Fundamental Investing – 10 commandments

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’ve been investing in the stock market for a decade now and in most years I have been beaten the FTSE100 by some margin. You can take a look at my more recent performance in the ‘My Trades’ section of my site.

I get a few emails asking for my approach. There is no universally accepted way to invest, otherwise we would all be millionaires. Here though are the 10 rules I stick to religiously, which have served me well:

  1. Fundamentals above everything else – Cash is all that matters in the long term.
    Remember that a stock’s true value is the discounted present value of future cashflows. When you value a stock you should always think about the actual or potential cash generated and not get distracted by anything else. Earnings, e.g. ‘EBITDA’, or even worse the dreaded ‘ADJUSTED EBITDA’ are often nothing more than PR. The first thing you should look at when a company releases results therefore is the cashflow statement.
  2. Never, ever invest without doing research.
    This doesn’t mean reading a couple of house broker notes, instead this should be balanced research which includes preparing your own valuation of the stock. As with rule #1, this valuation should be based on the potential for future cash development and your view on the risk/reward profile. I typically spend 10 hours on a stock before going anywhere near the buy button, you should do the same. It is so tempting when you see a share rocket to try and jump in, I have been guilty of it myself, but more times than not I have lost money, particularly on ‘penny stocks’ when at times you need a stock’s mid price to rise 10%+ to even get out of the market maker’s spread. So unless you want to spend all day staring at level 2 praying that the book turns in your favour then avoid this. Remember, there will always be another trade or investment opportunity. Final point – only when you can place a BUY order with confidence and you don’t feel the need to keep a constant watch on the share price, is when you have done enough research.
  3. Employ Targets rather than overtrading
    Set yourself a BUY and SELL target on each stock you research and stick to it religiously and only adjust this based on newsflow. It is very tempting to sell out at 10% profit or 20% profit but some of the biggest mistakes I have made is not letting my winners run. If you still believe there is upside why sell? By the time you add back stamp duty, transaction fees and the market maker spread you may need the stock to fall by 3-6% or more before a re-entry is economic.If you are getting anxious once you reach your SELL target, then consider to place a stop loss in to lock in some gains at a few % below the current share price, you might be able to let your winner run longer this if you repeat this approach. Remember sentiment drives the market as much as fundamentals. The later always beats the former in the longer term though.
  4. Be a cynic, look for the worse in everything.
    Question everything. The city is a very seedy place and you should be skeptical of everything, especially rumours but also information released by the company. With rumours, even when they come from credible news outlets they often turn out to be spoofs, which sadly can be attempts to drive the share price higher. This ‘whisper’ can often be driven by someone with a major position can exit. This is particularly true at the junior end of the market. When it company released news (RNS), don’t forget that companies employ PR firms to put positive spin on stories. You need to look beneath the PR.
  5. Momentum Trading – it has it’s place
    Don’t be tempted to jump into a stock based solely on momentum, you can make money on this approach but it is not investing, it is really no different from playing the casino. Instead be patient and do your research – rule #1.Don’t hate traders and chartists that play on momentum though either, love them. They are the guys who can often drive a price in a certain direction, this creates opportunities for us fundamental based investors. There are though always points where a stock becomes very cheap and very expensive, if you know the stock well you as a private investor can nimbly jump in (and out) at the right moment – this gives you an advantage over institutional investors.
  6. Beware Leveraged Companies
    A business model can be great and the company can be generating cash at an operational level, but watch out for companies that are highly leveraged. I’ve seen too many companies which are viable but the equity is practically worthless.Always remember that the debtholders have legal right over shareholders in the event of a liquidation. If debt covenants are breached the threat of these powers can be used for the bondholders to acquire assets often well below market value. Very rarely do shareholders escape with anymore than a few % of the company in these situations. Don’t be tempted to jump into distressed companies without doing a lot of research.
  7. Be prepared to cut your losses
    If new information is released which materially alters your valuation of the company downwards then be prepared to sell. One of the most common mistakes that new private investors make is to constantly average down on their loss making holdings. Accept that you will make bad investment decisions on occasion and learn from the mistake. What separates the long term winners from the losers is those who are not afraid to cut their losses.
  8. Risk Management
    Create a balanced portfolio and review your portfolio regularly. Through this ensure you are not too focused on one industry, or even worse one company. You should also compare your performance to a benchmark such as the FTSE100 total return index. If you regularly come in lower against the index you might be doing something wrong.
  9. Don’t over diversify
    Conversely to rule #8, avoid also having too many holdings, the maximum number of shares and funds in my opinion you should have at one time is 20-30. It is far too difficult to keep track of more than 30 holdings but also the more holdings you have the more likely you are to achieve the benchmark returns, so why not just buy a index tracker instead? I have around 20 stocks and 10 trusts across all my investments, ISA, SIPP and trading accounts. I know these 30 investments inside out and I can sleep easy at night knowing I have researched them well. Think Macro as well as Micro, particularly on trusts to ensure you are positioning yourself to where you think things will move towards. For example, is it time to start loading up on gold if you think uncertain times ahead?
  10. Learn From Your Mistakes and be Disciplined
    Embrace your mistakes. For every investment that goes wrong and you lose money on, spend some time reflecting on why. I always write down the key reasons why it went wrong for me and try and take away a few points to learn from. Don’t beat yourself up, particularly for black swans! I also keep a record of all my closed trades and assess whether I sold at the right time, if the stock went on to add another 10%, why? Some final advice – Develop your own investment handbook to capture your own learning and develop your own rules which work for you and that you promise you will stick to. The best investors I know are the most disciplined people I know. Good luck!

