The Safe and Cheap blog was meant not only to be an exercise in Value Investing, but also, and importantly, a journey towards better Decision Making. Although I've often found that the worlds of value investing and good decision making are intertwined, I reckon a separate post on the importance of 'process' is warranted.
The essence of this post is this - Bad process will inevitably produce bad long term outcomes, they might however, produce good short time outcomes. On the other hand a good process, if efficiently executed, will naturally, over time, lead to good long term outcomes. I would like to emphasize long term here as even a good process will unavoidably lead to bouts of bad short term outcomes. It is important to note that, bad short-term outcomes do not necessarily imply a bad process, but the importance of luck in success.
Consider the game of golf (which I love, no..hate, nah..love), which highlights the importance of process than no other. In order to execute a good shot, it is important that you, (a) have a decent swing (backswing, downswing and follow through), (b) a proper grip, (c) a good stance, (d) focus, and importantly, (e) keep your eyes on the ball. Having said that, there might be times when you don't do any of these and hit a good shot, but make no mistake, you will not be able to hit anything close to a 72 when you play a round. This is because over time, this bad process will catch up to you and produce a bad overall, long term (over 18 holes) outcome. A good process however, might lead to a bad shot or two; (1) perhaps because you took your eyes off the ball - a mistake in execution, and/or (2) because wind suddenly starts blowing and herals your ball to a tree (I am sure golf enthusiasts will understand) - the cause usually is a known unknown or an unknown unknown. But overall, you have the chance of hitting a good long term score. The same analysis can be applied to most sports. In professional sports , skill is also a big factor, which essentially comes from the perfection of a process. Likewise, if you regularly drive fast - well you get the point.
But we ain't in the discussing academics business, we in the allocating capital (and making money) business. Retail investors often focus on the historical performance of a mutual fund. A fund with good historical performance numbers usually attracts more capital, while a fund with bad short term performance usually faces withdrawals. Is this warranted? Sometimes it is, and sometimes it's not! We have to analyse the process each manager is following, and then reasonably determine, (a) if the process makes sense, (b) if it will make money, and importantly, (c) what is the downside (and if I am comfortable with that downside). A good manager with a good process may produce bad short results, but over time, the performance of the fund ought to reflect the superior course of action. In keeping with the disclosures, I have never been able to nail down George Soros process of making money (well not fully), and he produced good results and did it over a long period of time (If I was an academic, maybe I'd talk in sigmas). Likewise, in stock selection, it is important to focus on the process, and importantly, the downside risks, than worry about the outcomes. This process, coupled with heaps of discipline, over time, will inevitably lead to good long term results. It is also noteworthy that the inputs to the process are of prime importance. Bad inputs, coupled with a good process, will lead to a bad outcome - Garbage In Garbage Out (GIGO) principle.
In conclusion, all other things being equal, generally:
1) Bad Process, Bad Outcome - Inevitable in the Long Term
2) Bad Process, Good Outcome - Luck (outcomes from known unknowns and unknown unknowns are favorable) - a Short term phenomenon
3) Good Process, Bad Outcome - Luck (outcomes from known unknowns and unknown unknowns are unfavorable) - a Short term phenomenon
4) Good Process, Good Outcome - Inevitable in the Long term
Monday, October 12, 2009
Wednesday, September 2, 2009
Stock Analysis: Birchcliff Energy
BirchCliff Energy (TSX: BIR) is a junior oil and gas exploration, development and production company. Its objective is to acquire and hold, large working interests in several highly focused producing areas in the Peace River Arch where it can hold operatorship of its assets and control the infrastructure necessary to facilitate the exploitation, development and exploration potential of those areas. Birchcliff produces roughly 70% natural gas and 30% light oil and natural gas liquids (NGLs). It has two major properties:
(1) Montney/Doig - Montney/Doig is an unconventional natural gas resource play consisting of reservoirs in tight sands, siltstones and shales. Birchcliff has 166 net sections of land in the area where 57 sections have been assigned reserves of 314 bcf (57 mboe), assuming 2 wells/section and 2.8 bcf/well. Management (consistent with other firms in the area) believes that 4 horizontal wells can potentially be drilled on each section giving Birchcliff an inventory of around 600 wells with recovery reaching 5 bcf/well.
(2) Worsley - The Worsley oil and natural gas assets in the Peace River Arch area of Alberta was acquired in September, 2007 for total cash consideration of $270 million. The purchase price was equivalent to $17.53/boe of proved plus probable reserves, which after reserve additions has now come down to around $10/boe for 24.6 mboe. The Worsley property provides stable cash flow and commodity diversification when compared to the natural gas assets in the Peace River Arch. Birchcliff owns high Working Interest (WI) lands (>80%) and has been working essentially without partners or farm outs.
The 3 year average for the Finding and Development (F&D) costs excluding future development capital were $8.01/boe and including future development capital were $15.63. This average has been decreasing where the 2008 F&D costs excluding future development capital were $5.17/boe and including future development capital were $14.06/boe and are more indicative of future F&D costs.
Valuation
The valuation of the company is as follows:
Downside
The current Book Value (BV) of Birchcliff is $4.15/share and as per the market price of $6.4/share the company is currently trading at 1.5x BV. This is higher than many E&P in Canada which are trading for < 1x BV. Furthermore, with an Enterprise Value (EV) of $1.024 B and 2008 Cash Flow (CF) of $131 million; the EV/CF ratio for the company is around 7.8 which also is much higher than most of the comparables trading at 3-4x EV/CF.
2009 Cash Flows Assuming Birchcliff produces on average 12,500boe/day in 2009; at the current AECO natural gas price of $4/mcf and oil price of $50/bbl ($32/boe – 67% gas; 33% oil) Birchcliff’s 2009 cash flow would roughly look as follows:
Revenue: 12,500 boe/day*365 days*32 $/boe: $146 million
Royalties: 146 * ~15%: $21.9 million
All Expenses (~$16/boe):$73 million
Cash flow before taxes (Operating cash netback: $11.2/boe): $51.1million
The production could increase and/or fuel prices could increase resulting in higher cash flows, but the $80 million estimated by management for capital expenditures in 2009 is much higher than the current situation dictates and there is a risk of (a) equity dilution (b) increased debt load. Furthermore, assuming higher cash flows in 2010 and 2011, it still might not be enough after capital expenditures to repay the debt with an outstanding current balance of $250 million. Interest payments on the debt load come to around $10 million annually and this is manageable even under stress scenarios.
