is trying to add 200 additional staff.
- Process is now more time consuming than previous approach. Right now optimistic about the direction. By 1Q 2011 should be back to more normal activity.
Shallow issuance improved in October and they hope to see that continue over coming months
Most permits issued so far have been workovers and re-entry drilling that did not need to comply with NTL 06
It seems that a tiered risk format may be implemented for shallow gas wells in the near future to be followed by a similar process for shallow oil wells at a later date. This change would increase permit issuance.
- More detail on tiered risk approach. Generally the approach is to classify wells in tiers of risk, shallow, gas only, area , lower pressure, previously drilled, going to be a low risk well. As you go up, higher pressures, more productive zones, more liquids then higher risk.

Strategic Alternatives

They recently issued a press release on strategic alternatives. They want to maximize shareholder value. They Continue to believe their strategy is sound and international opportunities are attractive. Everything is on the table not limited to sale assets, sale, merger, recap. Do not plan to disclose developments until board approves a transaction.
- “Why not ride it out as this sounds like the bottom?”
  - Still a very uncertain environment. Can't guarantee that the permit process will improve quickly.
  - Also have certain liquidity needs that need to address early next year. Prudent to look at alternatives right now to better position the company for the future.
- “Strategic alternatives. What happened that got management to look in to this versus in July/August when that wasn't the plan. What changed in thinking?”
  - In summer still more optimistic that the regulatory environment would not be as difficult. In early summer they thought it might get back to early 2010 levels and return to cash positive by end of year.
  - It doesn't look like that now. More of a near term issue from a cash point of view. Still optimistic long term domestically. Still like opportunities internationally.
- “International strategy - update on those conversation?”
  - A number of rigs looking at acquiring are working rigs with contracts attached. Its more important for a qualified drilling contractor as a buyer as they have contracts.

Mexican Tax

46M unsecured credit from Pride used to replace surety bonds. HAWK is defending their tax position.
Received an unfavourable ruling on USD $21M.
HAWK believes court did not take in to consideration key expert testimony and have appealed.

HAWK Net Liabilities and Deferred Tax

2010-10-10T09:39:00.010-05:00

Andrew, the author of the excellent guest post on the HAWK - Mexican Tax Situation at Greenbackd asked for some clarification on my prior post regarding the recent sale of the Seahawk 2505. Specifically on why I was suggesting that the deferred tax shouldn't be counted in the liabilities. I realize that I had not clearly laid out my view on HAWK's balance sheet and how the non-rig assets and liabilities net out.

The short answer is that I had made some simplifying assumptions that vastly over-estimated the net liabilities. I had discounted much of the deferred tax liability but had not, in detail, worked out an accurate net asset/liability excluding rigs. I lay out the detailed and non-simplified answer below and find that the net liabilities are much smaller than the 30M number I had been using.

Deferred taxes, in HAWK's case, arise due to the timing differences between tax (IRS) based depreciation and financial reporting depreciation. In reality US corporations maintain two sets of books, one for the IRS and one for other stakeholders based on GAAP. Deferred tax assets and liabilities represent theses differences. If I purchase a rig for 10M and depreciate it in a straight line in my financial reports but use accelerated depreciation in my IRS filings then the "real" value versus the IRS value diverges. At year 5 it may be worth 7.5M in my financial reports but only 5M according to the IRS. If I was to then sell it for 7.5M (assuming that the financial reports accurately reflect asset values) then I would owe tax on the 2.5M difference as I had received a tax credit (effectively a credit) for the depreciation of the rig from 10M down to 5M. The notional tax I would owe on that 2.5M is a deferred tax liability. Also note that if in fact I only sold the rig for 5M then the actual tax liability would be zero even though I showed the liability in my accounts as 2.5M * 35% (assuming my tax rate is 35%).

So how does this apply to HAWK. Firstly they break out their deferred tax liability in their 2009 annual report as a 54.9M deferred tax asset and 114M deferred tax liability netting out to a 59M deferred tax liability. The asset side is primarily NOL and tax credit carry forwards (net of valuation allowances). The liability is entirely depreciation related. As outlined above, based on the different depreciation schedule used by the IRS and GAAP. Implicit in this liability is that original asset value minus liabilities is in fact fair value (if it wasn't then they would need to write down the asset value).

So the 59M deferred tax liability is entirely the result of more aggressive IRS based depreciation offset by tax losses and credits. We can quantify the difference between the IRS and GAAP based depreciation by dividing the net liability by the effective tax rate which is 59M divided by .35 which equals 169M. The rig value based on GAAP, net of GAAP depreciation, is 497M. Therefore the IRS value net of depreciation is 497-169 = 328M. The 328M is the same as the 5M is our simple example above. To the extent that our sale value is above 328M (5M) then we need to pay tax on that profit as we've already received a tax credit for the depreciation down to that level. However, if our sale value is only 328M (5m) then we owe no additional tax. 328M is around 16.5M per rig.

We now have a basis to assign a value to the deferred tax liability. If we think we'll receive more than 16.5M per rig then the liability kicks in. If we receive less than 16.5M per rig then the liability is zero.

The explanation above is based on the 2009 annual report because that breaks out the deferred tax assets and liabilities. The 2010 2Q 10Q does not. However, we can establish that over the 6 months in question the deferred tax liability has decreased by 21.6M. This is due to an increase in the deferred tax assets side of the ledger due to increased net operating losses. By the end of Q2 the total deferred tax liability was 39.6M. This means we can have rig values of 384M before the deferred tax liability kicks in. That is 19.2M per rig. If we work on 20M per rig, consistent with my prior post, then only 5.5M of the deferred tax liability would be incurred out of the 39.6M.

Below is an embedded google doc (I'm going to replace this with a more permanent image when I'm back to my regular PC).

This shows the 10Q balance sheet with adjustments. Liabilities are all at 100% aside from the deferred tax liability (as described above). On the asset side Cash and equivalents are at 100%. Trade receivables are at 85%, due from pride is at 100% because the due to pride is larger (on the liability side). Prepaid expenses relate entirely to the expected insurance payment for the Pride Wyoming and are more than offset by the accrued expenses also relating to the Pride Wyoming; As they a) are insurance payouts and b) offset on the liabilities side for the same reason, they've been marked at 100%. Other assets have been marked at 85% but they aren't really material if you disagree with the mark.

There is also a line on the liabilities side for Leases and Contractual Commitments. These are off balance sheet liabilities described in the 10-K. The Q2 10Q states that there are no material changes.

The bottom line is, excluding rig values, HAWK's net liabilities are only about 19M. As rig values fall or HAWK continues to make operating losses then the deferred tax liabilities are reduced by 35% of the operating loss/ capital loss until they reach zero and start to become an asset (a worthless asset in the even of a liquidation). From a headline $117M of liabilities plus 15M of off balance sheet liabilities, it's interesting to get down to a 19M net liability.

At the 400M rig value (20M per rig) I discussed in my prior post, less 19M of liabilities you have a share price of $32. At 16M per rig the net liabilities, excluding rigs, are around 13M for a price per share of $26.

This analysis ignores losses since the 2Q 10Q and also ignores liquidation expenses but they certainly don't change the indicative numbers. (In short the deferred tax liability would be zero, the net liabilities inclusive of liquidation charges might be 23M)

Part of the undervaluation in HAWK may be related to the difficulty in getting to that net liability/asset figure. After all if you take 8M per rig (scrap value) and subtract the headline liabilities and off balance sheet liabilities you're left with a $2.25 share price versus $11.55 if you use the correct net liability or $32 if you use the "correct" rig value as well.

Seahawk 2505 sale, impact on HAWK valuation

2010-10-08T05:12:00.005-05:00

Seahawk have entered a Memorandum of Understanding with Essar Oilfield Services India Ltd for the sale of the Seahawk 2505 for $14,550,000 plus some minor fees for training on the rig.

The sale is contingent upon Essar Oilfield Services winning tender MR/DS/MAT/CT/RIGS/CH/MAT-FLOATER/49(308)/2010 /P46JC10007.

Seahawk 2505 is Seahawk's 11th best rig of 20 according to my ranking criteria. It's close enough to call it the median rig. On that basis it's reasonable to multiply $14,550,000 by 20 to get a gross asset value of HAWK. To get the net assets we then need to subtract net liabilities, excluding rigs, of around 45M. This indicates net assets of 246M or $20.75 per share. This makes the same assumptions about liabilities made in previous posts (i.e. a liquidation so the deferred tax liability would not be realized).

The situation is actually better than this. The tender is for rigs in the PEL/ML ( Petroleum Exploration License/ Mining License) zone in India. Therefore Essar are going to incur costs in excess of $5M (based on generic mobilization costs mentioned by HAWK in their UBS presentation). Had the rig been in India it would have sold for at least $5M more. HAWK obviously don't want to sell their rigs to competitors in the US or Mexican GOM (and neither do HERO). They have created an opportunity to sell a rig that won't compete.

The deal is contingent on Essar winning the tender (which is interestingly only for a 150M mat supported jackup). If this happens then HAWK will get some much needed cash and will reduce their cash burn. If the deal fails then the offer highlights the true rig values in the current market. Based on HAWK's costs of 25k per day and a rig rate of 45k per day (current GOM rates), Essar would pay off the rig entirely during the 3 year contract, inclusive of mobilization costs. A 3 year payback is certainly indicative of a fair to cheap price, though I don't know what rate they are going to propose (their costs should be lower than HAWK's as they can use a foreign crew and will have lower insurance costs etc).

I suspect this announcement reduces the likelihood that HAWK are going to purchase a foreign rig package with debt.

Interestingly there may be opportunities for HAWK to relocate their mat supported rigs out of the GOM, albeit at a substantial cost. Finally, in a liquidation it shows that a median rig price of $20M for rigs sold to a local buyer (think a mixture of PEMEX and other GOM drillers) is possible. The deal price supports HAWK's claim that $20M per rig is supported by an independent appraisal from Basso for a net liquidation value of around $30 per share.

Seahawk (HAWK) Debt, Risk and Reward

2010-08-17T04:11:00.001-05:00

It’s important to understand how the risk-reward profile of HAWK is modified as they take on debt. In their quarterly call they indicated a strong preference for adding debt and adding rigs.

I’ve considered three scenarios.

1. HAWK retains their current leverage and uses asset sales to pay for operations. These asset sales will be at scrap values, around $7M per rig.

2. HAWK takes on 110M of debt and 50M of new assets. These new assets are 3M cash flow positive each quarter after interest. All of HAWKs rigs, new and old are security for this debt. It replaces the existing credit line. This amount of debt is below the scrap value of existing rigs + new asset value.

3. Hawk takes on $150M of debt and 50M of new assets. Similarly, these new assets are 3M cash flow positive each quarter after interest. All of HAWKs rigs, new and old are security for this debt. It replaces the existing credit line. This amount of debt is about the liquidation value of current rigs and new rigs, net of liabilities.

The “good case” is where HAWK continues their current cash burn, as modified in the scenarios above, until a point in time when rig market values return to December 2008 levels.

Case	Period until HAWK goes bankrupt	Value if recovery occurs just before bankruptcy	Value if recovery at 8 Quarters	Value if recovery at 16 Quarters	Residual Value	Notes
Case 1 (no debt)	23 Quarters	$200M (16.90)	$562M (47.40)	$320M (27)	$0	Hawk keeps selling rigs until they have no rigs left to sell or liabilities exceed net assets
Case 2 (Medium Debt)	13 Quarters	$706M (59.60)	$734M (61.90)	$40M (3.40)	$40M (3.40)	HAWK is liquidated by lenders but the liquidation yields more cash than the lenders had security because HAWK did not take on the absolute maximum amount of debt.
Case 3 (Maximum Debt)	18 Quarters	$671M (56.62)	$734M (61.90)	$680M (57.40)	$0	HAWK is liquidated by lenders and there is no residual because HAWK borrowed against the full, scrap, value of the rigs.

By taking on debt instead of scrapping rigs a large potential return is maintained at the expense of the time in which that return can occur.

The company values under each scenario are shown below assuming a return to December 2008 values in that period. The value added and subtracted by debt are shown along with the 40M residual value under case 2.

The degree to which debt will be a good or bad idea will depend on the covenants, the total debt load and the purpose for which they can use that debt. To the extent that HAWK can take on 150M of debt with few covenants (because their security is money good) and for general working capital, then I don’t mind the risk reward trade-off. To the extent that HAWK take on less than the maximum debt then there will be a residual value in the event of a bankruptcy. That residual value could easily be half of the current share price which will not be available if HAWK is allowed to liquidate their last rig (in reality their last few rigs because they have liabilities if not long term debt). With debt You sacrifice the last 1.5 years of potential turnaround for up to 3 times your upside.

Seahawk ( HAWK ) Mexican tax issue and fleet comparison with Hercules ( HERO )

2010-08-12T10:10:00.001-05:00

Hercules offshore has had similar, albeit much smaller, tax issues with Mexico. In March 2007 HERO received a tax assessment from the Mexican government for the 2004 tax year. The Mexican government then commenced an audit for 2005. This related to deductions and remittance of withholding tax for these deductions. HERO reserved 17M for the tax assessment and posted a bond for 13.2M. They settled for 10.8M. HAWK’s total assessment is for 93M plus $5M as a result of indemnifying PRIDE. Furthermore HAWK believes that the Mexican authorities could level a further 100M using the same methodology for other tax years. HAWK is being much more aggressive than HERO, especially as they have essentially no assets in Mexico. In this quarter HAWK have reduced their future exposure to the Mexican tax issue by 10M out of the 93M. It seems unlikely that HAWK will get any meaningful work in Mexico after likely walking away from their tax liability. However, demand in the Mexican GOM will divert vessels from the US GOM, tightening supply there.

There is a fantastic analysis of the tax issue at http://greenbackd.com/2010/08/10/guest-post-seahawk-drilling-inc-nasdaqhawk-and-the-hacienda . The possibility that paying the IRS ends up paying the Mexican authorities rather than HAWK is at least intriguing.

The tax issues relate to work for PEMEX. They are a major source of revenues for the Mexican government and the only way they are even going to sustain current, much lower, production is through substantial capital investment. There are currently about 50 rigs marketed and 70 or so including cold stacked in the US GOM. Demand was for about 90 from 2002-05. Maybe 70 since 2005 until the drop off in early 09. The commodity jackup demand has been almost constant at around 55 until early 09. As premium rigs abandon the GOM, never to return then demand will be met by commodity rigs or rates that are sufficiently high to lure the premium rigs back. If demand for commodity rigs stays at 55 with 10 of the 70 supplied off to PEMEX then HAWK will be running 18 rigs. If there is small additional demand from the lost premium rigs then HAWK easily gets to 100% utilization. That assumes HERO can bring their cold stacked rigs back online. Some of them apparently require a lot of Capex.

I have heard concern that PEMEX will lay off their jackup rigs and look to upgrade. The truth is that there are only 2 matt supported jackups in Mexican GOM so worst case they are a few percent addition to the US GOM commodity fleet. To the extent that PEMEX can add matt supported jackups then they’ll be getting more bang for their E&P buck.

On a different note I had a discussion on seekingalpha regarding the suitability of HAWK’s rigs and whether or not they would be the last to get contracts because their rigs were less desirable.

Comparison of HAWK and HERO GOM Fleet:

Across the portfolio HAWK’s rigs are newer (inclusive of upgrades)
Across the portfolio HAWK’s rigs can work in deeper water
HERO has 3 rigs that outclass any of HAWK’s. HAWK has no independent leg rigs. Aside from those three the rest the other 39 rigs are evenly matched
Stack Ranking Depth, age and capability HAWK comes out substantially ahead as shown below. (This multiplies the rank of Type,Upgrade, Legs and Drill)

Latest Update on Seahawk (HAWK)

2010-08-07T02:47:00.001-05:00

Having listened to the Hercules Offshore (HERO) and Seahawk (HAWK) quarterly calls there is some interesting information on the current state of offshore and potential minor changes to the HAWK thesis both positive and negative. This should be ready in conjunction with my original analysis on HAWK .

