Disclaimer: Shareinvestors is not authorised by the Financial Conduct Authority to give investment advice. Terms such as ‘Buy’, ‘Sell’ and ‘Hold’ are not recommendations to buy, sell or hold securities, these statements and other statements made by the author have the meaning only to express the author’s personal views on the quality of a security. Independent financial advice from an authorised investment professional should always be sought before making investments. CAPITAL AT RISK. Full Disclaimer here.
In the interests of absolute transparency I record all my share recommendations and produce a P&L in % terms on an ‘Inception to Date’ basis. Unlike a lot of ‘tipsters’ my trades also include a % adjustment for bid/ask and transaction costs.
I will also continue to state my positions at the end of all company specific articles too.
FEBRUARY ROLLING P&L
Here is the summary as at 28th February 2017. The average stock tip is 19% Inception to date, with 82% of my 26 tips in profit. On an annualised basis the average tip is 346%.
The principle detractors are my short calls on Genel and Sterling Bonds. My views have not changed on either. Genel publishes its full year trading results on 30th March 2016 and I expect heavy impairments to the balance sheet. Bulls will argue that much of the information is already known but I believe the potential extent of these impairments to catch some by surprise, particularly if the KRG arrears take a heavy hit. Regarding Sterling Bonds; I have seen nothing to indicate that my belief of a due correction is incorrect. Hurricane and Sirius were tipped again in the month and are currently both showing small losses, but I believe both to offer significant upside in the longer term.
Disclaimer: Shareinvestors is not authorised by the Financial Conduct Authority to give investment advice. Terms such as ‘Buy’, ‘Sell’ and ‘Hold’ are not recommendations to buy, sell or hold securities, these statements and other statements made by the author have the meaning only to express the author’s personal views on the quality of a security. Independent financial advice from an authorised investment professional should always be sought before making investments. CAPITAL AT RISK. Full Disclaimer here.
I covered Hurricane Energy (HUR.L) here shortly after the Lancaster Pilot hole flow test in September 2016, tipping the shares at 38p with a BUY target of 55p. This initial share price target was reached last week, returning investors 45% in just shy of 7 months. There has been plenty of positive newsflow in the past few months, so I take a look at what has happened since my first tip and whether I believe there is further upside from here.
QUICK FACTS
Hurricane Energy plc is engaged in the exploration of oil and gas reserves offshore of UK. Based on its most recent CPR the Company has two basement reservoir discoveries and has approximately 450 million barrels of 2C Contingent Resources on its acreage.
Vital Statistics as at 23rd February 2017 market close:
Current Share Price
52.75p
All Time High
58p – 7th Feb 2017
52 Week Low/High
58p – 7th Feb 2017
10.05p – 1st March 2016
Market Capitalisation
£635m
Enterprise Value
C£635m, minimal cash/no debt
Fully Diluted Market Capitalisation
£652m, 30m share options outstanding
PE/EPS
Not applicable for where Hurricane is in the cycle
WHAT HAS HAPPENED SINCE SEPTEMBER?
There have been three key developments for Hurricane Energy since my last post, they are 1) further progress on the Lancaster Early Production System (EPS), 2) an exploration discovery on the Lincoln prospect and 3) the exploration spud of the Halifax prospect on newly acquired ‘out of round’ licence acreage. Let’s take at look each in turn:
1) Lancaster Early Production System (EPS) development
Hurricane via RNS confirmed in November 2016 that it had signed Heads of Terms with Bluewater Energy Services for the use of the Aoka Mizu Floating Production Storage Unit. For oil and gas novices this is essentially a floating platform which will be hooked up to the two subsea production wells planned for the development. For the anoraks among us, you can find the full specs of this little beauty here.
Figure 1 – Aoka Mizu, Source: Bluewater
The Aoka Mizu has been deployed at the Ettrick and Blackbird fields for Nexen Petroleum UK since 2009. However, after just 7 years the field is now being decommissioned and the Aoka Mizu was retired from its duty. Hurricane and Bluewater have though reached an agreement to salvage poor Aoka from the Nautical graveyard and instead do various upgrades to bring her to the Lancaster field.
I covered the concept of the EPS in my previous piece but there have been some slight revisions to the core assumptions worth noting; Plateau production is now expected to be 17,000 barrels oil per day on producible reserves of 62 Million Barrels, previously reserve estimates were 53 million barrels. OPEX per Boe is now estimated to be $26 compared to $35 back in May 2016, a big improvement and most likely linked to improved terms on the FPSO lease. Moving in the other direction though CAPEX per Boe has increased from $318m to $400m.
It is worth remembering that the EPS is designed to produce for a period of 18-24 months and will unlikely form part of a larger Lancaster field development. One of the reasons for the EPS is that there is no existing production on the UKCS from basement reservoirs. The EPS will therefore give a long term indicator of reservoir performance and establish decline rates. This information, if positive, will allow the full field development to become ‘bankable’ and of course prove many doubters wrong in the process. The Hurricane team do though have an option to extend the FPSO for a further 10 years which gives flexibility on how a potential full field development plan could pan out. I have crunched the numbers and I believe a 15 year development on the EPS alone could given an NPV £430m on an unrisked basis. More on that later though….
2) Exploration Success on Lincoln
Hurricane announced a placing and open offer to raise £70m in late October. The proceeds were to fund a two well exploration campaign on two prospects nearby to Lancaster. One was the Lincoln prospect, which can be seen on Figure 2 below:
Figure 2 – Hurricane Licences and Assets. Source – Hurricane Energy
The Lincoln well was completed late in December taking around 40 days to drill down to a True Vertical Depth (TVD) of 2,135m. The initial results were very encouraging, a significant hydrocarbon column was encountered of at least 660m. This led Hurricane to state that ‘250 million barrels of recoverable oil for the Lincoln prospect may be conservative.’ We also later learnt that the Lincoln is likely a separate reservoir from the Lancaster, with no impact on the existing reserves of Lancaster. Furthermore the undrilled Warwick prospect is also likely to be part of the larger Lincoln field.
The well was not tested though, so as yet we don’t know whether the oil will flow nor we have no indication of the API of the crude, i.e. a sweet or heavier hydrocarbon. It’s clearly encouraging news though and I have prepared a very crude (pun intended) valuation below which I believe could place an unrisked valuation of at least £1bn on this prospect alone. Clearly though a few more ducks need to be lined up yet before we start throwing these figures around with more credence!
3) Halifax Drill in Progress
Halifax is the second of the two drill prospects and was acquired through an out of rounds licence application which gave us the P2308 licence. A previous well was drilled on this licence in 1998 by Arco, which revealed hydrocarbon shows just above the basement. Hurricane believe their seismic model indicates a well fractured basement similar to Lancaster and the belief therefore is that Lancaster actually extends well beyond the existing licence boundary of P1368, as illustrated on figure 2.
Given the Halifax well could be a critical input to the the broader full field Lancaster development, this well is also planned to be Drill Stem Tested (DST) if hydrocarbons are indeed present, which will give an early indication of flow rates. The Halifax well was spud on 16th January and although not explicit in the announcement I assume the targeted TVD of the well is circa 1620m, i.e. inline with Lancaster. Although this well is 500m shallower than Lincoln given the ferocious swell in the West of Shetlands around this time of year I don’t think we will hear anything until the first week of March at the very earliest. The DST piece, not conducted at Lincoln needs a particularly stable weather.
It is not uncommon to have some drilling delays in the West of Shetlands during the Winter months, rapid demobilisations during peak swell can often lead to integrity issues downhole. There could of course be a cost factor associated with any overruns, assuming a rig rate of $300,000 per day then we a probably looking at a total cost of around $42m for Lincoln/Halifax campaign to the end of Q1. Hurricane raised $85m (£70m) for the drilling campaign, to order Lancaster long leads and complete the FEED on the EPS. I therefore don’t believe there is much for shareholders to worry about at present, at least until we get further into in March without news. It’s also worth noting that in the grand scheme of what Hurricane are chasing then any overruns will likely be a pittance in the long run.
WHAT’S NEXT? WHAT NEWSFLOW CAN WE EXPECT IN THE COMING WEEKS?
The last year for Hurricane has been pretty much perfect, nothing could have gone better in my view, but what can investors look forward to over the next few months? The most material news of course is likely to be the Halifax result, but there are also two other catalysts for a share price move.
a) Halifax Well Result
As mentioned above we are likely to hear something from operations within 3 weeks. The chances of geological success are always slim so brace yourself for disappointment. But if the Halifax well ‘comes in’ then what reserves could we be talking about? Hurricane have not teased us with any figures at this stage, I think the only thing we can say is a ‘material uplift’. I therefore have discounted Halifax from my valuation (addressed later), but of course this represents a huge upside to the share price. Conversely, I also expect the share price to take a large knock if Halifax does not come in as prognosed and the speculators exit. This could represent a buying opportunity in my opinion though, the resources in the CPR will be more than enough to make Hurricane a major independent player, with our without Halifax.
b) Independent Reserve Report
The last CPR was completed in 2013 and the resources assigned to Hurricane at the time are summarised below. For those not familiar with the terminology please see this guideline.
