Reminiscences of a Stockblogger

Apr 19

Breaking my rule for Pan Orient

One of the rules that I try to follow is not to add to a stock that has fallen below my purchase price. I have been burnt a number of times by doing this. I have ended up trapped in the position, and further averaging down only adds to the problem.

The rule, like all rules, is not of the steadfast sort, and so I do break it from time to time. But when I break it, I do so tentatively, I think about the consequences, and make extra sure that my decision makes sense.

I broke the rule with Pan Orient on Tuesday.

I had a fairly small position in Pan Orient and had been waiting for something of a correction before I added to that position. I didn’t expect the extent of the correction that occured, but after some reflection I decided to add to the stock.

The news that sent the stock down was this news release. What sent the market scurrying was twofold; news that the L44 block exploration was not finding economic oil, and probably more importantly the news that the L53 block was experiencing a relatively high water cut.

In particular, in the news release the company said that the L53-DST3 well had been producing at 540 bbl/d of oil with a 60% water before it was shut-in and cased to perform a sidetrack of a deeper zone. In the February 27th news release the L53-DST3 well was producing at 1,200bbl/d of oil with no water cut.

This is potentially negative news, but its really anybody’s guess at this point just how negative it is. Since the reservoir is high porosity / high permeability it could be water from coning. It could also be that the perforated interval extended down below the oil/water contact or that it partially perforated a water zone. There are also plenty of examples of fields that successfully produce at high water cuts for years. The downside is that the watercut may be creeping into the oil zone and continue to increase with time until the well is uneconomic. Only time will tell.

The market neglected to put any value on the good news from the release. The L53-DST3 well tested a slightly lower sandstone zone (1,179m TVD versus 1,142 to 1,163m m TVD for the previous 2 zones) and that zone was flowing at 400 bbl/d.

In the L53-D2 well, Pan Orient tested the 5 zones that it had previously not tested but had referred to in the original news release of the L53-D2. In that January news release the company said:

Pan Orient is pleased to announce that the L53-D2 exploration well is currently on 90 day production test flowing 27 API degree oil at a rate of 1,015 barrels per day through 17.8 meters of perforations between 1110.8 meters to 1154.7 meters measured depth (860 to 890 meters true vertical depth), within one of six conventional sandstone reservoir intervals interpreted as oil bearing based on oil shows while drilling and open hole log and pressure data analysis.

The news release on Tuesday told us that 5 untested zones have now all been tested and all 5 were found to be oil producing. One zone tested at 929 bbl/d of oil while two others tested above 500 bbl/d. These zones are in addition to the originally tested zone from the January news release that tested at 1,1015 bbl/d and produced 40,917 bbl in the first quarter, which if you assume it was flowing for the full 90 day period means that the well flowed at an average rate of 454 bbl/d for that period.

The bottom line for me is that Pan Orient is finding a lot of oil zones and even if a couple of them don’t work out to be as wonderful as say Coastal’s Bua Ban, they are still going to produce a lot of oil and book a lot of reserves from them.

At this point it comes down to valuation.

Thailand production averaged 2,725 BOPD in the month of March, of which 1,702 BOPD was produced from Concession L53 and a combined 1,023 BOPD from Concessions L44, L33 and SW1. Production in the first quarter of 2012 averaged 2,541 BOPD. Based on the March production number and the basic shares outstanding of 56.7M, Pan Orient is valued at $52,000 per flowing barrel.

According to slide 5 of Pan Orient’s January 9th presentation, yearly cash flow at 2,500 bopd and at $100/bbl WTI should be around $60M, and at 3,000bopd it should be $68M. Again, with 56.7M shares oustanding, that puts the valuation at around 2.5x cash flow.

The company has cash and working capital on hand of $58.5M according to their January 9th presentation. So about $1 of the current shares price is attributable to cash.

Capital expenditures are expected to be $37M for the year so 2,000 bbl/d of cash flow more than covers capital expenditures. With the cash on hand in addition to the cash flow Pan Orient has a CAPEX cover that is rarely seen in the oil and gas junior industry.

I just think this looks over done. I wish now that I had waited another day to buy, as the stock trades at $2.50 whereas I added at $2.76. But I didn’t want to wait too long. The company will be releasing a reserves update on the L53 structure within a week or two and I think that could be a catalyst for the market realizing it has overdone the downside.

Apr 17

The US Economy: Is the data bad?

I put a lot of emphasis on the Weekly Leading Index published by the Economic Cycle Research Institute. The index is a leading indicator of US economic growth. The index and its smoothed annualized growth rate have both turned up recently.

Presumably this suggests an improving economy. Yet the ECRI has been sticking to a prediction that the US economy is going to fall back into a recession.

Why?

