Value Investing Ideas

I wrote about Actions Semiconductor here. The story has changed somewhat since then, but in a good way. Better yet, although the stock price has recovered somewhat, this is still a net-net play, and it is still trading below cash on book.

At the time I wrote the original writeup ACTS was resisting buying back shares, preferring to “grow” the business through acquisitions. Indeed, they ended up making a bid on an manufacturer, and it looked like a done deal. Management was playing this close to their chests, refusing to discuss the business or its prospects in their conference call. The analysts were very persistant, and several emphasized the extraordinary value that could be created by buying back ACTS ADRs.

Well, management listened. The acquistion was cancelled, and ACTS has retired over 9 million shares, or just over 9% of the outstanding stock, leaving 86MM shares outstanding.

At this point ACTS has $236.5MM of cash and equivelents on their books vs a market cap of 200MM. So, on cash alone you are still buying $1 for $0.85.

How about the business? Well, in this extremely difficult global crisis, they lost $0.02 two quarters ago, and $0.01 this most recent quarter. In other words, during global financial catastrophe they almost broke even, and had a huge war chest that would have protected them had they lost real money.

How about costs? Well, at the beginning of the year they announced that they were cuttting the salary of senior management by 20%, and then they cut the manager level salaries by 20% in the second quarter. They have not reduced the salaries of the technical staff. Management is eating their own cooking.

As I wrote before, this is a tough business sector to value. Changing consumer tastes in gadgets makes it extremely difficult to build a moat unless you have significant IP (have I written about DMRC? - they have a moat). Still, trading at a discount to cash, a huge war chest, and pretty much breaking even during a major worldwide crisis - it’s a no brainer to me. This company is ripe for a takeover, or merely for the share prices to recover once earning return to a normal level. In either case, management is continuing to help make your investment more valuable by buying back and retiring shares.

Several of you have asked me for updates on ATP. Rather than blather on, I’m mostly just going to link to an excellent write up on an analysts breakfast held by ATP this Thursday, where the bull case is laid out far better than I can make it.

However, let’s look at developments since the last time I wrote. ATP is pressing full steam ahead in developing Telemark, their company changing lease in the GOM. When it comes on line it will more than double ATP’s production. They got the developers to agree to foot the bill for the development, about $200MM, in return for getting paid with future profits. They have several asset monetizations in the works - selling the Gomez pipeline, selling Titan, et al. Al Reese said this is as “close to 100%” sure as anything could be, as you will see in the link. GE and other companies are interested.

As is typical with these fields, the reserve volumes used to calculate PV-10 is very conservative. If you look back at ATP’s history, they’ve beat these estimates by huge margins. Don’t get tooooo excited about that, as that extra production comes in on the back end, and the present value of money means you have to discount those cashflows over several years. But still, take the > $5B in reserves as a low ball estimate.

They have other irons in the fire. North sea, for example. They are currently bidding on and winning new leases in the GOM near their current hubs.

Their bankers are working very closely with them over Telemark. They recognize the great value in that field, and it’s pretty hard to believe they’d shut down the company to get their money a few weeks earlier. The risk right now is that ATP is not going to do their monetization for the debt until Titan is in place and ready to go, so if there were significant delays they could actually blow a few covenants.

I said Telemark is company changing. Let’s put that in perspective. At todays strip prices, ATP’s cash flows next year will equal the current market cap. Yes, ATP is trading at 1x 2010 cash flows. A typical number is more like 10x. ATP plans to have *all* of the debt paid off by then.

Okay, so I did blather on. Anyway, here is the link backing up those points.

http://boards.fool.com/Message.asp?mid=27920815&sort=postdate

There have been quite a few positive developments in ATP since I wrote about them last. Perhaps I will address them in a later post. However, elsewhere you see a lot of hand wringing over whether ATP will execute their plans for the next few quarters. Make no mistake, if they do execute them (and I see no reason why they won’t) it will be a transforming event for them - huge free cash flows, all debt paid off, etc.

However, for any company I own I try to “break it”. Figure out what can go wrong in a perfect storm, and get a feel for the results.

The PV-10 value of ATP’s reserves is $5.3B. The infrastructure value, almost all of it new construction with a 25-40 year life span, is $1B. That value is based on what it cost ATP to build it, not the present value of cash flows they will generate (which of course will have a greater value). This number is backed up by the deal made with GE, where GE paid the estimated value for the Innovator platform.

Total liabilities, including long term debt, income tax, accounts payable, etc., is just under $2B. That gives us an enterprise value of $4B, vs a current market cap of under $500MM. A pretty huge disconnect.

Why is the stock price so low? Everyone is hand wringing over the debt covenants. When ATP renegotiated their debt, it came along with a bunch of provisions, most of which I talked about before. They had to sell assets, devote 75% of the proceeds to debt reduction, they had to earn revenues at some multiple of the debt, etc.

Of their covenants, the requirement that debt be less than 3x EBIDAX gets the most attention. Right now the plan is to make the majority of that money via asset sales. They were helped along with a sweetheart deal with a driller, whereby the driller pays for the cost of development and gets paid with profits. Still, ATP has to execute some sales to meet the covenant.