Figure 3 – Hurricane Energy 2013 CPR, Source: RPS Energy, Hurricane Energy
My expectation is for a revised CPR shortly after Halifax is completed, so probably around April/May. I think we will likely see some shift in the categories for Lancaster and Lincoln, i.e. from prospective to Contingent and probably within contingent resources too. We will also likely see some upwards revisions of the numbers. Perhaps the most significant though will be the first reserve booking on Lancaster, I am expecting at least 60 MM Boe to be booked to the 2P category, i.e. commercial reserves.
The Hurricane team have already put out their own views on the potential size of Lancaster and Lincoln, so I would be very surprised if the revised CPR itself causes much of a reaction upwards in the share price, this document will be critical though in the financing process…
c) Financing the EPS
Hurricane needs to raise around $400m to fund the EPS, with the stated strategy being to bring a partner in through a farm out process. The Oil and Gas M&A market is really picking up at the moment so I would be really surprised if management can’t achieve this objective. The obvious candidate is likely to be BP given the proximity to its operated Schiehallion Field. Funding a share of this project would be a drop in the ocean for BP and potentially give them access to a much larger prize. It would also be a PR coup for BP, a British company investing in the next generation of North Sea oilfields. I am sure this would have the government and BP PR guys salivating. There are plenty of other matches for Hurricane too, but whomever it needs to be someone with a strong balance sheet.
A cautionary note, BP et al are notoriously hard to negotiate with and the issue for Robert Trice and the board will not be whether they can generate interest in Lancaster, it will be at what level of NPV that a potential partner places on the assets. I have every faith that Hurricane will do the deal which maximises shareholder value and with that in mind they are certainly not dependent on the traditional ‘farm out’ method. Looking at the deal put together by Sirius Minerals to fund a major project at sole risk then Hurricane can have every confidence that they can achieve what would be smaller fund raise. I have therefore in my own valuation have assumed a mix of 50% Debt and 50% equity.
SO LOTS OF INFORMATION, BUT WHAT IS THE UPDATED VALUATION?
Hopefully you are still with me after this long piece! Cutting to the chase, my own risked valuation is 75p per share as illustrated in figure 4, i.e. a 42% upside based on the current share price. This is inline with the latest broker targets of 69p-91p.
Now for the caveats; this valuation is something I have put together using very high level assumptions, I have had no input from the company other than the core assumptions on the Lancaster EPS which are in the public realm. The Lincoln and Lancaster Full field valuations are particularly high level given they are Pre-FEED assets. However, for those who want to get behind the valuation in more detail, my workings are here and please do go through them adjusting for areas where you might be more bullish or bearish.
I have tried to be as prudent as possible, assuming equity dilution, large risk factors, no success on Halifax and the assumption that we won’t get to $100 oil prices until 2043! I have also tried to keep things simple, assuming 100% field share.
Any further risks or upsides to consider?
The biggest risk to this company in the long term is being unable to get satisfactory long term production from the EPS. As all of the prospects are basement plays any disappointment could scupper the chances of the entire greater Lancaster region being developed. We won’t really get a feel for that though until the end of 2019. Before then the financing of the EPS is perhaps the key near term risk, I am fairly confident that an attractive financing can be put together, but the use equity and convertible debt could reduce the NPV per share significantly. The usual combination of CAPEX overruns and oil prices are also a risk too, but this is far from unique in this sector.
As a final note I would like to give credit the Hurricane Management team, what Robert Trice and his team have achieved in one year puts the boards of many junior oil companies to shame. Hurricane have managed to raise equity at premium at the very bottom of the oil M&A market, they have secured an out of round licence award and worked up a drill ready prospect in just a few months, not to mention further progress on the EPS. Amazingly they have achieved this with just 15 or so Full Time employees. We don’t know how the story will end but I don’t think anyone can claim management were not committed!
SUMMARY
Buy – Target 75p (42% upside)
There is still plenty of upside at the current share price levels in my opinion, even without Halifax. As development proceeds there is plenty more growth to come and I expect we will be see £1 within 12-24 months, barring any major disasters. The stock is though still somewhat speculative, so make sure it is part of a diversified portfolio.
Disclaimer – I have long positions in Hurricane equal to 2% of my NAV. ShareInvestors.co.uk requires me not to deal in this stock in the next two trading days from the date of the post being published.
This post is purely my opinion and should not be taken as financial advice. I welcome any alternative comments and will consider adjusting posts based on information made available to me.
Disclaimer: Shareinvestors is not authorised by the Financial Conduct Authority to give investment advice. Terms such as ‘Buy’, ‘Sell’ and ‘Hold’ are not recommendations to buy, sell or hold securities, these statements and other statements made by the author have the meaning only to express the author’s personal views on the quality of a security. Independent financial advice from an authorised investment professional should always be sought before making investments. CAPITAL AT RISK. Full Disclaimer here.
It has been an interesting year at San Leon Energy (SLE.L). After many years of struggling to create value from its existing asset base the company did a fairly impressive Nigerian deal in the summer of 2016. After a period of bedding down it emerged late in 2016 that San Leon was subject to a potential takeover from a mystery Chinese bidder and at a fairly sizable premium to the share price at the time. So the signals from San Leon towers were looking very promising indeed, I had hence rated this as a ‘BUY’ in both my previous posts. It has though gone very quiet from San Leon since the excitement of late 2o16 and we have so far had no formal update on the potential Chinese deal in the first two months of 2017. We did though get an operations update in the thick of ‘bury news’ season, on 3oth January 2016. In today’s piece I take a look at that Operations update and consider whether there was indeed bad news to bury and if so whether my BUY view on San Leon should change.
Quick Facts
San Leon Energy is an oil and gas exploration and production company. The company has a diverse portfolio of assets, but the core part of the business is a 9.72% economic interest (5.5% Shareholder interest) in the OML18 onshore block in Nigeria.
Vital Statistics as at 20th February 2017 close:
Current Share Price
53.5p
All Time High
57.125p – 13th Feb 2017
52 Week Low/High
57.125p – 13th Feb 2017
29.125 – 25th Aug 2016
Market Capitalisation
£241m
Enterprise Value
C£243m, minimal cash/no debt
Fully Diluted Market Capitalisation
C£251m
PE/EPS
Not applicable for where San Leon is in the cycle
The Operations Update
San Leon issued an RNS on its operations during the classic ‘no ones watching’ period on 30th December. This release was right in the middle of the traditional few days where companies attempt to bury bad news, so I was naturally sceptical. The operational progress on the ground was actually fairly good though, confirming that the OML18 production reached a peak of 61,000 barrels of oil per day (bopd) during the period. Production was around 50,000 bopd at the time of San Leon’s acquisition, so a 20% uplift in 6 months suggesting things are on track towards the stated target of 115,000 bopd by 2020.
Less positive however was the news on the payment situation and true to festive burying this update formed the final part of the RNS. By way of a refresher, two tranches of loan notes totalling $39m were due for repayment to San Leon by 1st January 2017. The counterparty to these notes is Midwestern Leon Petroleum but this company is ultimately dependant on EROTON for dividends to subsequently settle the loan notes with San Leon. See figure 1 below on how I understand the deal was structured:
Figure 1. Source – ShareInvestors.co.uk, San Leon Energy (Click for Large)
So let’s take a closer look at EROTON and the conditions needed to make these dividends upstream. Those conditions confirmed by San Leon in the Operational Update RNS are as follows:
The Company’s Admission Document, published in August 2016, provided details on the mechanism for dividends from Eroton to be made via Midwestern Leon. The conditions required to be met prior to dividends commencing were set out in paragraph 2.11 “Satisfaction of the conditions to approve distributions by Eroton” on page 59 and the Company is today providing an update on which of those conditions have been met.
The Company has been informed by Eroton that the following conditions have been met:
(i) the issue of a competent person’s report (ii) compliance with all financial covenants and ratios stipulated in the Reserve Bank Lending (“RBL”) facility agreement (iii) undertaking from Eroton to commence discussions on an optimal hedging strategy from 1 January 2018 to final maturity date of the RBL facility agreement and has to be in place by September 2017.
However, there are several conditions that have not been met:
The following conditions are yet to be satisfied: (iv) reservation of nine months’ worth of upcoming debt repayments due in the debt service reserve account; and (v) submission of audited financial statements by Eroton whereby 60 per cent. of audited net profits can be paid to dividends account.
The Company has been informed by Eroton that the timing for the satisfaction of these conditions is also influenced by the receipt by Eroton of the outstanding balance of historic cash calls from the Nigerian National Petroleum Corporation (“NNPC”), which was expected during 2016 but has yet to occur.
It transpires that EROTON does not have adequate reserves to make the dividend payments as yet. In my view this is likely to be a technical issue but also an actual liquidity issue. The main reason cited is the failure for the NNPC to settle historic cash calls. Fairly significant CAPEX has been expended on the OML18 licence to try and boost the production and it is suggested NNPC have not yet settled all of the bills in relation to this. EROTON does receive an income from the offtake of hydrocarbons, but it appears this is not enough to enable distributions upstream without NNPC settling its Capital account.