Electra Private Equity – Strategic Review due soon. Is it a buy?

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.


Private Equity (PE) is not quite the sexy sector it was a few years ago, but I would recommend all investors try and allocate some of their portfolio to PE money. The IPO market thanks to a bit of stability recently started to pick up again in H2 2016 after a quiet first half of the year. This means that a number of private equity houses may start looking to exit their investments and return money to shareholders. A great way to get involved in PE is through a private equity investment trust. These are trusts that trade like any other share on the stock market and are closed ended, i.e. fixed capital/number of shares in issue. Combine these two features and investments trusts allow you trade a highly illiquid investment class.

Electra Private Equity (ELTA) I see as having the greatest potential gains in the sector, it’s objective is to achieve a return on equity of between 10% and 15% per year over the long term by investing in a portfolio of private equity assets. It has been around since 1976 and currently has £1.74bn of funds under management. The fund is managed by a third party investment manager, Electra Partners LLP. Of the funds they manage 95% relates to Electra Private Equity plc.

What Makes Electra Investment Grade?

Over the long term Electra has a proven track record of delivering against its target. As at the end of 2015 the rolling 10 year annualised return was a whopping 13% a year. This compares to an average stock market of the S&P500 return of 7%.

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Fig 1 – Electra 10 yr annualised return – Source: Electra 2015 Accounts

If you had invested on 21st September 2006, i.e. ten years ago Electra would have delivered you a 226% return, compared to just 50% if you have had invested in a passive FTSE100 tracker. This includes the effects of dividends. This also shows that beating the index on average really does add up in the long term.

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Fig 2 – ELTA vs FTSE100 passive fund – 10 yr performance

But past performance doesn’t guarantee future success? What are the future prospects of Electra?

The NAV of Electra is only calculated semi annually but having adjusted for the antipated exit of Hollywood bowling though IPO and the Allflex exit I calculate NAV as £46.12. This compared to a share price of £43.66, a 6% discount NAV to share price, which implies the market is expecting a loss on some of Electra’s investments. You can compare this to a 20% NAV premium on one of the other major players in this sector, 3i.

See Fig 3 below the current investments of Electra. This covers a diverse range of sectors and includes some more defensive plays. Given the past record of Electra and a well diversified portfolio I don’t think there is any reason for such a discount to NAV on fundamentals.

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Fig 3 – Electra Investments. Source: Electra Website

So why the discount to NAV? Any other thing to be aware of?

There is one other thing bubbling away in the background, Edward Bramson a well known activist investor forced a review of the strategy late in 2015, the results of which should be concluded and announced imminently. Bramson is part of Sherborne investors the largest shareholder of Electra who has a 29.9% stake. The interim findings have so far led to the stepping down of several directors, Bramson himself installed as Interim CEO and perhaps the most controversial move, the firing of Electra Partners LLP as investment manager.

For me the performance of Electra has been strong and whilst there is always room for improvement I’m concerned about Bramson’s attempt to crack a nut with a sledgehammer. Bramson bought enough shares to force through his view of how to run Electra without amassing the 30% required to make a formal offer of the company. He now finds himself in tacit control without having to pay shareholders a premium. Electra Partners on the other hands finds itself on 12 months notice which means they could step away as early as 27th May 2017. The worry here is that EP know the investments really well and bringing a new investment manager on board involves a steep learning curve. That said the investment management could also be done in house, which could be a more cost effective method.

Summary
BUY – Electra on balance in my view is a buying opportunity at a discount to NAV.