I was reading through the ECRI’s publically available articles trying to find out why when I ran into this article. It describes a problem that has developed with the seasonal adjustment algorithms. It seems that the economic collapse that followed Lehman Brothers in 2008-2009 has led to a skew in the adjustment that is being made. Many of the seasonal adjustment algorithms are interpreting the downturn that occurred in Q4 2008 – Q1 2009 as a seasonal event that should be adjusted for.

Most data, both public and private, are seasonally adjusted. But the nature of the Great Recession seems to have had an unexpected impact on the statistical seasonal adjustment algorithms that are hard-wired to detect when the seasonal patterns evolve and change over the years. This is normally a good thing, but when the economy fell off a cliff in Q4/2008 and Q1/2009, it was partly interpreted by these procedures as a lasting change in seasonal patterns. So, according to these programs, data from Q4 and Q1 would be expected thereafter to be relatively weak, and therefore automatically adjusted upwards. Our due diligence on this subject indicates a widespread problem, resulting in many recent economic headlines being skewed to the upside.

The article was written in mid-March but as recent as last week the ECRI remained behind its conclusions and their conviction that the pick-up in growth is illusory. This SeekingAlpha article quoted Lakshman Achuthan (who is the chief economist and spokesman for the ECRI) recentlyas saying that year over year (yoy) growth, which would not be distorted by the 2008-2009 numbers, is not improving.

Please note that PCI growth yoy is still -2.2% and even q-o-q is -4.9%… With yoy growth in all the coincident indicators (GDP, industrial production, personal income and sales) all staying in cyclical downturns, and yoy payroll job growth, which had been the only holdout, now rolling over — as we had predicted a few weeks ago — it’s pretty clear that for now U.S. economic growth is worsening, not improving.

The rub is that the data we have been looking at from January through March may be overly optimistic. It is being overly adjusted to the high side. Now that we are into April, that is about to end.

The data isn’t great

Indeed we are seeing something like that in the recent numbers. The monthly jobs report was a big disappointment. The jobless claims number that came out last week spiked to 380,000.

Home sales, which to me would be the true sign of a pick-up in the economy, remain depressed.

Add to this the fact that gasoline prices are about the only thing that have recovered to pre-recession highs.

What does it mean?

The situation feels to me like another false start. To use the phrase coined by John Maudlin, we are in for more muddling through. Low growth rates, low interest rates; maybe the ECRI will prove to be right and we will dip into another recession.

As for my portfolio, I am of the mind that I am mostly in stocks that should perform well in this environment.

Given the bleak outlook, gold and gold stocks should do well. Of course gold stocks have done anything but well lately. I have to remind myself of the volatility of these stocks, how they can bounce up and down like a yo-yo and turn on a dime. I think that as it becomes more clear that the skies remain grey and the horizon dark, the gold stocks should recover. I am certain that the reason we have not seen a breakdown in the price of gold itself is because there is smart money out there that sees the same picture I am drawing.

The mortgage servicers, Newcastle, Nationstar, and PHH, should hold their own in this environment. Servicing revenues are not dependent on an uptick in home sales to the same extent as other housing related businesses. Interest rates remain at such low levels that these companies continue to accumulate incredible assets (in the form of new servicing rights) that will outperform in years to come.

The regional banks are a bit of a tougher choice. However when I look at many of the regionals, they remain below their price level before the European shock in the summer. The US economy may not be getting that much better, but it is slowly healing, and to see these stocks at lower levels is, in my opinion, a disconnect.

Apr 15

Week 41: A bit of a shellacking

Portfolio Performance

Portfolio Composition

Trades

Update

My practice portfolio has been taking a bit of a shellacking over the past number of weeks. I am down about 10% since the end of February when my portfolio (along with the rest of the market) peaked.

Why I’m doing poorly

When I looked at what has caused the downturn in the practice portfolio I found I could blame most of the loss on 3 things:

$1600 loss from Aurizon Mines. I never thought Aurizon would stay below $5 for as long as it has with gold prices still over $1600. Its bizarre but the same can be said for most gold stocks right now.
$2500 loss from Coastal Energy. Coastal peaked at around $21 per share and I sold Coastal for an average price of around $15.50. After having sold half at $17 I made a $1,000 mistake when I bought it back at $16 only to sell at $14.50.
$4900 loss from Atna Resources. I’m not sure what to say about this one. It was not fairly valued at $1.50 so I was not willing to sell. Now I have to sit through this correction to see if my thesis plays out as I expect

My emphasis on the mortgage servicers and the regional banks has thus far proven correct, and these companies are up slightly in the last month and a half. Unfortunately their gains have been dwarfed by the above losses.