Perhaps no surprise, it has been well published that the NNPC has historic cashcalls due to various oil companies operating in Nigeria of around $6.8billion. According to its website, the NNPC has now installed a mechanism which will lead to the settlement of historic cash calls (pre 2016) which is encouraging, but NNPC set a timescale of 5 years to do so. At present we don’t have visibility of the amounts owed to Eroton nor how much of the cash calls are required to be settled so that Eroton can start upstreaming cash. San Leon have confirmed that they are exploring other mechanisms to try and receive disbursements, but there has been no update on this so far in 2017.
What does this mean for San Leon? How is the balance sheet?
I have prepared an estimate of the cash position for San Leon as at End Feb 2017, i.e. now and where the company could be at April 2017 without resolving a payment mechanism with EROTON. It was envisaged that the CAPEX for OML18 should be self funded by the EROTON receipts from offtake, so I have not assumed any further contribution needed for this. I am also not aware of any material funding needs on the other non Nigerian assets.
My conclusion – San Leon must be running on fumes now if I am correct in my calculations, which I have illustrated by figure 2.
Figure 2. Source – ShareInvestors.co.uk
The big payments to/from San Leon relate to the Poland asset disposal and a settlement with former partner Avobone N.V also relating to the Polish assets. The net effect is a creditor of around $14m. The entire amount is though not due immediately with the payment profile being deferred as indicated in the RNSs, but all are due for settlement by the close of 2017.
All in all, unless I have got my calculations horribly wrong or Eroton stumps up some cash then San Leon will need to raise some further finance imminently. I have no reason to believe that a fundraise is indeed imminent apart from my ‘back of fag packet’ calculation above. I did though contact San Leon on 14th February and not to wish the Investor Relation team a happy valentines! I made an inquiry about the cash position and the plan to continue to fund the liabilities as they fall due. I have received no comment so far.
San Leon does have a few options at its disposal though. The company in its most recent annual accounts advised it retains a debt facility with YorkVille Advisors. As far as I can tell the terms have not been updated since issue in 2010, If I am correct this agreement provides for a credit line of upto £15m, however this is dilutive facility which means new shares are issued at a 6% discount to the current market price. I would therefore expect San Leon to try and avoid this if at all possible and secure some sort of bridging loan or other short term non-convertible debt funding. Given the projected cashflow from OML18 I believe the company is likely to have some success here in the now more buoyant Oil and Gas debt market.
The other option is for the company to try and defer payments to its creditors, the most material of course relate to the Polish settlement. However, clearly this is only viable as a short term measure and attracts interest of 5% per annum during the outstanding period, It is not clear the terms of default though, I suspect more punitive. Another consideration is that some of the corporate costs are provided by related parties, including CEO Oisin Fanning, so there could be some further flexibility here to delay.
All in all I don’t think these funding issues are a long term concern, this is a not another Kurdistan but short term San Leon needs to find I would estimate $10m imminently and assuming the deferred payment due to San Leon in respect of the Poland disposal is received on time in October 2017, then a further $10m or so is needed by the end of 2017. This I believe will settle the final Poland payments and any overheads. San Leon could require a further $4.5m if there is any delay to the consideration receivable.
In summary then, if Eroton can settle a reasonable portion of the $39m due then the above concerns go away. It is also worth noting that San Leon is not expected to have any material liabilities once the Poland settlement is off the balance sheet. We do though need clarity on the financial position of EROTON and a revised overview from San Leon on when distributions can be upstreamed. The promise of dividends to San Leon shareholders though still feels very far away until we receive this clarification.
What about the supposed Takeover of San Leon?
I covered the indicative 80p takeover offer in this piece here. Since then we have had no official announcement. The only output in 2017 is a another rumour of a second Chinese bidder. The cynic in me says this is likely placed by San Leon or an advisor, the motive being to try and force the first bidder to show their hand or up their price.
The market though clearly still does not believe an 80p deal will come to fruition given the shares are still trading in the low 50s. Tosca Fund, the largest shareholder are pretty much the only material buyer in the market and single handedly propping up the share price at the moment. To do so it has needed them to increase their holding from 54.41% as at time of the acquisition to 56.75% according to the last Rule 8.3 submission.
How will the deal end? We don’t know, it could be a way out for San Leon and its shareholders, but it does concern me that the due diligence is taking so long. For now though the priority is the financial position of EROTON and consequently how San Leon can settle its short term liabilities. Perhaps this is the same question our mystery bidder is pondering….
SUMMARY
Neutral
I have downgraded my view from Buy to Neutral. However, I certainly wouldn’t want to go short from here.
Long Term I believe this asset is still very attractive and even a part payment from Eroton would likely trigger a re-rate. The potential bonus of bid talks yielding a firm offer also makes this an attractive proposition. However, San Leon is back in my speculative bucket for now.
Watch this space though and those who have a higher risk appetite might consider a punt. As always, do your own research!
Disclaimer – I have no positions in any of the stocks mentioned. ShareInvestors.co.uk requires me not to deal in this stock in the next two trading days from the date of the post being published.
This post is purely my opinion and should not be taken as financial advice. I welcome any alternative comments and will consider adjusting posts based on information made available to me.
Disclaimer: Shareinvestors is not authorised by the Financial Conduct Authority to give investment advice. Terms such as ‘Buy’, ‘Sell’ and ‘Hold’ are not recommendations to buy, sell or hold securities, these statements and other statements made by the author have the meaning only to express the author’s personal views on the quality of a security. Independent financial advice from an authorised investment professional should always be sought before making investments. CAPITAL AT RISK. Full Disclaimer here.
It is pleasing to see investors making some serious money on AIM, the last 12 months on the junior market have been the most bullish I can recall for sometime. Today I take a closer look at a recent ten bagger, URU Metals. The company has raced ahead over 1000% in since November and a the placing yesterday at a premium has sent the shares sharply higher. Today I take a look at whether investors should take caution or continue to pile in? Notwithstanding that Momentum is also with this stock and we all know how important that is on AIM!
Quick Facts
Jim Mellon bought this to aim as Niger Uranium in 2008. The company had a few assets in Africa before returning some funds to shareholders. A new management team was then bought in and the company was renamed as URU Metals in 2010. The company today has a portfolio of mining assets.
Facts as at 13th February 2017:
Current Share Price
3.92p
All Time High
15p, April 2011 (URU era)
52 Week Low/High
Low 0.25p on 12th Feb 2016
High 4.4p on 13th Feb 2017
Market Capitalisation
£27m
Enterprise Value
C£27m (No Debt)
Fully Diluted Market Capitalisation
C£27m. Limited warrants/options in issue.
Asset Backing
Limited. $2.9 Intangible (Previously written down from $4.6m)
Assets and Strategy
The core asset is the Zebediela Nickel Project, with company stating “a Preliminary Economic Assessment (“PEA”) completed in 2012 reported inferred and indicated resources (Non-JORC) totalling over 1.5 billion tonnes with an estimated Net Present Value of US$317 million and a post-tax IRR of 18.6% (assuming a post-tax discount rate of 10%, nickel price of US$8.50/lb, production of 20,000 tonnes of nickel per year over a 25 year mine life, a total capex cost of US$708 million, and an opex cost of US$3.35/lb Ni).”
The problem is the Nickel price is well beneath that level today at sub $5/lb. I therefore realistically can’t see an appetite for investors committing $708m for an unrisked return of US$317m. The project is likely to need sustained Nickel prices above $8 for a period of time before investors commit, even then Investors are likely to apply at least a 50-75% discount to compensate for risk. This takes the NPV down to at least US$150 million and this is also likely to be before you add in the costs of financing and the PLC costs. The other risk for the investors is that the project resource is not JORC approved, i.e. an independant verification is yet to take place.
That said Zebediela is perhaps not dead in the water just yet. The company announced here it would kick off a new work programme in 2017 with a particular focus on magnetite (Iron Ore) potential. URU suggests 27 million tonnes of magnetite should be accessible but no doubt this could improve further, which clearly may improve the project economics. I’m not an expert on Iron Ore so to assess a potential value of this resource I look to an Aussie magnetite miner on ASX called magnetite miners. This company has a 3.9 billion JORC compliant resource of Magnetite, far in excess of the provisional figures quoted by URU and yet is just valued at AUS$20m. So whilst it may contribute to the coffers, is the magnetite really a game changer?
It will be interesting to see how the Zebediela project develops further though, clearly it is a major Nickel deposit (12th largest in the world) and it could be that the work this year reveals a more attractive business case. An earlier NPV estimate was $1bn so there may be levers to pull to close the gap back to this level. Although assuming a Pre Financing Risked NPV of $150m (£75m) compared to a £27m market capitalisation I would suggest the company is fully priced based on this asset alone.
The company does though also have an Oil shale/Uranium asset in Sweden called Narke which has ‘exploration target of 1.47 billion tonnes containing 303,000 tonnes U3O8 and 525 million barrels of oil equivalent’ according to the company. This is triple the amount of resource boasted by Berkeley Energia, a potential resource of 0.5 billion of oil is also interesting. That said it is very early days and no significant recent exploration drilling has taken place as yet and the Shale oil in particular may come up against all of the usual regulatory challenges. It is also not clear to me what the work programme is for 2017 on this asset and it doesn’t seem to be the focus of URU. I also note the assets have been impaired in the recent financial statements, which suggests directors are not placing much value on these assets.