But, is this a big deal? Sure, we don’t want them to blow the covenant. But suppose they do? They won’t go bankrupt over it, but pretend they did. ATP would be put up on the block, and over $6B of assets would be sold to generate $2 worth of money to pay off debtors.

While we would all be extremely disappointed by the demise of a company with such a great future, under any reasonable scenerio there would be more than enough money to pay off shareholders. Would we end up with $70/share? Probably not, trying to sell that many assets at once in this environment probably means we’d end up selling some things for less than they are worth.

So, while I’d hate for them to end up bankrupt (let’s very clear here, I don’t consider that a real risk), it’d hardly be a disaster. I’d fully expect to make money from the deal.

Realistically, blowing a debt covenant means sitting down with your debtor and renegoiating terms. Sure, they could demand repayment in full immediately, forcing some kind of bankrupcy proceedings. But is that likely? Given that ATP recently coveyed 3 limited-term NPIs for the development of Telemark (meaning the devlopers pay for the development, and get paid from future profits) we can conclude that there is future value in ATP. Debtors are unlikely to walk away from such cash flows. Instead, they’ll turn the screws a bit and get more favorable terms. Nothing is guaranteed - a debtor that needs cash can always demand repayment, but it is unlikely. If it does happen, stockholder still win, though much less than they could have.

So, what is the fear that makes ATP trade so low? I don’t know, I’ve never seen anything reasonable articulated.

edit: I haven’t bothered looking at all the little terms in the debt - with that we could get a more realistic assessment of what happens if a debt covenant fails. My position is: who cares? If I win even if the company breaks I don’t need to know much more.

This will just be a brief update. However, the price fall of the stock suggests either an incredible buying opportunity, or incredibly bad recommendation on my part. As always, I don’t invest based on short term (meaning under 3 years) price movements, but on long term value.

At the moment of posting, Innophos is trading at $8.84, for a PE of 1.0. That reflects an extraordinary pessimistic view of the long term earnings of Innophos. Innophos had their year end conference call in Febuary, and the transcript is available on their website here: http://ir.innophos.com/

Let’s look at what they had to say. I’m not going through the full thing; I’ll extract a few telling comments. Let’s start with the previous year’s performance:

“Full-year results can only be described as exceptional.”

“Innophos delivered solid results in the fourth quarter despite a selling environment that became significantly more challenging through the quarter. Net sales for the fourth quarter were up 50% over fourth quarter 2007”

But, of course, we buy stocks based on their future potential, not previous glories. And yes, we can’t expect a repeat of 2008. Here’s what Innophos has to say about that:

“Going forward as result of these pressures, we expect to see downward pressure on selling prices which are currently at historically high levels. In response, we are taking a more aggressive stance to retain our leading market position and keep profitable business going forward.”

“We are benefiting from declining sulfur, energy and transportation costs in comparison to 2008 levels”

There is about a 2 page description of all their business segments, with the market’s effects on costs and sales estimated. I can’t summarize all of that. Needless to say, there is pressure on them. They summarize with:

“In expressing an outlook for Innophos financial performance in 2009, we must consider several issues. We cannot now predict how severe the recession will be, nor the associated impact on industrial and agricultural demand. With the uncertainly around Mexican phosphate rock cost and operating levels, and along with greater competitive intensity, we have to conclude that we cannot offer reliable and specific operating income guidance for the year.

We can give you an idea of first quarter outlook. We expect that first quarter 2009 volumes will be up approximately 15% from fourth quarter 2008 levels. For selling prices, with the usual puts and takes from various customer agreements, we expect to increase prices in some areas, primarily in the US, but this will be offset in our less specialized product areas and should result in overall prices that should remain somewhat similar to those of fourth quarter 2008. Lastly, our cost structure should remain relatively flat as well.
Beyond the first quarter, volume impacts are uncertain and we believe are recession dependent. We do expect to see selling prices trending down, while Mexican cost structure increases also start to kick in mid-second quarter, again, to some extent affected by operating levels.”

Okay, not perfect news, but exactly what we would expect from a stellar company selling staples in a recession. In short, they (like everyone else in the world) have no particular insight into when the recession will end, and they will have to tighten their belts a bit until it is over.

Note that all of the uncertainty here is to the extent of the profitibility during the recession, not whether there will be profit, or whether IPHS will survive. Yet stock prices have plummeted. IPHS is currently selling for 40 cents less than last years EPS! They are being priced as if they are a fertilizer business, and as if fertilizer will never go up again. Hoewever, they are primarily a specialty products business, with margins in the 30%+ range, not the under 10% margin of raw products like fertilizer. They do sell raw materials, and lower end materials, and there they are facing significant competition from the Chinese and such.

I feel like typing more, but the situation is uncertain. We can set and weigh the different components of the business, try to estimate the future of the recession, predict prices for raw materials, predict how changes in China will effect competition, etc. I’d be a fool to think I could do that better than the managment of IPHS, and their position is: “I don’t know”.