Interesting

Across US GOM there are 47-48 marketed jackups, 32-33 are contracted and of those 9 are waiting on permits. 19 have contracts that expire by the end of September. Operators will need to secure new permits before the jackups will be contracted.
Before the freeze HAWK had 90% utilization of their marketed rigs.
There are +/- 70 jackups uncontracted in international markets and 20 more on order. Though international E&P is expected to increase over the second half. Remember that this only impacts HAWK to the extent that rigs would be moved back in to the GOM because of the lack of demand elsewhere. There is no reason to think that will occur as the economics remain poor and the matt supported jackups all-in costs are cheaper (because the rigs themselves are old and not worth much compared to newer, more flexible rigs)
HERO have sold another retired rig for scrap for 4.8M (the Hercules 155 a 150m rig).
Rigs are costing about 8-10k per day while idle. Compared to 4-5k per day for cold stacked rigs. The primary cost for cold stacked rigs is insurance.
There are two new permit requirements out of the Bureau of Ocean Energy Management relating to shallow GOM. Notice to leasees 05 (NTL 05) and NTL 06. Meeting NTL 05 has been relatively easy and is mostly the responsibility of the rig owners. It’s primarily around blowout preventers. Most of the HAWK rigs were already compliant. They are all compliant now, even the cold stacked ones would only need minor work if any. NTL 06 is much less clear and is the responsibility of the operator. There have been a few permits issued that met NTL 06 but they were for wells with few liquids. The BOEM is still trying to figure out what compliance with NTL 06 really means.
Rates are much better than last year and day rates are not likely to come down from these levels. The issue is not supply and demand (economic) but permit driven. Neither HAWK nor HERO is likely to take a contract below current levels. There is not likely to be a double dip in rig rates. There is also a belief (though I'm not sure of the foundation) that natural gas prices will improve.
Insurance rates for the next 12 months have been set and are (only) about 10% higher.
There is no additional news on the Mexican tax issues
Valuations for jackups have come down a little more since the first half of the year. This isn’t scrap value but orderly sales.
To be cash flow neutral HAWK would need 9-10 rigs at 90% utilization.
HAWK’s cash burn is about 10M per quarter but will be effected by, as yet unknown, repair costs on Seahawk 3000 which is about to go into dry dock for repairs.
HAWK’s current revolver is drawn by 6.4M.
There was no new news on the Mexican Tax dispute.

Changes the HAWK thesis positively

PEMEX has requested a 54% increase in their 2011 budget. The PEMEX capital process is subject to the vagaries of the Mexican political system so there is a great chance that between the request and the allocation the amounts will change. This is similar to the story told for 2010 which did not amount to much. There are 26 Jackups in the Mexican GOM. 13 are scheduled to come off contract in 2011. 28 to 35 rigs in Mexican GOM has remained constant throughout the cycle. The headline number is an additional 21 rigs if the CAPEX is allocated as requested. HERO would not be surprised if there were 35-38 rigs operating (net addition on 8-10) there by this time next year. Though PEMEX may not request matt supported rigs, whatever they request is likely to leave US GOM, further reducing supply in US GOM.
The combination of additional demand from PEMEX, scrapping of GOM rigs and rigs leaving the GOM is going to be very bullish, one day!
HERO and HAWK will not sell their rigs to potential competitors in the GOM. It makes selling them for scrap or repurposing them as accommodation units, mobile production units etc. HAWK are exploring selling cold stacked rigs as mobile production units. That said if there is a cash squeeze anything is possible
The pace of permits has improved in the last few weeks. If this momentum continues then the silver lining is the demand once the backlog of permits is cleared.

Changes the HAWK thesis negatively

HAWK is looking to add one or more packages of 2-3 IC rigs from outside the GOM that will be immediately cash flow accretive. Ideally in West Africa, Middle East, Far East or India. HAWK is one of the only potential buyers for jackup rigs world wide at the moment. For example, any acquisitions for HERO would need to be 100% equity financed as they have no room to take on further debt.
On their conference call HAWK was asked if they would sell rigs to buy back shares. After all why purchase someone else’s rigs when you can buy back your own greatly discounted rigs. The CEO said they want to diversify their sources of cash and that the float is already too small. I was very disappointed with this answer. Concerns about Randy Stilley (HAWK CEO) are magnified by this response. It is clear that he is not going to be a great capital allocator and is more interested in building HAWK into an empire than guaranteeing low risk returns to shareholders. The only way for them to add rigs is to take on additional debt which means they will look more like HERO where Randy originally came from (and oversaw a potentially equity killing expansion program). In his defence he has taken his compensation as stock for the rest of the year. This isn’t enough of a reason to get out of HAWK but it makes me more likely to get out in the low 20s. Also it is possible they will come up with a way to finance the additional rigs without taking the liability at the company level (i.e. a non-recourse loan) in which case, depending on how much equity they need to use, I’ll be proved wrong.

Seahawk Drilling (HAWK)

2010-07-25T02:05:00.000-05:00

INTRODUCTION

Seahawk Drilling, spun off from Pride last year, is an interesting opportunity selling at a discount to distressed liquidation value and a substantial discount to orderly liquidation value. HAWK provides jackup rigs in the Gulf of Mexico (GOM) primarily to natural gas exploration and development companies. The stock has become unreasonably cheap as a result of the Macondo blowout in April. HAWK price was 18.80 on the day of the spill and has fallen to 9.97 today, following BP down, even though the value of HAWK is mostly unrelated.

Stocks that trade at a discount to liquidation need to have a few factors acting against them. HAWK has plenty, though very few of these have changed since the Macondo blowout:

INDUSTRY

PRE-SPILL

* Competitors such as Hercules Offshore (HERO) are heavily indebted and when bidding are willing to sacrifice profitability for cashflow

* Shallow water GOM mostly produces Natural Gas, therefore interest in their rigs is tied to Natural Gas prices which are trading at very low levels so NG explorers are not exploring

* They operate in shallow water which may have been substantially explored and is likely in permanent decline

* Their rigs are old (Mat Cantilever and Mat Slot) and some customers like PEMEX have recently tendered for strictly newer rigs with higher specifications (Such as Independent Leg Cantilever)

* The matt supported rigs are only really suitable for the GOM and transport costs for Jack up rigs are very high so moving them is not generally an option though Hercules placed a mat-supported jackup off the coast of Malaysia in 2008.

* There are some new rigs coming on to the market and HAWK, as well as their competitors, have a number of rigs “cold stacked” (no crew on board and no maintenance)

* The market for used jackup rigs have reverted to 2004 levels having doubled since 2004 and fallen again

* The business is intensely cyclical

* It is no longer possible to insure 100% of liabilities for certain events such as hurricanes in the GOM and the insurance you can get has substantial deductibles

CHANGED AS A RESULT OF SPILL

* The industry recently turned up from a cyclical low only to be hit by the oil spill in the Gulf of Mexico (GOM)

* Though the government has not banned shallow water drilling they have added new permitting requirements. They do not appear to be onerous and some permits have been issued in the last few days to HAWK. It is unclear how long it will take to get back to a normal permitting level though the company believes it’s likely to add a few thousand dollars of costs per permit (generally once per well) and is primarily an issue of paperwork and certifications.

COMPANY

PRE-SPILL

* HAWK is responsible for damage caused by one of their ships during a hurricane, some (or maybe all) of which is covered by Pride’s insurance.

* Tax dispute with the Mexican Government

* They have lost money since the spin-off from PRIDE and though they have cash it won’t last forever. They are cash flow negative with around 6 months worth of cash on hand (all things being equal).

* Their credit rating, based on a simple credit scoring model, is very poor, though they have substantially no debt. This is reflected in the onerous security that their revolver has over 15 of their rigs.

* Pride are conducting an investigation into bribes paid by the precursor to HAWK which may end up subjecting HAWK to some consequences

* For two years after the spinoff (24-Aug-2009) they cannot sell substantially all their assets (liquidation) or issue shares due to the tax agreement with PRIDE (with some exceptions)

* The CFO recently retired after only a short time with the company (he joined pre spinoff and left post spinoff).

* The executive team is new and the CEO, who came from Hercules, was responsible for a large loss due to a bad acquisition at Hercules

* SG&A costs are unreasonably large at 48% compared to 8% for HERO (HERO has a 6 times larger revenue base and much of HAWK’s SG&A is related to cold stacked rigs).

* It is very difficult to determine the performance of the company while it was still part of PRIDE as the numbers are not effectively broken out.

CHANGED AS A RESULT OF SPILL

* Share price is near an all time low

With that rather large list of problems you’d need a great reason to be looking at HAWK. They include:

INDUSTRY

* The economics of drilling in the gulf discourage new entrants and fleet additions. Day rates for new $200M rigs would fetch about 100k versus day rates for old $20M rigs fetching 40k per day in the GOM. These new rigs can earn higher returns elsewhere while the matt supported jackups are unsuitable for most alternate locations. There were about 130 rigs in GOM in 2000, today there are closer to 30. At some point supply and demand will be in balance, mid-cycle demand may already exceed supply.

* Though there are 40 jackups under construction and 13 more on order, none of these new rigs are likely to enter the GOM because of the economics (100k per day for a 200M rig) and an inability to secure windstorm (hurricane) damage insurance.

* Competitors are leaving the gulf and are unlikely to return due to economics, legal liability, requirement for US crews, etc. This reduces the total available rigs. In the last few days there was an announcement of two Rowan, high spec, rigs leaving the GOM for the Middle East (http://www.reuters.com/article/idUSN0114280720100701).

* There are only about 15 cold stacked jackup rigs that are ready for service in the GOM of which HAWK owns 8. An additional 10 rigs would be required to return to January 2009 levels. The other 15 cold stacked rigs require substantial capital expenditure before they would be ready, of which HAWK owns 2.

* Requests for shallow water bids have increased 60% since this time last year (pre-BP spill). Exploration budgets for operators that include GOM are up an average of 22%

* The freeze on deep water drilling in the GOM may drive up crude prices substantially thereby increasing the spread between the BTU equivalent price of natural gas and crude oil. Some applications can switch to natural gas and the extremely cheap gas can be locked in using futures markets thereby supporting the capex to switch and creating additional demand for gas. The freeze may also drive some exploration to shallower water.

* Q1 2010 day rates are back at 2004 levels with 75% upside to a 6 year average.

COMPANY

* HAWK is trading at about 25% of book value, HERO trades at 28% of book with 872M of debt versus 325M of equity. HAWK has substantially no debt (6.4M in short term debt versus 35-45M in cash today).

* Trading at about 32% of Fleet Market Value as calculated from third party sources including appraisals

* Trading below the price you’d receive for liquidating their business and selling their fleet for scrap. This is the distressed liquidation value.

* They expect to end June 30th 2010 with 35-45M in cash. They are currently losing about 15M in cash per quarter based on the Q1 rig rates so all thing being equal they have about 6-9 months of cash on hand.

* There is an opportunity to secure work with PEMEX (Mexico's state-owned petroleum company). PEMEX’s premier field, Cantarell, is in substantial decline and one way to offset this is to spend substantially more on exploration. There are 18 jackups coming off tender with Pemex and to support their 2010-2014 business plan they may need closer to 40 (there are only 30 cold stacked rigs in the GOM, including those that require substantial capex to restart).

* The tax dispute between HAWK and the Mexican Government is with HAWK subsidiary companies which have no assets. Mexico recognizes the concept of limited liability in a company and even if it finds HAWK guilty is unlikely to be able to call on the parent company assets.

* Restricted stock grants to management have occurred at much higher prices and there are 350k options outstanding at a strike price of $26.

* The top 5 executives own $16.7M of stock, restricted stock and options valued at issuance. These are worth about $7M now or 6% of shares outstanding.

* The CEO had his employment agreement amended to take his salary from mid June to end of December 2010 as shares (restricted stock units - RSUs) and no cash, all 31,000 shares issued at the June 25th price. Non employee directors are receiving shares (RSUs) as their fee from April through December. They are both taking their balanced compensation in stock rather than cash as well.

VALUATION

Valuing HAWK is easy once you have inputs. The complexity is in developing mid cycle (average) inputs.

A company with negative cash flow eventually does one of two things; becomes cash flow positive or insolvent. By considering a whole cycle of rig day rate prices it is possible to calculate an average day rate to determine HAWK’s earning power. HAWK does not have rig rate history all the way back to 2004 so I've overlayed HERO (Hercules) rates by using the ratio for overlapping dates and apply the same for the missing ones.

	2004	2005	2006	2007	2008	2009	2010 Q1
HAWK Day Rate	$ 43,947	$ 62,711	$ 105,155	$ 89,964	$ 76,117	$ 66,400	$ 41,600
HERO Day Rate	$ 37,210	$ 53,098	$ 89,035	$ 78,456	$ 66,672	$ 52,649	$ 35,191

I’m going to use 68k as the mid cycle revenue per rig which is the best fit over the prior cycle. The average over the prior cycle is 74k but the 68k is a reasonable proxy for the gradual decline of the offshore GOM drilling industry (the suggested decline -line of best fit- is about 1k or 2% per year). Assuming the number of rigs is constant at 8 then the change in EBITDA is +82M at the 6 year average rig rate. Annual Q1 EBITDA is around –80M which would leave HAWK at breakeven.

Based on the utilization sourced from RigZone (http://www.rigzone.com/news/article.asp?a_id=94392)

70% is a fair mid cycle utilization rate which is 14 rigs. This is supported by the fact that Hercules has been able to deploy their entire fleet in peak times.

With a 70% utilization rate and 68k rig rate, using the incremental EBITDA table provided by HAWK

(http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9NTA1MjV8Q2hpbGRJRD0tMXxUeXBlPTM=&t=1), mid-cycle EBITDA would be about 85M (-80+165) for a mid-cycle EV/EBITDA of about 0.7 using end of Q2 2010 EV!

Further assuming that HAWK runs off their current assets and then liquidates with no residual value after 10 years they’d be worth about $32 using a discounted cash flow valuation. This doesn’t include a possible increase in rig rates because so much supply is permanently leaving the gulf or the scrap value at the end of 10 years.

BOOK, APPRAISED AND SCRAP VALUE

Book value for HAWK is $433M or $36.50 per share. This values their average rig at $21M. Using current rig values and some appraisal data, HAWK value their fleet at $377M, $32 per share and $18.9M per average rig.

The company asserts that current valuations around $20M are supported by an appraisal from Bassoe and “Jeffries Offshore Drilling Monthly”. It's also supported by a few transactions, albeit in an illiquid market.

The current market price of $9.97 values each of their rigs at around $5.3M.

There is excellent support for a distressed liquidation value in excess of $5M per rig. HERO entered contracts to sell two _retired_ Jackups that had been in long term cold storage for $5M each, essentially for scrap value. However bad things are in the GOM, steel prices are still doing just fine. One of the HERO rigs was a 1977 250ft which closed in April 2010 and the other is a 1978 160ft scheduled to close in Q2 2010. These rigs required substantial capital expenditure to re-enter service. These are similar to the HAWK rigs except that most of the HAWK rigs (18 of 20) have not been in long term cold storage and do not require more than 1-2M to get back into service. HAWK asserts that they would get far more from a liquidation of their rigs as the equipment on the rigs has substantial value before the steel is harvested. HAWK asserts the value is above $8M per rig.

Method	Price Per Share	Likelihood	Appreciation
Book value	$36.50	Low	266%
Realisable asset value	$32	Reasonable	221%
flow and rigs	$32	Reasonable	221%
Scrap Value + net assets	$10.50	V.low	5.3%

DOWNSIDE

Finally it's worth looking at the downside. Most of the downside comes from the company consuming the current value by converting assets in to cash in the hope of better times ahead. Assuming a reasonable worst case that HAWK have to cold stack all of their rigs and then sell down assets to pay for the fees; then HAWK's net asset value would equal today's market cap by Q4 2012 (11 quarters). It would take a further 22 quarters to get to zero as costs reduce with asset sell downs.

A more realistic case is the current burn rate of $15m per quarter. On that basis you'd get to Q4 2014 (19 quarters) before NAV=MCAP. Once NAV=MCAP, it's still possible to make money if there is then a recovery in rig values. Bear in mind that rig values were 30% higher at the end of 2004 and 2.6 times higher at the end of 2008 so even half the number of rigs in 2015 could be worth double today’s market cap on an eventual return to 2008 pricing. If a recovery took 2 years then they’d still have 15 rigs left and they’d only need to be worth 25% more to keep liquidation value at $32.

Similarly a drop in rig prices shortens the period of time until NAV=MCAP but bear in mind the cash flow from these old rigs is quite attractive compared to new rigs. The floor price for these rigs is scrap value. If that is all they could secure then the burn rate looks about the same as the cold storage case above. NAV = MCAP by Q4 2012.

