Saturday 31 March 2012

Highlight of the month - Penn Virginia Corporation

Last month, we have been very busy researching on U.S unconventional natural gas(NG) and liquids players as share prices of these companies have been plunging madly even though we believe they are already undervalued. This reminded us of our investments in Bank of America (BofA), not so long ago. BofA caught our attention when the share price was at $13. We began investing in the common stock (we have 'converted' our positions to the warrants) when it was $10, after which share price continued to decline to $5 in a few months. Of course, we dollar-cost along the way as it declined and also when it recovered. Coincidentally, the share price, now, has been flirting with the $10 range, and we have made some good money despite we started out at $10.
 
Back to the unconventional NG and liquids companies: We have been looking into the smaller players as they are the ones that have been 'sold out'. We have shortlisted Penn Virginia Corporation (our favourite), Comstock Resources and Exco Resources. In fact we are already invested in Exco Resources despite it is not the most undervalued of the three, as we decided to ride on Wilbur Ross’s coattail first before ‘gearing up’ on the other players. (Wilbur Ross has started investing in Exco when the share price was at $15, and has dollar-cost along the way as the share price declined to $6.50.)
 
As follows is a short investment thesis (expect a longer article in the future) of Penn Virginia Corporation (PVA):
 
Has been losing money (even after adjusting for the impairments of oil and gas properties) since 2008 as natural gas prices declined from a high of $7 range to $2.30. Has a higher cost structure than the other players. Expect them to continue losing money (based on GAAP). However, operating cash flows have turned in positive all these years.

What is attractive about PVA lies in (1) the price of the common stock, (2) the company’s establishment in 1882 and (3) misunderstanding of their real financial position and the change in company fundamentals not being appreciated by rating agencies and hence, institutional investors (major shareholders).

(1) Has a P/B of 0.3x. Its attractiveness becomes very obvious when compared to the market transaction related to the acquisition of Atlas Energy by Chevron for $3.2bn in Nov 2010, when natural gas prices are in the range of $3 - $4. Both PVA and Atlas Energy has proved reserves of 0.9tcfe, 1,100,000 net acreage, approximately same amount of debt and equity. The only difference is Atlas Energy has a more favourable hedge on its production and hence is making money, while PVA is losing money. The result: PVA has a market capitalization of approximately $200mn – less than 1/15 of Atlas Energy’s $3.2bn market transaction!

(2) Established in 1882, the management would have an intense desire to restore the reputation of being a ‘fallen angel’. We believe conservatism, rather than the ‘let’s go all-in’ mentality, will be adopted by the management when things get tough. Attitude matters!

(3) This would explain why the share price has been very cheap compared to its peers and that the company is not in the verge of bankruptcy. With reference to http://af.reuters.com/article/commoditiesNews/idAFWNA243320120314, we believe that S&P has employed a rigid model in assessing the credit profile of PVA. There are 4 assumptions that we have used in our credit analysis that were not supported by rating agencies, and these include (a) the oil and gas properties are extremely marketable (and therefore can be sold) in the marketplace and they have massive acreage as compared to their peers , (b) capital expenditures are discretionary, (c) additional proceeds from share dilution to fund capital expenditures (from our calculations, investors can still make decent money even though the share dilution were to occur when share price is $2.50) and (d) the shift from gas to liquids production will improve their cash flow position faster than expected by the rating agencies. While we are not providing the figures required to support our analysis on what we believe to be their real liquidity and financial position, we may do so in the future.
 
From a fundamental standpoint, PVA is definitely the weakest link among the other two companies that we have shortlisted. However, from an investment-attractiveness standpoint, we found more compelling reasons for an investment in PVA.

Sunday 11 March 2012

Why invest in Bank of America common stock when you can invest in BofA warrants?


Sypnosis:
With a modest intrinsic value per share of $20 based on a price/normalized earnings of 10x, the yield on BofA common stock is 159%. But why invest in the common stock when you can invest in the warrants with a maturity date on 16 Jan 2019 that would yield much bigger gains as book value and earnings would continue to grow at a modest rate in 7 years time?

Assuming a very conservative 6% CAGR growth in BofA’s book value and earnings, the intrinsic value per share 7 years later would be in the range of $30. While the 7-year yield on common stock becomes 289%, the warrants have a yield of 334%! Forget about BofA common stock; Consider the warrants!