So is the price fall justified? Well, they are going to be cash flow positive in 2009, they will continue to pay down debt, they will continue to be profitable. They still sell specialty products required for all kinds of staples. A segment of their business is still highly resistant to competition - food additives. They expect to maintain their margins in their specialty products.

Investors confuse uncertainty with risk. We cannot reliably make 2009 EPS predictions. We cannot clearly see what the competitive landscape will be in 2011 and on. What we can see is a company that has been making specialty chemicals for a very long time, remaining highly competitive, with high margins, with a strong balance sheet, cash flows, and the ability to compete and react to the market (something a debt heavy, poor balance sheet company often can’t do).

I don’t know what 2009 will bring IPHS. Read the transcript for some of the possibilities. What I do know is that this company will continue to make money, will continue to be very competitive, will continue to try to increase market share. Nothing is looming to make us think that IPHS is about to disintegrate - the uncertainty about it’s future is no more uncertain than a JNJ, Berkshire, etc. We don’t know next year’s earnings, but we know in the long term the company will continue to make money, and thrive. A PE of 1.0 gives us a huge margin of safety - far beyond the 50% required by value investors.

Actions Semiconductor is a Chinese fabless semiconductor company. Their main market is producing chips and platforms for mobile media players. No, not iPods, Jobs keeps all fab in house, but the plethora of systems flooding the Asian markets. They specialize in SoCs, or system on a chip. These integrate the functionality of an entire system on one chip. This vastly reduces the fab costs for devices since the circuit board complexity is greatly reduced, and as a result, offers improved reliability (fewer solder connections to go wrong, etc). They market other devices - for example, they just started shipping a GPS on a chip.

This is a competitive market, and it is pretty hard to identify a moat in this business, let alone predict sales rates, growth, future innovations, etc., all the things needed to determine what price you are willing to pay for the company. So, on to the “too hard pile” and on to the next stock.

Well, let’s just look at that balance sheet first. No debt, $3.05/share in cash equivalents, vs a stock price of $1.55 today. Yes, not only is it trading at 50% of cash, but 50% of enterprise value. In the trailing 12 months, their earnings were $0.54, a PE ratio of 2.9x. Net profit margin is 40%, and ROE is 17%.

On cash alone this is a screaming buy. What are the risks?

First risk is that this is in China. The rules can change at any time. We do not have the transparency into the cash - much of it is invested with major Chinese banks. Analysts probed this issue again and again in the most recent earnings call, and management assured everyone that the investments were equivalent (in safety and returns) to the US’ short term CDs.

Second risk, bad decisions by management. They seemed about to make a bad decision - they had announced plans to buy a touch screen manufacturer. No one really understood why - and they claimed that they could not name the business because they were partnering in the investment with others. They assured us the business would eventually be quite profitable, and that the business owners were investing their own capital. However risk is nothing more than uncertainty, and what could be more uncertain than an investment in an unnamed business not directly related to the core business of Actions? It seemed a questionable way to deploy cash, especially given the tight credit market and extremely low share price.

Management was repeatedly encouraged to buy back shares. The company acknowledged that was a great way to enhance shareholder value, but said they needed to grow the business long term. This makes some sense to me - looking at short term returns it is always great to see share buybacks at under 50 cents on the dollar, but it would also be nice if the business grew. That decision seems aligned with long term shareholder interests.

I must admit my interests are more short term on this one. The margin of safety is very large. We are actually being paid $134 to own a profitable semiconductor business - a company earning roughly $20MM EBIDTA.

Of course, like all semiconductor manufactures, they face a tough future. Earnings have been down, and are projected to fall further. Depending on your assumptions, the current share price could be normal (in this environment, not a typical market). However, I view the cash as a huge safety net. Yes, the company could turn unprofitable for a number of years, yes, they could fritter away the money in senseless acquisitions. However, they seem to recognize that danger, and are being conservative. It’s not hard to keep an eye on them and bail if they do anything outrageous.

If you are a Schloss type investor you would pick this up without a thought, as it is a perfect cigar butt purchase, and you would be insulated from significant losses with the other 100 equities you own. If you run a concentrated portfolio, you’ll definitely not want to take a huge position on this without more research than I have provided above. I think this company will have a decent to very good future. But if the stock was to appreciate to the point where they are giving the company away for free it’d still be a double for us.

Short term (a year or so) I wouldn’t be surprised if the shares went lower. If earnings do indeed go down, and the market is still depressed the price could drop quite a bit on the news. But, we are trading at 50% of cash. That cannot persist long term.

ATP and EDF just announced closing the £265MM agreement for the Tors and Wenlock transaction. That’s around $400MM vs a market cap of around $275MM. They are required to use 75% of this towards debt reduction, the rest can go towards share buybacks or such. With luck the stock prices will remain depressed while ATP implements their stock buyback.

In general I would put E&P (exploration and production) oil and gas companies in the “too hard” pile. They usually trade at a multiple that reflects people’s hope for what they might find in the future, and what that might be worth. You have multiple variables to predict – the size of the holdings they find, the cost of extraction, flow rates (a dollar today is worth more than a dollar 5 years from now), and future commodity prices. In short, what some people call prediction I call guessing or making things up. Too hard.