CEO John Zorbas has also made it clear ‘The preferred route would be a sale’ according to an article published in the Daily Mail. I have a feeling though further exploration work to at least get an independent JORC/CPR will be required on both Zebediela and Narke to get anywhere close to the Risked NPVs. It could be that other investors can see further value in the assets, but it is still a ‘buyers market’ for mining assets at present and for that I am especially apprehensive about placing excessive values on either asset.
It’s perhaps no surprise then to broaden its options URU is also though now considering making a further acquisition, in the Lithium ‘space’ (I hate that word), which I will discuss later. If you are a Lithium bull with a long term horizon this stock may have appeal but there are also a few other questions investors should consider before jumping in though:
1) Are investors aware of the Corporate Governance?
There are lots of related parties in the structure here, I have attempted to piece together all of the information and I believe the structure to look like this:
Figure 1 – Relationship Map, Source: Companies
NWT Uranium Corporation (NWT) is the largest shareholder but actually owns just 16.1% of the equity. It does though have two executive directors on the board, furthermore the board advisor also happens to be the NWT CEO. Fairly incestuous then and something for investors to be mindful of. The director influence means that NWT can call all the shots, the fact that both URU and NWT are run out of the same office shows that there is really no pretense about this either. This arrangement seems to have been put in place through a ‘relationship agreement’, as outlined in this RNS in 2010. At the time though this agreement seemed to allow for the placing of a Non Executive Director to the URU board, which is actually fairly common practise for a major shareholders. However, as mentioned above we have now ended up with NWT having most of the executive influence. It could be though that I have misread how this relationship agreement was supposed to work.
On the flipside, the directors do have substantial skin in the game both directly and indirectly, which has obvious benefits. The guys involved all boast impressive CVs and clearly have experience to get things moving. The holdings are also not so large that it would be impossible for other shareholders to call for an EGM either and vote through resolutions against NWT if ever there were the need, clearly it would be difficult though.
Why the Premium Placing?
I am always very cautious of small equity raises at a premium and/or small director purchases. These activities can often be used as ‘promotes’ ahead of larger equity raises. I use CloudTag as a recent example of this which had a series of smaller equity raises at a premium before signing up to a much larger and highly dilutive convertible instrument. I’m not for a moment suggesting this is about to happen here, but it is worth us looking into in more detail.
The recent equity raises for URU are shown below:
Figure 2 – Source: URU Metals, LSE
The most recent placing was at a huge 80% premium to the previous days closing price. This share issue was taken up 20% by NWT with the remainder to other unknown persons/entities. There appears to be no reason for such a large premium and on the face of it makes no commercial sense, especially given the placing is very small, i.e. just 11.8m shares representing just 2% of the existing share capital. To put this into context, an average of 52m shares a day had been traded in the month prior to the announcement, so it would have been fairly easy to pick up these shares in the open market at a much lower level.
It could be that the new investors are inside on a much bigger deal which will realise substantial value for URU, this is a potential explanation for the pricing and the most obvious reason would be disposal of one or both of the Zebediela or Narke assets. However, the directors would be obliged under the FCA and AIM rules to put this information out to market, the only exception would be if it was to jeopardise any commercial sensitivity around the deal.
Why is URU looking into Lithium Assets? Shouldn’t it focus on the existing asset base?
The company announced here in January 2017 that the company was pursuing new acquisitions, later it was suggested here that with the appointment of board advisor Henry Kloepper that the focus would be on Lithium. The existing asset base appears to have potential so why look to invest in Lithium assets? I shudder every time I hear the word lithium, it really is the promote asset of choice for junior AIM resource stocks in the same way that Onshore Oil and Gas assets were a few years back. Lithium captures the imagination with its increased demand from the industrial sector, particularly for its use in batteries. I can’t though recall any AIM miners achieving anything close to lithium production so far or doing any meaningful disposals of the said assets. If the existing Nickel/Uranium assets of URU are so good then shouldn’t the board focus on developing and monetising this existing base, to at least get them to a CPR/JORC compliant level? It could be though that the capital required to get to this level could be too much for a company of URU size, although I believe in the long term this is likely to realise the most value for shareholders. Other companies have managed it too, such as Sirius Minerals.
If you are lithium bull then let’s explore the lithium connection a bit further though, I refer you back up to the Relationship Map in figure 1, Henry Kloepper is advisor to the board to help URU look at lithium assets. As well as his hats of a) board advisor to URU and b) CEO to NWT, URU biggest shareholder he is c) also CEO of Frontier Lithium, who since 2013 has been developing the Pakeagama Lake exploration prospect. This resource contains ‘8.2 million tonnes of what is the highest grade lithium deposit in North America’ according to the company. According to Frontier’s RNS page they have had 4 sub CAD$1m fund raises in just over one year. So does Frontier need further funding and is it intended for URU to raise further funds to take a stake either directly or indirectly in the Pakeagama Lake project? I could be well off the track here but something for investors to ponder.
Clearly if the asset whether Pakeagama or otherwise is of a significant magnitude and depending on the structure then this is likely to also constitute a Reverse Takeover (RTO) under AIM rules. This could see the shares suspended for a period of time.
How many NOMADS?
Another thing that struck me about URU, it has been through quite a few NOMADs. There is no suggestion that any of the NOMAD’s have resigned and in fairness the most recent NOMAD northland has been in office for a couple of years now. Frequent changes in NOMAD can be a sign of ‘opinion shopping’ though. This doesn’t cause me major concern at the moment but something investors should consider if it happens again in future.
SUMMARY
Neutral
It is clearly an interesting time for the company and the stock has captured the imagination of private investors after a period of very little activity. It’s not one for me though, even ignoring the related parties transactions which I tend to discount any stock for.
I just don’t see enough value in the assets and/or a clear investment case just yet to justify further increases in the share price, at least before seeing a revised economic study of the core Nickel assets and understanding which Lithium Asset(s) the company has its eye on. I’d also like to see further progress on the oil/uranium asset with a clear work programme. Last but by no means least I would also rather not take the risk to get locked into a potential RTO involving lithium assets too!
That said I definitely wouldn’t be going short, but I believe new investors should proceed with caution. If you a) have the risk appetite for a speculative miners, b) you believe I have undersold the assets and c) are comfortable with a few of the questions raised then perhaps you will have a different view here. Momentum is also with this stock and we all know how important that is on AIM!
Good luck to all holders!
Disclaimer – I have no LONG nor SHORT positions in any of the stocks mentioned. ShareInvestors.co.uk requires me not to deal in this stock in the next two trading days from the date of the post being published.
This post is purely my opinion and should not be taken as financial advice. I welcome any alternative comments and will consider adjusting posts based on information made available to me.
Disclaimer: Shareinvestors is not authorised by the Financial Conduct Authority to give investment advice. Terms such as ‘Buy’, ‘Sell’ and ‘Hold’ are not recommendations to buy, sell or hold securities, these statements and other statements made by the author have the meaning only to express the author’s personal views on the quality of a security. Independent financial advice from an authorised investment professional should always be sought before making investments. CAPITAL AT RISK. Full Disclaimer here.
I covered Sirius Minerals (SXX) in a piece here in 2016, tipping the stock at 38p with a target to sell at 50p. When I wrote the piece I expected the 50p target to take at least 12 months to reach. The stock though raced ahead just two days later when it hit an intraday high of 52.5p in a very bullish summer market on AIM. The company later in the year closed its financing for its Potash project late in 2016, but rather disappointingly for longer term holders the stock trades hands today for just 18p, less than half of it recent highs and actually even 10% below the recent placing price.
QUICK FACTS
Sirius is developing a mine in North Yorkshire extracting the fertiliser Polyhalite (POLY4). Here are the quick facts on Sirius as at 12th February 2017:
Current Share Price
18.25p
All Time High
52.5p, August 2016
52 Week Low/High
Low 10.5p on 12th Feb 2016
High 52.5p on 23rd August 2016
Market Capitalisation
£760m
Enterprise Value
£760m – Expected to increase as debt used.
Fully Diluted Market Capitalisation
£1bn (includes convertible loan note)
Others
EPS, P/E Ratio and Dividend Not Relevant
What has happened since your last coverage and why the sharp decline in share price?
One of the biggest hurdles was securing finance for the project, which was completed in November 2016. The total raised was $1.1bn dollars (£900m), a significant amount for a company that started 2016 capitalised at £350m. The terms of the funding were as follows:
$250m Royalty agreement. The contract is for 70 years and gives a 5% royalty on the revenues from the first 13 million Tonnes produced per annum and 1% on any excess.
$400m Convertible Bond. The coupon is for 8.5% and convertible at a 25% premium to the Placing Price, i.e. $0.30 or 25p at today’s FX rate. The duration of the loan is 6 years and Sirius can call the bonds from December 2018 subject to terms. This gives Sirius potential flexibility to refinance the bonds, albeit the call premium is between 50%-75% of the nominal amount, so not so cheap to do so.
Placing and Open offer raising £370m through the issue of 1.8bn shares at 20p, a 46% discount to the share price close on the day prior to the announcement.