Upside
In order to analyze the upside it is important to decipher the Montney/Doig natural gas resource play. I have already analyzed unconventional gas resource in a previous post. The gas is there, essentially the challenge is to maximize the flow rate for the lowest cost. Specifically, Birchcliff has 166 net sections of land in the Montney/Doig resource play. AJM consultants have designed resources of 314bcf to 57 net sections assuming two wells per section each producing 2.8 bcf over its lifetime. Net-net there is only engineering risk and very little exploration risk. The management plans on drilling 4 wells per section giving them a total inventory of more than 600 wells, with each costing around $5million. Management also believes (in like with other firms in the area) that each well can produce 5bcf of natural gas over its life as technology improves. Conservatively, assuming on average 1.5-2.5 bcf/well and 600 well locations (certain), Birchcliff can potentially recover 900-1500 bcf or 150-250 mboe of natural gas. This will require a lot of future capital, where each well will cost around $5million and the company will need new processing facilities as production increases leading to additional capital expenditures. Presently, Birchcliff has proved and probable reserves of 98.5 mboe (82.3 net) adding all its properties, where the Worsley light oil pool contributes 24.6 mboe.
Comparables ARC, Encana, Talisman, Crew Energy, Canadian Natural etc. all have lands adjacent to Birchcliff lands in the Montney area, with Talisman’s lands being the closest to the Pouce Coupe area. Bigger firms in the area have been pioneering to economically extract resources from this area. Managements’ estimates of potential resources and technologies in the area are in line with these companies. Duvernay Oil Corp. which has the highest quality land in the Montney region was bought by Shell Canada for $5.9 billion including debt (it was an anomaly). Duvernay quotes gas-in-place of 50 bcf per section, while Birchcliff quotes at 30 bcf per section. Shell paid $38.87/mcf for proved and probable reserves of 152 mboe and received 450,000 acres of land. This purchase price discounted the future expected recoveries in the undeveloped lands. Birchcliff at present has 98.5mboe of reserves and 380,000 acres of undeveloped land.
Finally, – The current EV is equal to $1.024 B. Based on various combinations and comparable deals, we can assume that Birchcliff is worth between $2 B to $5 B for a 2.5x – 4x upside from the present prices. As long as management manages the balance sheet conservatively, Birchcliff should not have a problem attracting a bid in due time. Seymour Schulich a prominent Canadian investor owns 22% of this company and he is more or less waiting for a bid to cash out. Please note that the thesis here is for a takeover only, you are essentially buying a 'option' when you buy the stock. Personally, the 'option' has to be much cheaper than it currently is for me to purchase the stock, but I am posting the analysis nonetheless.
Disclosure: None
Friday, August 28, 2009
Stock Idea: Steinway Musical Instruments
Steinway Musical Instruments (LVB: $12/share) is a renowned manufacturer of pianos and band instruments. The piano segment (60% revenues) operates under the brand names Steinway, Boston, and Essex. The premium Steinway brand has an 85% market share and represents roughly 80% of the revenue in this segment. The band and orchestral segments (40% revenues) operating under Conn-Selmer divisions sell a wide array of other musical instruments and accessories. Steinway is not a growth story. It is however, a distinguished brand which has delivered consistent cash flows and has the added margin of safety in hidden real estate assets - it owns the 57th Street building in Manhattan and a waterfront manufacturing facility in Queens.
Bird in the Hand: The margin of safety in this investment comes from the hidden read estate value and the working capital surplus. As per a press release by the management in Feb, 2006, West 57th street building was purchased in 1999 for $30 million, is carried on the books at $24 million and has a market value of at least $100 million. In addition, the Steinway manufacturing facility in Queens is on the waterfront, has views of Manhattan and is carried on the books for $3 million but is worth around $200 million. Furthermore, the company has $172 million in inventory and there is precedence that it will not be liquidated but sold piece meal. There are other assets on the company’s books that have substantial worth. I would roughly peg the total value of the hidden assets at $200 million or $23/share after tax. The company does not need to own the aforementioned real estate to operate and hence the assets can be monetized without substantial effect on the operations (add: lease expense for factory, subtract: rental income from building).
Bird in the Bush: The company has an enterprise value (EV) of $285 million (including pension underfunding) with a market capitalization of $100 million. Steinway’s revenues have been flat averaging $375-$400 million for many years. The company has consistently had gross margins in the 28-30% range and operating margins normalize at 8.5%. Due to the consistency in operating metrics we can normalize cash flows and determine the valuation. The company on a normalized basis does around $45 million in EBITDA and approximately $20 million in FCFE. At 8x EV/EBITDA the company would be valued at $360 million. Looking at the FCF multiples, at 10x FCFE the equity of Steinway would be worth around $200 million. The stock has a 60-100% upside to $16-20/share just based on the operations. The earnings are depressed right now because of the macroeconomic conditions, I reckon, however that (a) there are so secular forces against the company, and (b) the company has not suffered permanent damage from imports or consumer demand.
In addition, there might be some growth opportunities in countries like China where Steinway is working to establish a presence. Chairman Kyle Kirkland and CEO Dana Messina have majority voting control due to their 100% ownership of class A stock, and therefore have full control of the major strategic decisions faced by the Company. They have made prudent decisions so far and have been fairly compensated, but this does pose a substantial risk. In conclusion, the company seems to be worth around $35-$45/share. This is a classic ‘buy on assets, sell on earnings’ play.
Disclosure: None
Tuesday, June 30, 2009
Hedge fund jobs..
A few posts ago I wrote about the Distressed Debt Investing blog, where Hunter brought some real insights into the process. Hunter's at it again! He's starting a new blog titled 'How to get a Hedge fund job'. Here he will dwell on his own experience and his networks to give reader a comprehensive understanding on what it takes to land Hedge fund jobs. At a time where unemployment is rearing its ugly head, Hunter's blog is a welcome relief. As someone who is looking for a mentor, I hope he comes up with some quality content helping me and people like me in their search!
Wednesday, June 24, 2009
what WB said about inflation..