However, recent market events have placed the prices of these companies well below their NAV – the calculated worth of oil&gas they have already discovered and have a way to extract. More on how those calculations are done later We have a special situation here; companies are being priced at a fraction of the proven worth of their assets in the ground. This gives us a huge margin of safety, as we are buying assets at a fraction of their value, and valuing everything else at $0 – i.e. all future earnings, all new finds, all infrastructure - $0.

ATP is a small oil and gas company working in the GOM (gulf of Mexico) and the North Sea. They are not a pure E&P company – they are not exploring new ground. Instead, they buy leases with reserves from companies that don’t want them for one reason or another (need to raise cash, shifting operations to another area, whatever). They have a 98% success rate at turning these leases into producing fields, which is unheard of in this business. They achieve this largely by having a very focused business model. 22% of the company is owned by senior executives – they are eating their own cooking, and have a very vested interest in making the company succeed.

They start by acquiring properties from other companies. For example, they acquired their Telemark property from a company that acquired Spiniker. The company had no use for the Telemark company, and sold it to ATP. It’s not that the field has no value, it’s that it was not part of the strategic vision of the company. So a change of ownership, a shift of strategy, etc., all brings valuable blocks to market for ATP to bid on.

ATP buys blocks close to each other, developing “hubs”. This is a key part of their strategy, at it keeps costs very low. Deepwater reserves are very expensive to produce and then transport. Having a bunch of small blocks strewn all over the place would be very expensive to produce and deliver. If you look at a chart of ATP’s properties, you will see they are clustered. ATP then develops the infrastructure to deliver these reserves to market. Then, any new acquisition can be delivered to market for the incremental cost of drilling and pumping, keeping costs very low. For example, when they purchased Canyon Express they got a 62 mile pipeline with a capacity of half a billion cubic feet per day. In a sense, they got that pipeline for free since they bought the property for the reserves, and they carry it on the books at $0. However, this pipeline is the closest interconnect point for all the properties they bought in 2008. This pipeline, valued at $0 with GAAP accounting, is adding tremendous value to the company by minimizing costs. Any other company buying blocks in that area either has to create/buy their own infrastructure, or lease the pipe from ATP. And, because ATP has hubs in these locations, the blocks are less valuable to their competitors.

The next part of their strategy is to maintain production control over all their properties. As they grow, they sell developed assets to generate cash for new acquisitions. This often leads to ATP owning part of a property, and another company owning the rest. By retaining control of operation, ATP can ramp up/down production in response to commodity costs and need for capital to develop other areas. This gives them nearly complete control over their Capex, and allows them to operate profitably with oil at $20.

The final part of their strategy was alluded to in the last paragraph. While they get their cash flows from producing and delivering reserves, they will also bring a property to producing status and then sell it to produce cash for new acquisitions.

E&P companies have stringent standards for terms such as “proved reserves”, “probable reserves”, etc. They are industry standards, audited by outside companies, and used to establish sale prices of assets and companies. Proved reserves means what it sounds like – oil or gas that has been proven to be in the ground and recoverable (it does us no good if you can’t get it out). Probable is the next step out – not as solidly proven, but the seismic, geology, etc., are there. A buyer has to decide how much to write that down to value it. These get packaged together into a number called the PV-10 value, which means present value minus 10%. The estimate is beyond the scope of this, but it looks at current oil/gas prices, figures out how much it will cost to get the assets out of the ground, how long (a dollar today is worth more than a dollar 3 years from now), discounts those future cash flows by 10% back to the present. A standard DCF, in other words, all to an industry standard for the field. It doesn’t mean that the assets are worth that exact amount today; after all, oil could go up or down, but it does reflect about what another company will pay for the assets. They have the same knowledge about future gas prices as anyone else, after all.

Almost every year ATP has improved their proven reserves (all # in Bcfe unless stated otherwise)

2000: 116

2001: 235

2002: 230

2003: 303

2004: 275

2005: 527

2006: 637

2007: 716

They are adding new blocks in 2008, which we will get to soon.

Right now they have 468 proved undeveloped, 248 proved developed, 119 probable developed, and 256 probable undeveloped. By 2012, they expect to have 95% of the undeveloped to developed. Note that the 98% success rate mentioned earlier refers to this – okay, we have it in the ground, can we successfully develop it? If you look at their history in creating developed reserves, they have increased it by 310% from 2004 to the end of 2007.

The recently calculated PV-10 value of the proven and probable reserves is $7.2 Billion. Remember that these numbers are produced by independent third parties, not ATP. You can buy the company today (market cap) for $266 million. That estimate was done on June 30th, with oil at $100 and gas at $7.5MCF. As we know oil is down, but gas is not too far from that price. I’m not going to tell you what value to give oil going forward, but I think you can see we can cut oil prices a lot and still be waaay undervalued here, assuming there aren’t other problems.