With the IPO market picking up again it is a good opportunity to get exposure to PE. Electra is currently valued below its NAV despite a brilliant track record. The current activism is a distraction but should be expected to conclude soon and I believe when ‘push comes to shove’ ELTA will retain EP as the investment manager, this should hopefully maintain an excellent performance. If I am correct you can expect the discount to NAV to narrow pretty quickly.

Disclaimer – I have a long position equal to 2% of my net assets in Electra Private Equity bought in at 3676p. I have no further positions in any of the other stocks mentioned and to my knowledge nor do any close family, friends nor associates.

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.

Genel Energy – Is there a future for long suffering Investors?

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.


Genel Energy is a company I have followed since its IPO in 2012 and I’m sorry to say I’ve owned its shares on many occasions. I was always hoping that Genel was about to turn the corner, on a micro level the company had so much upside but it has been the macro events that have really punished Genel. Shareholders have inevitably suffered, those unfortunate people who bought into the IPO are now looking a 90% loss from the £10.00 issue price. The steady decline is charted below in fig 1, it shows a company capitalised at over $2bn at its peak to just £250m today, where shares are trading hands at just 90p. Genel does have net debt though, so the true Enterprise Value is around £500m.

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Fig 1 – Genel Share Price


What’s the background on Genel?

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Fig 2 – Genel Activities, Source: Genel

Genel is the operator of the Taq Taq field in Iraqi Kurdistan and non operating partner in the Tawke field in the same region. These two fields give Genel 2P reserves of 264m boe and the production from these two assets as at June 2016 was a respectable 56,000 boe per day. Genel also has two promising gas assets in its portfolio, namely Miran and Bina Bawi which have contingent resources of 4.3tcf and 7.1tcf respectively.

The company also has some sundry exploration assets, in Morocco and Somaliland. At present these are fairly uninteresting and no exploration wells are currently scheduled.

What went wrong for Genel?

Genel has suffered the perfect storm of sustained low oil prices and its host not paying for the oil, due to itself not being able balance its own books because of the same low oil price. The Kurdistan Regional Government (KRG) has been erratic in paying Genel at best, even suspending all payments for a period in 2015. As a result Genel is currently owed around $350m from the KRG. I am certainly not going to criticise the KRG here, with the Islamic State moving in next door at the same time as a collapse in the oil price – it is a difficult one to manage. 

Genel’s issues were compounded when the Taq Taq wells started to go into decline in 2015. This forced Genel into reviewing the field model which ultimately led to the Taq Taq field’s reserves being cut in half in February 2016. The financial result here was a $1bn impairment charge to the December 2015 accounts.

Is the worse over with? Can Shareholders expect to make up any losses?

The short answer is – maybe. I’ve put together an overview of the material value streams, these are based on current 2P figures, i.e. reserves which can be accessed within the existing field development plan and with CAPEX which I expect to be covered by the Cash From Operations and current cash balances. I’ve also included the financing and Plc costs.

As you can see there is a 35% upside from the current share price of 91p. That said investors should be nervous about the risk of further reserve downgrades, ISIS knocking on the door, KRG payment delays and a whole host of other risks, thus the shares trading at a discount to NPV of 35% is reasonable to me.

Caveat – These are my estimates so please do your own sanity checks!

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Fig 3 – My NPV estimates


What about the Gas Assets and Other Upsides though?

There are plenty of other upsides, where we could look to identify further value. The additional possible reserves, i.e. 3P on Taq Taq are worth $595m alone per the CPR, the Gas Assets or Miran and Bina Wawi also have an NPV of over $1bn per a recent UBS broker report. There are also other exploration opportunities in the region with the potential to add value. The big issue though with all of these projects is though they require up front CAPEX, the gas project requires $2.5bn alone. Clearly Genel in a position of net debt cannot fund this, it would require a combination of equity, debt and JV partner entry to get this financing away. In a situation where the KRG are not paying Genel I can’t see this being possible nor worth proceeding with in this uncertain enviroment. This goes someway to explaining why OMV flogged their 36% share of the 7.1 tcf Bina Bawi asset for just $5m upfront, so if we take this as fair value then the figure 3 valuation is materially unchanged. It is worth noting there is up to $145m of deferred consideration to pay if Genel ever get this asset producing, but I doubt OMV are recognising this as an asset in their books!

Summary
HOLD – potential buying opportunity around 80-83p where discount to NPV looks apealing, all other things being equal.