Introduction on BofA. As of 6 Mar 2012, BofA common stock has a share price of $7.71, with a book value per share of approximately $15.45 and tangible book value per share of $9.10 on 13,765 million number of shares outstanding (including Warren Buffett’s stake).

As its annual pre-tax-pre-provision-profit (PTPP) since the 2008 financial crisis has been complicated by (1) the acquisitions of Merrill Lynch and Countrywide, (2) massive R&W provisions, (3) Gains in asset sales and legacy writedowns, (4) litigation expenses and (5) a huge salesforce hired to handle legacy mortgage issues, we have adjusted the PTPP and the normalized PTPP should be at least in the range of $50bn or $3.60 per share.

The PTPP of $50bn that has more-or-less been generated consistently for the past 3 years is a walloping figure when the $950bn of loans are taken into consideration; it has the ability to lose 5.23% of total loans outstanding (not only mortgage loans) annually and still break-even.

The balance sheet is also a fortress on its own as it has an allowance for bad loans of approximately $40bn or 4.45% of total loans outstanding while non-performing loans is approximately 3.5% of total loans; the 1% differential is an underestimation as some of the non-performing loans should return to performing status.

(In our $50bn PTPP calculation, we have not taken criteria (5) into consideration, but management has guided that at least $5bn of annual cost savings will be effected once the legacy issues are resolved and will flow directly to earnings. Every $5bn of incremental earnings is equivalent to $0.36 per share and will increase share price by $3.60 assuming a P/E of 10x.)

Utilizing a normalized provisions-to-loans ratio of 1.08% and a 30% tax figure, Profit after tax should be in the range of $28bn or $2.00 per share. All these translate to P/B of 0.52x and P/normalized earnings of 3.86x.


A modest intrinsic value per share of $20. The above table shows the past P/B and P/E that BofA common stock has been trading for the past 10 years. The average P/B and P/E of 1.86x and 11.62x is calculated based on the Dec 2004-2006 figures and Dec 2001-2006 respectively.

If a range of intrinsic value estimates is calculated based on past average P/B and P/E, there exists a profit potential of 200-300%. Our estimated intrinsic value per share of $20, therefore, is absolutely modest. (We suggest you do the calculations yourself – and be amazed!)

More on BofA. BofA’s circumstance in the 2008 financial crisis is unusual because BofA was supposed to be associated with the likes of Wells Fargo and JP Morgan that have (1) a huge banking franchise (deposits – viewed as ‘safe’ liabilities) and (2) a relatively sound investment and loan portfolio on the asset side (as opposed to Citigroup in particular), and should have weathered the crisis relatively unscathed.

However, the Countrywide acquisition has proved to be a blow, if not a fatal one. Share count has approximately doubled because of issuance of shares to finance the Merrill Lynch and Countrywide acquisitions but after which almost tripled due to the mortgage woes associated with the Countrywide acquisition which has resulted in large expenses for BofA, including elevated net-charge-offs, delinquency and nonperforming loans and provisions for loan losses in the range of tens of billions of dollars, approximately $15bn of R&W provisions and $5bn of recurring litigation expenses incurred in the past 3 years and at least $5bn of additional expenses incurred annually to handle legacy mortgage issues.

What was viewed as the competitive advantage in BofA’s annual PTPP of $50bn has turned blind to the investment public.

However, an investor in BofA has two advantages not recognized by the investment public: (1) Loans have a finite life of between 4-8 years and these problems will gradually be resolved, if not disappeared on its own. (We are already in the 5th year into the 2008 crisis!!! It has to end soon!) (2) A meaningful amount of expenses associated with the mortgage woes, like the R&W provisions in particular - just like workers’ excess compensation insurance - is a long-tail event. While large one-time expenses are booked, the actual outflow of these expenses is gradual. The economics of the business is, therefore, very attractive.

If, through verification, you are stupefied by how undervalued BofA common stock is, you can forget about BofA common stock; Consider BofA warrants:

Introduction on BofA warrants. BofA warrants are long-dated with a maturity date on 16 Jan 2019 or approximately 7 more years before maturity.

The current warrants price is $3.85, with a strike price of $13.30 (approximately equal to BV per share). The break-even share price, therefore, would be $17.15.

Downside risk is zero? Based on the current price and long-term nature of the warrants, I believe the downside risk is close to zero, if not zero. The payoff structure of a warrant is such that the investor of BofA warrants will lose its capital if the share price of BofA falls below $17.15.