ATP is estimating what they think they will actually produce based on new blocks that they have added to their operation. This is an estimate, but the last time they published an estimate they met that estimate and then some. They estimate that there is an additional 76MMBoe of recoverable oil and gas. When you add this to the analyst’s estimate, you get 7 barrels/share. If you take the analyst’s words for it, you get 5 barrels/share. In that case, you are paying from $1 to $1.5/barrel at current share prices. I can afford that, can you? Of course, ATP has to pay to extract and transport the oil, but their costs for this are very low, as I’ll discuss soon. In short, they can easily make money with oil at $20/barrel. And remember, this places the value of everything else at $0 – pipelines, drilling platforms, future discoveries and cash flows resulting from them.

Two things to look at left: 1) should we believe these prices, and 2) is ATP healthy? A no to either one would have us not buying the stock no matter what the possible reward. Rule 1 – don’t lose money, which means don’t take risks.

Should we believe these prices? The market does. ATP is carrying more debt than they should (which I will address in the second point, are they healthy), and introduced a program to pay it down by $600M. This payback is part of the debt covenant they have with their lender. The company even initiated a competition: if they achieve this in 2008 (and I believe they will), they will pay the mortgage of all the employees for a year! To do this, they have to monetize their assets, i.e. sell off some of their drilling leases. The downside to that is of course they don’t get the future profits, but they will be in a very strong situation from a credit point of view.

To this end they recently sold a block for $82M ($102/bbl and $9/Mcf). This block was 0.8% of their proved reserves and 0.5% of their proved and probable. This suggests that the company as a whole was worth $10 Billion dollars, if we assume that none of the probable reserves work out. This ignores the extra 40% that ATP estimates that they will produce. $10Billion on proved reserves alone, vs a market price of $266 million. This is not my estimate. This is not an analyst’s estimate. This is what a competitor paid ATP for their proved reserves. As a side note, and this is way beyond the scope of this post, the price paid was completely in line with other sales by the industry. No one got ripped off here. And, if anything, this suggests that the PV-10 calculations were pretty conservative, which put it at $7.2 Billion. Or, decide the PV-10 is correct. Your choice. Companies usually trade at a small multiple of the PV-10, say 1.3x or so, because after all these are E&P companies, and we should expect them to discover more reserves in the future. Recall that ATP just buys reserves that already have been proven, so “discover” is misapplied in this case. But I’m not going to go down that road, I think you can see a bit of a margin of safety in these numbers.

In October they announced a deal with EDF. They sold 80% of 2 fields for $416MM, and have an option in place to sell the last 20% by the end of the year, which would add to the $600MM required by the debt agreement. The purchase has been approved, and final signatures are expected to happen between Dec 10^th and 20^th, though there is a small possibility of missing that date. This sale does not make a significant impact on the 7 barrels/share that ATP owns (or 5 barrels if you want to stick with the Jan 2008 numbers), yet the sale price was 1.5x the market cap for the entire company. A sliver of the company for 1.5x what you can buy the entire thing for on the open market. So, a second competitor that values ATP at an extreme multiple over the current stock price.

There debt agreement requires them to put at least 75% of the monetization proceeds towards debt reduction. ATP has announced plans to buy back stock with the rest of the money as soon as the debt is paid. They also have stated that they should have further asset sales to announce sometime soon after the new year. I will show some computations on the effect of share buybacks on shareholder value in a bit.

Is ATP healthy? That is the big question. As noted above, they are carrying debt . I am going to skim a bit over the numbers – you must read the recent report and the last several presentations by ATP (aug 11, Oct 7, and Oct 10th, here: http://phx.corporate-ir.net/staging/phoenix.zhtml?c=123846&p=irol-presentations). Briefly, right now ATP has the capacity for 95 M Bbls/d and 250 MMcf/d. From that you can calculate cash flow. Useful life for the facilities runs from 20 years to 50 years. They are located in hubs to reduce costs. Their reserve replacement ratio has been 223%; the last 3 years was 438%. Their success rate in developing their assets has been 98%. They have a huge inventory of undeveloped reserves to drive growth in 2008-2012. They recognized that the debt was a bad idea, and are deleveraging. 22% of ATP is owned by senior management. Year to date cash flow from Gomez alone is $219M (compared to the company selling for $266M), with net revenue of $236M. You can add up the rest: we are trading for under 1X 2008 cash flow. This is not a cash flow story, as the cash flow will be used to purchase new leases and convert undeveloped into developed, but it shows that the money is there and coming in fast. Furthermore, they plan to reduce Capex by $200M next year, and increase production flows.

In the end, you have to decide how you feel about that debt. Certainly the turmoil in the market could make it hard to sell things off quickly, but remember the pressure is coming from within – management – not without – the banks. So ask yourself: what is the risk of cash flows stopping to an extent that ATP cannot service their debt? Given how fungible their reserves are, and that they have $278M in cash on the books as of 6/30/2008, it would either require a catastrophe at a major hub coupled with a financial market where they could not sell off any of their leases, or oil dropping to a few bucks.

Let’s look at the enterprise value. Market cap is $266. Preferred stock is $0. Debt is $1609, cash is $278. 266+1609-278= $1.7B. ATP could be bought for $1.6B today, vs $7B if they never aquire any more reserves and do nothing but spin down the company, and just let the infrastructure rust. After the monetizations, debt should be around $1B, leading to an enterprise value of $988MM.

