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Constellation Energy Partners

August 27, 2009 5 comments

A small-cap natural gas pure play that is selling for 23% of its Net Asset Value (NAV). The opportunity provides a huge margin of safety and an extremely compelling upside.

Company

Constellation Energy Partners was formed by Constellation Energy Group in 2005. In Nov 2006 CEP was taken public. Constellation Energy Group still owns 28% of CEP, although they are looking to divest and looks like will sell their stake.

The company’s current assets include natural gas and oil reserves in the Black Warrior Basin in Alabama, the Cherokee Basin in Oklahoma and Kansas, and the Woodford Shale in the Arkoma Basin in Oklahoma. NatGas accounts for 99% of its reserves.

For tax purposes the company is a MLP.

Industry

Everyone has read the headlines about NatGas selling at 7-year lows. Although if you listen to the management team of most NatGas companies, it is clear that prices will rebound into the 7-10 range in 2010 and even higher in 2011.

From the EOG’s most recent conference call:

Mark Papa [CEO]:
“Our view of the North American gas and oil markets is consistent with our previous earnings call, except that we’ve become more bullish regarding 2010 and 2011 gas prices. We still expect North American gas prices to remain quite low through year-end.

As you know, we’ve historically devoted a lot of work to developing domestic gas supply models and we think our current model is the most granular and best we’ve ever built. It’s telling us that December 2009 domestic production will be 4.8 Bcf a day lower than year-end 2008 and this deficit will deepen further throughout 2010. When added to the Canadian supply drop of at least 0.8 Bcf a day, we expect the gas market to turn sometime early in 2010 almost regardless of what happens to LNG imports.

Everybody seems to be focusing on the supply growths from new horizontal plays, but the 800 pound gorilla in the room is Texas vertical gas production. This represents the largest single block of production in the U.S. 16.3 Bcf a day in December ’08, and the rig count here has fallen from 450 rigs in January 2008 to 145 rigs today [Aug 4 ’09].

Our model shows production from this large segment of domestic production will fall from 16.3 Bcf a day at year-end ’08 to 13.2 Bcf a day by year-end ’09 and then 11.6 Bcf a day by year-end 2010 down 4.7 Bcf a day over two years. In my opinion, this is the most important well population that people should be focusing on if they want to understand what’s going to happen to gas supply over the next 24 months.”

In order words, NatGas prices are bound to go up in 2010 and 2011. All the near term concerns about storage don’t impact NatGas’ future prospects.

Reserves

As of Q2 ’09, CEP has total proven reserves of 232 Bcfe, with 99% of it as natural gas. It owns 3 reserves: Black Warrior Basin (111.6 Bcfe), Cherokee Basin (115.7 Bcfe), and Woodford Shale (5.1 Bcfe).

As of Q2 ’09 the average daily production was 48MMcfe. So the company is producing 18.25Bcfe per year. At that rate the company has over 12 years of production reserve. This is definitely not a growth company, but it has plenty of years left of production.

The company does not into to spend much capital on new drilling, not until the commodity market recovers. This will allow the company to redirect the cash flow to pay down debt.

Production Costs

The company’s production costs is about $3.1. The company is not the most efficent in production costs but it is right around average w/ the industry. At current NatGas prices the company is at a loss with its production costs. The hedges that the company has protects it in the current market. As the market rebounds their non-hedged production will be profitable and increase cash flow.

Hedges

The management has shrewdly hedged its production for the next 5 yrs. The hedges are in the $7-8 range, allowing the company to create stable cash flow. The company hasn’t hedge its entire annual production but a large chunk of it is hedged for the next couple of years

2009 – 6  Bcfe – $8.39
2010 – 12 Bcfe – $8.19
2011 – 10 Bcfe – $8.46
2012 – 9  Bcfe – $8.34
2013 – 8  Bcfe – $7.33
2014 – 6  Bcfe – $7.03

With the annual producton of 18 Bcfe, the company is likely to produce 9 Bcfe in the last 6 months of 2009. The company has hedged most of that production in the $8 range. So the company’s cash flow for the rest of 2009 will be extremely stable. With the annual production of 18 Bcfe, the company has hedge over 50% of its production in 2010 and  2011. This should allow the company to easily ride out the currently low NatGas prices and wait until more realistic market prices. The management team has stated that it purchase more hedges at the right price. We expect the company to hedge more of its production as the market prices recover.