Case	Rig Prices	Quarters of Cash burn to NAV=MCAP*	Additional Quarters of cash burn to bankruptcy
Current Burn (15M per Q)	Current	19	28
All rigs cold stacked	Current	11	22
Current Burn (15M per Q)	Scrap	11	22

* remember that if rig prices return to 2008 levels by this point in time then liquidation value will be higher than it is today even with half as many rigs!

CATALYST

The most obvious catalyst is the resolution of the Macondo blowout. Latest reports are that could be as little as a few weeks away. That is likely to initiate a gradual re-rating of GOM companies. HAWK was selling 18.80 before the blowout which is still at a substantial discount to NAV.

Aside from that a catalyst is less well defined. Over time the industry will move up from the cyclical trough. HAWK has the assets (convertible to cash) to wait.

CONCLUSION

As a going concern, or orderly liquidation, HAWK is worth around $32. From today’s price that’s over 3 times upside and management are well incented to see this happen. Even if things stay this bad for another two, or even four, years it doesn’t substantially impact the valuation as long as rig prices improve with the cyclical upturn as they always have. The stock has probably become so cheap due to liquidation of all things GOM related. While the spill has created some interesting opportunities, this one offers a robust margin of safety due to the absence of debt and the presence of substantial assets.

The price before the Macondo blowout had a 50% upside to orderly liquidation value versus 3.5 times now. At cyclical average rig rates HAWK is currently trading at .7 times EV/EBITDA and less than distressed liquidation value. New shallow water regulations have had an impact on HAWK but they have not more than halved the value of their rigs to less than the scrap value.

Valuation of Eagle Rock Energy (EROC) post transactions

2010-07-25T01:39:00.002-05:00

Eagle rock energy has completed the transactions noted here http://longterm.blogspot.com/2009/09/natural-gas-partners-ngp-proposed.html and here http://longterm.blogspot.com/2009/10/revised-ngp-proposed-transaction-with.html .

As part of the proxy solicitation process EROC disclosed management estimates for 2010 through 2013. These were used by Madison Williams and Company to provide a fairness opinion on the transaction. We can use the data to value EROC based on management’s view of Distributable Cash flow over that period.

Management provided optimistic, pessimistic and base case estimates where the fee to NGP is paid in units, which is what occured.

	2010 Q3	2010 Q4	2011	2012	2013
DCF Base	20,474	21,820	105,966	111,516	116,504
DCF Optimistic	25,673	27,126	161,501	178,239	253,168
DCF Pessimistic	15,624	17,116	31,806	27,915	(44,981)

DCF – Distributable cash flow

Using that data and taking a weighted average (base*4+optimistic+pessimistic)/6 we can do a dividend discount model valuation. With an 11.8% discount rate (calculated using a fundamental beta – if anything this is a little high as average debt over the life of the cash flows will be lower than the starting debt) the weighted average value is $9.81 using the shares outstanding also provided in the disclosure documents.

The proxy also include a relative valuation of EROC based on various valuation metrics and comparable transactions. This values EROC between 7.37 and 11.06, with an average of $9.22.

This data can further be used to estimate the value of the warrants at 3.13.

A reasonable valuation for EROC is around $9 and the warrants around $3. This is higher than my earlier estimates due to a number of factors. The public equity raising has not been required. New hedges have been acquired and a lot has happened to the company and the economy

YTC Resources (ytc.ax ytc:ax)

2010-04-04T00:51:00.001-05:00

YTC Resources is a microcap ($36M AUD) Australian mining and exploration company. It’s probably the cheapest gold miner that I identified in this post on Cheap Gold Mining Stocks.

Projects

They are focusing on developing a mine for their Hera project while they continue to explorer their gold, base metal and tin projects in New South Wales, Australia. The companies projects include:

Hera Project
- An advanced, undeveloped, high grade gold-base metal deposit with the potentially to rapidly advance development for modest capital expenditure
Doradilla Project
- Early exploration stage with a bonanza grade silver-bismuth drilling results
Baldry Project*
- Early exploration stage gold drilling results
Pound Flat Project
- A tin prospect that has been explored in detail by other companies from 1978-1982 with a shallow tin oxide deposit on top of a tin deposit. This represents the potential for a future low-cost, high margin mining operation with modest capital expenditure requirements
Giants Den Project*
- High grade alluvial tin deposit but with limited scope for economic extraction.
Tallebung Project*
- Good potential for a shallow, medium tonnage, low grade tin deposit at the historic Tallebung mine.
Torrington Project*
- Very little modern exploration conducted on these tenements but they are cover historic areas that have produced over 100,000 tons of tin. No activity in 2009.
Kadungle Project*
- Early exploration indicates large, low grade, porphyry copper-gold mineralization. No activity in 2009 but a gravity geophysics survey is schedule for 2010.
Tingha Project
- New exploration license for YTC but the area contains historic tailings and contained historic alluvial tin deposits.

* these projects were part of the initial float of YTC.

Doradilla and Giant’s Den both contain Indium which is a precious metal with increasing high tech applications including LCD and plasma screens.

Most of the readily ascertainable value in YTC lies with the Hera project.

Hera Project

The Hear project has an interesting history. It was discovered in 2001 by Pasminco, Triako purchased it from Pasminco’s receiver in 2003. They completed a pre-feasibility study in 2005 and then CBH took over Triako in a $70M scrip deal. Hera was Triako’s major asset at the time. CBH increased the size of the resource and permitted the initial parts of the mine (decline). Then in 2009 YTC purchased Hera from CBH for $11M in cash plus a royalty interest of 5% of gold Dore production capped at 250k oz. YTC also purchased an 80% interest in the nearby Nymagee JV for $1M in cash. Best case CBH got $11M plus around a $15M royalty stream over time. YTC got a $66M project with substantial upside that CBH had paid around $70M for in 2005. CBH wanted to use the cash proceeds to focus on core projects including their nearby Endeavour project. This is another great example of cashed up juniors that purchased assets from larger companies who needed or had “better” uses for the cash during the GFC. This bottom fishing during the financial crisis is common to a few of my favourite ideas including Cape Lambert and Bass Metals. This savvy behaviour augers well for TYC’s capital allocation decision making.

YTC’s analysis based on the work the CBH undertook presents a mine plan for only one of ten lenses identified in the area. This is the base case mine plan. This base case has an NPV of $90m according to YTC’s analysis excluding capital expenditure (capex). Subtracting the estimated 23.4M of capex leaves an NPV of $66.6M AUD. The discount rate used appears to be 10% and this is relatively close to my calculation of 10.5% once mining begins. The current discount rate is 9.5% before the mine development commences (the difference is based on the amount of cash on hand). These are close enough that I would not make an adjustment. The NPV is based on $800USD gold but at an AUDUSD of 0.7 (1142AUD/oz). This is only slightly lower than the current $1100USD gold at .92 ($1195AUD/oz). Finally there appear to be substantial optimizations that YTC are exploring to reduce costs that ought to improve the NPV. These optimizations and a definitive feasibility study will be released this year.

YTC believes there is an easy addition of the 1530 and West lens to add 2 years to the mine life which would increase the NPV by 16M less exploration costs.

To fund the Hera acquisition and to develop the project YTC conducted a capital raising placing 123M shares at .21 for $26m before costs. The company will need $23M to get the mine into production and currently have $10M on hand (the $26M raising had to cover the purchase of Hera also). The shortfall will come from another capital raising or from debt. The risk of another capital raising may be holding the share price down. At the current 21c share price the company would need to issue another 71M shares (42%) above the current 169M shares outstanding. Ideally I'd like to see the company do a heavily discounted rights offering, something like 1:1 for shares at 10c.

Valuation

YTC have net assets of $27M including capitalized exploration and evaluation expenditure. $10M excluding E&E. It is reasonable to use the $17M capitalized exploration & evaluation expenditure minus Hera’s $12.2M as a conservative value of YTC’s other assets, adding a multiple to this starts to become more aggressive (the multiple is used in the “Good Case” below).

*Valuation based on decreasing levels of confidence*
Case	Description	Additional Value	Total Value	CPS
Worst Case	Net Cash		$ 10,000,000	$0.06
Base case	Hera project base case	$ 66,000,000	$ 76,000,000	$0.45
	Other Projects (at 1x book)	$ 4,900,000	$ 80,900,000	$0.48
Improving case	Hera project with likely extension	$ 15,000,000	$ 95,900,000	$0.57
Good Case	Hear Project with extension and other projects (1.5x book)	$ 7,350,000	$ 103,250,000	$0.61

YTC History

The company was established in March 2004 in Orange, NSW.
In September 2006 they developed a strategic alliance with Yunnan Tin Group LTD of China,
In January of 2007 the company’s name was changed to YTC Resources, reflecting the alliance with Yunnan Tin and Yunnan Tin invested 2.67M in March 07 thereby acquiring 50% of the company at 20c per share.
YTC started trading on the ASX in May of 2007. They floated 14M shares at 25c each for $3.5M while tin and non-ferrous metals were at an all time high. This reduced Yunnan Tin’s ownership to 33%.
In July 2008 Yunnan Tin purchased 2.7M shares at $1 each for exploration purposes. YTC changes their strategic focus to acquisition during the GFC. In late 2008 the Giant’s Den project was deemed to be uneconomic after a substantial drilling program.

Ownership

Directors own 8.4M shares (5%) and 3.5M (2%) options for a total of 7% of shares outstanding. The CEO Mr Rimas Kairaitis received a salary of $200k to Dec 2008 and then took a 25k pay cut in 2009 due to the GFC. Yunnan Tin owns 20% of YTC and Wonderful Investments Limited owns 9%. Yunnan Tin is the world’s largest producer of tin and major non-ferrous metals and has mineral exploration, mining, dressing, smelting chemical production and marketing interest. Yunnan Tin has interests in two listed companies on Chinese exchanges. Wonderful Investments is somewhat mysterious company out of Hong Kong and is apparently unaffiliated with Yunnan Tin. They appear to have no other investments except for YTC. Suffice it to say that “China” owns 27% of YTC. The alliance with Yunnan Tin gives YTC access to substantial operational and marketing expertise, potential capital and the Chinese resource market. In turn YTC have the right to bid/quote for any tender issued by YTC and to negotiate an off take arrangement on commercial terms.

YTC’s share holding is in line with the Australian Government’s foreign investment view which is that Chinese companies can be partners but not outright own Australian projects. Therefore YTC does not have the opportunity to buy out all of YTC. The strategic fit for them is presence in the Australian market and the off take agreements. Yunnan Tin have bought some of their shares in YTC at much higher prices than today’s.

Recommendation

YTC trades for 1.24 times book versus 3.8 times book for the Precious Metals/ Minerals industry which would support a valuation of 64c. Compared to the share price today at 21c, YTC has a base case valuation upside of 130% with reasonable upside to 200% and more. I’d buy YTC at 21c and would be a seller in the 50s in the absence of new data.

(I’ve revised the amounts under capitalized E&E to firstly show the correct amounts and then to remove Hera.)

Cheap Australian Small Cap Gold Stocks

2010-04-03T21:39:00.001-05:00

Based on the excellent RCR Gold Company Review and some additional research I’ve evaluated a number of smaller Australian Gold Stocks. I’ve shown the highest rating ideas below.

Company	Symbol	EV resv+resource us$/unit	Price to Book	Current Price (PPS)	% fm 12 month low	Mine	Blended NAV (PPS)	Distance fm target	All time high date	All time high price (PPS)	distance fm all time high	Mcap (M)	Debt (not net of cash)
Noresman	ngx.ax	$ 35.40	2.3	$ 0.74	45%	WA	$ 1.35	82%	Nov-09	$ 1.35	82%	$ 84.60	6m
Eleckra	ekm.ax	$ 23.00	2.9	$ 0.11	250%	WA	$ 0.19	76%	May-07	$ 0.65	519%	$ 20.56	-
Dragon Mining	dra.ax		1.39	$ 0.08	66%	Finland	$ 0.19	123%	Oct-07	$ 0.15	81%	$ 61.20	17m
North QLD Metals	nqm.ax	$ 180.60	1.2	$ 0.23	15%	QLD	$ 0.48	109%	Dec-07	$ 0.53	130%	$ 65.40	-
Cortona	crc.ax	$ 33.40	0.8	$ 0.15	21%	NSW	$ 0.35	141%	Dec-07	$ 0.52	259%	$ 24.68	-
YTC resources	ytc.ax	$ 86.50	1.3	$ 0.21	110%	NSW	$ 0.75	257%	Aug-07	$ 1.43	581%	$ 34.48	-

These stocks are particularly interesting because I believe the macro environment supports a higher gold price. These stocks, because they are so small and under researched, have the potential for great returns regardless of the gold price (well not if it falls 50%) and the potential to scream higher if gold does.

The common trait of these opportunities is a very small market cap, a very low Price to Book (average is 4), and a low EV to total resource and reserves (average is 95).

The macro problem for Australian gold stocks is the Australian Dollar. Gold is worth less in AUD as the AUD strengthens. (The alternative view is the cost as a % of each oz increases if measured in gold.) This is a risk but substantially less of a risk while the AUD is at .91 USD. The AUD probably has 10-15% to purchasing power parity. You get the added bonus of a higher AUD gold price if markets (especially China) correct and the AUD falls though Australian stocks do not usually reflect this bonus, they just fall.

All of these stocks are sufficiently undervalued that they warrant further investigation. YTC seems particularly interesting. I’ll post some detailed analyses shortly.

Bass Metals (BSM.AX AX:BSM R2F)

2010-02-13T01:06:00.001-06:00

Bass Metals is a junior miner with operations and exploration in Tasmania, Australia.

The value in Bass Metals is made up of the Hellyer Mine Project, net assets and exploration potential. They currently have a small mine called Que River that has generated enough cash to fund their exploration program to date. The Que River ore is current processed by a third party and this arrangement has generated enough cash flow to get the Hellyer Mine Project through a definitive feasibility study.

Hellyer Mine Project

The Hellyer Mine Project is based on mining the Fossey, Hellyer and Que River deposits and then processing them at the Bass Metals owned Hellyer Mill. The Definitive Feasibility Study (DFS) for the Hellyer Mine Project assumes the development of a mine at Fossey with ore processed at Hellyer Mill.

The key aspects of the Definitive Feasibility Study are:

Two to three year mine life
Undiscounted free cash flow of around $50M, discounted closer to $40M
Produces Zinc, Lead and Copper/ Silver/ Gold concentrate

The opportunities created include (but are excluded from the DFS valuation):

Conversion of the nearby 2.3M tonne resource at the Hellyer, Que River and Fossey deposits into reserves which could be added opportunistically to increase the mine life (or run the mill at full capacity).
Extraction of the 800,000 ounces of gold and 550,000 tonnes of zinc, lead and copper in the Hellyer Tails Dam. Note that these are resources not reserves. BSM is studying how to extract them economically but may not be able to find a way.
Exploration of BSM’s extensive tenements in a historically productive area.

The exploration potential is particularly interesting because it appears that advances in geological techniques may bring about discoveries that would have been missed when these areas were previously evaluated. There are large zones that had been previously dismissed. One zone in particular (the Amoeba Zone) looks prospective using the new techniques but had previously only had one drill hole! The Fossey deposit was only recently discovered within 150m of the Hellyer mine which was mined from 1987 to 2000 when it was exhausted. If a new, substantial ore body can be discovered within 150m of a mine, using new techniques, then there is certainly the possibility of more major finds. Pervious geological evaluation had focused on a north south line along the historic discoveries. Fossey is East West and BSM are going to be using their new techniques on prospective East West ore bodies. Bass estimates that only 25% of the potential “ore host horizon” has been effectively tested for ore bodies.

Since the DFS was published BSM have negotiated an off take agreement with Nyrstar for the Zinc and Lead concentrate. The terms are better than those assumed in the DFS.

History

Bass metals was incorporated in 2004 and called Resource Finance and Investment.