I wouldn’t be rushing to sell at the 91p level but I wouldn’t be buying further either. There is a lot of potential upside here, but until the KRG repays all past debts and ensures that IOCs are paid reliably then the KRI simply does not represent an environment for investment for me and hence I can’t assign much value to the gas projects or the additional KRI exploration/prospective resources at Taq Taq and Tawke. If you are already invested my advice would be to hold and see how the KRG situation unfolds, oil above $55 for a period of time would help too!

Disclaimer – I have a long position equal to 2% of my net assets in Genel bought in at 105p. I have no further positions in any of the other stocks mentioned and to my knowledge nor do any close family, friends nor associates.

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.

San Leon – 19% dividend yield. Too good to be true?

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’ve been meaning to cover the return of San Leon for a while and today I’ve finally got around to it. Late in August San Leon return from suspension with the announcement of a deal in Nigeria and connected equity placing to the tune of £170m, at 45p a share. The shares today are trading just below the placing price at 44.62p, this gives an Enterprise value of around £195m, so is there plenty of value to be had here?

What is the background of San Leon?

Prior to the deal being done, San Leon had a range of fairly uninteresting exploration and appraisal stage assets, in Europe, Morocco and Western Sahara. The later of these assets had meant San Leon was no stranger to controversy, with a Major Norweigan Pension Fund blacklisting the company for ‘serious violations of fundamental ethical norms through its onshore hydrocarbon exploration in Western Sahara’. The Norwegians are not the only group either than San Leon have offended, Oisin Fanning the San Leon Energy CEO has been deeply unpopular with shareholders throughout his tenure. Oisin had been rewarded significantly through his £900,000 salary, despite San Leon not achieving much up until now. Protests from shareholders led Oisin to take his salary in shares, at least that way rewarding him for success. (For me his salary is still extortionate compared to the limited operations of the company.)

So what is this latest deal announced by San Leon?

On 22nd January the shares were suspended on AIM due to the takeover of Mart Resources Inc, together with Midwestern Oil resulting in an indirect acquisition for San Leon of a 9.72% stake in producing asset OML18 onshore Nigeria. Mart the acquired company was a Calagary based TSX listed company and San Leon’s co acquirer Midwestern Oil is a Indigenous Nigerian company, part owned by the Delta state government. The other two partners are NNPC, the Nigerian National Oil Company and Sahara, another Nigerian private energy company.

It is unclear to me the status of the operator EROTON post deal as Mart was a major shareholder in this entity, but I suspect San Leon, Mid Western and Bilton will continue to procure the services of EROTON as operator at least in the near term. I do note though that San Leon has a right to provide oil field services under the agreement so it a bit unclear how this will work post deal. It should also be noted that San Leon is also the only non indigenous partner. The complete Joint Venture structure is show in Fig 1 below:

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Fig 1 – Source: Broker Report – Post Deal Completion

OML 18’s estimated gross 2P reserves are approximately 576 MMbbl of oil and approximately 4.2 Tcf of gas and its gross 2C contingent resources are approximately 203 MMbbls of oil and approximately 1.6 Tcf of gas. A pretty significant asset then for sure, production wise as of June 2016 OML 18 was producing at approximately 50,000 bopd of oil and approximately 50 MMscfpd of gas. Oil production is expected to peak at 120,000 boe per day by 2020, this requires though CAPEX of around US$1.8bn, this being fully funded by production. The final key metric; Opex per Boe is estimated to be between US$10-13 per Boe. It is clearly an exciting asset.

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Fig 2 – Nigeria Licence Map

More good news came on 26th August whenSan Leon announced it had conditionally raised approximately GBP170.3 million (US$221.4 million) through an equity raise to fund the above acquisition, subject to shareholder approval which is likely to be granted on Tuesday 20th September.

San Leon post completion will also appoint Mutiu Sunmonu, highly experienced former Nigeria Country Manager of Shell as Non Exec chairman, this seems like a sensible appointment. Also appointed as Non-Executive Chairman is Ewen Ainsworth, former Finance Director of Gulf Keystone Petroleum and current Finance Director of Nostra Terra, two companies which have failed to deliver for shareholders so I’m less excited about this appointment. Overall though it is pleasing to get some non executives on board to place a check on the executive board. The executives will be the same as today, Oisin Fanning, Joel Price and Alan Campbell.

This is undoubtedly an ambitious deal and I can’t recall a fund raise as big on AIM this year…

But can the Nigeria deal turn around the companies fortunes?