I fret every time a value guy talks about macroeconomic conditions, but here I am talking about inflation. Swarmed by the talking heads, I went up on the Himalayas (BRK shareholder letters) to get some real advice from the guru (Warren Buffett). 1978-1982 was a time where real inflation actually took place, before the then fed chairman Paul Volcker raised rates to as high as 21.5% (can you imagine that) to reign in inflation. Fortunately, we have WB's 1978-1982 shareholder letters to decipher the time and his strategy (which as always he just lists out!).
While you and I talk about commodities and real estate etc., he was still looking for businesses but with the following characteristics, " Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital." Essentially, business like See's Candy. When talking about commodities, he favors the lowest cost producers. We want to watch the downside, we want to make sure we make money even if inflation does not take hold.
Any fixed income security is likely to produce real term loses in a high inflation environment. He was absolutely against long term bonds, and mostly looked for bonds with conversion rights or distressed securities. When talking about return on capital you have to figure the inflation effects and then the taxation effects. A 10% bond with 8% inflation and taxes would not make any real return! In case of equities, the corporations will be paying taxes on nominal income and not real income. Considering owners can only use real income, this means the corporations would pay taxes on deficits!
I can only say so much and not a fraction as good as WB, so I would highly recommend the Berkshire Hathaway shareholder letters from 1978-1981.
While you and I talk about commodities and real estate etc., he was still looking for businesses but with the following characteristics, " Such favored business must have two characteristics: (1) an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital." Essentially, business like See's Candy. When talking about commodities, he favors the lowest cost producers. We want to watch the downside, we want to make sure we make money even if inflation does not take hold.
Any fixed income security is likely to produce real term loses in a high inflation environment. He was absolutely against long term bonds, and mostly looked for bonds with conversion rights or distressed securities. When talking about return on capital you have to figure the inflation effects and then the taxation effects. A 10% bond with 8% inflation and taxes would not make any real return! In case of equities, the corporations will be paying taxes on nominal income and not real income. Considering owners can only use real income, this means the corporations would pay taxes on deficits!
I can only say so much and not a fraction as good as WB, so I would highly recommend the Berkshire Hathaway shareholder letters from 1978-1981.
Thursday, May 28, 2009
What chu think about TicketMaster?
Past
TicketMaster (TKTM) is the world’s largest live entertainment ticketing and marketing company. The company is a primary and secondary ticketing (thru ticketsnow.com) retailer in theUS
You and I both have had experience with TicketMaster and loathe would be too nice a word to describe the feeling. They make way above the economic rate of returns and have successfully passed price increases to customers - something a monopoly can do. Ticketmaster secures its monopoly by goading the venues into multi-year agreements that empower Ticketmaster to act as their exclusive vendor. So what was a cost center for venues (ticketing) has become a steady source of income. They have been a monopoly ever since the early 1990's and have maintained and increased their position even after the advent of the Internet and increasing number of players. They are very Microsofteqe in their business practices and took/are taking a lot of heat for their monopolistic actions. It was spun off of IAC in mid-2008. In essence, TicketMaster is a toll booth.
In 2008, Tktm had revenues of $1.45B with an ebitda of $225 million for ebitda margins of 16%. The margins have however come down from the mid 20's over the past few years. TKTM is trading at $7.50 for an EV of $1060 million and an EV/EBITDA ratio of 4.7. It traded for as low as $3.50/share in March 2009.
Present
This is where things get convoluted. Live Nation, TicketMaster's biggest client fired TicketMaster and said they'll do their own ticketing (LYV brought 13% of revenue in 2008 for TKTM). Live Nation also intends to poach TKTM's clients. Live Nation operats on razor thin margins but has a large presence in the live entertainment business. TicketMaster then bought a majority interest in Frontline Management and brought Irving Azoff (someone you wanna read about) as CEO. With this TKTM controlled a lot of very high profile artists and became a threat to Live Nation. Live Nation and TicketMaster then decided to merge (50-50 share) and have all the intended approvals except the regulatory approvals (which might be tough to get!).
In this business, the main parts of the puzzle are: (1) Artists (2) Promotors (3) Venues (4) Ticketing and (5) the Fan. Live Nation is the worlds biggest promoter, has control over various venues and artists (because they can pay them more than anybody else, given the scale). TicketMaster has ticketing and venues (thru exclusivity arrangements) and now artists thru Frontline. Combining these two business would vertically integrate an industry and crush the competition, but I don't think a stockholder would complain.
Future?
The files are with the Justice Department and they along with the states are taking a deep hard look at the merger. I'd say there is a 50-50 chance. They do have a case when they say touring is the main source of income for the artists and the record label model is broken with the illegal downloads etc. They might be asked to divest certain assets like ticketsnow.com for the merger to pass.
If the merger does not happen that is where things become uncertain. A couple of scenarios:
1) Live Nation comes back to Tktm for ticketing and they Frontline works with Live Nation, in essence they collude (kinda)- will they be able to pull this off?
2) Live Nation does not come back. TicketMaster decides to go into the live event promotion business (with Frontline managing artists) and these two operate in a duopoly - can they?
3) TicketMaster faces increased competition from Live Nation in the ticketing business. TicketMasters market share decreases - but by how much? Can Live Nation severely damage their moat?
They exposed themselves by announcing a merger. I watched the senate hearing on the TicketMaster/Live Nation merger and it was well worth watching. There is information on the history, business practices, competitors, future etc. etc. Now TKTM is cheap (given market position, margins, ROC), it might get cheaper but given all the uncertainties is it safe? what chu think?
TicketMaster (TKTM) is the world’s largest live entertainment ticketing and marketing company. The company is a primary and secondary ticketing (thru ticketsnow.com) retailer in the
You and I both have had experience with TicketMaster and loathe would be too nice a word to describe the feeling. They make way above the economic rate of returns and have successfully passed price increases to customers - something a monopoly can do. Ticketmaster secures its monopoly by goading the venues into multi-year agreements that empower Ticketmaster to act as their exclusive vendor. So what was a cost center for venues (ticketing) has become a steady source of income. They have been a monopoly ever since the early 1990's and have maintained and increased their position even after the advent of the Internet and increasing number of players. They are very Microsofteqe in their business practices and took/are taking a lot of heat for their monopolistic actions. It was spun off of IAC in mid-2008. In essence, TicketMaster is a toll booth.
In 2008, Tktm had revenues of $1.45B with an ebitda of $225 million for ebitda margins of 16%. The margins have however come down from the mid 20's over the past few years. TKTM is trading at $7.50 for an EV of $1060 million and an EV/EBITDA ratio of 4.7. It traded for as low as $3.50/share in March 2009.