Between incorporation and June 2005: They raised $1M. Purchased a suite of exploration projects and raised $2M to fund the purchase. They entered into a couple of farm-in / joint venture agreements
July 2005- June 2006: $3.5M IPO in October 2005. Exploration success at Hellyer-Que River project. Changed their name to Bass Metals
July 2006- June 2007: Developed a mine plan for Que-River and commenced mining. Ore sales agreement for the Que River mine. Added new tenements.
July 2007- June 2008: $1.8M profit. Que-River mine in production. Identification of Fossey Zone. Generation of other early stage targets including Heazlewood and Switchback
July 2008- June 2009: $2.4M profit (excluding accounting gains on Mill acquisition). Continuing development of the Fossey Mine plan. Continued mining at Que-River. Acquisition of Hellyer Mill, all supporting infrastructure, Hellyer tailings resource and dredge for $4m. It is worth noting the incredible value that BSM received for their $4m.
Subsequent to June 2009: Release of the Definitive Feasibility Study for the Hellyer Mine Project and capital raising.

Capital Structure

In the December quarter of 2009 BSM raised 15.3M before costs which resulted in an increase of shares outstanding to 171M from 104M. RMB Resources have been mandated to provide a $12M debt and hedging facility. The terms include hedging 30% of the lead and zinc concentrate. This is in addition to 2-4M bass options to be granted to RMB which will be exercisable at 10% above market. The options probably reduce the value of equity by half a cent but the use of debt increases the value of equity by much more than that. Any company with debt is taking more risk than a company without. Given the financials in the DFS a debt of $12M versus EBIT of $24M would give BSM a credit rating of at least AA. Other credit scoring models show that there is little risk in the assumption of $12M in debt.

Valuation

The Hellyer Mine Project has an NPV of $40M at an 11.5% discount rate which reflects the risk of BSM based on their maximum cash drawdown and assumption of debt.

Assigning a 75% chance of converting the additional resource into reserves to extend the mine life by 2 more years (assuming the same economics) with a lower discount rate of 8% adds $17.6M

Finally adding net assets by:

Taking cash and deferred tax assets at 100%
Receivables and inventory at 80%
Plant and equipment at 50%
Derivatives, other assets, mine properties, Capitalized exploration and evaluation at 0%
Liabilities at 100%

Leaves net assets of 16.97M (coincidentally almost equal to cash of 16.7M!). Since the DFS was published commodity prices have moved, the valuation here assumes the DFS prices for commodities though the realized price today would be slightly better.

*Commodity Price Assumptions Fossey DFS*
Commodity	% of Fossey DFS	Units	DFS Price	Current Price
Zinc	46%	US$/t	1,950	2,151
Lead	31%	US$/t	2,100	2,060
Copper	4%	US$/t	6,000	6,672
Silver	17%	US$/oz	15	15.51
Gold	2%	US$/oz	980	1092

AUD:USD			.87	.89

Putting this together you can build up to some rather high valuations for BSM, compared to the current price. Shares outstanding do not include expected options issuance for the RMB facility.

*Valuation based on decreasing levels of confidence*
Confidence	Source of value	Size	Per share
Most Conservative (Hellyer Project fails) – Liquidation value	Net Assets	$16.97M	10c
Conservative (Hellyer project delivers to DFS but no reserve additions)	Hellyer Project Per DFS	$40M	33c
Less Conservative (Hellyer project is extended by conversion of resource to reserves) – Reasonable intrinsic value	Hellyer project extension, 75% chance of extension cash flow	$17.6M	43c
Blue Sky (Elephant/ baby elephant / outsourced milling)			43c++

Relative Valuation

Though Reuters categorizes BSM as being in the precious metals industry they should be in the Mining/ Metals industry. Mining / Metals has an average price to book of 1.17 today. That would value BSM at 37c. Precious metals comprise 20% of the Fossey DFS. The average price to book in precious metals is 3.45 which would make the case for a relative valuation of BSM nearer to 50c.

Conclusion

I’d value BSM between 33 and 43c with the higher end of that range still providing quite a conservative basis for valuation, that is at least 100% upside from today’s close of 21.5c . The valuation will improve as resources are converted into reserves and it will improve as debt is paid down. When you consider that only 25% of the potential zone has been evaluated, the blue sky upside is many times more. I’d hold a position until quite close to 43c and in the absence of additional discoveries or resource conversion, I would sell.

2009 Predicitions Reviewed

2010-02-02T03:15:00.001-06:00

I posted Turnaround on December 28, 2008. I’m going to review the predictions:

This will not be as bad or even nearly as bad as the great depression
- Well this looks obvious now but really wasn’t obvious 12 months ago.
Prices have overshot to the downside, in part due to deleveraging
- This turned out to be very true but there were 3 more months of pain to endure
The recent situation is unprecedented and the response from government and monetary authorities has been unprecedented this will bring forward the recovery in commodity prices (at least relative to dollars).
- Commodities have been on a tare
The US Dollar is going to go down substantially once the deleveraging ends, this will be more like quarters than years
- The USD had already peaked against the AUD in October 2008. The recent rally in AUD began in March 2009 and has seen the USD drop by half.
US Treasury bond prices are unsustainable but may remain that way for some time. They are the short of the decade but you may not see any reversal in the next 12 months (don't fight the fed, the fed wants rates very low right now).

You would have made money on this

Many stock are an excellent buy at current prices based on the underlying value of their businesses.
- S&P 500 is up 72% from the low and 32% since the original predictions post. This is less than other worldwide markets!
The worldwide fiscal response is targeted at infrastructure projects this will add incremental demand to commodity prices while low prices in the later quarters of '08 have reduced supply.
- The Goldman Sachs Commodity Index is up about 80% since December 2008.
The major drop in asset prices was caused by credit markets seizing up, this problem is coming to an end (based on indicators such as the TED spread) though the economic slowdown persists. Half of the reason for the decline is resolved and asset prices will start to reflect this even while economies are in recession
- This took a few more months but the stock market certainly did turn while the economy was still in recession
The stock market will turn in advance of the economy. There will be no economic news to indicate that stock prices are going to turn.
- As above
Broad markets will probably retest their recent lows in the first half of 2009. It could be profitable to buy some insurance at today's and increasingly higher prices.
- Spot on. There was 25% downside from December 28th.
Commodity stocks survived 7 months into the US recession and 10 months into the bear market. They are fundamentally unimpaired and will likely lead us out of the bear market.
- The GSCI is up nearly 3 times more than the S&P 500 since December 2008.
Bank stocks will likely do well over 2009 because they were likely priced for the end of banking. Unfortunately they are too complicated to analyse so I won't be touching them.
- BKX was at 42 in December 08, It’s now at 47 which is 12%. Not exactly an outperformance. The learning here is when something is “too complicated to analyse” then I should stay far, far, away rather than make predictions about it!

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.

Mesa Royalty Trust (MTR)

2009-08-16T05:12:00.001-05:00

Mesa Royalty Trust was formed in 1979 by Boone Pickens. In 1985 he reacquired 88.6% of the trust leaving the small 1.86M shares remaining.

About 75% of their royalties come from US Natural gas, the remainder from Natural Gas liquids and Oil.

A simple model based on Natural Gas prices shows that MTR should be worth closer to $37 from today’s price of $24.85. Instead the trust is being priced off short term cash flow, which will be around $1.90 this year for a yield of around 8% .

Gas	MTR Value	Appreciation
$ 8.00	$ 44.96	81%
$ 7.00	$ 39.93	61%
$ 6.50	$ 37.20	50%
$ 6.00	$ 34.43	39%
$ 5.00	$ 28.92	16%
$ 4.00	$ 23.41	-6%

Simple valuation model based on NG

It is quite hard to develop a full financial model for MTR because they don’t have detailed financials on the wells that pay the royalties. Therefore both the NG only and the crude models are based on correlations to historic distributions. The correlation is quite good for just Natural Gas but as you would expect it’s slightly better once Crude is included.

Gas	Crude	MTR Value	Appreciation
$ 8.00	$ 90.00	$ 49.45	99%
$ 7.00	$ 80.00	$ 42.81	72%
$ 6.50	$ 75.00	$ 39.48	59%
$ 6.00	$ 70.00	$ 36.16	46%
$ 5.00	$ 65.00	$ 30.72	24%
$ 4.00	$ 60.00	$ 25.29	2%

Valuation model based on NG and Crude

The $6.50 NG & $75 crude cases closely reflect current long term strip prices. It’s therefore quite easy to make the case that MTR has 50%-60% price appreciation potential. If you believe that Natural Gas is going to move closer to it’s longer term average. My target Crude price is $112 per bbl based on my long term crude forecast and updated long term crude forecast. I have not developed a long term natural gas forecast. McDep is now using $8, $1.50 above the strip. Using $6.50 gas and $112 crude values MTR at $48 for appreciation of 95%.

There have been some problems with Mesa’s calculation of reserve life. They have previously based their calculations on the calculations by the operators that pay royalties. I don’t see a problem with this. However before their 2007 annual report they sought out an independent review of their reserve life. To quote from the 2007 10k

“The December 31, 2007 reserve estimates for the San Juan Basin properties were prepared by a third party reservoir engineering firm, whereas the December 31, 2006 and 2005 reserve estimates were prepared by the Working Interest Owner. Revisions to previous estimate in 2007 are primarily due to professional differences in judgment regarding estimate of San Juan Basin reserves.”

The difference is not small! They cut their natural gas reserves in half and their liquids by more than half. On that basis the trust has reserves until about 2020 which is my baseline case. However, if the professional differences are in fact in favour of the operators then there could be substantially more reserves and a higher value for MTR.

Liquidation Year	MTR Value @ 6.5/75	Additional Value
*2020*	*$ 39.48*	0%
2021	$ 42.21	7%
2025	$ 51.83	31%

Valuation Sensitivity to reserve life

MTR is a trust and as such has no management (and no management expenses) only a trustee. SEC filings are sparse and currently quite late (due to the reserve issue mentioned above).

The value of MTR increases in direct proportion to the price of natural gas. A 10% rise in long term natural gas prices causes a 10% rise in Mesa’s value. Therefore you get to participate on a long call on Natural Gas prices while you are paid 8% to wait. Compared to UNG (MTR has a correlation of about 80% to UNG) where you have a cost of carry and management costs MTR is a fantastic deal.

I have no idea when natural gas will recover. The beauty of an idea like this is you get paid to wait and then you get paid once the waiting is over. The main risk is these sorts of ideas is truncation risk and that isn’t going to happen when there is no debt.

Mesa Royalty Trust has no debt and no management risk. There is 60% price appreciation to very conservative energy price assumptions. There is substantial leverage to additional reserves and higher long term energy prices with little risk and actual reward while you wait.

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.

Strike Resources Limited (SRK SRK.ax)

2009-01-07T02:26:00.003-06:00

I've spent some time looking into Strike Resources Limited (SRK) after seeing that they were a major holding of Orion Equities Limited (OEQ) which is trading at about 1/3rd of book.

At face value Strike (SRK SRK.ax) is a resource company selling for 2/3 of cash of hand. They have an iron ore tenement that may have been worth as much as 400M to them at the peak along with a coal mine that will nearly pay for itself in one year of cash flow. This is what attracted me. On the downside here is some history of the founders:

Farooq Khan and Victor Ho are both executive directors of Strike. They founded a company called FAST SCOUT LIMITED which started trading in March 2000. They almost immediately announced that they were going to attempt to list on the NASDAQ in the US. They had no product or revenue. In their first year they were involved in court case. By 2003 their principal business was Employee Internet Management and management of share investments. They lost 11M in 2002 and 1.7M in 2003.
By 2004 their principal activity was Virtual Web internet filtering, the pursuit of other internet technologies and the management of investments. They lost another 1.6M. They also became involved in yet more litigation this time with Rivkin Financial Services Limited. Fast Scout were accused of insider trading though the judge found no merit in the case.
In 2005 they announced a proposed change in business activity to the resource sector. They lost a further $1.7M in 2005 and changed their name to Strike Resources as well as raising new capital.
By 2006 they were a resource company with Iron Ore, Uranium, Gold and Copper exploration opportunities. They lost $2.2M.
In 2007 they IPO’d their uranium portfolio as Alara Uranium Ltd (which is now trading at 3c). They made 2.3M in profit including the IPO profit from the Alara IPO. Aside from that non-recurring item they lost 4.4M. They removed uranium from their business description.
Farooq Khan and Victor Ho took $2.4M in compensation, including equity compensation, in FY 07, remember this is against a loss from continuing operations of $4.4M. Directors in total took $6.2M including equity compensation.
OEQ - Orion Equities Limited also has Farooq Khan and Victor Ho as directors along with Yaqoob Khan who was originaly a director of Fast Scout. OEQ owns a substantial numer of SRK shares. OEQ sold the Berau Coal Project to SRK in exchange for shares in SRK and options. This allowed OEQ to show a $17.5M gain albeit non-cash. Farooq owns 50% of OEQ though Victor Ho owns none. At face value, selling the coal assets to SRK is a transfer of wealth from SRK shareholders to OEQ which is 50% owned by Farooq. It's worth asking yourself why OEQ sold Berau Coal when it did.

Strike is now locked in litigation in Peru and criminal charges have been discussed. Of course SRK's management insists that the claims are without merit. Peru is a good location for mining. The independent Fraser Institure has published an index of locales. Peru scores about 55 along with New South Wales and Victoria! Their Iron Ore tenement may really be a valuable asset.

As for their coal mine; Indonesia scores a 15 out of 100 as a mining jurisdiction and is 7th from the bottom of the list. Another mining company executive is quoted as saying “Indonesia: No security of tenure, transparency, etc. Shame, as it is technically one of the best countries in the world to explore.”.

It is critical to understand that $40M USD of capital expenditure or $57M AUD would leave $16M AUD if they don’t spend another cent on any other corporate activity. That expenditure will be in one of the worst mining jurisdictions in the world. That is assuming that the capital expenditure is really only $57M AUD. If it goes over by 25% then SRK is out of cash.

To value Strike you have to look at their cash and what it’s going to be used for. If the Indonesian mine goes ahead next year then there will be little to no cash left in the bank. So it isn’t reasonable to value SRK based on today’s cash when they have already planed to spend it.

All in all the origins of this company are very shaky. They’ve never really made money and the founders look like professional promoters switching from hot sector to hot sector while spending time every few years in court. Their new directional shift to Indonesia probably continues their money losing tradition and in 2 years time they’ll be explaining how the mine isn’t producing anywhere near forecast due to political issues. They’ll also have used up the cash they need for their one great iron ore asset in a secure jurisdiction. Finally they are paying themselves substantial amounts of shareholder money (cash and equity) while continuing to lose money.

I’m tempted buy at 38c but I have to pass.

Investing in Gold, Junior Miners and Certificates

2009-01-03T20:42:00.005-06:00

In my previous post I mentioned a couple of reader questions. This answers the second question.

I want to invest in gold, I love junior miners but with such a decline in the Australian dollar are Perth mint certificates worth considering?

My answer for gold is quite similar to the answer on shorting US dollars. I think the best position is in gold mining shares. They will benefit substantially from the drop in input costs (steel, fuel, rubber etc) and gold isn't down much. The equities have been hammered and that doesn't reflect the overall value in the gold stocks. I was buying Novagold but stopped after their announcement regarding cash flow problems. As of Friday these have been resolved on awful terms to existing shareholders. However the price of Novagold, now, with their cash problems resolved, is attractive.

I like Northgate Minerals (NXG NGX.TO), Western Goldfields (WGW WGI.TO), First Magestic Silver (FR.TO) and Silver Standard Resources (SSRI). These are all producers or about to be producers. The interesting thing about gold/ silver mining is that inputs and outputs are in large part determined by global forces so currency fluctuations don't matter as much. The US miners are going to benefit from a falling USD as it will lead to some costs decreasing as compared to the price of gold. That makes them somewhat attractive even if you're buying in CAD or AUD. If you buy an Australian mine then input costs will decline with a rising AUD but so will realized gold prices.

Given that exchange rates mostly even out for gold producers and quite a few other commodity producers, the best criteria (aside from value which is obviously paramount) is politically secure reserves.

Perth Mint Gold certificates in AUD or USD bought with a 3rd currency (such as CAD) will perform identically as certificates purchase in that 3rd currency (such as CAD). The gold versus exchange rate movements all cancel each other out. ABN AMRO Markets offer something called a QUANTO certificate which takes the USD movement in gold and applies it to another currency. Primarily Euro of CHF. You could probably create such an instrument with GLD and currency options.

It is reasonable to assume that worldwide government reaction to the financial crisis will be inflationary. Warren Buffett has said as much. Buying gold mining shares selling at substantial discounts to net asset value (which is relatively easy to determine) is a good way to benefit though it's important to realize that input costs will also rise.