This is not an investment story that requires calculation of the value of the infrastructure. But, to put some color on that, consider some of their major projects. Gomez cost them $300MM, with a useful life of 20 years. Telemark I is 91% complete, has a 50 year life, and has cost $515MM to develop. The extremely valuable pipeline they own is carried on the books at $0. Cost of development and sale prices are different things, but it is trivial to see there is a lot of value being carried here that the NAV calculations are ignoring.

In short, a company with a market cap of $266 Million has been valued as having $7B in reserves by external auditors, and $10B by a competitor when oil was at $100. I call that a margin of safety, and then some.

Interest costs are around $100M a year. This will vary quarter by quarter as interest rates fluctuate, and of course will lower as they pay down the debt. The terms require that 75% of any asset sales be used to pay down debt. They refinanced in June, at LIBOR + 5.25, and this loan has several conditions relating to the asset sale, maintaining Debt/EBITDAX radios, etc. They are good terms for shareholders - as it forces the company to keep the company healthy, but of course they have to maintain cash flow. The debt agreement is in effect to 2012, which should insulate them from the current credit market. Call it luck that they did this in June if you want (Al Reese, CFO calls it that), but the result is a company insulated from the credit crisis being priced as if on the verge of bankruptcy.

On cash flow, their sales are hedged, so sales are somewhat predictable. You can get the latest information from the quarterly reports. Of course, as each quarter rolls around, the oldest hedges expire and they have to contract new hedges at current market rates, but this still provides visibility into cash flows for the near term future. The cash flow for the first 6 months of 2008 was $292M. 2009 should yield around $700M, depending on where oil/gas prices fall at the time. In 2009 new projects are coming on line which should boost production around 40%.

On the other hand, in response to the credit landscape and lower oil&gas prices, they have planned to reduce Capex in 2009 by $200M. Since their whole business is changing undeveloped proved into developed proved, they can slow down or speed up development at whatever rate they want. That’s an important point. While Capex is high for this company, they have almost total control over it. There is Capex for actually pumping and transporting from the well, but that all results in a profit. The major Capex is due to development - drilling, etc. This will result in lower cash flows in 2010 then expected. Still much higher than now, but lower than originally calculated.

Finally, let’s look at value/share. I don’t try to predict share prices, since the market is crazy, but it’s worth seeing what kind of value is locked up in the shares, and what kind of return we might expect from a share buyback.

PV-10: 5.3 Billion

Debt: 1.6B

cash: 300M

shares: 35.9M

5.3B + 300M - 1.6B / 35.9M = $111/share

Now, companies don’t trade at PV-10. A lot depends on what people think the future might be, etc. But that is a simple ballpark, and it doesn’t include the 40% extra that ATPG thinks it will recover beyond the PV-10 conducted by outside auditors, but it also doesn’t consider Capex, taxes, etc. Still, I’d be happy buying shares up to $40-50 or so.

Okay, as I noted, they will start a share buyback once the 600M debt is paid back. Of course, this requires that the prices stay this irrational while they execute the buy. But, let’s dream, shall we:

$70M buyback = 3.5 million shares $20 (> 2x current prices)

Debt: 1B (debt paid off)

Cash 230M (less 70M buyback)

PV-10: 4.7 (less the 600M sale)

Shares: 32.4

4.7B - 1B + 230 / 32.4 = $121/share

Such is the beauty of share buybacks when share prices are low.

It you want to break your heart, try making it a bigger buyback, or at a lower share price. Break it from the heart palpitations, I mean!

What are the risks? A storm would cut production. I ask myself, what will the impact be on the bottom line in 10 years? Short of the “perfect storm” which hits all their various hubs (in two entirely different places in the world, I’d say the impact would be small. Naturally, the stock price would take a great hit for awhile, but I would welcome that. Even if every well was destroyed in some kind of global capacity, their reserves would still exist, and they would just endure the incremental costs of rebuilding the infrastructure.

The real risks I see are more along an ecological disaster followed by a multibillion dollar lawsuit. That would be tough to recover from, and would permanently destroy value.

So there you are. A company trading at a huge discount to their value if they closed up shop tomorrow, with positive cash flows, and the ability to make a profit even if oil is cut in half. 22% of it is owned by company executives, and they will be announcing deals in the coming days whereby they are selling a sliver of the company for 1.5x the current market cap. The valuation of their reserves was calculated by independent third parties, and competitors have shown they support those valuations by paying hard cash for assets from ATP.

IPHS is a quite small, underappreciated, underfollowed specialty chemical business. Who cares? A small chemical business – how good could it be?

Simple. IPHS sells food additives to the major food and beverage manufacturers in the United States. These additives add flavor and shelf life to products – products like Bisquick, Oscar Meyer, and Coca Cola. They also produce phosphates for things like detergents, toothpaste, asphalt, etc. In short, pick up a name brand food product from your grocery shelf, and there’s a very good chance that IPHS has a tiny piece of that product (and thus, profit). Go to the cosmetics counter, and IPHS is there.

Before we look at the numbers, let’s look at the business as a business. Who do they sell to, do they have a moat, what are their sales prospects in this environment, and do they stand to grow.