Debt

The company has $220M oustanding on its $225 of its borrowing base. The company initially had a borrowing base of 265M. The base was reduced to 225M which caused the outstanding amount to be greater than 90% of the borrowing base. The company has been forced to place a temporary distribution suspension on its dividend.

The debt matures on Oct 2010. The company will likely generate 50-70M between now and Oct 2010. The company also has 16M of cash on hand. The company has made paying down the debt a priority. If the company redirects majority of its cash flow and the current cash towards debt paydown, the company will likely have around 150-170M in debt at Oct 2010. The debt load will be miniscule when compared to the company’s expected proved reserves of 210 Bcfe at Oct 2010. The company will easily able to refinance and rollforward its debt. Although the interest rate on the debt might go up, we don’t expect the higher interest rate to have much impact on the cash flow. We expect the lower principal amount to easily mitigate any increased interest rate.

Cash Generation

Compared to the company’s cash generation, the company is extremely undervalued. The company had adjusted EBITDA of 17M in Q2 and 17.3M in Q1 of 2009. The adjusted EBITDA in the most recent quarters:

Q2 09 – 17M
Q1 09 – 17.3M
Q4 08 – 18M
Q3 08 – 18.8M
Q2 08 – 20.5M
Q1 08 – 17.5M

The 2008 numbers are higher than 2009 due to non-hedged sales at much higher prices. For Q3 and Q4 of 2009 we expect the company’s EBITDA to keep decreasing because of the non-hedged sales will be at depressed values. Although given that it has most of its 2009, 2010, and 2011 production hedged, we expect the company to still make mid-teens in cash flow per quarter.

As for CapEx, the company spent 25M this year on getting new rigs placed. We think the CapEx will be less this coming year since with low NatGas prices it doesn’t make sense for management to increase or keep production at current rate. Even if you expect 25M in CapEx, you are looking at around 35-50M of FCF

Valuation

Based on the company’s 232Bcfe of proven supply, the company’s NAV is $13/share. At the current share price of $3, this is a huge margin of safety on a company w/ hard assets. If we expect the NatGas prices to hit $6-7, you are getting the company for around 20% of NAV. Talk about dirt cheap.

There is plenty of talk about storage running low and it might cause NatGas prices to go well below the $2.80 range. This is absurd irrational ‘noise’. Also the $13 NAV.

The likelyhood that NatGas stays below $3 is a worst case scenario: depression economy + storage of NatGas stays at a high + production stays at peak levels + commercial/residential demand doesn’t rebound. I think the worst case scenario is unlikely to happen or presist for a long period of time. CEP’s hedges protect the company and buy time until the market rebounds.

Risks

Present value of reserves is calculated with the price assumption of current strips  for the future years (most of them at 6+). If gas stays at this level 3 years in a row they could be in problems or if strip prices fall of a cliff (depression scenario). With strips < $4 the NAV is negative.

The biggest fear w/ the stock is the debt level. The $220M of borrowing against the borrowing limit of $225 is scary. Although the debt is not due until Oct 2010. Also the company has $16M of cash in provide some cushion. Finally, the company can monetize its hedges or some of its NatGas reserve in a worst-case scenario where the company needs near term cash. We believe the extremely discounted share prices provide a huge margin of safety in a Yellowstone like scenario.

The temporary suspension of distributions is something income-sensitive investors will not welcome. Although for value investors we will happily exchange the company pays out dividends for using the cash to payoff its debt. Also, it is likely the company’s suspension is temporary and that company will payout dividend in the near future. We expect the company to be well below the 90% of borrowings by Q4 of 09 (it can easily happen at end of Q3). The distribution payout doesn’t impact out investment thesis (although it would be nice to get the dividends). At current share price to NAV, the shares are an easy 5-6 bagger.

