Continual Evolution

HNR: Is the recent price drop justified by deterioration in fundamentals

Rating: 2.67 (3 votes) Vote:

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I have previously posted about my rationale for a large position (in fact my largest holding) in Harvest Natural Resources (NYSE:HNR).

Lately, the stock has not done too well - in fact it is down about 25% in the last few weeks. So I have been doing some digging to see if anything changed regarding the fundamentals.

The main trigger for the decline seems to be an analyst downgrade (2 levels below previous). Rather strangely, the main reason he gave for the downgrade was the lack of stock price appreciation in response to a positive event (more on this later). I expect a better reason from a professional analyst: if there is no fundamental deterioration and the price is lower than before then I would expect the stock to be upgraded rather than downgraded.

The positive event the analyst referred to is the recent sale of a neighboring oil field asset by Anadarko (NYSE:APC), which established a comparable market value to HNR's relatively illiquid assets. Now the APC sale established a value of proven & probable ("2P") reserves of about $6 to $8 per barrel of oil equivalent. Using comparable metrics, the enterprise value of HNR implies that their oil & gas assets are being valued at $3 per barrel of oil equivalent, implying that the stock is selling at least 50% below what just the Venezuelan assets are worth. Note that the "Chavez" discount would be shared by both APC and HNR assets since they are neighboring fields. And there are more assets outside Venezuela that are not being valued in the stock price at all.

Today the company announced its Q1 results which indicate that the recovery towards normal oil production is still intact, albeit a bit slower than I would have liked. Production is up to 13.3Kbpd which is up slightly from last quarter. While I am a bit disappointed at the slow pace of progress, most of the disruption due to the two year hiatus seems to be finally over, and normal operation seems to have resumed. During the conference call, the CEO suggested that the peak production that is possible (based on pre-disruption 2004 performance) may be in "mid 40Ks" range, as more and more production drilling takes place. And since the fixed costs are high, every extra barrel of oil produced adds disproportionately into profits.

The CEO also hinted at more stock buybacks ahead - he suggested that the stock price is irrationally cheap but that the $18M pre-approved buybacks could not be done due to constraints of quite period following internal news about the quarter. Since the total EV is only about $200M, a buyback of about $18M can be significant. The CEO also said that the analyst downgrade made no sense to him.

HNR has been adding geographical diversity to their asset base with fields in Gabon, Indonesia and (recently) two small fields in US, further reducing risk and improving the chances of positive surprises.

But the main reason to invest in HNR is the huge leverage as production recovers from the current 13kbpd (where its a bit above break even due to large fixed costs) to a possible figure near 30 to 40Kbpd over the next few quarters. This will also add to the recovery factor assumed in pricing the assets under ground which also should add to the enterprise value of HNR.

I think that HNR is even more attractive at the current price and the weakness over the past month presents a great buying opportunity.

Trade: Buy GU

Rating: 1.00 (1 votes) Vote:

Founded in 2001 and based in Hong Kong, Gushan (NYSE:GU) is the largest producer of bio-diesel. It converts waste such as vegetable oil, animal fat, and recycled cooking oil for use in a range of diesel engines, including diesel engines found in trucks, mass transit vehicles, marine vessels, and generators. The by-products of its bio-diesel production have various commercial applications in the food, pharmaceutical, and manufacturing industries. It sells its products to direct users, wholesalers, and retail gas stations. The Chinese government has mandated that 15% of fuel must be renewable by 2020.

Gushan is growing rapidly. Its 4Q 2007 revenue grew 50% yoy (31% sales volume and 14% price increase) to $138M. Operating income increased 104% to $53M. With Jan 2008 opening of a new Beijing plant and its existing three production facilities, the company proposes to double production cpacity during 2008, as well as drive volume efficiencies from better utilization of existing plants. It has targeted increasing its annual production volume nearly 50% in 2008.

It has $189M of net cash. I estimate its diluted Earnings/ADS share to be approximately $0.7 so PE@13/sh is about 18. Its fast growth thus implies a forward PEG less than 0.5, making it compellingly cheap at the current price.

I think its a good way to bet on alternate energy as well as China, now that the Chinese market has had a large correction.