The specialty chemicals business has several very large barriers to entry. First, these are largely food additives with a relatively low cost/lb. A China upstart couldn’t easily enter the business because 1) cost of shipping would eat into the margins, and 2) freshness – you don’t want food additives intended to enhance flavor, purity, clarity, or shelf life sitting around on a cargo ship. China is trying to compete, read the latest conference call transcript for details, but to date it is not a significant factor, and it will always be a difficult environment for them.

Second, and far more importantly, these are food additives for very identifiable products (Coke!) which are regulated by the FDA. Say I wanted to start a competitor to IPHS. No problem (ha)! First I have to figure out a flavor profile identical to what Coke currently uses. Then, I have to get FDA approval for my additive. After that, I have to go to Coke and convince them to switch suppliers, a supplier they have been happy with for decades. I have to do all this, then sell at a lower operating margin than IPHS, and somehow pay off the expenses incurred in all the R&D. Finally, the cost of these additives on a volume basis is quite small – it represents a very small fractional cost for the final product. Maybe a penny for a box of Bisquick. You’d have to undercut IPHS quite a bit to get a customer to switch to an unknown company and product. Finally, you’d be undertaking all this risk to get part of a market share from a $300 million company – who in their right mind would do that? No one, so far, in the multi-decades that IPHS has been in business.

Third, this moat and relative low product cost gives IPHS very strong leverage with their customers. Say they doubled the price of an ingredient that currently costs 1 cent per box. This represents a huge increase in IPHS’ operating margin. OTOH, the customer is basically unable to balk – they have no alternative to IPHS’ additives. Sure, they could either go develop the additive themselves, or to a competitor of IPHS (there are a couple), but this will be at least a couple year lead time, all to avoid a 1 cent increase in the cost of the product. To date, since the spinoff, IPHS has not exerted this leverage on their prices, but in their most recent conference call they said this is in the plans for the following quarters. The only risk is raising prices so high that they alienate their customers. A doubling of prices overnight would probably do that, but a quarter by quarter modest increase of prices will be absorbed easily. This is a better moat then Buffett’s See’s Candy has. They raise prices every January 1^st, and people keep buying. IPHS can do the same, and their customers need the product far more than a candy eater needs See’s Candy. Against this we have to balance the cost for IPHS to do business. It’s no advantage to raise prices if operating costs are skyrocketing. As a chemical company, they have to buy raw materials. What does that landscape look like? Well, first, they have a long history of passing along increases in raw prices to the buyer. This is an easy thing to do, partly because of the moat, and partly because all of their competitors face the same raw price increases. These additives are going into consumer staples, so it’s not like the buyer can slow down production in the face of added costs. Everybody is going to buy toothpaste, detergents, bread (IPHS sells bread leavenings) and Coke no matter the price of phosphate rock (the raw material). But IPHS has negotiated long term supply agreements for their phosphate rock. The long term nature allows them to predict costs raises and raise product costs in plenty of time to avoid losing money. IPHS has raised prices several times this year already in light of developments in phosphates (more about that later).

The stability of the business should be clear. They have been selling these chemicals to the same buyers for decades. Bisquick is going to sell this year, it is going to sell next year, it is going to sell ten years from now, regardless of the economy. No one is going to stop washing their undies. I remember when I was a starving grad student – I dug into my couch cushions to find the 50 cents needed to buy a can of Coke. I went without almost all niceties, but I still supported by caffeine habit. Over 20 years later, and I still drink Coke (not Pepsi). 40 years from now, if I’m still alive, it’ll still be Coke. That’s a moat.

While I don’t like trying to predict macro conditions, they have been favorable to IPHS. China has been clamping down on phosphate exports, recognizing how important the chemical is. Phosphates rose, and IPHS passed the cost along to the customer. Demand for agriculture phosphates was way up in 2008. This has gone back down, and I think the market has misinterpreted IPHS as an agriculture phosphate business, because the stock price has been pummeled, back to near the IPO price.

Okay, the numbers. Is it a compelling buy at these levels? 2007 EBITDA was $105MM. In comparison, EBITDA for the last quarter was $112.9MM!! EPS for 2008 should run somewhere over $9/share. In comparison, IPHS is trading at $14.86 at the time of writeup. That’s about 1.5x trailing earnings. The future is hard to see, but their exposure to the ag business is not what Wall Street is thinking (given that low share price). If they hold on prices, they should earn at least as much, and if they start putting in price increases due to their moat, they stand to earn quite a bit more. But let’s not get greedy. Even at 2x earnings this is a screaming buy.

Another way to look at earnings: I don’t have the numbers for the most recent quarter, but this summer they were getting around $12-14MM a month as a spread between what they bought materials for and what they sold them for. Their ROE is 119.5%! Free cash flow should be around $100MM. In that light, they are trading at 3x FCF – an absurdly low multiple for a company with such a large moat in a economically defensive industry. While you wait for the stock price to normalize, you get rewarded with a quite nice 4.5% dividend.