Present
This is where things get convoluted. Live Nation, TicketMaster's biggest client fired TicketMaster and said they'll do their own ticketing (LYV brought 13% of revenue in 2008 for TKTM). Live Nation also intends to poach TKTM's clients. Live Nation operats on razor thin margins but has a large presence in the live entertainment business. TicketMaster then bought a majority interest in Frontline Management and brought Irving Azoff (someone you wanna read about) as CEO. With this TKTM controlled a lot of very high profile artists and became a threat to Live Nation. Live Nation and TicketMaster then decided to merge (50-50 share) and have all the intended approvals except the regulatory approvals (which might be tough to get!).
In this business, the main parts of the puzzle are: (1) Artists (2) Promotors (3) Venues (4) Ticketing and (5) the Fan. Live Nation is the worlds biggest promoter, has control over various venues and artists (because they can pay them more than anybody else, given the scale). TicketMaster has ticketing and venues (thru exclusivity arrangements) and now artists thru Frontline. Combining these two business would vertically integrate an industry and crush the competition, but I don't think a stockholder would complain.
Future?
The files are with the Justice Department and they along with the states are taking a deep hard look at the merger. I'd say there is a 50-50 chance. They do have a case when they say touring is the main source of income for the artists and the record label model is broken with the illegal downloads etc. They might be asked to divest certain assets like ticketsnow.com for the merger to pass.
If the merger does not happen that is where things become uncertain. A couple of scenarios:
1) Live Nation comes back to Tktm for ticketing and they Frontline works with Live Nation, in essence they collude (kinda)- will they be able to pull this off?
2) Live Nation does not come back. TicketMaster decides to go into the live event promotion business (with Frontline managing artists) and these two operate in a duopoly - can they?
3) TicketMaster faces increased competition from Live Nation in the ticketing business. TicketMasters market share decreases - but by how much? Can Live Nation severely damage their moat?
They exposed themselves by announcing a merger. I watched the senate hearing on the TicketMaster/Live Nation merger and it was well worth watching. There is information on the history, business practices, competitors, future etc. etc. Now TKTM is cheap (given market position, margins, ROC), it might get cheaper but given all the uncertainties is it safe? what chu think?
Sunday, May 10, 2009
Dimon and the Letter
Most of what I've know has come as a result of 'hop' reading, which essentially means reading something, finding something interesting and hoping on to read about this something interesting. So when Warren Buffett at the AGM recommended Jamie Dimon's letter, I had to read it! Needless to say it is a wonderful letter. I second Tom Brown when he says this is the type of stuff we expect from Warren Buffett (the AGM fills in some holes). It is a must read..
It is becoming apparent that an equity investor doesn't just need a good understanding of the industry but also needs to comprehend the credit markets and value the political risks. WB famously said that even if Alan Greenspan (the then fed chairman) told him what his next move will be, it will not effect how WB invests. This makes sense because as value investors we look for under priced securities with a margin of safety and it is as simple as that. But on the other hand, I reckon, some awareness of the macro conditions is an absolute must and being 'street smart' important. JPM shareholder's letters gives a good summary of past mistakes, present challenges and a recommendation (not just a complain) on future reform.
It is becoming apparent that an equity investor doesn't just need a good understanding of the industry but also needs to comprehend the credit markets and value the political risks. WB famously said that even if Alan Greenspan (the then fed chairman) told him what his next move will be, it will not effect how WB invests. This makes sense because as value investors we look for under priced securities with a margin of safety and it is as simple as that. But on the other hand, I reckon, some awareness of the macro conditions is an absolute must and being 'street smart' important. JPM shareholder's letters gives a good summary of past mistakes, present challenges and a recommendation (not just a complain) on future reform.
Thursday, April 16, 2009
Unconventional Gas
This is not about a particular stock, but about the natural gas sector in general and an analysis of the unconventional reserves. This would be a good starting point if an investor wants to establish a position in the natural gas sector. Also, it explains the success of unconventional e&p companies.
Natural Gas
Natural gas is one of the cleanest burning hydrocarbons and an essential energy source. The depletion rates for natural gas in the U.S. for the fields put into production in 1990 were down 17% after the first year, those put into production today deplete more than 30% during their first year of operation. Demand for natural gas in the United States has more than doubled over the past two decades. However, since 1996, domestic production of natural gas has grown at an annual rate of well below one percent. This slow increase is due to a number of factors, a primary one being that currently producing gas fields are maturing and producing less gas. Overall Canadian production is projected to remain relatively flat and exports to the United States, after factoring in expanding Canadian use, are expected to decline. Canada is expected to use more natural gas to heat buildings and to produce unconventional oil from tar sands, which uses heat from natural gas.
At present, more than 25% of daily U.S. gas production is recovered from tight and unconventional reservoirs which have become an increasingly important part of the equation in meeting natural gas demand. These unconventional gas properties usually have low risk F&D costs less than $2.00/mcfe which are further decreasing over time as efficiencies increase and shale gas reservoir knowledge improves. The unconventional gas reserves are usually tapped using horizontal well technologies, which have depletion rates of upto 70% in the first year of production and require continuous drilling to meet demand. Notably, the overall marginal cost of natural gas supply, including finding, development and operational costs is around $6.50/mcf. Another positive factor effecting natural gas is the potential Cap and Trade system as natural gas is a clean burning fuel. The European experience shows, as carbon prices increase (>$25/ton), the marginal cost of an inefficient coal-fired vs. an efficient natural gas-fired plant will cause a partial switch towards natural gas.
The current situation is that about 45% (from 1,606 to 884) of U.S. rigs have been shut since September 2008. Drillers need to add more than 3.5 bcf/day to offset declines and this means that the gas production going forward will decrease, at a faster pace than demand. This will naturally in due time, lead to higher natural gas prices. Natural gas futures for delivery in January 2010 are trading at a 49% premium to the April contract.
Unconventional Resources
In order to analyze the upside it is important to decipher the unconventional natural gas resource play. These resources could be in the form of tight gas, shale to name a few. Tight gas is typified by large volumes of low quality rock, moderate porosity (ratio of the volume of openings to the total volume of material) and ultra low permeability (measure of the ease with which fluids will flow). fields. The complexities of the depositional setting influences both porosity and permeability in the region, resulting in rapid variation of rock quality over short distances. Most tight reservoirs have to be fractured before they will flow gas at commercial rates.