Keegan Resources: Trading almost at cash

Looking ahead I don’t plan to sell any of the gold stocks I own at what I would call ridiculously cheap prices. In fact I did the opposite on Friday; I bought a position in a new gold stock, Keegan Resources. I got Keegan off of a article on Mineweb that listed a number of gold explorers trading at market capitalizations that had fallen to levels where they were mostly covered by the company’s cash balance. Keegan has a cash balance that makes up about 87% of its market cap. I am of the mind that such a large cash position takes a good deal of the risk out of the stock. I will write up Keegan shortly.

Less of what isn’t working with Equal

I did sell some Equal Energy this week. I sold because A. the stock continues to go down even after the announcement of a Mississippian joint venture, which proves that like it or not I have been wrong in my thesis, and B. I am becoming nervous about the falling price of NGL’s and Equal, while being equally weighted between liquids and natural gas, is heavily weighted to NGLs in its liquids.

Back into Arcan

I bought back into Arcan Resources this week. The stock has come well off of its highs, down from $6 to $4.50. At this price, and given the company’s recent production estimate of 6,000 boe/d, it is trading at a reasonable $80K per flowing barrel. The company also announced a boomer well on their southern Virginia Hill lands:

Arcan drilled and completed the Virginia Hills 13-32-64-13W5 (“13-32”) Beaverhill Lake horizontal well, with excellent results. The 13-32 well was drilled to a total depth of 4505 meters and flowed at a rate of 1773 barrels of oil equivalent per day (“BOE/D”) averaged over the first seven days and 1226 BOE/D averaged over its initial 21-day production period, with maximum day rates of 1900 BOE/D (92 percent light oil), flowing dry oil up 4.5″ casing.

Margin

I also wanted to note that a discrepancy has occurred between my practice account and the actual account that I try to track with it. I’m on a lot more margin in the practice account. I’m not positive when this happened, but I don’t look that closely at the practice account balances and I so it wasn’t until this week when the margin in my practice account hit double digits that I noticed that things were out of whack. If my practice account were to reflect the same percentage as my actual account the margin would be around $2,500. I think that what happened is that I am not strict about making sure the ratio of shares that I add in the practice account matches that of the actual account and I tend to round up, so over time I have been taking on more shares of each stock than I should. Anyways I’m not sure what I am going to do about this because if I were to reduce each of the stocks that I have overweighted I would have to take a commission hit of $10 per trade because that is the standard commission charged in the practice account. I think I will just try to slowly reduce the discrepancy over time until I get the account back into alignment with reality.

Apr 14

2 Comments

Looking at the business of Cal-Maine Foods

I’m going to have to spend some time over the next few weeks evaluating stocks that I don’t own in my portfolio covered by this blog. These are companies of a few portfolios that I am taking on the responsibility of managing. Many of these companies I am not terribly familiar with, and so I am going to have to learn what they do and whether they are businesses worth holding onto.

One of the larger positions that I am inheriting is Cal-Maine Foods. In this post I am going to focus on Cal-Maine’s business. In a subsequent post I will look at the effect of the European legislation that is causing egg prices to increase substantially in Europe, and try to draw a conclusion on whether I will hold onto or sell the stock.

What they do

Cal-Maine was founded in 1957 in Jackson Mississippi. The company came on to the national scene when they bought out Ralston Purina in 1972. Since that time they have completed 16 more acquisitions of other egg producers.

Cal-Maine is the largest egg producer in the United States. They sell shell eggs in 29 states, primarily in the southwestern, southeastern, mid-western and mid-Atlantic regions of the United States.

Cal-Maine distinguishes between eggs. They sell regular eggs, and they sell specialty eggs. A specialty shell egg is one of either a nutritionally enhanced, cage free and organic egg. In fiscal 2011, specialty shell eggs represented approximately 25% of our shell egg dollar sales, as compared to to 21% in 2010 and 19% for fiscal 2009. Retail prices for specialty eggs are less cyclical than non-specialty shell egg prices and are generally higher due to consumer willingness to pay for the increased benefits from those products.

Is the company growing?

Cal-Maine says that the shell egg business grows about 1% a year. So this isn’t exactly Facebook. In the last fiscal year (ended May 30th 2011) Cal-maine sold 820,000 dozen eggs. Egg sales have been growing consistently over the past few years at a rate that is higher than the industry growth rate, though this growth rate has been still only been in the low to mid single digits.

Below is the growth in eggs sold since 2007. The 2012 number has been pro-rated to 12 months and I wasn’t sure how much to adjust for seasonality so I might be a bit on the high side here.

Costs and Margins

The cost of producing a dozen eggs have been increasing for Cal-maine. The main input cost is the cost of feeding the chicken. Feed for chickens are corn and soybean meal and so the costs of these inputs are directly related to the cost of corn and the cost of soybeans. Both commodities tend to fluctuate quite a bit, and because of the growth of demand for corn from the developing world, as well as the ethanol subsidies, feed costs have been on what seems to be a secular uptrend over the past few years.