Disclosure: Long CEP

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Categories: Investment Idea

Investment Checklist

August 18, 2009 3 comments

Charlie Munger is famous for saying that investors should use a checklist for selection of companies to invest in. Mohnish Pabrai recently presented on the lesson he learned from the 2008 Credit Crisis and talks about his process for creating his extensive investment checklist.

Categories: Uncategorized

The Second Wave

August 18, 2009 Leave a comment

The sub-prime tidal wave might have passed, although the second major wave is on its wave. The problem with prime borrowers is going to hit the real estate market soon, as prime borrowers run into difficulty making payments on their loans.

The problem with prime borrowers isn’t the falsification of income or loan documentations, instead it is unemployment.  As prime borrowers lose their jobs they will struggle making payments on their loans. The ones that are able to find another job will have to take on steep pay cuts, making it hard to balance their personal books.

The prime borrowers’ defaulting on their loan will be a challenging situation for the real estate industry. In most cases, prime borrowers bought houses with extremely high values, whereas the sub-primer borrower was buying houses at the average or below-average valued houses. The sub-prime properties have been quickly taken out of the market by investors or others who can afford to buy these houses at huge discounts. When you are talking about a house with an average value of 150-300K, you can find investors or first-time buyers can come up with the down payment and afford the interest payments. Although when you start talking about houses with 600k-1M in value, there are not many individuals who will be able to afford these houses. So you will have a situation where the banks will have to take huge losses on the values of these houses or be stuck with them for a long time. In either case, the second wave is coming and it won’t be an easy situation to fix.

The Washington Post has a good article on unemployment and the impact on prime borrowers.

Categories: Uncategorized

Quarterly Update

August 14, 2009 2 comments

We have decided to start providing quarterly updates of our views on the market and especially on our holdings. Our take on these quarterly updates is very different than what the traditional market view is. The markets are addicted to a constant stream of data. The company’s quarterly reporting has dramatic impact on the market’s valuation of the companies. We do not believe a company’s quarterly performance makes or destroys a company or industry. Instead we see these quarterly reporting sometime creating buying of selling opportunities depending on Mr. Market’s over reactions.

The quarter ended 6/30/09 is like a kid overdosed with chocolate. The kid has been hyper and running around making everyone laugh. The audience is over joyed and entertained by the childish actions. Mr. Market is the kid over dosed by earnings that ‘beat the expectations.’ The audience are the players in the market, who have become jovial by these ‘unexpected good news.’

Although the companies are reporting strong earnings, the results are altered by short-term cost cutting measures. Companies have slashed jobs, cut back on capital expenditures, and have used accounting gimmicks (most common is buying back debt at discount to par value) to show strong earnings. These earnings might look good in the short-term but companies can only slash fat so far. After that, you start eating away at the meat, which can have adverse impact in the long term. Investors who are taking these earnings to mean that good times are here, will be regretting it soon.

A review of the our holdings and their quarterly performance:

Caraco Pharma: This is our largest holding. We know the company is struggling with FDA compliance issues and were expecting the operating performance to be dismal. Our main concern was the cash position on the company and whether the company is still positioning itself for the long-term prospects. The company’s cash position is strong 65M (47M net cash after the 18M of debt is taken out). The company is also making investments in R&D and building long-term value. The company changed its CEO, bringing back Jitendra Doshi. We believe the new CEO and the company’s strong cash and long-term prospects look extremely strong compared to the price we built our position.

If Mr. Market takes a negative position on the company’s short-term outlook and starts selling the company for a bigger discount than we initially purchased shares, we will be backing up the truck.

WellCare: The company had phenomenal earnings and strong future guidance. We expected the company to have a strong future outlook. The main concern with the company was the legal issues with the FDA. The company looks to have resolved these issues and is starting to look beyond it. The market is starting to realize the value in the shares and we will believe the shares will appreciate substantially from here.