Assuming a very conservative 6% CAGR growth in BofA’s book value and earnings, the intrinsic value per share 7 years later would be in the range of $30. The break-even price of $17.15 is approximately 43% below the estimated intrinsic value of $30, 7 years later. (Book value per share and EPS would increase to $23 and $3.00 respectively. At the break-even share price of $17.15, the P/B becomes 0.74x and P/E becomes 5.7x.)

What is the probability that on 16 Jan 2019, BofA share price would fall below $17.15 or trading below P/B of 0.74x and P/E of 5.7x?

An awesome 7-year yield of 334% on the warrants! Now on the upside: With an estimated 7-years-later intrinsic value per share of $30, P/B and P/E would become 1.29x and 10x respectively. The main flaw in my argument is, of course, earnings and book value do not compound at a rate of 6% per annum moving forward.

However, clues of the past (especially the 1990 case study of Wells Fargo) have suggested that my projected growth to be absolutely conservative. Assuming my argument is not flawed, the warrants will yield an awesome 334%! (BAC common stock still yield a pretty figure of 289% though)

While the 7-year yield differential between the common stock and warrants may not seem sufficient to compensate the risk associated with the payoff structure of the warrants, the differential should be much wider and hence the risk much lower.

Remember, I have left out criteria (5) in calculating the normalized PTPP which will increase the share price by $3.60. Also recall that the cost price of the warrants is $3.85. This will result in an incremental profit of about 100% on the warrants, but only 50% on the common stock.

When (1) such incremental earnings power is coupled with (2) a higher than 6% CAGR growth in earnings for the next 7 years and (3) a higher than P/E of 10x on 16 Jan 2019, the yield differential between the warrants and common stock is going to be very big. Also remember that the warrants are tradable in the market, which gives flexibility to the investor to sell before maturity.

By now, you may be apprehensive of the too many assumptions and calculations involved in our investment thesis on BofA warrants.

So let’s put the 1990 case study on Wells Fargo into perspective: Based on information provided in 1990 Warren Buffett letter to shareholders, Wells Fargo was trading at price/PTPP of 2.23 when Warren Buffett bought it. 9 years later, Wells Fargo share price increase by 1000%!!

Today, BofA is trading at price/PTPP of 2.14!!! And our assumptions and calculations dictate that the current share price of $7.71 will only increase by 290% to $30, 7 years later.

If BofA share price was to increase by 500% (We are not even thinking of anything in the range of 1000%), imagine what the warrants yield will be! <Hint: What is ($46-$13.3-$3.85)/$3.85)?> Most importantly, the risk underlying an investment in the warrants is close to zero, if not zero, to our understanding.


Disclosure: Long BofA warrants but none on BofA common stock.

If you are interested in our portfolio allocation of securities, do enter this link: http://valueground.blogspot.com/p/portfolio.html

(‘Provocative’ comments are most welcomed regarding our portfolio allocation as we would expect it.)

Sunday 4 March 2012

The U.S. Banking Sector – Gems to be Uncovered



(Source: Google Finance)

The above chart shows the comparison between the % returns of the S&P 500 Index (red line) and the KBW Bank Index (blue line).

As shown, the U.S. banking sector had suffered a massive sell off since the subprime crisis and till date, it is still down 60% compared to the S&P 500 which has almost recovered to the level since 2007. This decoupling between the two indexes has been the result of the indiscriminate selling of the U.S. banks with investors largely driven by headline news from the Eurozone rather than their actual underlying fundamentals.

Even though there is much to be worry about regarding the state of many European nations, we believe the situation has been largely overblown. Unlike their European counterparts, the U.S. banks had undergone a period of extreme distress since the Lehman collapse and the survivals of today had gone through a period of major consolidation.

Systematically important financial institutions have become even BIGGER to FAIL, especially so when they are central to the survival of the U.S. economy. Under the scrutiny of the federal and state governments, the U.S banks have deleveraged and their balance sheets are at one of its strongest. The banks are recapitalized, with many of them holding on to reserves not seen in decades that they had operated.

At present, we believe the U.S. banking sector holds a lot of opportunities. The assets and earnings power of many such institutions have been greatly underestimated due to provision for loan losses, litigations, R&Ws, etc.

In our subsequent posts, we will go into detail to explain some of the large financial positions we currently held in our portfolio.

So stay tuned!

(Feel free to take a look at our portfolio.)