Advances in technology, principally the Horizontal well technologies with multiple fractures have allowed the unconventional resources to produce at very economic rates. Although no two unconventional resources are alike; tight gas sands and shales have been found and developed for decades. E&P companies (I would suggest, at a minimum to go thru their latest presentations) like Chesapeake Energy, XTO energy and more recently PetroBank among others have used advancing technologies to economically extract resources from unconventional reserves. Economics per well dictate returns of 25-100+% with horizontal wells depending on the natural gas prices.
My research suggests that most of the unconventional gas resources (tight sand or shale) economically speaking are similar in the sense that they are (as management states) long life, repeatable, low risk, large reserve, natural gas resources. Technological improvements have increasing made it possible to economically extract resources from such resources. The recovery factor in these resources usually ranges from 20-30%. The difference economically arises from the development costs. Therefore, factors such as technology, spacing between wells, frac positioning and drilling costs are central and will affect the rate of returns. The challenge is to maximize the flow rate for the lowest cost.
At a time, where most of the integrated oil and gas companies are struggling to add reserves, these unconventional E&P companies can be a good opportunity to add long term, low risk reserves.
Natural Gas
Natural gas is one of the cleanest burning hydrocarbons and an essential energy source. The depletion rates for natural gas in the U.S. for the fields put into production in 1990 were down 17% after the first year, those put into production today deplete more than 30% during their first year of operation. Demand for natural gas in the United States has more than doubled over the past two decades. However, since 1996, domestic production of natural gas has grown at an annual rate of well below one percent. This slow increase is due to a number of factors, a primary one being that currently producing gas fields are maturing and producing less gas. Overall Canadian production is projected to remain relatively flat and exports to the United States, after factoring in expanding Canadian use, are expected to decline. Canada is expected to use more natural gas to heat buildings and to produce unconventional oil from tar sands, which uses heat from natural gas.
At present, more than 25% of daily U.S. gas production is recovered from tight and unconventional reservoirs which have become an increasingly important part of the equation in meeting natural gas demand. These unconventional gas properties usually have low risk F&D costs less than $2.00/mcfe which are further decreasing over time as efficiencies increase and shale gas reservoir knowledge improves. The unconventional gas reserves are usually tapped using horizontal well technologies, which have depletion rates of upto 70% in the first year of production and require continuous drilling to meet demand. Notably, the overall marginal cost of natural gas supply, including finding, development and operational costs is around $6.50/mcf. Another positive factor effecting natural gas is the potential Cap and Trade system as natural gas is a clean burning fuel. The European experience shows, as carbon prices increase (>$25/ton), the marginal cost of an inefficient coal-fired vs. an efficient natural gas-fired plant will cause a partial switch towards natural gas.
The current situation is that about 45% (from 1,606 to 884) of U.S. rigs have been shut since September 2008. Drillers need to add more than 3.5 bcf/day to offset declines and this means that the gas production going forward will decrease, at a faster pace than demand. This will naturally in due time, lead to higher natural gas prices. Natural gas futures for delivery in January 2010 are trading at a 49% premium to the April contract.
Unconventional Resources
In order to analyze the upside it is important to decipher the unconventional natural gas resource play. These resources could be in the form of tight gas, shale to name a few. Tight gas is typified by large volumes of low quality rock, moderate porosity (ratio of the volume of openings to the total volume of material) and ultra low permeability (measure of the ease with which fluids will flow). fields. The complexities of the depositional setting influences both porosity and permeability in the region, resulting in rapid variation of rock quality over short distances. Most tight reservoirs have to be fractured before they will flow gas at commercial rates.
Advances in technology, principally the Horizontal well technologies with multiple fractures have allowed the unconventional resources to produce at very economic rates. Although no two unconventional resources are alike; tight gas sands and shales have been found and developed for decades. E&P companies (I would suggest, at a minimum to go thru their latest presentations) like Chesapeake Energy, XTO energy and more recently PetroBank among others have used advancing technologies to economically extract resources from unconventional reserves. Economics per well dictate returns of 25-100+% with horizontal wells depending on the natural gas prices.
My research suggests that most of the unconventional gas resources (tight sand or shale) economically speaking are similar in the sense that they are (as management states) long life, repeatable, low risk, large reserve, natural gas resources. Technological improvements have increasing made it possible to economically extract resources from such resources. The recovery factor in these resources usually ranges from 20-30%. The difference economically arises from the development costs. Therefore, factors such as technology, spacing between wells, frac positioning and drilling costs are central and will affect the rate of returns. The challenge is to maximize the flow rate for the lowest cost.
At a time, where most of the integrated oil and gas companies are struggling to add reserves, these unconventional E&P companies can be a good opportunity to add long term, low risk reserves.
Tuesday, April 14, 2009
Distressed Debt Investing
This blog was meant to present my ideas and opinions, but there is something very interesting going on at the Distressed Debt Investing Blog. This is a topic that really interests me and for anyone who is interested in detailed distressed debt analysis this blog is a must.
I've been really busy and therefore have not posted as much as I'd like; having said that I'll try to post regularly from now on...
I've been really busy and therefore have not posted as much as I'd like; having said that I'll try to post regularly from now on...
Friday, February 20, 2009
flation - In or De?
"I don't know" is where I will begin (and end). But in between, let me present some differing views. Everyone (and I mean everyone) is convinced that Fed's actions will produce massive inflation going forward. I am sure you have seen the charts showing money supply a year ago and today and the chart is off the charts. The popular view is that we'll face some deflation and then massive inflation. OK, but my problem here is that when everyone is convinced something will happen, it usually doesn't!
Barron's recently interviewed Ray Dalio of Bridgewater Associates (excellent interview) and asked him the inflation question. He said, "A wave of currency devaluations and strong gold will serve to negate deflationary pressures, bringing inflation to a low, positive number rather than producing unacceptably high inflation -- and that will last for as far as I can see out, roughly about two years." So no inflationary worries there! Furthermore, a Matin Wolf article in the Financial Times (another excellent article) compared the current recession to Japan's and drew some lessons. He is more worried about deflation, than about inflation. The argument here is that this is balance sheet recession (similar to Ray's point) and these ones (a) take time (b) inflict pain (c) are not easy to tackle. But again, no inflationaly worries..
