Thursday, July 24, 2008

Between a ROC and a hard place (II)

ROC proposes to purchase AZA by issuing 0.792 ROC shares plus 5 cents per every AZA shares. It is reasonable to assume that each CEO thought he had a good deal. The proposal at the time it was made values AZA at a 40% premium based on ROC's share price at that time.

So we have these three alternatives:

1. both CEOs believe it is a good deal because AZA is undervalued and ROC is market value.

2. both CEOs believe it is a good deal because ROC is overvalued and AZA is market value.

3. both CEOs believe it is a good deal because ROC is slightly overvalued and AZA is slightly undervalued.

In an environment where all eyes are focussed on oil and all matters related to it, I rate the chances of the market undervaluing AZA as extremely low to non-existent. So scenario 1 is extremely unlikely, scenario 3 is quite unlikely and scenario 2 is your best bet.

I suppose that every rookie trader, upon looking at the deal, would sell ROC and buy AZA.

So it was a very very dumb decision not to sell ROC when the deal was announced. Dumb mistake.

So what now?

Using a rather crude measure (pun intended) of dividing market cap by announced 2P reserves, I compared 8 stocks in the sector, namely AZA, NXS, ROC, TAP, ARQ, AWE BPE and AED. Of all these, AZA, ARQ and AED have similar market caps. Apart from TAP, ROC has one of the highest dollar value per barrel of 2P reserves (about $24). As a matter of comparision, NXS, AZA and BPE come in at the low to mid teens per barrel. You can refine the calculations by backing out cash, shares, gas assets, etc but I am only using a crude measure. Better to be vaguely right than precisely wrong.

This shows that the market has placed a hefty premium on exploration success. For example, TAP is at $34 per barrel with only 6.5 m 2P reserves.

For comparison, AZA has no exploration, just the BMG resources at 27m. I backed out 65.7 m worth of NXS shares which it holds, and I arrive at $14 per barrel.

ROC at current prices with $24 per barrel, in comparison to its peers, has a significant premium build into its price for blue sky exploration.

I believe that ROC is quite likely to have some success in Angola. But to catch up with its peers, it needs to add at least 14m barrels to its reserves to justify its current price. It will probably add another 5m barrels from its Chinese development fields, so Angola has to come up with another 10 m barrels.

AZA is now trading at $1.18. ROC's offer at its current price of $1.58 still values AZA at $1.32, a premium.

Again, I stress that this is a crude measure, and does not account for the fact that some of ROC's producer wells have already been developed, and that AZA's BMG resource requires another $1 billion (about $45 per barrel) to develop.

On a valuation basis, I believe ROC is at best a hold at this time, and as a hedge to the portfolio for rising oil prices, it will still play a part.

Wednesday, July 23, 2008

Between a ROC and a hard place

ROC Oil is an oil production and exploration company with tenements in Australia, China, Britain and Africa. It is listed on the Australian Stock Exchange.

I have been long for some time, but the share price is getting a shellacking.

I will post my thoughts on the business operations and management in another post. This post is a post mortem of how I believe I went wrong with this trade.

First, I wanted an oil stock to hedge my other holdings, and to take advantage of increasing oil prices. I bought a small stake at the start. Prices dipped and then firmed, and I waded in with a bigger stake on the upturn. I had even written down a stop loss point.

The price tanked. The funny thing was two black swans occured. Roc announced a massively diluting takeover of Anzon Oil, which has no exploration assets, just a production resource with its reserves estimate at risk. This takeover will dilute the exploration upside potential of Roc, although I can see the rational of increasing production income to fund the exploration on a larger scale. Then the much beloved CEO suddenly went ill and passed away. The negativity surrounding this stock is such that it responds not at all to oil price increases, but responds massively to oil price decreases. It also responds not at all to exploration goods news.

Mistake one was not selling at stop loss point. Mistake two was not selling when it was evident that the reason behind the trade is obviously incorrect.

Now what do I do? I am looking at a paper loss of about 25%. So I need to reassess as to whether there are any reasons to hold this stock at this price.

Which brings me to my next post.

Tuesday, July 22, 2008

Shark Prime

Well, I am long IMF now. Not the IMF that all readers may be familiar with. IMF is a company listed on the Australian Stock Exchange. It makes money by funding large scale litigation and taking a nice big slice (bite) of the proceeds.

This "loan shark" company is run by lawyers and bankers- what a match. Management has a sizable stake, and looks like the company is in the right place at the right time with a few spectacular near corporate collapses in the market, and by my reckoning, quite a few to come.

There is some $42m in the bank and no debts, the company redeeming all of its convertible notes recently. It has 120 m shares on issue, so we have cash backing of about 35 cents per share. Looking at getting a further $37 m by August if the Court approves the settlement deal with the poker machine giant Aristocrat. I do not see why the Court will stand in the way. So that adds another 31 cents for cash backing, and voila, we have 66 cents per share. The shares last traded at 68 cents. We have 2 cents per share for ongoing enterprise value

So, for a measly A$240,000, you get to own a portfolio of over 28 pieces of funded cases. Ok, just for clarity, current market cap is $82m, cash and expected cash by August is $79 m. So about $300,000 for enterprise value being ascribed by Mr Market at the time I write.