This is what feed costs look like over the past 5 years.

Cal-Maine doesn’t take any forward pricing positions to hedge feed cost. So you can basically look at the price of corn, and to a lesser extent the price of soybeans, and that is what the costs are going to be for that quarter.

Apart from the feed cost, other costs associated with producing eggs consist of the cost of operations, labour, electricity, the usual. There are also processing and packaging costs. The total costs of doing business, and the margins, are illustrated in the table below for the past 5 years as well as thus far in 2012:

Again, its clear that the cost pressures are primarily on the feed side. Processing costs and non-feed farm costs have risen slightly over the past 5 years, but not enough to warrant any concern.

Earnings, ROE, and ROA

Earnings fluctuate pretty significantly depending on feed costs and egg prices:

But even with the cyclicality, its not a bad business. Profitability has been consistent, even through the recession. Return on Equity has consistently been above 15%. Return on Assets has consistently been above 10%.

Two ways to grow the business

Cal-Maine highlights a 4 pronged growth strategy but I am going to focus on the two of those prongs that I think are most promising.

Acquisitions
Specialty Egg Business

Acquisitions

Pretty much all the competitors to Cal-Maine are family owned businesses. At the JP Morgan conference the CEO, Fred Adams, pointed out that there is always generational turnover in these businesses and that turnover represents opportunities for acquisition. What that means in english is that the younger generation isn’t always interested in running a boring egg business and without anyone to take over when the parents are ready to retire, Cal-Maine can buy them out.

I stole the chart below from the Cal-Maine presentation at the conference. As you can see, none of the companies below are publically traded and most of them are family owned.

Obviously the advantage that Cal-Maine has is that it can take over these companies and quickly integrate them into their much larger operation. Presumably there are cost efficiencies to be had.

In response to a question about acquisitions this is what Cal-Maine’s CFO Tim Dawson said about the company’s appraisal process:

When we talk about industry valuations we want to talk about the model we use. We aren’t able to predict egg prices. When you talk about an EBITDA model at the end of the day you are really basing that off of egg prices. And we admit that we can’t predict egg prices. So what we do is we send in a team of internal appraisers, and we do a depreciated replacement cost appraisal of the assets. And then make an adjustment based on how good or bad the market that they service might be.

So basically an acquisition is going to be done based on the equipment, machinery and labour value of the operation. Basically, how much would it cost to build this operation from scratch? By looking at the acquisition target this way, they don’t have to make cash flow predictions that would of course be tied to egg prices.

The CEO, Fred Adams had this to add:

If someone wants to sell their business we are usually the first one they call because we have a good track record. And if someone wants to sell their business its really just putting a value on the land, buildings and on the equipment. Everything else is dollar for dollar whether it is receivables or inventories. We’ve been very successful in the past, we’ve missed one or two but we’ve been told we were probably over-paying.

The company is well positioned to take on more assets at the moment. They have an extremely clean balance sheet and net cash per share of $158M (about $6 per share).

You will also note that shareholder equity is $453M. Total shares outstanding are a little under 24 million. That puts the book value of the company at $18.88. The company has consistently been growing book value at $40M to $50M a year for the past 5 years.

Specialty Eggs

Specialty eggs represent the second growth potential for the company. Cal-Maine produces specialty eggs through the Egg-Land’s Bestä, 4-Grain, and Farmhouse eggs brand names. Retail prices for specialty eggs are less volatile than prices for regular shell eggs. They get a higher, more stable price for specialty eggs. What is not clear from the 10-K and from the presentations I have listened to is whether the specialty egg business is actually a higher margin business. Given the company’s desire to expand further into the business I would assume it is, but I can’t find informaiton anywhere that states the margins of the specialty business versus the regular shell egg business.

The company is growing the Specialty egg business at a brisk rate. In 2011 it grew at a 14% clip and so far in 2012 its growing at a 9% clip.

Europe and the egg crisis

The third potential growth opportunity for Cal-Maine comes in the way of an unexpected egg shortage that is occuring in Europe, brought on by changes to legislation that have resulted in the loss of a large chunk of the egg producing chickens. This is the topic that I am going to focus on in my next post.

What to make of the valuation

On a first glance at Cal-Maine, here is what I see. I see a company that is running a decent business, a business that is profitable and bringing in cash, and they are reasonably priced. At $36 they are trading at 12.5x last years earnings and 10.9x the average earnings over the past 5 years. This excludes the $6.60 of net cash that they have on their balance sheet.

I think though that the key to the stock in the near term is whether the situation in Europe is going to spill over into the United States. Right now I’m not sure of that, so I am going back to my hole to do some more research and figure out whether Europe can have a positive impact on a company for a change.