On the other hand a handful of very respected value investors including Seth Klarman, David Einhorn and Mohnish Pabrai are really worried about inflation and are putting their money where their mouth is! Seth Klarman as I mentioned in a previous post said, "We think inflation could become out of control in 3 to 5 years. Yet, we might not wait for that position. Hence, perhaps early, we have a large inflation hedge. We don't own gold as a commodity. We won't disclose our inflation hedge, yet with enough work, you can find true inflation hedges." David Einhorn of Greenlight Capital in his latest shareholder letter said, "Our current chairman of the Federal Reserve, Ben Bernanke, is an "inflationist". When times were good, he supported an easy money policy. Even when the Fed raised rates...bubble formation...money printing...Our guess is that if the chairman of the Fed is determined to debase the currency, he will succeed. Our instinct is that Gold will do well either way: deflation will lead to further steps to debase the currency, while inflation speaks for itself." Mohnish Pabrai in this annual letter to his investors went a step further and gave his macro view on the economy going forward. I mean this is an ardent Buffett follower and hes talking about the macro view and the massive inflation and high interest rates in the future. He has geared his portfolio towards hard assets like low cost barrels in the ground, low cost iron ore reserve etc. Said another way - hes buying commodities!
Only time will tell what will happen. This is a time when many wonderful business are selling for way below their intrinsic values. The challenge in this market is to identify and buy the safest and the cheapest stock (or debt). The macro world can change very fast; are you agile enough? As a value investor if you are overly worried about the macro view, a smart hedge I can understand, a core holding - not so much!
Barron's recently interviewed Ray Dalio of Bridgewater Associates (excellent interview) and asked him the inflation question. He said, "A wave of currency devaluations and strong gold will serve to negate deflationary pressures, bringing inflation to a low, positive number rather than producing unacceptably high inflation -- and that will last for as far as I can see out, roughly about two years." So no inflationary worries there! Furthermore, a Matin Wolf article in the Financial Times (another excellent article) compared the current recession to Japan's and drew some lessons. He is more worried about deflation, than about inflation. The argument here is that this is balance sheet recession (similar to Ray's point) and these ones (a) take time (b) inflict pain (c) are not easy to tackle. But again, no inflationaly worries..
On the other hand a handful of very respected value investors including Seth Klarman, David Einhorn and Mohnish Pabrai are really worried about inflation and are putting their money where their mouth is! Seth Klarman as I mentioned in a previous post said, "We think inflation could become out of control in 3 to 5 years. Yet, we might not wait for that position. Hence, perhaps early, we have a large inflation hedge. We don't own gold as a commodity. We won't disclose our inflation hedge, yet with enough work, you can find true inflation hedges." David Einhorn of Greenlight Capital in his latest shareholder letter said, "Our current chairman of the Federal Reserve, Ben Bernanke, is an "inflationist". When times were good, he supported an easy money policy. Even when the Fed raised rates...bubble formation...money printing...Our guess is that if the chairman of the Fed is determined to debase the currency, he will succeed. Our instinct is that Gold will do well either way: deflation will lead to further steps to debase the currency, while inflation speaks for itself." Mohnish Pabrai in this annual letter to his investors went a step further and gave his macro view on the economy going forward. I mean this is an ardent Buffett follower and hes talking about the macro view and the massive inflation and high interest rates in the future. He has geared his portfolio towards hard assets like low cost barrels in the ground, low cost iron ore reserve etc. Said another way - hes buying commodities!
Only time will tell what will happen. This is a time when many wonderful business are selling for way below their intrinsic values. The challenge in this market is to identify and buy the safest and the cheapest stock (or debt). The macro world can change very fast; are you agile enough? As a value investor if you are overly worried about the macro view, a smart hedge I can understand, a core holding - not so much!
Friday, February 13, 2009
Value Investor and Shorting
This is somewhat of a tricky subject for Value investors. Warren Buffett (WB) doesn't short - for very good reasons. Most of the seasoned value investors that we emulate are long only portfolio managers. Berkshire Hathaway shareholder letters are said to be everything one needs to know in order to make money in the markets but WB lists no rules for shorting. Ben Graham on the other hand pair traded, but WB dint copy that practise because he observed that for every 4-5 'wins' there was a 'loss' which would more or less wipe out the 'wins'. On the other hand, there are many enterprising investors Paulson, Watsa et. all that successfully shorted in the past 2 years and made a killing. Anyone who was long only in the last 2 years has lost money. Anybody who was short anything has made money. This means that the outcome was favorable, but was the decision right? If the decision was right the process must have been right. On the other hand, if the decision was wrong, then 'luck' must have all the credit and not the process. Lets look at this.
Now why doesn't WB short? As Keynes said, "Markets can remain irrational longer than you can remain solvent". WB has said that, Charlie and him had identified a lot of securities which were overvalued and would correct, but could never determine when they will correct. This is the essence of it. When a bunch of long/short hedge fund managers were asked to identify some mistakes - 90% answered that one of their biggest mistakes have been shorts going against them (the thesis was that the security is overvalued). A very good example would be VolksWagen, u'd probably be having nightmares if you were short VolksWagen!
One thing is clear, with the advent of large pools of capital the markets have been and will be a lot more volatile. Long only portfolio managers will probably have to suffer short (or long) periods of under performance. (A) There is nothing wrong with this (B) Volatility is good for the value investor because it creates opportunity. The catch here is that you can take advantage of this opportunity only is you have dry powder. So a lesson here could be that holding some amount of cash is good, you don't have to be 100% invested all the time. A more aggressive lesson could be to find out ways to capitalize on the volatility - to learn from Paulson, Watsa and Ben Graham.
In Security Analysis, Ben Graham says that if a bond is trading for 100 and its callable at 102, it would be a mistake to go long at 100 as the downside is way more than the upside (opposite of what a value investor wants). Well, but what about shorting the bond at 100? The downside now is $2 plus the interest and the upside is $100 (the bond was trading in the mid 60's a few months later). If the whole idea here is to make 'bets' with heads I win and tails I don't loose that much, then this makes sense. Today credit default swaps (CDS) are available which isolate the credit risk in the bond which is exactly what we are interested in. In a lot of these cases the downside to these instruments for a lot of companies in early 2007 was very little and the upside much much greater. It is a neat way to bet against a company or a sector, given that the CDS's are cheaply priced. Anybody thinking should study Paulson, Watsa and Ackman and their trades over the years.