The financing was the last major piece of the jigsaw to get the project going and yet the shares are now trading at less than 50% of their peak, why? The shares got well ahead of themselves, on a fully diluted basis the shares were valuing the company at almost £3bn, it seemed the market had forgotten that a significant equity injection was required and the debt funding was likely to have a convertible feature. The new equity holders and loan note holders needed a much larger discount to take part in this placement to ensure a satisfactory return, particularly if their valuations were inline with my own, which I outline later. The secondary market initially didn’t know how to react to the placing price being at such a steep discount, consequently it took some time for the price to fall towards the placement price, this allowed opportunists participating in the placing to take a quick profit.
Around 1.8bn new shares were issued as part of the placing and around 30bn shares have been traded since, so much of the overhang is likely to have cleared now. The daily volumes as indicated in figure 1 have also started to fall away, so it’s now time to think about what is a fair valuation based on fundamentals alone….
Figure 1 – Source: Yahoo Finance, Share Investors
So what is a fair valuation for Sirius Minerals?
The company is well covered by brokers who all have BUY targets of varying degrees. The company has also communicated a Project NPV of $15bn, but this doesn’t take account of the financing. I have done a crude valuation myself based on a Risked Discounted Cash Flow and my calculations show a risked NPV of £2.4bn and a fully diluted fair value of 44p per share.
I have adopted a prudent price assumption for POLY4 and assumed the convertible loan note will be turned into equity. I have also only ran the model to 2038 to cover the probable JORC reserves of 280 Million Tonnes as opposed to the full contingent resources. I have further risked the NPV at 60%, this is perhaps excessively harsh but there are still fairly large risks to the project. I would look to lower the risking once further offtake agreements are signed and the Muriate of Potash spot price starts to recover. I have discussed these risks in more detail below.
WHAT ARE THE RISKS AND POTENTIAL FURTHER UPSIDES FROM HERE?
1) Polyhalite Price (Poly4) and Offtake Agreements
Traditional fertiliser is what is known as Muriate of Potash (MOP) which currently accounts for the majority of fertilisers sold worldwide. Sirius Minerals are mining Polyhalite (POLY4) which contains four of the six macro nutrients needed for organic growth. POLY4 contains though just 14% potassium which is the principal product used as fertiliser. This compares to around 60% for MOP, this has led to some commentators to label it as an inferior product. However, trials commissioned by Sirius indicate the product has resulted in impressive boosts to the yields of crops compared to its more common cousin MOP. For example, the use of POLY4 increases Tomato yield by 73% compared to 20% for MOP. The other stated advantage of POLY4 over MOP is a lower Chloride content which makes it ideal for crops sensitive to this input.
Based on research Sirius estimate a price of $140-$160 per tonne can be achieved based on a 10-20 Million tonnes per annum supply, see the supply and demand curve below in Figure 3. The good news for Sirius is that it currently only has one competitor, the nearby by Boulby Mine which mines and markets a similar compound under the name Polysulphate.
The overall fertiliser demand is estimated to be around 200 Million Tonnes per year by 2018 according to the United Nations. Sirius believe that its product can actually be a substitute for up to 376m Tonnes of products based on a different study though. Given that the combination of Boulby and Sirius Production will be initially only 10 million tonnes it is therefore safe to assume, that that the POLY4 price is likely to be driven by the global spot prices of MOP intially. Based on information released by Sirius it appears that POLY4 attracts around a 33% discount to MOP, I have based this on the current contracted volumes weighted average of $145 per tonne as released by Sirius in its most recent investor presentation in December, this being when the MOP price was $215 per Tonne.
Figure 4, Source Y-Charts, Vancouver MOP
MOP prices are currently at a 10 year low as indicated in figure 4. Longer term I believe the demand for Potash will continue due to a growing global population. Projections are that the world population will grow at 1.1% a year. Supply though is predicted to continue to outstrip demand in the short term, Sirius alone adding between 5%-10% of global supply by 2027, depending on which study you believe. This excess supply means that in the next two years the MOP price is predicted to fall a further 10% to $190 per Tonne, given the discount implied by the offtake agreement this could be as low as $133 per Tonne for POLY4. It is worth noting though that the discount to MOP and to the nutritional value of POLY4 has the potential to narrow once the product is marketed further and is tested in commercial quantities.
There is also evidence of mothballing of some less profitable mines, so this downtrend in prices may reverse and with Sirius having a very profitable mine it is likely to be able to carry on producing even as far down to prices to $50 per Tonne i.e. 1/3 of the current spot price and continue to be be cashflow neutral. The ability to do this for periods of time allows Sirius to benefit from the potential for much higher prices in the longer run. In the valuation I have adopted $145 per tonne for 2017 and inflated by the 1.1% year population growth. Any further downside is captured in the general risking I have applied. The POLY4 price is likely to be volatile depending on supply/demand but given the long term demand growth and with the current MOP Spot price being at a decade low the downside risk is likely minimal.
Sirius still needs to secure further offtake agreements for it product too. It has so far signed 5-10 year ‘take or pay’ offtake agreements for 3.6Million Tonnes per year with customers over 3 continents. This issue is not urgent as Sirius will not hit this level of production until 2023, so it has plenty of time to further market the product toward securing offtakes for a good proportion of the 20 Million Tonnes per annum capacity by 2027. The company also has a further 4.5Million Tonnes in Letter of Intent agreements which it can hopefully convert into binding agreements over the coming years.
2) Project Overruns
The mine is four years to first production and it will be six years before the initial phase of the project is complete. There will be ‘ups and downs’ in a project of this nature. I’ve lost count of the number of horror stories that I’ve heard over the years from EPC contractors in the extractive industry. A recent case I heard was production wells being drilled and tied into a gas plant only to find the first well produced oil and not gas! For Sirius it is unlikely to come across a fundamental flaw in the project such as that one, but there will be technical challenges for sure, the bottom line is that you can do as much exploration and appraisal as you want, but Sirius will only know what they have once they start developing the project. Perhaps not a great surprise then that according to EY the average budget overrun on ‘mega’ mining projects is a staggering 62%!
Management though are hugely experienced and have impressed me greatly with how they are on track to take an AIM minnow to the FTSE250, if not higher. I have confidence therefore that Sirius will deliver close to budget. The project is also using standard techniques and the existing mines in the area derisks the geological challenges somewhat. The NPV also isn’t hugely sensitive to modest CAPEX overruns given the huge project return, but overruns will require further funding and depending on the magnitude this could result in more equity in the company being needed which could dilute the existing equity holders.
3) Stage 2 Financing
This feels fairly low risk, various banks are already tasked to secure debt funding for the remaining financing needed. Assuming the project execution is on track there should be limited risks of securing the next stage financing at competitive rates.
4) One Trick Pony
Sirius minerals has just one asset and one product, this means that a combination of some or all of the above risks will be more concentrated here than those in a more diversified company. This naturally leads to a risk discount in the value versus a more diversified peer. However, if you have a well diversified portfolio already then you can use this discount to your advantage, particularly if you intend to hold for the long term.
5) Further Resources
On top of the 280 Million Tonnes of Polyhalite included in reserves there is a further potential reserve of 2.6bn tonnes. This should stretch the mine’s life well beyond 2038 and further exploration is likely to take place once the initial mine is on well on track.
6) Transfer to Main Market
Sirius has stated it is seeking to transfer to the main market of the London Stock Exchange by the end of 2017. Based on current market capitalisation it is currently the 329th largest company on the exchange. This makes Sirius a potential FTSE250 candidate and if the share price increases further within the next few months it is almost certain to guarantee entry to this index. This means tracker funds and ETFs will need to buy Sirius on entry, which is likely to add further buying pressure.
SUMMARY
BUY – Target 41p, 124% upside
Initial target for 41p with significant further upside beyond as the project matures and is further derisked. The biggest risk is the development of Potash prices but Sirius with the margins of the project is in a very good position to survive any weakness in prices.
Further share price growth is possible over the longer term too. A share price of over 100p on first production, i.e. 400% gain would not be a fantasy. This is a ‘one trick pony’ stock though so ensure any holdings are part of a well diversified portfolio.
Disclaimer – I have long positions in Sirius Minerals equal to 5% of my NAV. ShareInvestors.co.uk requires me not to deal in this stock in the next two trading days from the date of the post being published.
This post is purely my opinion and should not be taken as financial advice. I welcome any alternative comments and will consider adjusting posts based on information made available to me.
Disclaimer: Shareinvestors is not authorised by the Financial Conduct Authority to give investment advice. Terms such as ‘Buy’, ‘Sell’ and ‘Hold’ are not recommendations to buy, sell or hold securities, these statements and other statements made by the author have the meaning only to express the author’s personal views on the quality of a security. Independent financial advice from an authorised investment professional should always be sought before making investments. CAPITAL AT RISK. Full Disclaimer here.
I previously tipped Ovoca Gold in 2016 due to the extraordinary discount of its liquid assets vs. its market capitalisation, you can read the piece here. A number of shareholders, both current and past have since contacted me to express their disappointment in management, more specifically management’s lack of engagement with shareholders and consequently a share price languishing at a steep discount to fair value. During the same period the disconnect between these liquid assets has widened further, based on my calculations the market’s valuation is now just 1/3rd of the total liquid assets, i.e. £7m versus combined cash and shares in Polymetal of £19.6m.