China Marine Food: The company keeps delivering on the growth and generating the cash flow we expect. The management team is building its IR and getting the word out about the company. The company got approval for listing on AMEX and has started trading on AMEX on Aug 10th.

PhotoChannel: The company keeps growing and generating cash. The margins and the business model is working beautiful and the company is positioning itself for a huge 2010. Even in one of the worst economic environment, the company keeps producing strong growth.

Ternium: We invested in this steel producer because of its ability to generate strong cash flow and the exceptional management team. The management closed on the Venezuelan plant and we believe the company will use the $2B in proceeds to build a plant in Brazil. Ternium’s strong position in Mexico, Argentina, and likely Brazil will produce strong cash flows for one of the best run steel companies in Latin America.

Pinnacle Corp: A wonderful quarter. The management delivered on everything it has promised over the last 12 months. The company got a $25M loan secured by its spare parts. This should basically guarantee the company’s ability to pay off the debt in Feb ’10. Management has fixed the problems at Colgan and the Colgan operations showed the results. The company is finalizing the labor agreement. And, management is close to materializing on its ARS holdings. The company won’t get par value on ARS but it will get lot more than the 85M in loan it backed by the ARS. Finally, the company is currently making around $3 per year in CF, with growth potential in 2010. The company’s shares look cheap at current prices. We have believed in management’s ability to delivery and management delivered big time. We need to be patient with this holding and let Mr. Market realize the value here.

Harvest Natural Resources: We are dumb founded at the prices this company is selling for. At one point the company was selling for less than cash on hand, not to mention they have millions barrels of proven oil and rights to development in many other parts of the world. We believe the oil prices are bound to move up and HNR will keep producing strong cash flows. Management is exception at allocating the capital from the Venezuelan reserves into potential fields in the rest of the world.

Penn Traffic Corp: The management is working on stabilizing the company’s EBITDA. The company has cleaned up its balance sheet and it looks like the operations are stabilizing. We invested in the company with expectations of the company being bought out by a large competitor. Management has its bonus package lined with acquisition of the company at double-digits. We are pleased with what management is doing and are happy to wait until an acquirer comes with a strong offer.

General Growth Properties: Major news has moved the shares up substantially. The bankruptcy is proceeding as expected. GGP is in the driver’s seat in the bankruptcy. We don’t expect any major breakthrough until 2010. We believe the return on this investment will be substantial.

We are excited about the potential for our businesses. We believe in the business models of our investments and believe we have an exceptional management team running them. Mr. Market will take its time to come around and realize the value in these companies. While we plan to wait for Mr. Market to come around, we have made a major mistake in our capital allocation that cost us on substantial returns. We enjoy an environment where we can find plenty of investment opportunities, we sometimes cannot act on it because we don’t have the cash on hand. In the previous quarter we didn’t have cash on hand to invest in our holdings, even though Mr. Market was giving it away for a much bigger discount then when we initially purchased our stake. Holding cash is a defensive position that allows for a quick offense when the stocks drop. Some of my holdings dropped over 70% in the last 12 months. Not having cash around, we couldn’t double or triple down. Going forward, we will always keep a strong cash position, ready to strike it things get even cheaper.

Categories: Updates

Global Ship Lease

August 1, 2009 1 comment
GSL was spun-out by CMA CGM, the third largest liner shipping company. GSL has 17 ships that it owns and leases out to CMA on long-term contracts. The lease rates to be received are fixed, so GSL gets a steady cash flow. Also GSL is not impacted by the drop in lease prices, due to the long-term nature of their contracts. CMA owns a 40% stake in GSL, so there is an incentive for CMA to ensure that GSL doesn’t go into bankrupcy.