Let's see, from 2003 to 2008, the company funded about 29 cases which have concluded. They lost or withdrew from 10, but settled or won 19, so about 2 to 1 ratio. Over the same period, it spent $23m and recovered $77m. Past performance is no indication of future performance of course. But the industry mechanics are favourable. Consider this, the cost of litigation has gone up steadily over the years, but not quite nearly as much as the market capitalisation of all listed stocks, in strict dollar terms. Claim sizes based on stock market losses (or gains) as compared to litigation costs will rise on a near exponential basis. So in bald terms, for every dollar punted by IMF, it sees increasing returns in real dollar terms. It is like a company selling a product which has a ratchet price increase build in- much like cigarettes and petrol in Australia. Perhaps a comparison of the case portfolio and recoveries over the last few years will illustrate this concept.

There are competitors in the market obviously, but IMF should remain top dog for quite a while. Two main reasons, first is size. The court system in Australia punishes losing litigants by making them pay a portion of the legal costs of the winning party. Another peculiarity is that the court also ensures that winning litigants are not out of pocket for such legal costs against a losing litigant, by making plaintiffs provide security for costs. Therefore, balance sheet size matters, because not only is the litigation funder such as IMF required to pay the plaintiff's own legal bills, it has to provide a bank guarantee for the other side's legal bills in case it loses. In a multimillion dollar claim, legal costs could exceed several million. Multiply that over a portfolio of 30 cases.

Second reason is that it is not just a question of deep pockets that makes this business successful. You have to pick your cases well. IMF loses money not only if it loses the case, but also if the case drags on for several years without a verdict. The quality of your portfolio is essential. And also you need to have a sizable portfolio to smooth out results. And there is a virtuous cycle at work. Because IMF is choosy and picky over its cases (plus it has an investigative arm to fund investigations into a case), potential litigants and their lawyers will approach IMF for funding purposes first, because if it is approved by IMF, chances are you have a near sure winner. I think of this concept as being the case of "the fish that John West rejects."

Well, let's see. Time will tell. I believe that by year end, cash in bank for IMF net of loans will exceed market cap. Pure dirty "Ben Graham" play with a bit of Fischer upside. You got to love that.

Wednesday, July 9, 2008

Your Serv

I am writing about Servcorp (SRV). SRV is a company listed on the Australian Stock Exchange. It operates serviced offices throughout Australia, Asia, Europe and the Middle East. It has no exposure to the US and the UK.

Basically, all that SRV does is that it takes out long term leases of whole floors of office space in prime locations, fit them out, and then rent them out, usually on a short term basis.

The founder, Alf Moufarridge, owns over 60% of the shares on issue. His two sons and daughter are in key positions in the company. This is both a comfort and a concern.

There are various competitors, notably the Regus Group. SRV aims to make itself special by developing proprietary technology to provide business solutions to its customers.

The company is conservative, and has a pile of cash with no significant debts. It has probably close to AUD$1.00 per share in cash. The business throw out lots of surplus cash, and capex requirement, after fitting out of floors, is minimal.

As at 9 July 2008, the market value of SRV is AUD$268m. Strip out cash of $80m, and you have a business going concern for $188 m, which is earning net profits after tax of about $30m per year.

Looks terribly attractive, so what has gone wrong? Well, perhaps being lumped into the property sector classification is doing it no favours, especially with publicised problems with GPT, another listed property trust, although this would really be comparing apples to oranges. Perhaps other shareholders are getting concerned with the previously proposed option packages to the Moufarridge juniors.

What could happen from here?

Well, it continues making heaps of money from the booming Middle East, Hong Kong, Singapore and China markets, holds itself steady in Japan, does okay in Europe, and have a slight decline in Australia. It throws off more cash, opens more floors in booming economy locations, such as perhaps China and India.

What could go wrong?

Well, the world economy falls off a cliff, killing demands for serviced offices, leaving SRV with half empty floors across Asia, Australia, and the Middle East, which it pays about AUD$1m per floor as fixed rent every year, increasing each year based on inflation indexation. AUD$80m in the bank is a good enough buffer for perhaps 2 to 3 years, so a prolonged 4-5 year downturn will hurt badly, although by then most of the leases would have expired.

Or, Mouffaridge juniors get caught up with white elephant ideas, and divert resources to developing technology which the market does not want.

Of course, I do not know how this will play out, but I do not see the world economy falling off a cliff. Declining economic environment perhaps ironically may increase the demands for serviced offices as entrepreneur and start ups shy away from long term lease commitments.

Just a blog for the record, and I can revisit this later on to check any reasoning errors.

Disclosure: I am long SRV.