The perception from the market is that the company has not made any material progress in any direction since 2014. Looking at the RNS archive, it shows that virtually nothing has been filed apart from what is statutorily required in past 4 years. I accept that the existing Stakhanovsky asset was hard to develop during what had been a period of lower gold prices, but what is less excusable is no evidence of any business development activities outside the existing asset base. All considered it feels it difficult to stomach that the board is currently drawing around $400,000 of salaries per annum against a backdrop of stagnation. I have therefore decided to contact management, a copy of the email I sent is included in figure 1.
I am disappointed to say that 5 days later I have yet to receive a response but to elaborate on my own position in the meantime; I believe management should commit to a strategic review of the Stakhanovsky Asset with a clear ‘go/no go’ decision, or at very least the publishing of milestones to get to a ‘go/no go’ decision. I would also propose going forward Quarterly operational updates outlining what management have achieved in the quarter. If the above cannot be committed to then it is my belief that the company should consider liquidating the company and returning the proceeds to shareholders, this could return up to a 250% gain to shareholders based on current share price.
The directors currently hold 48% of the company so it will be difficult for minority shareholders to have an impact, but nonetheless I urge all existing shareholders who share similar views to get in touch at gavin.alan.uk[@]gmail.com . Please remember to state your shareholding.
Figure 1 – Email sent to management
Disclaimer – I have long positions in Ovoca equal to <1% of my NAV. ShareInvestors.co.uk requires me not to deal in this stock in the next two trading days from the date of the post being published.
This post is purely my opinion and should not be taken as financial advice. I welcome any alternative comments and will consider adjusting posts based on information made available to me.
Disclaimer: Shareinvestors is not authorised by the Financial Conduct Authority to give investment advice. Terms such as ‘Buy’, ‘Sell’ and ‘Hold’ are not recommendations to buy, sell or hold securities, these statements and other statements made by the author have the meaning only to express the author’s personal views on the quality of a security. Independent financial advice from an authorised investment professional should always be sought before making investments. CAPITAL AT RISK. Full Disclaimer here.
It is another Macro article for me today as I look to add some quality trusts to my long term investment portfolio, so in this piece I take a look at China. Over a decade ago when I first started my career China was en vogue, if you didn’t have a large weighting to China in your portfolio then you must be quite simply bonkers, after all Chinese stocks had surged around 250% in little over 15 months from summer 2006. In those years the common thinking was that the business cycle was a thing of the past and the only way was up, that was until the 2008 financial crisis. Today though many investors are still steering well clear of China, with a trio of concerns, namely credit bubbles, doubts around the integrity of Chinese financial data and the slowing of official growth rates. But are these concerns overdone?
How is the recent performance of Chinese Stocks?
In Local and USD terms the MSCI China index is sitting at pretty much the same level it was at right before the 2008 financial crisis, at around 1,000. See Figure 1:
Figure 1 – MSCI All China Performance – Source MSCI
There are two fairly extreme swings to comment on, during the 2008 financial crisis when the index declined by 50%, before quickly recovering. The second was almost an exact symmetry of the first, various actions by the government set the conditions to unintentionally allow fevered speculation in 2014/2015. During a matter of months from late 2014 and early 2015 shares were up around 100%, closer to 150% if you take the Shanghai Stock Exchange Index (SSE) in isolation. Again though the markets collapsed just as quickly. This incidentally remains somewhat of a risk factor of the Chinese markets in general, it is a common stereotype that the Chinese love to gamble, there is though some substance behind this. This behaviour has manifested itself in stocks but also many commodities over the last few years. That said intentional capital also contributed heavily and together they allowed massive disconnects between shares listed in between Shanghai, Shenzhen and Hong Kong, a clear sign that rational thinking went out of the door!
After the market correction referred to above though the current fundamental stock market value according to research by Star Capital for China is 7.2 on Price/Earnings, low by any comparison. CAPE is around 12.8, this measure divides current market capitalisation by the average annual earnings over typically the last ten years. It is therefore a measure which takes into account the booms and busts. You can compare China’s score of 12.8 and 7.2 to the USA which scores a CAPE of 26.4 and PE of 21.8. So the indicators of short term and long term value opportunities are present. However, we need to look forward to see if we really have value…
So, what are the future growth prospects?
China has been growing on an annualised rate at around 9%. Growth has though begun to steadily slow since 2012 and this trend is projected to continue through to 2020 as illustrated by Figure 2:
Figure 2 – Source: WorldBank, ShareInvestors
The point for much debate is whether you actually believe the figures put out by China, this is whether the earnings posted by the companies are materially correct but also whether the economy is really growing at 6-7%. Some commentators believe the growth on the ground could be as low as 1%. If you do believe the official figures then we can expect a total of 35% GDP growth from now until the end of 2021.
Exploring the headline figure a bit deeper, Economic growth and thus the fortunes of Chinese enterprise is driven by investment, domestic consumption and exports. China has had a solid recent history of infrastructure investments and there is little reason why this should slow on the demand side. China’s debt though has exploded since the financial crisis increasing by 2/3rds and now running at 2.5 times its GDP. This may limit the Infrastructure Investment activities and potentially also put a break on domestic consumption. The total ratio though is around the same as the USA ,so the total amount of debt in itself not necessarily an issue, especially given China is in growth phase. The speed of the development of this debt pile though is alarming and a large proportion of this borrowing is linked to real estate, sound familiar?
The debt is though largely locally funded through the large Chinese domestic deposits. Commentators when predicting the China bubble is about to burst fail to appreciate that China’s saving rate is around double the world average. This is not to deny that the debt growth needs steadying and that credit control needs focus. Further, In an apocalyptic scenario the government is likely to have the capacity to bale out a good proportion of the bank’s balance sheet too.
Figure 3 – Source: WorldBank, ShareInvestors
Now to the final function of GDP growth, exports. China is starting to lose some of its comparative advantage in exports, wage growth is continuing which reduces the competitiveness and global demand continues to be tepid. There also continues to be the Trump factor, the US represents around half of China’s total trade surplus of $44.6bn. There remains a risk that Trump could bring China into his protectionist agenda, with some commentators suggesting a 3% slowing in growth levels at the extreme end. So far it is Mexico that has been his main target. My personal view that the comments Trump has made on the deficit with China are purely political and he knows that taking on China is a step too far, is likely to hurt too many US companies and consumers who benefit from cheap Chinese inputs. The analogy you can think of is one of a school bully picking on those he considers weak.
China though is nonetheless focusing on boosting domestic consumption to reduce its dependence on the export markets. China’s current consumption is around 38% of its gross domestic product, again significantly lower than average and it needs to get consumers to spend more. This is a challenge and careful policy choices to promote quality companies serving the domestic market as well as a sound fiscal policy are required. It will be interesting to see how this next stage of the economy transitions.
A lot of the above analysis is based on official figures, but can you trust them? I don’t doubt that China ‘smooths data’ but whether the largest country on the planet is able to consistently materially misstate its numbers to me is highly unlikely. Assuming I am correct then given the valuation then the investment case for China is compelling.
So how do I get Exposure to China?
There are hundreds of Unit Trusts, ETFs and Investment Trusts covering this sector. My favourite though is Fidelity China Special Situations (FCSS). This trust launched in 2010 dragging Anthony Bolton out of retirement in the process. The rockstar of the fund management world created a feeding frenzy at the time which saw the trust trade at a premium. I always avoid listed equity funds trading at a premium, you are already paying the fees of the asset manager and there is no need to pay a premium to the underlying assets too, even for a man that returned 19.5% per annum over a decade. The China Special Situations trust soon hit turbulence too and at one point was trading 30% lower than IPO price. Investors consequently left in droves which eventually created a reasonable discount to the underlying assets. This discount has stuck even during a period of outperformance, but more on this later.
Here are some quick facts as at 6th February 2017:
Current Share Price
179.3p
All Time High
195.3p, October 2016
52 Week Low/High
Low 109.7p on 12th Feb 2016
High 195.3p on 21st October 2016
Market Capitalisation
£990m
Enterprise Value
£1.06bn
Net Assets and (Discount)/Premium
£1.15bn / (13.7%) discount to Share Price
Dividend Yield
1%
Anthony Bolton eventually stood down from the trust and aussie Dale Nicholls took the helm. Dale has posted the best returns in his sector over the last 5 years according to CityWire, so you are in safe hands. No surprise then that the Fidelity China trust has beaten its benchmark comfortably, by 100% over a 5 year period as shown in figure 4. A stellar performance although the last year has been more disappointing, returning 17.5% growth in NAV compared to a 20.4% growth in benchmark MSCI China Index. However, I’m never one to dwell on short term performance.
Figure 4 – Source: Fidelity December Monthly Report
What is the latest investment strategy of the trust?
The relative weightings of the sectors vs. the benchmark are listed below. You will notice large overweight position in Consumer discretionary, thus trying to take advantage to the stated government policy of boosting domestic consumer spending. The largest underweight position is on the financial sector, again this seems sensible and reflects concerns around the explosion of credit, also discussed above.