Shorting the US dollar

2009-01-03T20:38:00.006-06:00

I received a couple of questions that I thought a broader audience may be interested in reading. The first question regards the US dollar and the second on gold. I'll post the gold answer later.

What is the best way to short the US dollar

There are probably five primary ways to do this.

1. Through forex ETFs or mutual funds. I think http://www.merkfund.com/ has some that might be interesting. I think one of his funds does currencies and gold. All of these are implicitly short USD and long something else

2. Currency futures. Your risk reward is the same as a regular forex transaction except instead of daily interest you receive interest in a zero coupon fashion through the price paid. A forex position has no expiry whereas a futures position does.

3. Currency future option. This has a well defined risk, never more than the option price paid. The upside is the same as the currency futures position. This loses value over time as do all options.

4. Forex position. This is effectively borrowing in one currency to buy another. This is really no different to taking a 100k loan from your bank, converting it into another currency and then depositing it in that currency. In fact, that is the mechanism that is used. This can be achieved with an extremely low margin value (2%). Therefore the upside can be substantial compared to your margin but you can also easily get wiped out unless you fully fund the transaction (i.e. don't use margin). You earn interest in the long currency and pay interest in the short currency. If you make money on the spread then it's is said to have negative cost of carry and conversely there is a cost of carry.

5. Investing in productive assets in foreign countries. This is simply investing in foreign countries. If you are US based then it might be investing in Europe, Australia, China etc. If you can find undervalued assets in these countries then you get the double whammy of currency appreciation and price appreciation. You also receive dividends in the foreign currency which over time should grow. This is ultimately what Buffett ended up recommending after taking type 2 or 4 positions previously. He realized that the cost of carry created a situation whereby he needed movements to occur in a certain time frame.

You need to be careful that the company you are investing in overseas doesn't cancel out your forex position. A retail business would have expenses in foreign currency (buying products from china) and in local currency (staff) and all profit would be made in local currency. A service business would likely have both profit and loss in local currency. A gold mine would have profit in foriegn currency (based on the USD gold price) and costs largely in foreign currency (USD price of tractors, diesel etc).

As I am investing with Australian dollars and I expect the AUD to appreciate against most currencies then I am forced to primarily invest in Australia. As I expect to lose money on any foreign positions based on Forex movements. I have somewhat hedged this with out of the money currency futures options but they have a cost which is unfortunate. If I earned or invested based on USD today then I'd be almost entirely invested outside the country.

As a value investor the most business like approach here is to invest in productive assets overseas. Have those assets grow and create earnings in foreign currencies over time. The problem with all the alternatives is the ongoing costs and the requirement to not only be right but to be right in a specific amount of time.

If you were determined to make a speculative bet on currencies I'd recommend options. Just make sure that you have sufficient funds to roll positions over for a few years and the discipline to actually do that. I've bought quite out of the money AUDUSD options at below 1% of face value because I believe when the currency moves occur they'll be quite significant and because I don't want to use much capital in case it takes a long time.

Turnaround

2008-12-28T03:52:00.003-06:00

I'm going to write some more about my 2009 forecast and 2008 results in a future post but here are some of the broad ideas. One of the key things I'm expecting is a substantial recovery in base metals, energy and broadly in commodities. This is simply because prices have fallen so far that the economy can do badly and still perform better than the market is expecting. I expect that:

This will not be as bad or even nearly as bad as the great depression
Prices have overshot to the downside, in part due to deleveraging
The recent situation is unprecedented and the response from government and monetary authorities has been unprecedented this will bring forward the recovery in commodity prices (at least relative to dollars).
The US Dollar is going to go down substantially once the deleveraging ends, this will be more like quarters than years
US Treasury bond prices are unsustainable but may remain that way for some time. They are the short of the decade but you may not see any reversal in the next 12 months (don't fight the fed, the fed wants rates very low right now).
Many stock are an excellent buy at current prices based on the underlying value of their businesses.
The worldwide fiscal response is targeted at infrastructure projects this will add incremental demand to commodity prices while low prices in the later quarters of '08 have reduced supply.
The major drop in asset prices was caused by credit markets seizing up, this problem is coming to an end (based on indicators such as the TED spread) though the economic slowdown persists. Half of the reason for the decline is resolved and asset prices will start to reflect this even while economies are in recession
The stock market will turn in advance of the economy. There will be no economic news to indicate that stock prices are going to turn.
Broad markets will probably retest their recent lows in the first half of 2009. It could be profitable to buy some insurance at today's and increasingly higher prices.
Commodity stocks survived 7 months into the US recession and 10 months into the bear market. They are fundamentally unimpaired and will likely lead us out of the bear market.
Bank stocks will likely do well over 2009 because they were likely priced for the end of banking. Unfortunately they are too complicated to analyse so I won't be touching them.

There are two great articles one from the WSJ and the other from Fortune by Ken Fisher which broadly agree with me.

As a value investor the right question about the above is so what! As Seth Klarman explains in Margin of Safety when you make macro calls you need to be right on the call, make it before everyone else does, make it before the market has priced it in, convert the idea into the correct trades, identify when the trend has become correctly priced and again trade out. This is vastly harder than buying undervalued securities of businesses and then selling them when they reach fair value. Therefore the only real take away is that STOCKS ARE CHEAP RIGHT NOW(especially resource stocks)!

AHUG - A good value investment

2008-12-06T23:11:00.002-06:00

I've likely lost between 10% and 25% on my AHUG investment which I've written about here and here.

In my last analysis I outlined the risks but left out the one that occured. Allco went into administration. There was an offer in excess of $45 on the table before that. The administrators have now negotiated away most of the money that was going to AHUG, to Allco's banks. AHUG holders will now get about $11.53 plus a share in the liquidation of the HIT trust.

The HIT trust had

$9M in cash as of September 30th.
As of 30th June they also had $58M in various investments offset against $53M in loans
$2.8M in receivables and other assets.
$6M in payables.

That would net out to $8.2 in assets or $8.47 per unit of AHUG. They would probably not realize that much but it seems unlikely that there would be less than $2 a unit.

AHUG holders are being asked to vote to accept $11.53 plus the residual in the HIT trust. For AHUG to be worth more lots of legal maneouvers would need to go well. They are:

Trust applies to have proceeds of Alleasing sale quarantined while they try to enforce the letter of support (LoS)
Trust receives leave from the courts to pursue the LoS
Trust is succesful in enforcing the LoS form some amount.

If the trust could not get the monies quarantined then a succeful case would leave AHUG holders as unsecured creditors of Allco which is probably worth nothing.

I'd estimate the likelyhood of success here would value AHUG higher than $11.53 and i'm sure the receivers recognize this. Instead they are using the current fear to bully holders into a worse position. (This reminds me of deal or no deal where the banker offers an amount worse than your expected value but the fear of loss causes the player to take it).

I, for one, accept the bullying and will vote to accept the $11.53 plus the residual from the winding up of the HIT trust.

I'm left thinking that this was the perfect value investment. A good chance of making multiple times my investment (heads I win) and a small chance of losing a little (tails I don't loose - much). The actual chain of events was almost unforseeable back in August, yet the inherent margin of safety in buying 60c worth of assets for 17c resulted in a managable loss. This position has far outperformed the market since August!

Seven Networks (SEV)

2008-12-04T01:37:00.003-06:00

Seven Networks (SEV) is the parent company of a number of entities including a joint ownership (47%) of the Channel Seven TV network. SEV has the following assets (per share based on 222M shares) as at 30 June:

* 1.2Bn in cash (5.45 per share)
* 1.2Bn in equities including 20% of WAN (5.45)
* 800M in Seven Media Group (the Channel Seven JV) (3.64)
* 25M in property (.11)
* Telys (prefered equity described below) (-2.25)

As of 19th September they gave an update on their equity portfolio and cash
* 1.3Bn in cash (5.91)
* 1.1Bn in equities (4.97)

There has been some discussion in the press about Seven Media Group (SMG) being essentially worthless because of their debt. They have about 2bn in debt and then effectively 1.6bn in equity split between KKR and SEV. They do not pass dividends back to SVN because all of their, currently depressed, earnings go to pay off the 2bn in debt.

SMG may be worth zero. In SEV's last filing before spinning out SMG they had 1.8Bn in assets of which maybe 1.4Bn are attributable to SMG. Net of SMG's debt, which is obviously NOT recourse to SEV, there may not any asset value. That 1.4Bn is at cost, though so property etc may be worth much more. There also hasn't been any dividends paid from SMG to SEV because all the cash is used to pay interest. It seems likely that there is still some value in SMG but a lot less than the $800M at cost.

Adding the most recent numbers up you get about 8.74 excluding SMG or 12.38 including it as valued on the balance sheet.

They have announced and are conducting a share buyback. They are repurchasing up to 40M shares and seem to be doing so below $6. Assuming that they repurchase 40M shares at $6 with the most recent equity prices you get:
* 0.96Bn in cash (5.33 per share)
* 1.1Bn in equities including 20% of WAN (6.08)
* 800M in Seven Media Group (the Channel Seven JV) (4.44)
* 25M in property (.11)
* Telys (prefered equity described below) (-2.76)

Which would be 8.79 without SMG or 13.24 including it.

SEV has no debt and isn't liable for the debts of those companies that it invests in.

There are also preferred shares (TELYS) outstanding trading as SEVPC. They are trading at 76.1c on the dollar and yield 4.564% on face value or 6% if purchased today and they're fully franked which is the equivalent 8.6% interest with no franking. They step up by 2.5% in May 2010 and are perpetual so they don't have to be redeemed. They have a 27% yield to maturity if they were redeemed on May 2010. The YTM is reduced to 20% if they were redeemed in May 2011. Of course they may never be redeemed in which case based on today's interest rates you'd get 10% before tax. The $496M of SEVPC outstanding could easily be redeemed with SEV's balance sheet though I expect it's not in the best interests of shareholders to do so at the moment. The SEVPC money is effectively paying for the share buyback.

Book value in July 2007 was 10.31 a share and the stock traded above that and as high as 14.46 (for one day) before the current retreat. SEV pays a 6.2% franked dividend while you wait.

Kerry Stokes is the major shareholder in SEV and he is likely to deploy the cash at rates of return better than cash. As he holds around half the shares outstanding you should expect him to act in the interests of share holders! There is an excellent interview in the Australian with Stokes where he clearly lays out, in April 08, that he expects media values to fall substantially and then he will become a buyer.

In buying SEV you get around $8.79 in cash and publicly traded equities, net of the TELYS, for $5.50 as of 4th December. Adding in a token amount for SMG you get $9.35. The equity portfolio likely owns shares that in turn are substantially undervalued. You also get the opportunity to participate in the upside if SMG's situation improves. Finally you get Kerry Stokes to find cheap media companies during a crisis with the 900M he deliberately kept for such an occasion -- all for free!

2008 February – December Predictions Closing Some Positions

2008-11-18T04:08:00.003-06:00

Of my 7 levered ideas for 5% of your portfolio in 2008 I think that 1,2,3 & 6 are pretty much ready to be closed out:

1. NASDAQ will see another major fall off a higher peak. QQQQs see less than 40 (buy puts on QQQQ especially as it heads higher) (45.59 on Feb 1 - now 28.37, puts would have made about 8-10 times your money)
2. Junk bond spreads widen substantially (buy puts on JNK) (46 on Feb 1 - now 30.43, puts would have made about 8-10 times your money)
3. Japanese yen appreciates against a basket of currencies but especially against the Euro (and maybe GBP) (long JPYEUR) (.0063 on Feb 1 - now .0082, 30% unlevered return)
6. The banking index falls even more from here and banks keep announcing new write downs every quarter (buy puts on BKX RKH) (96.11 Feb 1 - now 46.12, puts would have made 10-12 times your money).

I'll review the performance at the end of the year but I think these have had most of their appreciation.

Opti Canada (OPC OPC.to)

2008-11-08T18:51:00.004-06:00

I've written extensively about Canadian Oil Sands Trust since 2005. I've recently looked into Opti Canada. An oil sands company about to start commerical production with a somewhat modified, cheaper, process. OPC (OPC.to) is trading at CAD $2.54 and is almost certainly worth CAD $10 +, potentially even closer to $20 over the longer term as they have a very long reserve life and a cheap cost of production.

The problem is debt!

They CAN run out of cash and/ or they can violate covenants on their debt. S&P announced today that Opti was placed on CreditWatch with negative implications. There is a "very real risk of violating its covenants on its revolving credit facilities should there be start-up problems with the upgrader or bitumen production does not ramp up to expected levels in first-quarter 2009,"

It is important to understand that the risk of violating convenants doesn't mean that they ran out of cash. They can still have cash available but their $500M credit line could be withdrawn.

It's very likely that there will be problems getting the plan to commercial production, we just don't know if they'll be sufficient to violate covenants. I can't even find a good reference to what all the convenants are. I've been able to find that there is a covenant relating to debt to equity (though not calcuated on a GAAP basis) and I've also found that they need to declare they have sufficient cash to complete the project before drawing down any additional cash. Furthermore their $100M short term revolving credit line expires in June 09 and will need to be refinanced or extended.

Anyone buying this needs to understand that you have a chance to make a lot of upside and a chance to lose all you investment. Compare that with a Canadian oil sands trust or Suncor; you have a chance to make 3+ upside and no (almost no) chance of losing it all.

I've bought a little OPTI but without detailed disclosure on the covenants you're flying blind. The Notes are selling at 68c on the dollar or a 17% yield to maturity.

Interesting Reading - Nickel, Buffett and AUD

2008-11-06T19:40:00.002-06:00

Article in the Australian about Nickel miners. Mincor and Panoramic get favorable mentions.

Brilliant Motley Fool article on Buffett's recent Buy call and how the media is sceptical. The media is always sceptical of Buffett at turning points. He's always right.

National Australia Banks' Ipod Nano index, their version of the Economist's Big Mac Index, shows the Australian dollar as the most undervalued.

Panoramic Resource (PAN PAN.ax)

2008-11-02T08:13:00.002-06:00

Panoramic Resources has a similar story to Mincor. They have cash and receivables of $94M (netted off against about $16M in payables and $26M in tax liabilities) plus $109M in the money hedge book. They have 193M shares on issue which is about 80c a share in net cash and equivalent.

PAN closed at $1.08 on Friday though they have recently been as low as 75c and as high as $6.15.

Their cash costs are $6.05 per lb with current AUD Nickel prices at $8.47 per lb.

Merrill Lynch 5-Sep-08 research report values the company at around $5 per share. Their short term nickel forecast is higher than reality but their longer term forecasts are likely too low ($8.5 in 2011 and $8 in 2012). WilsonHTM value the company at $3.51 with current resources. Their Nickel price assumptions are higher than Merril's.

As with Mincor, there is little downside when the company is selling for cash value (or net cash plus equivalents). It's not clear if the company is worth $3 or $5 but it is worth more than $1.08.

Mincor (MCR MCR.ax)

2008-11-02T02:46:00.003-06:00

Mincor Resources is traded on the Australian Stock Exchange.

They have net working capital of $76M (all amounts in AUD) and total cash and receivables of $111M. With about 200M shares outstanding they have a net cash value of 37c. They are debt free. When you add in the value of their hedge book (estimated at about $39M) then that rises to about 56c per share. The share price closed below 70c on Friday.

Their cash costs per pound are about $5.79 as of the end of September 2008. The current (2nd November) Nickel price in AUD is $8.05.

They have put in place a plan to keep cash costs within $5.4 - $5.7 per lb and are now planning to mine up to 25% less ore if prices remain poor.

A reasonable estimate of Nickel prices for valuation is $11.21 AUD ($8.47USD) . That is based on the 2002-2007 average Nickel price and Australian Dollar USD exchange rate (AUDUSD 0.755). Deutsche Bank's research report on Mincor is based on $9USD Nickel and an AUDUSD of .74. They value the company at $2.80. They traded as high as $5.19 in the last 12 months.

With a conservative 4 times upside and selling near cash and equivalents this looks like a great opporunity.

Purchasing Power Parity Valuation for the Australian Dollar

2008-10-25T23:11:00.002-05:00

With the recent, incredible, drop in the Australian dollar foreign stocks look a lot more expensive based on purchases with AUD. It's very likely that the AUD will eventually appreciate against the USD and lots of other currencies but any investment in those other currencies has an automatic headwind once that happens.