GSL has substantial loan for the 17 ships. It has over 550M of debt. The loan covenants require that GSL maintain at least a 90% of debt-to-ship value ratio. The ship value ratio is determined by taking the market value of ships in the second hand market. If the company has 90-100%, GSL can’t paid dividends. For example, in last quarter of 2008 the company’s ratio was well below 90%, GSL paid out $.23 dividend for the quarter. A debt-to-ship value ratio over 100% allows the banks to force default.

GSL is not directly impacted by the market condition. Let’s look at the Net Income and Cash Flow for the 3 most recent quarters:

–   NI         –  CF
3Q       (.3)M    –  12M
4Q      (43)M    –   13M
1Q      11M      –   15M

So basically in some of the worst quarters in decades, the company increased cash flow (net income is impacted by hedges for interest rate). So operationally the company can pay the current interest expense and still generates plenty of cash.

Currently GSL has a debt-to-ship value of over 100%. GSL has been in this situation since early ’09. GSL got the banks to give the company extra time to come up with the fair value of the ships. Basically the market was putting ridiculous low valuation on ships, so GSL was getting an extremely low value. Also, GSL makes about 13M of FCF, so why would the banks force a company that can pay its interest expense and has plenty of additional cash (to support a higher interest rate or pay down principal). Since Feb ’09 the company has gotten the bank to extend the agreement. The company is working with the bank to amend the agreement so the company can start paying dividends again.

From the bank perspective, it doesn’t make sense to force the company into default. First, the company can pay the interest expense (about 4.5M per quarter). Second, by forcing default the banks will be stuck w/ ships in a market where the value of the ships is extremely low. So the banks would take a loss by selling the ship at these depressed values. Third, GSL has a steady stream of cash coming. With the long-term rates, GSL is not exposed to current market rate fluctuations. So I know what this company can make and whether it can keep making the interest payments. Finally, GSL makes plenty of FCF each quarter. So if I’m the banker, I’m thinking how do I force the company to pay me more. If I’m the banker, I work with this company to either increase the interest rate or force the company to make additional principal payments.

GSL’s biggest risk comes from what CMA is doing. As long as CMA can keep paying the monthly charter rates, per agreement, GSL will make its steady cash flow. CMA is a private company, so getting data on it is hard. The main concern regarding CMA is that it has tons of CapEx that it has signed agreements for. With the bad credit crisis and already having a ton of debt, people have concerns over CMA’s ability to survive. Although CMA can get out of those CapEx agreements by paying a penalty and cut back on other expenditures. Also, CMA roughly gets 40M in dividends from GSL, so CMA would look to cancel lease agreements with other lessors first.

The shares of GSL has dropped substantially for mainly two reasons: the CMA concern (whether GSL’s agreements will be honored by CMA) and the temporary hold on dividends payout has dropped the shares dramatically. The CMA concern are valid, although CMA has options to cut or control its CapEx. Also CMA has been buying back its debt in the open market at huge discounts, so management is taking the right steps. As for the hold on dividends, I think this is only temporary. The management definitely wants to pay out those dividends and CMA wants the dividends. Once the bank issues are fixed, I think the dividends will be reinstituted. Also there has been huge selling in GSL shares recently, I think this is because a major holder started unloading once the dividends were put on hold.

The shares currently trade at $1.40, a market cap of 98M. Remember the company was paying dividends of $.23 per quarter, so you are getting a 70%+ dividend yield if the old dividends are reinstated. Most likely dividends will be cut. Even if they only pay 10% of the old dividends, $.02 per quarter, you get about 6% yield. I think the company’s dividends won’t be $.23 per quarter, but at the current prices you will most likely get a high double-digit yield. Also, you have a company still making 50M of FCF. Even if the banks increase the interest rate, you still are getting a company for an extremely low FCF multiple. No matter what happens, once the debt-to-ship issue is resolved, the shares should give you a multi-bagger return from the current prices.

More reading:
http://seekingalpha.com/article/116455-global-ship-lease-undervalued-and-undiscovered
http://seekingalpha.com/article/118400-global-ship-lease-cash-flow-more-important-than-dividends


Categories: Investment Idea