Figure 5 – Source: Fidelity Monthly Report
Are there any other Risks to ponder?
As with all foreign currency investments there is a risk of Exchange Rate. The trust does not hedge the underlying holdings against GBP. The GBP exchange rate has weakened against the Yuan by over 20% since late 2014 and those who follow my posts will know I am a long term bull on Sterling. I therefore do expect moves in currency which will reduce potential gains on this investment, however the investment case still looks compelling.
Summary
BUY – Fidelity China Special Situations Trust. Remains a buy whilst discount remains >10% to NAV
I believe the Chinese markets currently have an attractive valuation and the fears about a Chinese crisis are overdone. In addition the Fidelity trust is already discounting in a 14% or so fall in prices, combine the two and there is a significant scope for outperformance.
There is a risk of volatility in this investment, some may be based on facts some may be based on excessive bullishness or bearishness, so pay close attention to movements and take action accordingly.
Disclaimer – I have long positions in Fidelity China Special Situations equal to 1.5% of my NAV. ShareInvestors.co.uk requires me not to deal in this stock in the next two trading days from the date of the post being published.
This post is purely my opinion and should not be taken as financial advice. I welcome any alternative comments and will consider adjusting posts based on information made available to me.
Disclaimer: Shareinvestors is not authorised by the Financial Conduct Authority to give investment advice. Terms such as ‘Buy’, ‘Sell’ and ‘Hold’ are not recommendations to buy, sell or hold securities, these statements and other statements made by the author have the meaning only to express the author’s personal views on the quality of a security. Independent financial advice from an authorised investment professional should always be sought before making investments. CAPITAL AT RISK. Full Disclaimer here.
In the interests of absolute transparency I record all my trades and produce a P&L of all of my share tips.
I will also continue to state my positions at the end of all company specific articles too.
January ROLLING P&L
Here is the P&L as at 31st January 2017, which assumes you had taken a long/short position on my recommendation on the date of the article with £1,000 capital at risk. I do not always take exposures in all of the stocks I tip due to risk management purposes, i.e. not placing too much capital in one area. I may also have higher or lower exposure to individual stocks so this is not my actual gain/loss.
The average stock tip is 25% Inception to Date, with 92% of my 18 tips in profit. Annualised return over 400%.
Disclaimer: Shareinvestors is not authorised by the Financial Conduct Authority to give investment advice. Terms such as ‘Buy’, ‘Sell’ and ‘Hold’ are not recommendations to buy, sell or hold securities, these statements and other statements made by the author have the meaning only to express the author’s personal views on the quality of a security. Independent financial advice from an authorised investment professional should always be sought before making investments. CAPITAL AT RISK. Full Disclaimer here.
Easyjet has had a turbulent year during which it has seen its share price almost cut in half. It’s hard to believe the shares were priced at £16 in February of last year, today they are trading below £10. The perfect storm of decreasing fairs and increased costs have seen the sellers take charge in recent months, but could we be near the bottom? After the recent Q1 trading update I take a further look at this unloved share and assess whether Easyjet’s share price will return to flying high or whether there is more turbulence to come for shareholders.
Quick Facts
As at Wednesday 1st February 2017:
Current Share Price
939.3p
All Time High
1915p, April 2015
52 Week Low/High
Low 873.00 on 17th Oct 2016
High 1,601.00 on 1st Feb 2016
Market Capitalisation
£3.77bn
Enterprise Value
£3.56bn
Net Cash/(Debt)
£202m -Sept 2016 Results
P/E and EPS
8.78 / 107p – Sept 2016 Results
Dividend Yield
5.73%
What has gone wrong for EasyJet?
Easyjet perhaps needs no introduction, it is one of original budget flight operators. The company operates 820 routes across europe and the near east with over 250 aircraft on its books, either leased or owned. The financial years 2011 to 2015 were very good for EasyJet, posting growing revenues, earnings and operating margins as illustrated in figure 1 below.
Figure 1 – Source: Easyjet, Shareinvestors.co.uk
The most recent financial year though, ended September 2016 showed an end to that trend. Revenues continued to grow but margins and consequently earnings dropped. The reason? Easyjet had been hit by two factors simultaneously, both declining revenues and an increasing cost base, a situation no company wants to be in.
What has happened to EasyJet’s Revenues?
Whilst top level revenues have been growing year on year for a number of years the actual revenue per passenger has been declining fairly rapidly since 2013, with the revenue per Km descending even more rapidly. See Figure 2 below.
Figure 2 – Source: EasyJet, ShareInvestors.co.uk
The budget airline model is continuing to be extremely popular and the major airlines and other entrants have taken note of this. To give just a few examples; the big players such as IAG, of which BA is a member has started to increase its offering in this area, not to mention the continued strength of Ryanair and two ‘new’ emerging budget players Wizz and Norwegian all adding capacity. It’s also worth noting that Norwegian also has somewhat of a USP in its long haul transatlantic offering too, particularly as this can add transit traffic to its short haul services. It’s no surprise then that with all this increased supply that prices have started to fall.
As a side note, for the year ended September 2016 Easyjet still actually manages to generate the most revenue from passengers per each KM flown though when we compare to the core competitors. Norwegian has the highest overall revenue per Passenger, being explained by its budget long haul flight offering. See figure 3 below:
Figure 3 – Source: Companies, Shareinvestors
What is behind the cost increases?
The declining revenues are not necessarily an issue in itself, growing capacity afterall should theoretically lead to economies of scale, indeed in 2015 Easyjet was able to strengthen its margin despite falling ticket prices. Things though started to deteriorate in 2016 with margins dropping from 14.7% to 10.7% year on year, see Figure 4. The most recent quarterly result for EasyJet showed an even worsening picture and outlook. Costs were higher than revenues and thus margin was now in negative territory. It is worth noting though that Q1 covers the period September to December, this is traditionally the slowest quarter for the aviation industry and thus is unlikely to represent the full year picture. The company still expects FY17 to be profitable, more on that later though.
Figure 4 – Source: Easyjet, ShareInvestors.co.uk
To understand the drivers of this headline cost increase let’s take a look a deeper look at the cost base in Figure 5.
Figure 5 – Source: Easyjet, Shareinvestors.co.uk
It is pretty clear where the drivers of the cost increases are, you can hopefully see it is the ‘airport’ and ‘other operating’ categories. Much of these costs are euro denominated and hence are sensitive to the collapse in Sterling’s value post BREXIT. Fuel is also notable, whilst the cost has declined moderately, this is though against a backdrop of an oil price which has fallen by 50% over the same period. Unfortunately for Easyjet fuel is priced in $ so has been unable to fully benefit from the fall in price, it’s forward hedging programme also means there is a lag in the benefits of a lower spot fuel price.
This is not true of EasyJet’s main competitors though as figure 6 shows below. This shows how the European carriers, particularly Wizz and Ryanair have been able to control the cost and a good chunk of this is down to the effects of foreign currency. The result? Wizz and Ryanair are still posting margins in the mid/high 20% compared to EasyJet’s margin of 10.6%.
I must confess I have been a little lazy in how I have calculated figure 6, I have simply taken the last reported results from each competitor, which in the case of Ryanair and Wizz was the last half year and for Norweigan the last quarter. This overly punishes Easyjet which has its full year results of 2016 included, this obviously includes the traditional weak period of October through March. That said I don’t feel it materially changes the conclusions of the article.
Figure 6 – Source: Companies, shareinvestors
So what are the prospects for a turnaround in the share price?
Based on guidance from Easyjet I have estimated in Appendix 1 that the company is still likely to generate almost £250m of earnings for FY2017, putting the company on a P/E ratio of around 14. This is not too shabby, especially when you consider a dividend yield of over 5.5% too. Ultimately EasyJet is a fundamentally good business which is having a dip in fortunes. Revenue pressures are unlikely to subside so cost control is key and this is a function of two parts, a) Real Cost Savings, i.e. on a constant fuel and currency basis b) Macro picture.
On point a) Management are focusing on delivering cuts, but are they succeeding? Figure 7 shows the declining cost per seat on a constancy currency basis, i.e. with the effects of FX stripped out. I’ve also adjusted for general inflation. This looks impressive at first glance showing a reduction in cost per seat of around 10% in the past three years. There is though another macro theme here to consider, the declining fuel price. I’ve therefore also plotted the rebased fuel price adjusted to GBP over the same period (orange) in figure 7. Given that fuel makes up around 1/3rd of Easyjets costs I assumed Easyjet can only access 1/3 of the gains, this is therefore also plotted in Figure 7, in grey.
The result now seems less impressive, figure 7 shows EasyJet’s cost reductions were actually lagging behind the fuel prices reductions from 2014 to 2016. This of course can be explained by forward deliveries of fuel, Easyjet hedges forward between 45%-65% of its fuel requirements 24 months out. In Q1 2017 though the cost savings are now below the reduction in fuel prices which is encouraging. In the analyst call last week, management state they have delivered ‘lean cost savings’, but warned much of these are being eroded by increased passenger claims against disruption. Nonetheless green shoots and management will continue to focus on costs, including looking at the organisation.