I used the Economist Big Mac Index as published in July 2008 and updated it with the most recent exchange rates. The economist calculated that the AUD was 6% undervalued in July 2008 (at 0.97), that has now moved to 40% undervalued (at 0.62). In July there were 14 major currencies that were cheaper than the AUD, now there are only 7.

South Africa
Malaysia
Hong Kong
Phillippines
Thailand
Iindonesia
China

The following countires fell off the list, even though they are still undervalued, just the AUD fell further

Taiwan
Russia
Japan
Singapore
South Korea
Chile
Mexico

Of the major currencies that I might invest in

Canada could see a 33% depreciation against the AUD,
USD 40% depreciation against the AUD,
Euro 50%depreciation against the AUD,
Japan 28% depreciation against the AUD,
New Zeland 21% depreciation against the AUD,
Singapore 18% depreciation against the AUD.

On the upside
China has about 17% upside but is pegged,
Indonesia and Thailand have 20% upside,
Hong Kong has 25% upside but is pegged,
Malaysia has 40% upside and
South Africa 42% upside.

Those countires with even weaker, unpegged, currencies than the AUD are not exactly the most desireable investment locations!

For example imaging buying a canadian company for $2 CAD with $2.51 AUD at today's exchange rates. If that company rises to $20 CAD but exchange rates move to purchasing power parity then that $20 CAD becomes $16.8 AUD. That is a 6.7 times return instead of the 10 times return in Canadian dollars.

Conversely buying a Hong Kong company at $2 HKD for 41c AUD today would be $5.18 AUD if the company rose to $20 HKD and the currencies moved to PPP. A 13 times return in AUD for only a 10 times return in HKD. Unfortunately the HKD (and largely the Chinese RMB) is still pegged to the USD so it's likely to be weak in the medium term until the pegged is eventually dropped.

The bottom line is that Australian companies with expenses in AUD have a 20%-40% appreciation advantage over other major exchanges right now. This point is unlikely to be lost on international investors for long and makes a strong case for AUD denominated accounts to remain local.

Strathmore Groundhog Day

2008-10-25T00:38:00.003-05:00

See my previous posts on STM here, here and here.

It is worth looking at the previous, savage, bear market in Strathmore's stock to understand why things will work out ok this time around. Yahoo has STM weekly price records back to late 1997. It started trading at about $3.85 in late '97.

In March 2001 it dropped below 30c for the first time. It then bounced around reaching a low of 6c and didn't definitively break back up above 30c until October 2003. That is about 2.5 years.

It rose to $5.18 in May 2007 and first broke 30c again in October 2008. If history repeats we could go nowhere for 2.5 years and we'd be looking at 2011 before Strathmore's stock price recovers. Though keep on reading to see why I don't think it will even take that long.

March 2001
In March 2001 Uranium was trading around $7 per pound. At that time STM "elected to sharply reduce its expenditures and conserve cash. The Company eliminated all exploration and pared back on the non-essential properties decreasing the number of claims held ". As of December 31st 2001 they had $119,000 cash and equivalents. They periodically sold shares to raise a few hundred thousand dollars primarily to stay in business. In the year 2000 the loss for they year was $400,000.

2002
By the end of 2002 they had $11,784 in cash and equivalents and used $213,735 in cash for the whole year 2002. By this point there were about 8M shares outstanding.

2003
By June 30th, 2003 they had $5,308 in cash and equivalents and were spending annuazlied about $300,000 a year.

October 2008
In October 2008 STM broke down below 30c. Spot uranium is down to $44 but according to Resource Capital Research's September 2008 review, long term contracts are still priced around $80. The spot prices in the low $40's are "driven by the emergence of distressed sellers and others driven by cash flow requirements according to TradeTech."

This time around STM has around $11M in cash and equivalents. They may have a current burn rate of up to $800,000 a month to meet current exploration commitments.

Future Budgets
The CRITICAL question is what comes next. It seems obvious that once cash gets down to $4-$5M they will dramatically reduce expenses and move into maintenance mode just like they did last time. Even if maintenance costs $1M now instead of $200-$300k last time around, then they will have 4-5 years cash. When they get down to the last couple of million then they can fire everyone and pair back their claims to bring expenses down to the 0.5M level which stretches out their life even more.

It is ridiculous to think that STM is going to keep spending $800,000 a month until all their cash runs out. They have been through exactly this experience before and they have a track record of putting the company on hold while they wait for things to improve.

Similarities to last time

Bear market
Dramatic fall in stock price

Differences to last time

Uranium prices are still profitable for STM, last time around they were not
STM has a lot more money, $11m versus only $120,000 last time
Massive deleveraging of hedge funds
Uranium fundamentals are still in place, last time around they were not. Resource Capital Research says "Planned and proposed new nuclear power reactors worldwide have increased in the past two years. From Jan ’07 to Aug ’08 there was an increase of 96 reactors from 222 reactors (Jan ‘07) to 318 reactors (Aug ‘08), a rise of 43% since Jan ‘07. This compares with 439 nuclear power reactors currently in operation and 36 under construction. A total of 60 new reactors are expected to be commissioned by 2014."

Bottom Line

Uranium fundamentals are still in place.
Strathmore can easily wait 5-6 years, if need be, with current cash reserves. The financial crisis is not going to last 5-6 years. Even if they have to issue equity at 10c to raise $500,000 for another year that would only be 5M shares out of 72M or 7%, compared to 62% of the company back in 2002.
STM has gone through exactly this scenario before, a cratering stock price and a bad economic backdrop. They survived and can use the same strategy this time around.

A hug for AHUG (Allco Hybrid Investment Trust Alleasing Hybrids)

2008-09-27T01:36:00.004-05:00

I wrote about the AHUG securities here in my post about general Allco securities. I indicated that they were worth about 60c on the dollar in the absence of the Allco guarantee. After Allco confirmed they would not honor the guarantee I estimated a value of closer to 50c on the dollar for AHUG based on an Alleasing sale between 120-180M and an appropriate portion of Allco's Mezzanine money to be kicked back to AHUG holders.

My weighted average purchase price across accounts was $17.88 adjusted for purchases made a few days before the previous interest payment.

AHUG was trading at $10 before it was suspended pending a sale of the Alleasing trust which took Allco about 2 weeks longer than they expected. An announcement was made on Friday outlining the terms of the sale:

Sale of Alleasing trust for total consideration of $146M
$20M of that is deferred for 18 months and subject to various conditions, warranties etc
Allco gets $49.9M total consideration
Alleasing gets $49.9M total consideration
AHUG holders get $41.97 within 2 months of completion which is estimated to occur on 30th November
AHUG holders get $8.03 after final payment of the deferred amount subject to adjustments
AHUG holders have to agree and no doubt waive all their other rights

AHUG is now trading again and traded as high as $38.1 before closing at $33, a reasonable 230% rise from the pre-suspension price!

A quick look at the numbers shows that a purchase today at $30 would provide an annualized 119% return or 40% over 4 months followed by an additional 27% after 20 months from now.

The outstanding risks are:

The sale does not proceed - Alleasing needs to continue to pay interest and Allco may still be on the hook to redeem AHUG. Allco had other bidders and would almost certainly be able to find another buyer, though at worse terms
The deferred amount is substantially less than forecast - from today's price almost all the value is in the January 09 payment anyway. The deferred payment is just a bonus
AHUG holders vote down the proposal - Allco can try to force the sale, though I'm not sure this would succeed. Allco could put the trust into receivership, in this case it seems likely that AHUG holders would eventually get more than proposed except if the trust was liquidated which doesn't seem to be in anyone's interests. I don't think a receiver could recommend liquidation if the company is so obviously worth more as a going concern. AHUG holders could still pursue the Allco guarantee.

The trust is worth book value + additional residual value + interest margin + new business margin. This is roughly -30M + 180M + 60M (over 2 years) + 45M (assuming 5% on assets as new business is written). This comes out at 255M. Therefore CHAMP Private Equity, the purchasers, are getting a good deal and ought to be motivated to see this close. Allco are motivated because they have to desperately raise cash to meet debt level agreements. AHUG holders are motivated because they may see 60% in a runoff but that would be in 2-3 years time. Given this business environment, 41% return now and 9% return in 18 months is about the same thing or slightly better.

Therefore a buy around $30 is still looking good and is much lower risk that a buy at $10 before the announcement (and much lower reward).

Strathmore (STM) Minerals Liquidity

2008-09-16T22:35:00.004-05:00

I mostly recently wrote about Strahmore Mineral (STM) here. My valuation hasn't changed but the stock price certainly has. It is now trading around 40c, a price last seen in 2003. This chart is worth looking at to see that this has happened before. Mind you the last time STM traded at 40c long term Uranium was trading at a fraction of $80, about $10 in fact during a bear market.

The only real, fundamental risk that could justify such a low price is running out of cash. A quick analysis can put that issue to bed:

Their cash burn rate is between $2m and $4m per year. This is substantially within their control based on how much they spend on exploring, advertising and travel. They have $1M cash on hand (after paying $1m for Chord) and $10m in bonds and bond funds which were unimpaired as of June 30, 2008. They also have about $4m in unlisted investments which could be worth something. They are also due $400,000 from Great Bear upon execution of a deal to buy Chord. If the deal doesn't happen then the cash won't come.

Let's take the most conservative approach and say $11m cash and REAL cash equivalents. That is at least 3 years worth of cash expenses and it could almost certainly be extended out further.

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.

The obvious question is what could have caused such a fall in their share price. I think the obvious answer is that there is not much liquidity in their stock. Only a few hundred thousand shares trade every day and a big player is having to sell. Consider that Sprott had an interest in Strathmore and the press is reporting substantial redemptions. Even if Sprott wanted to increase their Strathmore exposure they would achieve that by selling less than they sell of other things. Buyers are scared to death and probably (like me) spent most of their available cash buying at the terrific prices on the way down to here!

Risk Reward 5 years : 15:1

Allco Securities (AFG AFGHA AHUG RJT)

2008-08-23T01:48:00.003-05:00

Allco AFG - The Parent Company
Allco's (AFG) stock price has fallen from a 52 week high of 11.45 to 44c as of the close yesterday. Allco had senior debt coming due and market capitalization covenants were triggered, this lead to doubts that they were going to be able to refinance. On 15 July they announced an agreement with their banks to roll over the debt until September 2009 and that the market capitalization covenants had been removed. As a result they are paying a little more interest on their borrowings.

As the major risk has been removed I had a look over some of the securities inside the rather complex web of Allco. In summary, based on the liquidation value I think that the AFG equity is probably worthless (except as a call option).

Allco Subordinated Notes AFGHA
AFGHA, the Allco subordinated notes are probably worth about what they're trading for based on assets - around 20c on the dollar (while paying 50% interest). A Yield to maturity of 57% if you wait until redemption in 2017 or 84% if you can redeem on reset in 2012. This is based on valuing their various business as follows (this is equity so debt has been subtracted from assets, in the case of debt exceeding assets the equity has been marked at zero if the debt was recourse):

Aviation - $723M (equity value on their balance sheet less intangibles)

Rail - $42M (equity value on their balance sheet less intangibles)

Shipping - $134M (equity value on their balance sheet less intangibles)

Infrastructure - $154M (equity value on their balance sheet less 20% discount on equity holdings less intangibles)

Property & Financial Services - $0 (negative equity, non-recourse debt)

Funds Management - $40M (equity value on their balance sheet less 60% discount on equity holdings less intangibles)

Group Investments - $160M (20% discount on assets used to calculate equity value on their balance sheet less 80% discount on equity holdings less intangibles)

Total assets of $1,255M versus corporate debt of $1,539M. This clearly leaves no residual for equity. There are $341M of notes outstanding which are impaired by $283M, leaving a face value of 17c on the dollar. Right now these subordinated notes are effectively the non-voting equity of Allco. They're trading at 20c. It seems very likely that Allco will continue as a going concern so the notes will pay out a 50% yield each year with little risk of capital loss because liquidation value is around the current price (except to the extent that I've overvalued any parts of their business). I've reduced their equity by 2.7Bn. The company has indicated that it is going to write down closer to 1.5Bn so my assumption is that reality is much larger. There is little margin of safety in a liquidation but as a going concern you get 50% interest per year which is a reasonable margin of safety.

Alleasing Debentures AHUG
AHUG the Alleasing debentures are probably worth 50-60c on the dollar (without the Allco parent guarantee), they're currently trading around 20c with a 50% yield and they are due to be redeemed on 17th August 2009 at par (105c on the dollar in this case). That is a yield to maturity of over 400% if they are in fact paid out at par. There is a reasonable case that they will be paid out at par because Allco has given the trust a letter of support to:

"provide sufficient financial assistance to Alleasing Trust and its controlled entities (...) to enable them to continue their operations and fulfill all their financial obligations until at least September 2009." Allco financial report 31 December 2007.

I expect that Allco is going to arrange a sale and as part of that sale they will ask the debenture holders to take a haircut, maybe more like 60c on the dollar leaving a 200% yield to maturity.

This Brisbane Times article (http://business.brisbanetimes.com.au/business/shareholders-cop-risks-of-deals-with-allco-bosses-20080309-1y8k.html) discusses the letter of support and the likely strength of such a letter. It says they are usually binding and would usually have been approved by the board. The article also says that Allco’s problems are due in no small part to all the self dealing between the company and it’s executives.

This Sydney Morning Herald article (http://business.smh.com.au/business/allco-mulls-alleasing-sale-20080408-24kz.html) indicates that there has been some interest from buyers in the Alleasing trust. They were interested in paying in excess of debt, though in this case it’s not clear if they mean the mezzanine debt or the debentures.

On liquidation based on the balance sheet AHUG doesn't have any value and the mezzanine finance provided by Allco would take a haircut based on the balance sheet as I’ve adjusted assets as follows:

Initial total assets: 850M

Other: -7.2M
Deferred Tax: -21M
Intangibles: -120M

Revised total assets: 706M

However, the residual values of leases are under reported by accounting convention. Once this is adjusted for, along with additional earnings losses, then the debentures have value of around 50 to 60c:

Revised total assets: 706M
Additional Residual value: 175M
New Assets: 881M

Revised Liabilities 954M

Again assuming that Allco does not honor the letter of support. The debentures worth 50 - 60c obviously wipes out the equity.

Rubicon Japanese Trust RJT
Since I wrote about this RJT has revalued their assets. See my comments in brackets
Finally RJT is the Rubicon Japanese Trust. This is a managed investment scheme invested in Japanese property. They are managed by Allco (Allco is the Responsible Entity). RJT had a similar problem to Allco in that senior debt was coming due and the trust was concerned that they may not be able to roll it over. In addition they were getting increasingly large margin calls on their foreign exchange hedges. On 1st May 2008 they announced that they had reached an agreement with their banks until 31st March 2009. Under this agreement they need to reduce their debt and unwind their forex hedges. They confirmed their earnings expectations for the year in the same announcement.

RJTs balance sheet's assets seem real and the property valuations are quite recent. It is possible that some property values will have moved to the upside since the property valuations. Therefore in an orderly liquidation you'd need to know the discount from book that the properties would go for. I have no idea but the market is estimating a 25% discount to book. Given that property prices in Japan have held up I don't expect it's more than 10% which leads to a NAV of 53c ( The revaluation was 14% in JPY and 18% in AUD. This is much higher than I expected ), a 500% increase from the last trade at 8.8 cents. ( now their NAV is 30c and the shares trade at 6c which is a 500% upside). Part of the trust's strategy is to sell some assets to reduce short term debt and to buy back some securities. They were originally envisioning using 50M to buy back units. At today's price you could buy back the whole trust and still have $10M left! ( They are unlikely in a position to use cash to repurchase units when they are so close to exceeding debt covenants ) A catalyst will occur once a few sales happen at close to book value, debt is retired and the buy back begins. The trust is not going to pay distributions for a year or so. This has contributed to the price decline but is a positive for the NAV of the trust because it increases their viability.

Once the debt issue was resolved (or postponed for a year) there was still the problem that the Responsible Entity, Allco, might become insolvent. If this occurred then it would likely affect RJT in multiple negative ways. As Allco has just announced a resolution (or at least a temporary one) to their debt problems, RJT appears to have at least a year to get back on track by reducing gearing and working to reduce the gap between NAV and market price.