Trade: Buy GFA

Rating: 3.00 (1 votes) Vote:

Gafisa S.A. (NYSE:GFA) is one of largest homebuilders & developers in Brazil. They develop land subdivisions, commercial buildings, and have recently started building entry-level housing.

The stable growth pattern of Brazil and good fiscal management has dramatically declined inflation and interest rates (into single digits down from 20%+) in the last few years. The fast growing middle class and the cheaper availability of home financing (no subprime!) has created a significant demand for affordable housing. In response Gafisa, which started out as a high end builder, is now focusses on the affordable segment of the market. Gafisa will also benefit from increasing leverage as external bank financing for longer term mortgages becomes available.

2007 actuals:
Operating Revenues $697M (up 77%)
EBITDA $109M (margin improved to 15.7%)
Net income $85M (up 89%)

Analysts based in Brazil expect EPS for 2008 to be around $2.5/ADR share (I computed this average of 15 analysts by converting to USD and adjusting for ADR ratio).

This translates into 2008 PE of around 15 and since I expect annual growth to exceed 30% for the next few years, it seems cheap at PEG of < 0.5.

A near term catalyst is the stock's recent inclusion in EEM & Bovespa indexes.

I think GFA is a good way to bet on Brazil.

Perspective on housing

Rating: 2.00 (1 votes) Vote:

I have been trying to get a synoptic sense of where we are in the housing triggered liquidity and credit crisis.

Unfortunately, fundamental metrics seem to indicate that the housing problem still has a long way to go before it will turn. For example, using ratio of home prices to rental rates as a metric, economists are suggesting that average home prices have declined only 10% of the 25% needed to restore affordability.

A full 25% decline will cause about 20 million people to have negative equity (25% of all homes). This will result in $6 trillion or $7 trillion in total capital losses in housing and $1 trillion of that will be losses to the financial sector. So far only a fraction of that has been declared. Thus we will continue to see more declarations of losses for quite a while.

On the other hand, the inventory of newly built house has finally stopped rising and even started declining due to sharp reductions in new houses being built coupled with the drop in prices. If this process continues then eventually we will reach the point at which new houses will have to be built again and normalcy will be restored. I think we are still multiple quarters away from this point.

Since the stock market is a discounting mechanism it should recover somewhat sooner that these underlying fundamentals would suggest. Thus there is a reasonable probability that we will see the market turn this year, although not perhaps within the timeframe of this round of our competition.

The housing situation impacts the entire portfolio, but it particularly impacts two of my positions: LOOP and RATE.

Loopnet (LOOP) is the leading online "MNLS" type listing service targeting brokers of commercial real estate. They make money on subscriptions and hence are indirectly driven by real estate transactions rather than on prices. They reported in their last release that they are seeing revenue shift from buyers to sellers who pay them to list their properties. I think LOOP is still a good buy at this point so I will continue to hold it.

Bankrate.com (RATE) is the leading website that aggregates information on mortgages, credit cards, automobile loans, money market accounts, certificates of deposit, checking and ATM fees, home equity loans, and online banking fees. It makes money by supplying this information to leading newspapers (100+ papers, including WSJ, NYT & USA Today) as well as by charging for click-thru when users click on its rate table entries. Its business has held up really well through this crisis (in fact it has continued to grow!). This is because shifts in interest rates drive fresh traffic to its website as consumers shop for optimal rates. I think this will be a good stock to own right through the housing recovery.

Opacity discount

Rating: 3.00 (1 votes) Vote:

I like to invest in foreign companies that are represented by their ADRs on US exchanges. Besides the usual fundamental reasons, one can often get a discount due to the relative opacity of relevant statistics and news on the widely read web sources such as Yahoo Finance.

An opacity discount is currently available on my largest holding, Harvest Natural Resources (HNR), a US company which has most of its assets located in the politically risky Venezuela.

In March 2006, Chavez forced all foreign oil companies to transfer substantial chunks of ownership to a state owned company in exchange for ownership of some new unexplored fields. The situation remained foggy until October 2007 when a new decree was signed and the new ownership terms finalized.