Another possible solution here is LEAPS. Having determined that shorting a stock is a bad idea, a PUT might be useful in achieving the desired trade. This however reminds me of the guy who bought PUTs on Yahoo! in 1999 just to have them expire one month before the 2000 crash. In addition, yours truly shorted Countrywide Financial (CFC) in 2007 when it was at $35 using PUTs just to sell at a loss (around $38) on rumors that Bank of America will acquire them at around $45. But if one is convinced that a particular stock is a good short, a put strategy can be devised whereby the person starts with the small position and increase the 'bet' if the stock goes higher, use the increasing weight of bets to your favor - Kelly formula. These are also, heads I win and tails I don't loose that much investments, albeit if done properly.
In my opinion, shorting should be done very selectively and when the odds are greatly in your favor. Yes, same applies to going long, so maybe super selective is the right word. Another takeaway here could thinking about shorting stocks vs. shorting sectors (wherever your circle of competence falls). Having said all this, I am a novice when it comes to shorting and what is involved is another post. This post was meant to argue that shorting is within the value investing framework.
Now why doesn't WB short? As Keynes said, "Markets can remain irrational longer than you can remain solvent". WB has said that, Charlie and him had identified a lot of securities which were overvalued and would correct, but could never determine when they will correct. This is the essence of it. When a bunch of long/short hedge fund managers were asked to identify some mistakes - 90% answered that one of their biggest mistakes have been shorts going against them (the thesis was that the security is overvalued). A very good example would be VolksWagen, u'd probably be having nightmares if you were short VolksWagen!
One thing is clear, with the advent of large pools of capital the markets have been and will be a lot more volatile. Long only portfolio managers will probably have to suffer short (or long) periods of under performance. (A) There is nothing wrong with this (B) Volatility is good for the value investor because it creates opportunity. The catch here is that you can take advantage of this opportunity only is you have dry powder. So a lesson here could be that holding some amount of cash is good, you don't have to be 100% invested all the time. A more aggressive lesson could be to find out ways to capitalize on the volatility - to learn from Paulson, Watsa and Ben Graham.
In Security Analysis, Ben Graham says that if a bond is trading for 100 and its callable at 102, it would be a mistake to go long at 100 as the downside is way more than the upside (opposite of what a value investor wants). Well, but what about shorting the bond at 100? The downside now is $2 plus the interest and the upside is $100 (the bond was trading in the mid 60's a few months later). If the whole idea here is to make 'bets' with heads I win and tails I don't loose that much, then this makes sense. Today credit default swaps (CDS) are available which isolate the credit risk in the bond which is exactly what we are interested in. In a lot of these cases the downside to these instruments for a lot of companies in early 2007 was very little and the upside much much greater. It is a neat way to bet against a company or a sector, given that the CDS's are cheaply priced. Anybody thinking should study Paulson, Watsa and Ackman and their trades over the years.
Another possible solution here is LEAPS. Having determined that shorting a stock is a bad idea, a PUT might be useful in achieving the desired trade. This however reminds me of the guy who bought PUTs on Yahoo! in 1999 just to have them expire one month before the 2000 crash. In addition, yours truly shorted Countrywide Financial (CFC) in 2007 when it was at $35 using PUTs just to sell at a loss (around $38) on rumors that Bank of America will acquire them at around $45. But if one is convinced that a particular stock is a good short, a put strategy can be devised whereby the person starts with the small position and increase the 'bet' if the stock goes higher, use the increasing weight of bets to your favor - Kelly formula. These are also, heads I win and tails I don't loose that much investments, albeit if done properly.
In my opinion, shorting should be done very selectively and when the odds are greatly in your favor. Yes, same applies to going long, so maybe super selective is the right word. Another takeaway here could thinking about shorting stocks vs. shorting sectors (wherever your circle of competence falls). Having said all this, I am a novice when it comes to shorting and what is involved is another post. This post was meant to argue that shorting is within the value investing framework.
Thursday, January 1, 2009
Stock Analysis: Domtar (UFS)
Domtar (UFS: $1.70) is a manufacturer and marketer of uncoated freesheet paper in North America. The Company also manufactures papergrade, fluff and specialty pulp. This is not to be confused with newsprint where the demand is steadily declining and there seems to be no light at the end of the tunnel. Uncoated freesheet is the paper that you and I use in our printers, envelopes and books. Look around you and you will see a lot of it lying around, we will always need it! use it! Do you remember how much it cost you the last time you purchased a stack? How many times have we heard the phrase, "blah is not worth the paper it is written on"? It is definitely an expense for corporate America but one that does not hold much weight in terms of cost; it will probably be the last thing that is cut from corporate and household budgets alike.
Industry:
Demand is decreasing because of the digitization of everything. We don't need as much paper anymore - we use the internet, use kindle/iphone to read e-books, advertisers/retailers are not demanding much paper for pamphlets/catalogs. The demand has been declining at a 2-3% rate since 2000, I expect the demand to be flat to slightly positive going forward. The good thing is the industry saw this coming - they consolidated! Domtar is the largest producer of Uncoated Freesheet Paper inNorth America with market share of 34%; while International Paper has 26%, Boise Cascade has 9%, Georgia Pacific has 7% and Glatfleter has 4% market share. The top 5 companies control more than 80% of the market and that means a lot of pricing power.
Uncoated Freesheet paper is a commodity market. In a commodity market where price determines market share, it is important to be the low cost producer - Domtar is! The price setting mechanism at the margin is the cost of production of the highest cost producer. The paper industry is one of the most capital intensive industries in the US. As a comparison, per dollar of output, it takes twice as much investment in PP&E to produce paper as it does cars. In addition, manufacturers have to deal with strict environmental and health safety issues. Aldabra (a blank check company for UFS) notes that there hasn't been a new mill built in the last 12 years. Aldabra estimates that it is paying about $1.625 billion to purchase manufacturing assets that would cost in excess of $4 billion to build new. In other words, returns on capital for new capacity are so low that it's economically impossible to build new capacity. These costs create high barriers to entry making it unlikely that new players will emerge. In essence the view is this:
(1) New competitors will not come in as there are high barriers to entry
(2) The industry has consolidated and collusion can take place in terms of price increases
(3) Yes, demand is declining but prices can be passed to the customers (the view is that this is akin to the tobacco industry where they initiated price increases to combat declining demand - keeping the top line fairly constant)
Company Valuation:
Domtar has a market capitalization of $870 million and EV of $2.8 billion for a ttm EV/EBITDA of 3.5x. Domtar is producing around $800 million in EBITDA/year, which I will assume as fairly constant as the lack of demand in the short term will be taken care of by the savings from the synergies from the merger (yes synergies are real here!). Domtar's capex is around 30% of the D&A expense and it has been aggressively paying down debt (does not have immediate maturities) from the cash flow generated. We can value Domtar anywhere between 6-8x EBITDA conservatively and at those valuations I get around $5.20/share - $8.26/share.