A couple of investors have taken a 5% or larger position in RJT, after Allco's position was liquidated on a margin call. They include Babcock and Brown, Yu Man Ying Lulu (the daughter of the chairman of Hong Kong Construction- a major Chinese property developer) and Ingot Capital Management (the managers of a UK based investment fund). The selling pressure has likely been exasperated by selling as a result of margin calls and broker failures such as Opes prime. ( the problem with RJT now is that they are very close to exceeding gearing covenants. They have warned that exceeding such a covenant due to a further reduction in asset values could trigger a number of loans to become due immediately. On this basis this does not seem like a reasonable risk. NAV after the revaluation stands at about 30c per share )

In order of return we have RJT 500%, AHUG 400%-200%, AFGHA 57% and finally AFG 0%. ( since RJT is so close to exceeding their debt covenants AHUG seems like the best choice followed by AFGHA and finally RJT seems worth a small punt)

Sensible Comments on Australian Banks

2008-07-23T10:21:00.002-05:00

The publisher of the Intelligent Investor, an Australia based value investing newsletter was on sky news talking about Australian Banks. At last someone is saying that the banks have opaque balance sheets and even as the interviewer tried to bully him into recommending banks the publisher stuck to his position. He couldn't recommend the banks because no one know what the true state of their assets and liabilities are.

Aussie Banks Gone Wild

2008-07-15T03:27:00.004-05:00

I wrote about banks in late April , specifically that it was impossible to value them. This was generic but I think the Australian situation is worth discussing in more detail.

There are lots of market prognosticators in Australia promoting the banks as a fantastic investment. They've fallen so far and have such high yields. The fact is no one knows what Australian banks are worth right now because there is no transparency about their assets and liabilities.

The "Barefoot Investor" a common sense, popular, newspaper columnist, talks about Australian banks as being "strong companies" that you can "buy on the cheap". He goes on to say "Investors are reacting as though Australian banks are as vulnerable as their problem-prone European and US counterparts. They aren't." . The fact is he has absolutely no idea how prone they are. They don't have to report their assets and liabilities in a way that would give him or any other potential investor any idea about their financial strength.

According to the "Report on Foreign Portfolio Holdings of U.S. Securities" there is 32.6bn of long term US agency debt sitting somewhere in Australia. There is a further 10bn of US Treasuries, 27Bn of corporate debt and 6.6bn of short term agency debt. For a start they have lost 10% (10% of 70bn is 7bn) over the last year in foreign currency movements or 33% over the last 3 years. The agency debt is not over mortgages (houses) but is only secured by Fannie and Freddie.

"Australians are more indebted than Americans and Australian houses are higher priced and less affordable than those in the US. If anything, the Australian economy is more vulnerable to a housing/mortgage market crisis than the US.". This article briefly discusses the difference between US and Australian accounting standards. The fact is that Australian banks do not need to mark their assets to market and instead show them on their balance sheet at cost. This means that all the garbage they have purchased from the US, such as the CDO & CLO exposure that NAB had to admit to lately, is still shown at the price they bought it for rather than the much lower price that they could get it for it now.

The banks have not come out with voluntary disclosures about their assets and liabilities precisely because they don't want you to know.

Try this at home and see if the bank will value your home at what you paid for it when the price goes down!

So far we've covered the fact that banks have toxic product on their balance sheet and that they don't have to value at market prices. There is another enormous set of liabilities and assets that they have completely hidden off their balance sheets. This includes derivatives with a notional value of 12.9 Trillion. Far more than the $110bn of equity capital (as of February 2008, the equity is probably much lower now and the liabilities have probably risen). As of September 2007, Westpac had nearly 100 times their equity in derivative exposure. The banks may believe that they have "slick" risk management systems but so did a long list of US and Australian institutions that are no longer with us. These systems use models based on the recent past and there is a long history of them failing at inflection points.

Analysts and journalists are all making the same mistake. They're looking at the earnings power of the banks and not at their balance sheets. Sure the banks competitive position is improving. The problem is - are they a viable going concern?

To value a bank and know that it's a viable going concern you need to be able to evaluate all of these factors. The banks do not release the appropriate data for you to do so. They may be a great buy at these prices or they may be technically insolvent. It's foolish to recommend them when the data just doesn't exist in the public domain to analyse them.

Strathmore Minerals (STM) Comparative Valuation

2008-07-10T06:49:00.004-05:00

I wrote about Strathmore Minerals back in 2005 , it has done a wonderful round trip from around $1.8 up to $5.50 or so and then back again to about $1.51 today. In fairness they spun off 1/3 share of FIS which is worth about 25c.

I mention this because Rio Tinto just sold their Kintyre deposit in Western Australia. They received $495M USD for between 62-80M pounds of Uranium Oxide (U3O8).

Importantly

Rio never completed a JORC compliant reserve estimate

You aren't allowed to mine Uranium in Western Australia and both the state and Federal government are against Uranium mining.

Rio has sold the in ground resource for $5.88 to $7.69 per lb. Of course grade matters and based on this reference the grade in Kintyre is bettwen 1.5 - 4 Kg/t U3O8 (.15% - .4%).

Strathmore's average site has a grade of 0.7 Kg/t and only a quarter of their pounds on an equity basis exceed 1.5 Kg/t. Their best grades are at 2.1 Kg/t. Clearly none of STM's areas are as high quality as the Kintyre deposit. That has to be balanced in Strathmore's favor against the fact that mining Kintrye is currently illegal.

STM has between 1.3 and 1.6 lb per share depending on how you weight the measured, indicated, inferred and non-NI 43-101 resources. At the price Cameco and Mitsubishi just paid, STM would be worth $7.5 - $12 per share. STM is worth less because of the awesome grades at Kintyre but this needs to be balanced against the uranium mining ban and lack of JORC compliant resource estimates.

Asian REITS

2008-07-08T02:10:00.002-05:00

Marty Whitman and Warren Buffett have both recently, in their own way, promoted owning productive assets in currencies that will appreciate. Buffett has highlighted that it’s better to own productive assets than straight currency because often in currency transactions there is a negative cost of carry (which I’m experiencing right now with my short GBP JPY and short EUR JPY positions).

Whitman has explicitly commented on his large holdings in Hong Kong and lesser holdings in Japan. Hong Kong is so exciting because the Hong Kong dollar is still pegged to the US dollar and unlike the Chinese RMB has not moved at all. It is inevitable that the HKD will either freely float or be replaced by the RMB. Either outcome will move it vastly from its current 7.79 HKD per USD peg. A quick and dirty estimate would be the Economist Big Mac index which puts the rate closer to 3.73 . Singapore scores about 18% undervalued and Japan about 17%. Other PPP analyses point in the same direction.

Hong Kong, Japanese and Singaporean businesses, where the primary income is foreign sourced, will not see the sort of appreciation that a domestic business will realize when the eventual exchange rate revaluation occurs.

With the current subprime and gradually spreading (to Alt-A) mortgage morass, companies that own real estate worldwide have been impacted. Their cost of capital has gone up substantially. They have had trouble refinancing and investors have sold their shares because of the sector taint. Hong Kong is not going to get any more land, neither is Singapore or Japan though Japan is getting fewer people which is somewhat equivalent. These factors lead me to look into Singaporean, Hong Kong and Japanese companies in the real estate business and especially REITs.

It’s easy for an outsider to think that Japan must be coming out of its economic slumber because things have been so bad for so long. In fact left to its own devices it may well. Unfortunately its public companies appear to be driven by something other than a desire to reward shareholders (http://seekingalpha.com/article/73151-bureaucrats-parochialism-and-the-japan-discount). In researching a number of real estate related companies they are all in many different businesses (one was in real estate and fish food). Their return on equity is woeful (though ROE is woeful across the board in Japan) and the business environment is against them. Finally many of them actually lost money on an operating cash basis. This sounds like an opportunity if only there was some catalyst. From the government on down, it sounds like Japanese companies are as staid as ever. Every Japanese company thinks it’s a conglomerate. US companies have wisely spun out non core businesses so that you are left with an easy to analyze, consistent core. Trying to analyze Japanese companies (when the report is even published in English) is difficult.

Singapore ends up in the middle of the pack with some good discounts to net asset value, better distribution yields and excellent medium to long term asset appreciation potential. The currency doesn’t have such a tailwind as the HKD but Singapore is the destination of choice in Asia if you want to both live in Asia and breathe air. It’s a small peninsula with excellent exposure to commodities, financial services and technology. As fortune would have it (for a new buyer) one of the major REITs in Singapore has recently had to conduct a large rights offering to pay back some of a bridging loan. This is the result of the subprime crisis spreading out all over the world and the resulting contraction in credit. This REIT is largely owned by two other larger companies, one of whom provided the bridge financing and both of which have fully subscribed to the rights offering. There is very little chance of bankruptcy given the corporate support (no one is talking about bankruptcy but it is the ultimate risk).

K-REIT Asia is trading at price to book ratio of 0.65 (post rights issuance), it grew its NAV by almost 90% last year, will reduce it’s gearing to about 50% and is close to an all time low in stock price. After the rights issuance nearly 80% of shares will be in the hands of the two largest shareholders who plan to sell down over time. This site is very kindly keeping tables of Singapore REITs key financial ratios and it’s easy to see that K-REIT is quite undervalued. With a yield of 5.1%, you can borrow money at 3.76% in USD (that’s from a bad broker!) and still get paid in Singapore dollars while you wait for K-REIT to reach NAV and for the Singapore dollar to reach purchasing power parity with the USD. K-REIT has upside somewhere between a double and a triple.

Having saved the best for last, let’s look at Hong Kong. This small island is not getting any bigger. It is going to have a special prestige for a long time to come that is not equaled by moving out of the special administrative region and into PRC proper; just like most financial firms are not moving out of Manhattan into cheaper office space in Nashville.

Champion REIT has $7 worth of assets and is selling for $4. It has a yield around 6.25% and increased its NAV by 16% last year through upward office revaluation. They previously owned a single office building and are now diversifying into retail. They purchased a property for potentially a 10% discount (from a related party, though some analysts believe they overpaid) and expect to achieve similar yields to their current A-grade property. They are small, have a gearing ratio of 26% and currently have $600M of cash on their balance sheet. Their current arrangement with their primary owner (the ones that are selling them the new property) has some financial engineering elements which the company believes has kept shareholders away . The new acquisition will remove these elements and leave in place a regular REIT which is likely to be a catalyst for revaluation.

Prosperity REIT has a NAV of 2.5 and is selling for 1.61. It’s yielding closer to 8% but has a higher gearing ratio of 33.5%. They only increased their NAV by 5% last year and have $25M of cash on their balance sheet. They are less interesting than Champion REIT but still seem like great value.

By way of comparison it is interesting to look at The Link REIT which is selling at a 25% premium to NAV with a 4% yield. It should give you some confidence that REITs in Hong Kong don’t always have to sell at a discount.

A final Hong Kong real estate company of interest is Great Eagle. It is actually domiciled in Bermuda which puts me off but NAV is $24 and they are selling for $21.3. They have a PE of 3 and a 2% dividend. They are involved in property, mainly in PRC and Hong Kong but with some worldwide exposure. It is the company that sold the office building to Champion REIT and they retain a large holding in Champion REIT. They have grown their core (take it with a pinch of salt) earnings by 55% over the last year. They are concentrated in Asia and the southern hemisphere with a little exposure to the US. They had $14Bn of mainly Hong Kong property at the end of 2006 and this was revalued upwards to $17.6Bn by the end of 2007. They are interesting because of their large land and property portfolio and the potential this has for upwards revaluation. Over the long term they are retaining and reinvesting assets whereas the REITs are paying out retained earnings.

Up to the minute reports indicate a strengthening of demand in Hong Kong for quality real estate which should allay fears of the US real estate crunch affecting these ideas. In fact "Mass market property prices are still 35 to 40 percent below their peak in 1997," said Nicholas Kwan, Asian head of research at Standard Chartered Bank .

REIT’s attact more favorable tax treatment in Singapore where there are no taxes levied on rental income or capital gains even if eventually distributed to foreign individuals. Hong Kong charges 17.5% tax on income at the corporate level (actually at the SPIV level) and then distributions to domestic or foreign holders are not taxed.

By comparison US office REITS have a median price of 2 times book and a median yield of 6%. Even the lowest price to book value is 1.2 though the highest dividend yield is 9.7%! Even after the carnage in US real estate, REITs are cheaper in Asia. The US office REITs are also 30% above their 52 week lows and 20% off their highs.

With the opportunity to wait for a doubling in price to reflect current asset values (or compounded earnings growth in the 40% region in the case of the non-REIT) and then another doubling (if you account in USD) for removing the USD peg these make for some interesting, low risk, high reward ideas off the beaten (US/ Australia / UK) track.

Revising Felix Resources (FLX) fair value down

2008-06-08T18:43:00.001-05:00

The Queensland government has announced an additional 3% royalty on all coal shipments over $100. This reduces the value of Felix Resources by about 50c to around $24.50.

Valuing Felix Resource (FLX)

2008-05-19T05:39:00.000-05:00

I first wrote about felix in December 2005 noting that is was very undervalued and that there was a lot of upside in coal.

Since then thermal coal prices have doubled and coking prices seem to have tripled. Having sold a few shares in the 7's I quickly revistied my valuation. The quick revist seemed to indicate a fair value price closer to $17. I spent some time today rebuilding my model based on the latest data from the company and a more detailed model of their business.

It's pretty easy to make the case that the company is worth $25. I also worked out some sensitivities which others might find interesting.

There are so many assumptions that go into such a model (you can see a number of them in the table above) but if anyone is interested i'm happy to post more of them. Importantly I assume AUD/USD parity.

Anyway there is still plenty of upside in Felix as long as coal prices hold. I still believe that coal will not only keep up with oil but increase more than oil. Since my original analysis oil is up 166% and thermal coal has only doubled.

email address

2008-05-19T05:18:00.001-05:00

Here is my email address if anyone wants to contact me. I used to have a form but the site it was hosted on went away.

What's Next

2008-04-24T22:30:00.004-05:00

What is going to happen next in the markets. I have no idea.

I continue to worry that there could be a significant downside move. I think the chance is substantially greater than 50%. A move below 40 on the Nasdaq and 20% or more in the broad banking indices. Tech stocks are in better shape than the banks. They are going to experience substantial weakness as the US economy slows but consumers still want technology and tech business will still be able to provide it. The Qs have a P/E of 19.34 and price to sales of 2.34. The earning component of PE is going to decrease by 20% or more over the next 9-12 months and that could well decrease price similarly.

A broad based bank index such as the BKX has a trailing PE of 10.86 but banks have all lost incredible amounts of money in the last quarter. (What is a PE when earnings are negative!) It is impossible to value banks today. Even the bankers don't know what their assets are worth.

In an excellent book on Valuation published in 1996 Damordaran he mentions that it's almost impossible to value banks using the discounted cash flow method because it is so hard to understand how they earn money. He suggests a dividend discount model or compounding of ROE. This is interesting because I'm sure in the late 70's you could easily value a bank but in the intervening period something changed. They developed exotic instruments, applied substantial leverage and then moved their riskiest assets out of their financial statements.

Banks are going to have to live with a fundamental re-rating of their businesses because of this lack of transparency. Banks appear to go through the following cycle:

1. Environment provides for a reasonable profit
2. Banks see their competitors making a higher profit
3. Banks stretch for yield to show profitability like their competitors (Latin American loans in early 80's, subprime crisis now)
4. The stretch-asset implodes
5. Banks give back all the additional earnings (above the basic economic earnings they should have made) in writedowns and become effectively insolvent
6. Government supports the banks for some time while they rebuild their capital
7. Banks return to a model that shows a reasonable profit

We're in stage 5/6 right now. Once we get back to stage 7 we will see much lower returns on equity and much lower dividends. The ROE and dividends will be representitive of the true economics of their businesses.

All in all this provides a reasonable basis for being short tech and banks in a broad way. Sentiment is incredibly bullish right now and that could go on for a couple of months. I expect there will come a point over the next 4 months where both the Qs and BKX will be trading substantially lower and I'm positioned as such.

This all needs to be taken in the context of a much larger, long, position in very undervalued stocks. These all happen to be in the resources sector.