While some "crazy dictator" discount is justified, I think the market has overreacted in this case due to lack of visibility caused by the hiatus in releasing quarterly financial numbers from April 2006 until now.

HNR owns $97M in net cash (= $2.7/share) and has an enterprise value of $311M. It is trading below $13/share at the time of this writing.

HNR can be valued in two different ways:

Asset based Valuation:

HNR owns proven reserves of 1.3 Barrels of oil equivalent (Boe) and 2.2 Boe of proven+possible (P2) reserves. Past analysis has put a value of $8/Boe on comparable Venezuelan P2 reserves, which implies a stock price of $21/share for HNR. This ignores the third category of "possible" unexplored reserves (P3); if we include this, HNR owns 4.3 Boe/share which would imply a much higher valuation.

Cashflow based Valuation:

HNR produces 15K barrels of oil/day (down from 30K/day in Jan05 & up from 14K recently). Using a DCF analysis with 10% discount, the company estimates the net pretax value to be $1.7B. Taking out 50% in taxes leaves a DCF valuation of $27/share.

To be sure, one needs to apply a huge (50%?) "Chavez" discount to these numbers. On the other hand, there are significant upside factors that could increase the valuation significantly:

- HNR will be short receiving a one-time back-payment for oil delivered but not paid for the period Q2 2006 to Q3 2007.

- Now that the money is flowing again, HNR will ramp up production quickly. It should be able to double the current production of 15K bpd to 30K bpd, the rate before the Chavez disruption took place. Workover of old wells now should add value (one workover rig started operating Dec 07). A New rig is starting in Q108 and 1 more being selected for Q2 and another for 2009. Last time they had 2 drilling rigs they went from under 20K bopd to over 30K bopd in 6 months. This could be a 2x upside.

- The boe/share numbers assume a recovery factor of 13% which is conservative since they have demonstrated a factor of 27% in the past. Upside of 2x. The converstion of P3 into P2 and P2 into P1 will add value.

- The $8/boe figure assumed above was used when the price for Venezuelan oil was $46/b. It is now $80/b. Another 1.5x upside.

- HNR also owns fields in Indonesia and Gabon that are unexplored and hence not priced into the calculation so far. Unknown upside.

Taking into account all of these possible upsides, I think HNR is significantly underpriced, even after applying a 50% Chavez discount.

The near term catalyst for HNR will be the earnings release for Q4 and FY2007. Since the company could not post its numbers since April 2006 until the agreement was finalized, the stock price has been severely depressed due to lack of visibility (think of all the screens, indexes, and ETFs for which HNR failed to qualify). As this situation gets fixed in the next few weeks (expected release before mid-March), the stock should provide a nice return.

Musing about real estate

Rating: 2.33 (6 votes) Vote:

The real estate slowdown has primarily hit residential housing starts so far and hence affected the home builders more than any other group. In fact the home owners seem to be in denial and hence the actual house prices have not yet come down - people seem to be sitting tight, hoping for a turnaround. As a result the inventory of unsold houses keeps growing. I think the actual markdown of residential real estate prices still has to happen in the months ahead (disclosure: I own SRS which is effectively a short position on real estate). Thus we are very far from any kind of bottom on house prices as opposed to housing starts.

In the meanwhile WSJ is now reporting the first signs of weakness in commercial real estate, suggesting that the weakness is spreading:

The report is an early sign that the commercial-property sector is being dragged down by the growing reluctance of lenders to extend credit for anything related to real estate, which in turn could create a new drag on the economy and additional problems for investors. Declining commercial-property values could lead to an increase in default rates on commercial real-estate loans and on commercial mortgage-backed securities.

I own Loopnet (LOOP), which is the leading online "MNLS" type listing service targeting brokers of commercial real estate. They make money on subscriptions and hence are indirectly driven by real estate transactions rather than on prices. I think LOOP will benefit from any change in conditions which causes more transactions; hence I think it is a buying opportunity on any further weakness.

Thus I think for now I well stick with both SRS and LOOP even though at first glance they seem to be bets in the opposite directions. SRS should directly benefit from the forthcoming markdown of prices and LOOP from the resulting froth.