Figure 7 – Source: EasyJet, Boe, ShareInvestors
What is more likely to improve profitability though is point b) from above, the macro situation. Easyjet has stated in its guidance that for every cent strengthen/weaken in the $:£ it can expect a +/- £2.4m on the full year pre tax result and +/- £0.6m on a 1 cent movement in the €. Note, the average GBP:USD was 1.24 in Q1 so I assume this is the benchmark.
I personally expect sterling to strengthen, a combination of BREXIT certainty in the UK, UK interest rate increases and Trump uncertainty in the next 2-3 years could see Sterling strengthen back up towards $1.50, this would add £100m to earnings. This would place EasyJet on a P/E of around 9, deep in value territory. If management do deliver on real costs savings then we can expect further upside.
Are there other Risks to consider though? What about the balance sheet?
The balance sheet was strengthened at the start of the year, €500m was borrowed for 7 years at an extremely attractive fixed rate of 1.125%. This is a much better deal for Easyjet than for the lender, perhaps showing how desperate lenders of Euros are given the low yield on the currency. The issuing of debt in Euros will no doubt also assist in EasyJet’s hedging programme. Total debt at year end is expected to be around £1bn, assuming no further bumps in the road. Interest cover should not be a problem for the foreseeable future, but is the dividend safe?
The operating business of Easyjet is generating plenty of cashflow, covering the dividend twice over (see appendix 1). However, Easyjet is committed to plenty of CAPEX to upgrade to a more fuel efficient fleet, expecting CAPEX of £1bn in both 2018 and 2019. Free cash flow after capex will not be sufficient to cover dividends. However, Easyjet has access to up to £3bn of loan notes and has undrawn access to 2/3 of this facility. Gross gearing is expected to be around 27% at the end of 2017 and by the end of 2019 it’s likely to rise to 50%. This is a perfectly sustainable capital structure, assuming EasyJet can continue to borrow at around 1.5%-2% at a fixed rate. I therefore believe that assuming no worsening of the underlying business then the dividend is unlikely to be cut.
There are plenty of other risks though to contemplate, further supply and a reduction in demand could make the environment even more challenging. Easyjet was one of the few companies though that made profits in 2008/2009 and the budget sector is arguably less cyclical. That said this is not a risk to be ignored, all the main players are increasing capacity and thus even if demand holds up then I would be surprised if we see revenue per passenger increases for a while.
The recovery of oil price and the corresponding effect on jet fuel is another very tangible risk. The oil price is starting to head towards $60 as OPEC cuts supply. I would be very surprised though if we oil prices above $65 in the next two years, there is simply too much supply which becomes profitable at that level. The fuel price as at the end of December 2016 was $533 per Mt, Easyjet has hedged 83% of 2017 at $613 a MT and 54% of 2018 at $513 Mt. That said the unhedged position will still affect the pre tax earnings by +/- £3m for each $10MT change in the fuel price.
Further currency weakness will of course also be an issue, but I can’t see much more downside here. In fact Easyjet’s european competitors are posting some exceptional margins but they are not immune either from the macro picture, the Euro may face headwinds this year depending on the economic and political success of the zone. This has the potential to damage margins of the competitors, Easyjet on the other hand standing to benefit from any weakening of the Euro.
Summary
BUY – Target 1070 – 21% upside, includes dividend
With a dividend yield of 5.73% Easyjet is starting to have appeal against the FTSE100 yield of 3.73%, also against Ryanair and Wizz who are do not pay dividends. I can’t see a threat to EasyJet’s dividend in the next few years in all but the most apocalyptic scenarios. The forward PE ratio I expect to be around 14 but this could fall below 10 on a strengthening pound and further real cost savings. There are though plenty of risks to ponder, including further competition suppressing prices and further macro headwinds relating to currency and fuel prices. On balance though I see more upside than downside and it’s also worth considering that Easyjet is a particularly good hedge if you hold lots of stock whose earnings are primarily in US$, especially oil companies, of which I have a reasonable exposure in my portfolio.
Disclaimer – I have long positions in Easyjet equal to 2% of my NAV. ShareInvestors.co.uk requires me not to deal in this stock in the next two trading days from the date of the post being published.
This post is purely my opinion and should not be taken as financial advice. I welcome any alternative comments and will consider adjusting posts based on information made available to me.
Disclaimer: Shareinvestors is not authorised by the Financial Conduct Authority to give investment advice. Terms such as ‘Buy’, ‘Sell’ and ‘Hold’ are not recommendations to buy, sell or hold securities, these statements and other statements made by the author have the meaning only to express the author’s personal views on the quality of a security. Independent financial advice from an authorised investment professional should always be sought before making investments. CAPITAL AT RISK. Full Disclaimer here.
Just a quick comment on the roller coaster that was the FITBUG share price this week and what lessons in my view need to be learnt by companies, market participants and advisers alike. The sorry saga I refer to started before market open on Wednesday this week, when the company released this RNS Reach(RNS-R):
Fitbug Holdings Plc, the AIM quoted digital wellness technology provider for corporate organisations, today announces a customer win with a global financial services group in Asia…
Fitbug has secured an initial 1-year corporate wellness programme, which includes ongoing service revenue, together with an order for 14,000 device”
The release was brief and with no financials to support the statement, but on first glance looks impressive, a major customer and 14,000 devices, that is until you remember this was a RNS-R and by definition non price sensitive (more on this later). This statement nonetheless saw the company shares rise over 550% at their peak on the day, at one point topping out at 1.07p on an open of 0.2p. The shares were finally suspended at request of the NOMAD, but not until 3:30PM on the same day, with Fitbug being forced to clarify its trading position. This happened yesterday afternoon here. The company revealed in that update an expectation of lower revenues and continued losses, albeit slimming them modestly vs. prior year. The real crusher though was the future guidance relating to yesterday’s Contract win.
The Board expects this contract to provide in the region of £60,000 in ongoing service revenue in 2017.
So when you add in costs to service the contract the actual impact on Fitbug’s current and future earnings will be minimal, if not nil.
The market quickly adjusted and the shares are now swapping hands at 0.35p, so those who bought in at peak would be sitting on 60% losses as at today. The whole affair really in my view demonstrates the worse of the AIM market and lessons need to be learnt.
How it could have been all avoided
This all boils down to poor communication, which started with the announcement being made via RNS-Reach (RNS-R), which is a non-regulatory news service, in other words a platform used for communicating non price sensitive information. RNS-R can be used for example to communicate broker research or investor presentations, as was this case with Zenith Energy here. It can also be used by non-listed entities to communicate to the market, for example prior to IPO. You can see recent releases made by RNS-R here to give you a flavor of what it is used for. With this in mind here are three ways this sorry mess could have been avoided:
Way #1
Given this was a RNS-R, any rational investor would have limited reason to buy the shares. However herein lies the problem, AIM is dominated by retail investors and a large % of which are not familiar with the difference between RNS-R and RNS. Hardly anyone had picked up on this subtle fact when I looked on the bulletin boards and Twitter during the peak madness yesterday. Let’s also remember that this contract/release would have had an independent review too, NOMAD’s need to review all releases to market, if it was material release then Fitbug would have been instructed for the release to go via RNS. My belief therefore is that all RNS-Rs released which contain contract news or similar should be labelled for absolute avoidance of doubt as ‘this release is not considered price sensitive’ by the company or even better by service provider LSE automatically.
Way #2
The release had limited information which lent itself to fevered speculation. If releases are not clear and explicit this can lead to users speculating on the missing gaps, this is compounded by the increasing use of social media to comment on small caps. Fitbug knew that the contract was not material but chose to be very vague on the detail. I accept that the terms of some contracts need to be kept confidential for reasons of commercial sensitivity, but the company could have stated either that ‘this contract win does not alter guidance given to the market’ or is not ‘expected to have a material effect on the trading or financial position of the company’. Fitbug may well say this was a RNS-R so it shouldn’t need to, but then I return to my first point and I still think there is a duty of care to shareholders here.
Way #3
The shares were suspended 7 hours into the trading day. Why did it take so long? Whatever excuses the company has for putting out an unclear release, what I really fail to understand is why the brakes were not put on this as soon as the share price reacted 20%, let alone 100%, 200%, 300%, 400% and 500%. This again lands mainly in my view in Fitbug’s court, but also with the NOMAD and AIM regulation.
Wrap Up
You will probably call me Captain Hindsight or you might think I am in dreamland given how the AIM market operates at times. I’ve singled out Fitbug here but the reality is that they aren’t alone and I’m also not for a moment stating there was any deliberate intent here, but things need to improve.
I also don’t know much about Fitbug so I won’t comment further on whether this is a BUY or a SELL, one thing I will say though is that it looks like shareholders can expect a cashcall in the near future, with the cynic in me thinking this was a pre funding marketing exercise which backfired…
“The Board remains mindful of the funding needs of the business moving forwards, particularly with the Company’s corporate wellness growth strategy, and will continue to keep this position under review.”
Disclaimer – I have no positions in any of the stocks mentioned. ShareInvestors.co.uk requires me not to deal in this stock in the next two trading days from the date of the post being published.
This post is purely my opinion and should not be taken as financial advice. I welcome any alternative comments and will consider adjusting posts based on information made available to me.