I also did a DCF on this and without posting my model here - assuming no growth, capex equal to 30% of D&A and a 10% WACC I get around $7-8/share. Domtar also has some NOL's (from years of losses) which I will not bring into the equation to be conservative. What I guess I am trying to say here is that Domtar is grossly undervalued and it is obvious! It can be an absolute home run if the competitors keep behaving rationally - keep demand and supply in check and Domtar keeps paying down debt.
But I am not buying and here's why:
(1) A major major assumption is that the competitors will behave rationally and keep demand and supply in check. It has been happening, but will it keep happening? Game theory says otherwise!
(2) They only have pricing power to a point. According to some experts, it costs about 10%-20% more to import uncoated freesheet paper than to manufacture it domestically. So firms have room to raise prices but not by much - eventually imports will start kicking in!! The only thing that is keeping the industry profitable is consolidation. If there is excess supply, they will again be led back to their old unprofitable ways. Also in a soft market if the suppliers hold the line, firms from Asia or Latin America who themselves might be facing economic headwinds might 'dump' their paper in the NA market.
(3) Abitibi-BoWater is marketing a new kind of paper made from mechanical pulp. They also commissioned a study which found that this paper has a lower environmental impact than the paper from traditional chemical pulp.
(4) This is a company (and industry) that has huge operating leverage and in a scenario where soft demand persists the fixed costs will eat into any profits they might make. Although Domtar is a low cost producer and the price is essentially set by the high cost producers; the price of uncoated freesheet paper has to be around $ 500-$550 (it is at around $1000 right now) for them to break even.
In essence, I don't see what the team at Baupost is seeing. They have a 7.9% position in Domtar and are one of the biggest shareholders so they must be really convinced? Does anyone else see things differently?
Disclosure: No Position
Industry:
Demand is decreasing because of the digitization of everything. We don't need as much paper anymore - we use the internet, use kindle/iphone to read e-books, advertisers/retailers are not demanding much paper for pamphlets/catalogs. The demand has been declining at a 2-3% rate since 2000, I expect the demand to be flat to slightly positive going forward. The good thing is the industry saw this coming - they consolidated! Domtar is the largest producer of Uncoated Freesheet Paper in
Uncoated Freesheet paper is a commodity market. In a commodity market where price determines market share, it is important to be the low cost producer - Domtar is! The price setting mechanism at the margin is the cost of production of the highest cost producer. The paper industry is one of the most capital intensive industries in the US. As a comparison, per dollar of output, it takes twice as much investment in PP&E to produce paper as it does cars. In addition, manufacturers have to deal with strict environmental and health safety issues. Aldabra (a blank check company for UFS) notes that there hasn't been a new mill built in the last 12 years. Aldabra estimates that it is paying about $1.625 billion to purchase manufacturing assets that would cost in excess of $4 billion to build new. In other words, returns on capital for new capacity are so low that it's economically impossible to build new capacity. These costs create high barriers to entry making it unlikely that new players will emerge. In essence the view is this:
(1) New competitors will not come in as there are high barriers to entry
(2) The industry has consolidated and collusion can take place in terms of price increases
(3) Yes, demand is declining but prices can be passed to the customers (the view is that this is akin to the tobacco industry where they initiated price increases to combat declining demand - keeping the top line fairly constant)
Company Valuation:
Domtar has a market capitalization of $870 million and EV of $2.8 billion for a ttm EV/EBITDA of 3.5x. Domtar is producing around $800 million in EBITDA/year, which I will assume as fairly constant as the lack of demand in the short term will be taken care of by the savings from the synergies from the merger (yes synergies are real here!). Domtar's capex is around 30% of the D&A expense and it has been aggressively paying down debt (does not have immediate maturities) from the cash flow generated. We can value Domtar anywhere between 6-8x EBITDA conservatively and at those valuations I get around $5.20/share - $8.26/share.
I also did a DCF on this and without posting my model here - assuming no growth, capex equal to 30% of D&A and a 10% WACC I get around $7-8/share. Domtar also has some NOL's (from years of losses) which I will not bring into the equation to be conservative. What I guess I am trying to say here is that Domtar is grossly undervalued and it is obvious! It can be an absolute home run if the competitors keep behaving rationally - keep demand and supply in check and Domtar keeps paying down debt.
But I am not buying and here's why:
(1) A major major assumption is that the competitors will behave rationally and keep demand and supply in check. It has been happening, but will it keep happening? Game theory says otherwise!
(2) They only have pricing power to a point. According to some experts, it costs about 10%-20% more to import uncoated freesheet paper than to manufacture it domestically. So firms have room to raise prices but not by much - eventually imports will start kicking in!! The only thing that is keeping the industry profitable is consolidation. If there is excess supply, they will again be led back to their old unprofitable ways. Also in a soft market if the suppliers hold the line, firms from Asia or Latin America who themselves might be facing economic headwinds might 'dump' their paper in the NA market.
(3) Abitibi-BoWater is marketing a new kind of paper made from mechanical pulp. They also commissioned a study which found that this paper has a lower environmental impact than the paper from traditional chemical pulp.
(4) This is a company (and industry) that has huge operating leverage and in a scenario where soft demand persists the fixed costs will eat into any profits they might make. Although Domtar is a low cost producer and the price is essentially set by the high cost producers; the price of uncoated freesheet paper has to be around $ 500-$550 (it is at around $1000 right now) for them to break even.
In essence, I don't see what the team at Baupost is seeing. They have a 7.9% position in Domtar and are one of the biggest shareholders so they must be really convinced? Does anyone else see things differently?
Disclosure: No Position
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