I could make up a detailed spreadsheet for projected earnings, document all kinds of assumptions, but why? If you have to reach for a calculator, move to the next stock. $100MM FCF in a $300MM company.

The naysayer will point out I’m doing computations on market cap, not enterprise value. As part of the spinoff, quite a bit of debt was passed on. This is a typical strategy with spinoffs – create a company with huge cash flows to service the debt, and the returns are very significant. The cash flows will allow them to deleverage, adding shareholder value. Make what assumptions you want on forward enterprise values, and you can come up with a yield, forward PE, whatever. The bottom line is they had around $383MM debt at the start of the year, and should have paid it down to around $327MM as of Sept 30^th, and expect to have it down to around $250MM by year end, with a cash balance of around $125MM.

A growing business with an extremely strong moat, selling products to Coke, Bisquick, toothpaste, deodorant, laundry soap manufactures, at a 2.1PE and 4.5% yield. No calculator needed, this is an obvious buy.

I have not investigated this one in detail. However, the facts as I know them:

Magna is an auto parts supplier. As such, it’s stock price has been hammered, like the rest of the industry. However, they have almost no long term debt, and $21.29 cash per share, compared to a ticker price of $31.50. So, you are buying the business for about $10/share. Compares that to last year’s free cash flow -  $14.75. At that, it is trading at less than 1x trailing FCF.

Now, I haven’t looked at their future prospects in detail. ValueLine projects FCF of $13.95 this year, and $15.65 next year. I put little stock in predictions, even ValueLine’s.  The question is, how much of their business depends on Detroit? In the medium to long term there is no way the world is getting rid of autos, so to my way of thinking now is the time to buy so long as you aren’t betting on a specific auto manufacturer to survive. Some are going to fail. Chrysler is 13%, Ford is 15%, BMW is 19%, and GM is 24%.

With this huge cash flow and no real exposure to the credit market, MGA stands to make acquisitions of it’s flailing competitors.

I haven’t sorted out the risk/reward equation for this in my mind yet, so I have not purchased shares. Given the number of riskless investments in this environment, I find it hard to take on much risk right now. However, the FCF yield is extremely compelling right now.

This is NOT A RECOMMENDATION TO BUY. Information only. Really. Also, note that I wrote this awhile ago, when the market wasn’t offering such compelling ideas.

Bexil corporation is the easiest company in the world to value, and the hardest to talk yourself into buying.

Cash on hand: $43.71/share
debt: $0
income: $100K/quarter, net taxes (income from cash invested in treasuries)
other assets: none worth mentioning.
Share price: $23

Buy $44 in cash for $23

What gives?

They sold off their previous business (York Insurance Services Group, Inc) in 2006 for cash. Since then, they have been looking for a new company to buy. So far, bupkiss. Nothing. They just have the money sitting in treasuries and money market funds. From that they are deriving a bit of income, and paying the meager salaries. Essentially treading water, neither adding or diluting value.

Since the sale they have been stating that they want to buy a new business. Their criteria are Buffett-like:

• A proven track record with demonstrated earning power.
• A seasoned business with solid customer relations.
• Good return on equity, little or no debt.
• Solid management. Audited financials required.
• Particularly interested in a “spin-off” from a larger company

However, while Buffett has been snatching up companies, they have done nothing. Come on, already!

Bexil is largely owned (well 25%) by a parent company Winmill, which basically runs some funds, owns some subsidiaries. They seem to have let this languish for some time. The stock trades OTC, and has zero press or interest.

upside:

Scenerio 1: they decide to go out of business, and issue a 1 time dividend.
ROI: 83%

Scenerio 2: They buy an average company for what it is worth. Stock price adjusts to company’s value. ROI: 83%

Scenerio 3: They take advantage of the unique market we are in, and buy a company at a significant reduction. We get 2 multipliers here: the crazy stock price of Bexil itself ($44 for $24), and then the discount of the company bought (say 50% discount). ROI 160%+

Scenerio 4: Same as scenerio 3, except the company they buy has appreciation potential of 15-20% yearly. ROI: sky is the limit.

Downside:

1. They buy a bad company for too much money, frittering away the value. They would have to pay 2x what the company is worth for us to break even, > 2x for us to lose money. ROI: 0% to worse than 0%.

2. They issue or incur a lot of debt to buy a bigger company, reducing the enterprise value down to about the stock price. ROI: 0%.

Difficulties:
They only have $38M in cash, so they are restricted to micro-caps. This market is turning some good companies into microcaps, however. It’d be pretty exciting to buy an already extremely undervalued company for nearly half off that price.

Catalyst:

Buying a company, or issuing a special dividend. Winmill puts the pressure on them to realize value.

There is no way to know what they will do. They talk the Buffett talk. Will they walk it? Who knows. Work out what you think the probabilities of each the scenarios are above, and you can put an expected value on the stock (with large margin of error).

Value? Value trap? I dunno. I just thought it was interesting to share - pretty darn rare to ever be able to buy $44 for for $23. Schloss would be all over it. Buffett would pinch his nose and walk away (unless he could buy majority control). In this market I’m finding 10-20 baggers (more about those in future posts. Why put cash in a company that has done nothing with their cash in 2 years?