2008 February – December Predictions

2008-02-03T01:28:00.001-06:00

1. NASDAQ will see another major fall off a higher peak. QQQQs see less than 40 (buy puts on QQQQ especially as it heads higher)
2. Junk bond spreads widen substantially (buy puts on JNK)
3. Japanese yen appreciates against a basket of currencies but especially against the Euro (and maybe GBP) (long JPYEUR)
4. Sugar and cotton substantially outperform NASDAQ or S&P 500 (SUGA.L COTN.L)
5. Gold and Silver end the year up from here (calls or futures contracts in GLD and SLV)
6. The banking index falls even more from here and banks keep announcing new write downs every quarter (buy puts on BKX RKH)
7. Prestige named banks and the major few monoline insurers are able to access capital and do not go bankrupt (buy calls on MBIA)
8. Japanese small caps substantially outperform NASDAQ or S&P 500 especially in USD (JOF JSC)
9. I continue to believe that my core holdings of Canadian Oil Sands, Northern Dynasty, Strathmore, Fission and Silver Standard will do very well over the next few years. I’d add on weakness, especially Northern Dynasty. I don’t know what will happen over the next year except that you should be prepared to take advantage of buying opportunities in these names.

If you have to own larger cap or well known stocks then Archer Daniels Midland and Conagra are statistically cheap with good dividends (1% and 3.5%). They will benefit from the agriculture boom and will perform well over the next year. (Though not better than the core holdings over multiple years). BHP, Xtrata and Rio Tinto are other blue chip opportunities to add to on weakness that will perform well over the coming years.

I would allocate about 5% of your portfolio to 1-7. As you can see they are all leveraged ideas which should help to balance out short term underperformance in your core holdings.

2007 Performance

2008-02-03T01:26:00.000-06:00

2007 Performance

In my 2007 predictions I forecast:

1. A recession or very low growth period
2. Credit spread expansion
3. Silver, Gold, Oil, Coal and Uranium little changes or down slightly
4. The fed flooding the system with liquidity
5. The goldilocks forecast of moderating but still significant economic growth leading into a reacceleration in the later half of the year would be incorrect
6. 40% chance that NASDAQ 100 would be up
7. 50% chance that commodities would be up

1. I really expected 1 to occur earlier than the very beginning of 2008 so I’m going to call that early rather than wrong.
2. I’ve been dead right on 2 and predicted that would be the best risk reward trade of 2007
3. I was wrong on Gold, Silver, Oil and Coal. Uranium is down from January 2007. I was right not to sell any of my stocks in these commodities.
4. The fed has absolutely flooded the system with liquidity but only since the beginning of 2008 so I’m going to call early rather than wrong
5. The consensus goldilocks forecast was wrong making me correct
6&7 NASDAQ and commodities ended the year up quite a bit and I was wrong on them.

So 3 right, 2 early and 2 wrong. My performance for the year was about 50% in USD so I managed to capitalize on the rights.

Liquidity

2007-12-27T20:41:00.000-06:00

Every financial news service, blog or magazine is talking up the fed and ECB's flood of liquidity. Unfortunately almost no one has done the hard yards to determine if in fact there has been a net liquidity injection.

I was perplexed as to why the fed would only reduce the funds rate by .25% at the same time as using alternate methods to increase liquidity. If they actually wanted to increase the supply of money all they needed to do was lower the fed funds rate which seems simple enough. Of course they didn't want to do that because inflation is so high.

What they instead have tried to do, by slight of hand, is create the appearance of pumping money into the economy without actually doing so. This trick is supposed to improve confidence (the current crisis is in part one of confidence) as long as no one realizes what's going on.

Well... John Hussman has done the work and determined that the 500bln that we heard about from the ECB was in fact a net withdrawl of liquidity (as it was done at the time of a repo auction when an even larger amount of repos had just expired). What we were not told is over 500bln of repos expired and the ECB added 500bln back - net results was a drain.

A similar game is going on with the US Federal Reserve. They keep announcing liquidty injections, on days when repos exprie, which are vastly overstated once you net out the liquidty withdrawls from the repos. The net fed injection has only been around 20bln.

The bottom line is that central banks are not massively reflating the economy. This is not so good for gold or other precious metals (though there are a lot of other bullish factors for them) and it greatly increases the chance of a recession sooner rather than later.

2007 Outlook

2007-01-11T03:51:00.000-06:00

I’ve been thinking about my forecast for this year. At the highest level I believe that market neutral is a great idea for the next 12 months. There is a good chance that the US will see a recession this year and a great chance that we will see a quarter or two between negative 2% and 0% growth. Of course a recession is an aggregate measure of the performance of the economy and many sectors can perform reasonably well while a few perform terribly, this bifurcation will be the hallmark of the recession or at best very low growth (VLG) period. Credit spread expansion is probably the low risk high reward trade of the next 12 months but I'm not planning on making the trade.

Commodities are going to perform incredibly well over the next 5 years but the next 1 year could on balance see a period where prices end the year little changed or even moderately down from here (which is significantly down from their highs, especially oil, silver, gold and copper). Throughout this forecast you can measure commodities by looking at Silver, Gold, Oil, Coal and Uranium as these are the ones that I have a position in.

You can obviously sell all these holdings but I have decided not to for two reasons. Firstly because of an event that will happen coincident with the recession/ VLG scenario. Bernake will flood the system with liquidity because he doesn’t want our hosing bust to turn out like Japan. This will be wildly bullish for commodities and the exact timing of it is very hard to predict. This will be the setup for the next big leg up in commodity bull market. Secondly selling the holdings would incur significant tax payments.

I plan on implementing this with a mixture of QQQQ (Nasdaq 100) puts and keeping my long positions. Probably on a 2:1 short for long basis as the beta of my longs is at least double that of my shorts. The danger of a market neutral strategy is both sides of the trading going against you. The worst possible scenario would be good tech performance and poor commodity performance. This is very unlikely but possible. At least on the QQQQ side I’ve used options so I can only loose the premium which was very cheap about 8% of my equity for equal net beta coverage.

The best scenario for the year would be terrible tech performance and great commodity performance; a scenario which is somewhat realistic given that the BRICS (Brazil, India, China, South Korea) economic growth will not necessarily moderate and even if it does, as long as it’s not negative then their consumption in ’07 will be greater than last years.

The consensus forecast for this year is the Goldilocks forecast with moderating but still significant economic growth leading into a reacceleration in the later half of the year. While I’d loose on my puts, my commodity heavy portfolio will do excellently. The consensus never picks recessions or other turning points and I think they’ve got it wrong.

I’m looking forward to commodity prices dropping and Nasdaq dropping at the same time. I’m going to try to pick the bottom (which I will fail miserably at) and then sell the puts and buy whatever of my favourite stocks have dropped the most. I’m excited about ending the year in a much better position than I started it.

It’s worth saying that I’ve though the recession/VLG scenario was possible in late’05 mid ’06 but less likely, hence I had less downside protection. This time around the chance is more than 50/50

VLG/ Recession scenarios – 70%

Nasdaq up, commodities down – 10%

Nasdaq down, commodities down (standard recession VLG fare) – 50%

Nasdaq up, commodities up (strong growth resumes by EOY) – 20%

Nasdaq Down, commodities up (massive reflation)– 20%

Goldilocks – 30%

Nasdaq up, commodities down -10%

Nasdaq down, commodities down – 20% (liquidity and/ or growth reduced in BRICS)

Nasdaq up, commodities up (standard fare in global economic synchronised boom- see last 3 years ) – 50%

Nasdaq Down, commodities up – 20%

I make money on 3, 4, 7 & 8 (50% chance). I stand to loose on 1 & 5 (10% chance).

2 & 6 (40% chance) are the most interesting because whether I make a little money, breakeven or lose depends on how the Nasdaq compares with commodity prices. I actually think that the Nasdaq 100 has more to loose than commodity stocks because its components are more highly valued and generally technology is deflating while commodity prices are inflating.

I expect to end the year moderately up and owning more shares of my favourite commodity stocks bought at cheaper prices. I expect to outperform the major indices, I expect to see a lot of volatility (which helps my puts make money) and a year of moderate capital gains.

Let the year begin!

2006 forecast review

2007-01-03T22:21:00.000-06:00

My 2006 forecast is here. I'm going to review them line by line and see how I did. It's important to remember that these were all contrarian calls at the beginning of 06. The average return of my forecast was 31% if it were equal weighted and you traded the mentioned stocks and currencies. It was better again if you traded the commodities. My results for the year were substantially better because I was weighted towards the stocks, took no currency position and held larger positions in the better performers.

1. NASDAQ tanks - inverted yield curve, bull market long in the tooth, crazy valuations, presidential cycle, fed tightening all portend an economic slow down which will almost certainly drag the NASDAQ down

6.7% loss! The QQQQ finished 2005 at 40.54 and trade today at 43.24. I still believe I'm early rather than wrong.

2. Silver rises - silver demand has not been met by mine supply for decades, there is less silver in the ground than any other metal, silver is consumed by industrial processes, inflation. These have been the case for some time so I expect this to continue crawling in my direction

41% gain. Silver finished 05 at around $9 and trades at 12.65 today.

3. Oil doesn't drop - No big oil discoveries in decades, reserves have not been replaced by majors for a decade, Saudi Arabia has no more light oil, Alternative sources will come online but only at high prices. Canadian Oil Sands (COS.un COSWF) reaches a yield of 10% on today's price.

Oil ended 05 at around 62 and trades today at 58.32. COS.un is not yet yielding 10% on 05 prices. I still like COS and it's up 25% on the year from $25.18 to $30.16 but the forward yield is still only around 7-8%.

4. Lead (the metal) doesn't drop more than 10% - China, India, Brazil continue to grow at very high rates and consume lead products (cars, batteries), lead in deficit, decline of the dollar. Ivernia (IVW) does well in this environment.

20% loss on IVW. Lead did very well moving from 50c a year ago to around 80c today. IVW, however, went from $1.84 to $1.47. IVW is worth more than it was a year ago but managements execution has been so poor that I'm not adding money.

5. Uranium doesn't drop - High oil prices, increasing energy demands, Uranium is the cheapest source of energy, Uranium in deficit. STM doubles and is probably bought out (I'd rather it wasn't!)

Up 86%. STM traded at $1.9 at the end of 05 and $3.53 yesterday. Uranium rose from around $35 to around $75 over the same period. STM is even more undervalued than it was a year ago.

6. Coal doesn't drop as much as the experts expect - Coal is the second cheapest source of energy, coal is required to produce steel, over production of steel requires more coal (steel can drop and coal increases), supply constraints due to infrastructure, Australia is closest to China and India, developing technologies like hydrogen and coal gasification support coal demand. Felix resources up.

A rise of 86%. FLX traded at 2.27 a year ago and $4.23 right now. Exact coal prices are difficult to come by but prices were the same to down 5% according to my research. Finishing at around $55USD.

7. The drop in the NASDAQ scares the market and everything drops for a while and then commodity stocks revive without a revival in the NASDAQ.

Well NASDAQ hasn't fallen so this is out the window.

8. US Rates peak for this cycle and fall from that peak, USD falls against Canadian dollar, USD falls against AUD.

Rates may well have peaked but didn't fall. USD has fallen against AUD moving from around .74 to nearly 80c a rise of 8%. USD has stayed about constant with the CAD after a decent fall during the year and then a rise back to late 05 levels.

Google Checkout

2006-06-30T03:54:00.000-05:00

I have read a lot of reporting on Google Checkout but no one seems to have made the link between Checkout and their core advertising products. Once Checkout achieves critical mass they can completely remove click fraud by charging per purchase instead of per click or some combination thereof. The strategy will leave the competition behind with click fraud while google are the only game in town offering pay per purchase advertising.

Oil from coal costs $40 a barrel

2006-05-12T06:53:00.000-05:00

As part of an article on oil prices falling over the next 50 years Australian Bureau of Agricultural and Research Economics executive director Brian Fisher said that Oil can be produced from coal for around $40 a bbl. He was saying that this probably sets the fair value for Oil over the very long term. He might be right but the infrastructure to produce 120M bbl per day of oil from coal is probably 50 years away too! It also doesn't take account of the increased price of coal when the extra oil demand arrives - so maybe the number is much higher.

Either way this is very bullish for coal. Coal is pretty overlooked right now by the investment community and I really like Felix Resources on the ASX. I've blogged about them before and believe there is over 3 times upside from the current price without a large increase in coal prices.

Coal is the cheapest source of energy aside from Uranium (though plants are so much cheaper). The price of cheaper sources of energy will rise as consumers switch to the cheaper sources and there are quite a few coal companies that are well below their 12 month highs. A good way to get in on the commodities boom with pennies to the downside and dollars to the upside!

Resource boom can't go on, warns Costello

2006-04-22T20:12:00.000-05:00

Peter Costello, the Australian treasurer, has warned that the resource boom can't go on. (see http://www.theaustralian.news.com.au/story/0,20867,18877827-2702,00.html).

"But Peter Costello yesterday warned investors who loaded up on mining stocks - like those who dived on dotcom stocks in the late 1990s - could be burnt when the boom grinds to a halt. "
"We think there's a couple of years left, but it will not be permanent," he said. "The resource boom won't last for ever. If you put all your eggs in the resource company basket, you'll be in as bad a situation in a couple of years as all those who put all their eggs in the tech basket in 2000."

What he doesn't understand ( and if he did understand he wouldn't be a politician he'd be a rich investor) is that there is almost no similarity between resources and tech in terms of valuation. In the end a bubble is all about valuation and major metal companies and oil companies trading well below the market multiple IS NOT A BUBBLE. A company with no plan to ever be profitable raising $300M is a bubble. A company earning a few million dollars, selling for billions is a bubble. Companies trading at 50 or a 100 times earnings is a bubble. A company trading at 10 times earnings is NOT. Was the treasurer forecasting the end of the tech boom in 2000???

Mr Costello said he did not foresee any faltering in China's economic development.

"I don't see any reduction in demand or global growth rates. The Chinese boom has a way to run. I think what may change the situation, however, is supply."

This is actually somewhat sensible but mostly wrong. Orthodox economics says rising prices bring on supply. What isn't factored in is that new mines can take many years 5 - 10 to come to production. With all the environmental controls, wacky governments etc it is hard to bring supply to market for most of the world. Furthermore, there are not massive supplies sitting in the ground waiting to come out; on the whole the easy resources have been found.

DON'T TAKE YOUR ECONOMIC ADVICE FROM THE GOVERNMENT!!

Thoughts for 2006

2005-12-27T23:54:00.000-06:00

Pundits often post their thoughts for the coming year. I'm going to do the same but with a twist. I'm going to limit my comments to those that I actually have a position in.

1. NASDAQ tanks - inverted yield curve, bull market long in the tooth, crazy valuations, presidential cycle, fed tightening all portend an economic slow down which will almost certainly drag the NASDAQ down
2. Silver rises - silver demand has not been met by mine supply for decades, there is less silver in the ground than any other metal, silver is consumed by industrial processes, inflation. These have been the case for some time so I expect this to continue crawling in my direction
3. Oil doesn't drop - No big oil discoveries in decades, reserves have not been replaced by majors for a decade, Saudi Arabia has no more light oil, Alternative sources will come online but only at high prices. Canadian Oil Sands (COS.un COSWF) reaches a yield of 10% on today's price.
4. Lead (the metal) doesn't drop more than 10% - China, India, Brazil continue to grow at very high rates and consume lead products (cars, batteries), lead in deficit, decline of the dollar. Ivernia (IVW) does well in this environment.
5. Uranium doesn't drop - High oil prices, increasing energy demands, Uranium is the cheapest source of energy, Uranium in deficit. STM doubles and is probably bought out (I'd rather it wasn't!)
6. Coal doesn't drop as much as the experts expect - Coal is the second cheapest source of energy, coal is required to produce steel, over production of steel requires more coal (steel can drop and coal increases), supply constraints due to infrastructure, Australia is closest to China and India, developing technologies like hydrogen and coal gasification support coal demand. Felix resources up.
7. The drop in the NASDAQ scares the market and everything drops for a while and then commodity stocks revive without a revival in the NASDAQ.
8. US Rates peak for this cycle and fall from that peak, USD falls against Canadian dollar, USD falls against AUD.

I'm sure I’m going to be right in these calls just not sure that it will happen over the next 12 months. The only time based position I have is in my QQQQ puts which expire in Jan 07, I'll probably buy more expiring in Jan 08. There is a chance that the drop in US markets will create a gun shy environment for stocks and even though commodities will outperform, commodity stocks will not. That is the second most likely scenario.

Worst case scenario, NASDAQ rises, commodities fall signficantly, USD rises against all currencies. Quite unlikely.