Based on the house broker report here the unrisked NPV of the project is $514m (£395m), i.e. double the current market capitalisation. In fact if things go well the project will have paid back by 2018 (see fig 1) and if things work out the asset should throw off cashflow from there. This seems like excellent value, especially when you also consider San Leon have also promised to return 50% of the Free Cashflow (FCF) to shareholders, the 2017 dividend yield is a whopping 19% at todays share price! The 2017 Price/FCF ratio is also around 3x, so on every level this is a value play and that is before further upsides are considered such as developing the contingent resources and taking part in other exploration prospects in the region.

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Fig 3 – Anticipated cashflow per Brandon Hill Broker Report

 


So what’s the catch? What are the risks?

A company with a Forward Price/FCF of 3x and a dividend yield of 19% usually means one thing – investors don’t believe a word management say. You see these crazy dividend yields a lot with some of the Chinese AIM stocks where fraud and other suspicious activity means most investors treat the whole sector as bargepole. However, San Leon despite some questionable practises is definitely not to be associated with that lot.

Nigeria definitely poses a risk, many investors know the Afren corruption story and many are also aptly aware of an increase in violence in the Delta region, this can often lead to sabotage giving a production downtime risk. That said the partnership structure may make it is easier for the JV to co-exist with the local communities, indeed there have been no recent interruptions to production at the field.

The field has produced well since Eroton took operatorship in 2015, but to maintain and increase production a significant programme is required, as noted above. That said no significant debottlenecking is required to raise production, the work looks limited to workovers, new drilling wells and associated infrastructure. In theory this looks straight forward, however I am unclear of Erotons role going forward given the change of JV structure and it should be noted that neither San Leon nor Midwestern have a significant track record as successful producers/developers.

Summary

BUY – Target 65p, capitalising at £280m with still plenty of room left in the NPV valuation.

San Leon knows it has pissed off shareholders previously and thus it is encouraging to see improved corporate governance with the appointment non executive appointments, Oisin taking his salary in shares and finally a mechanism to return cash to shareholders.

There are some risks for San Leon on this asset but there is nothing that causes me too much concern and having a heavyweight in Mutio Sunmono should be able to assist on many of the ‘on the ground’ issues. The dividend yield of 19% and Price/FCF of 3x means that management have plenty of room to screw up significantly and there still be significant value here.

A potential way of investing is to take a small exposure now and add more once the deal is concluded and the production in the first few months is reported.

Sepura – Good news, Henderson increase their stake.

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.


Yesterday I tipped Sepura as a speculative buy here, that being despite a turbulent year where it managed to destroy 95% of shareholder value. Those brave investors though who agreed with my view yesterday and bought in could have already turned around a 10% gain. I am always nervous though about these more riskier trades, but I was very relieved this afternoon to see Henderson notifying Sepura that they had increased their stake from 15.89% to 18.37%. Does this helps to derisk the trade towards my target of 20p?

Who are Henderson and why are they buying?

Henderson are a major asset management company and are Sepura’s biggest shareholder. The two funds invested by Henderson with a stake in Sepura are the AlphaGen Volatis an activist style hedge fund with $1.5bn under management, it has a 6.53% stake.  The second is the £150m Open Ended Henderson UK & Irish Smaller Companies Fund with a 11.83% stake. The Open Ended Fund has Sepura has one of its top 10 investments and 2.2% of the total fund.

Should I follow Henderson into Sepura?

All shareholders are not made equal despite what you might think. Henderson is the biggest of Sepura’s shareholders and backed the last placing. You can pretty much guarantee that the Henderson Fund Managers were the first people that acting CEO Richard Smith picked up the phone to call when the dreadful RNSs and profit warning was released. I suspect Henderson have had explained in detail the drivers behind what has happened and the future plans to make things right, this may include various hints as to what may be behind the corner. Henderson may even have had a part to play in the disappearance of CEO Gordon Watling. The hedge fund is an activist fund so this is not an unreasonable assertion.

Given the close access to management that Henderson combined with their deep knowledge of the company then further buying is definitely a positive. However, word of warning, the open ended fund has woefully underperformed its benchmark in the last two years, unsurprisingly the fund is ranked just 1 out of 5 on morningstar’s fund review. So can Henderson be trusted to know what they are doing? Unfortunately there is limited information on the hedge fund so I can’t comment on the performance there.

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Summary

Whether you have confidence in Hendersons or not, the fact they are buying and not selling will have a major impact on the price, irrespective of your view on potential value in these shares. Today’s TR-1 derisks the trade somewhat but this is still a high risk trade, don’t bet the ranch….

REITERATED SPECULATIVE BUY – 20p

Disclaimer – I have a long position equal to <1% of my net assets in Sepura bought in at 13p. I have no further positions in any of the other stocks mentioned and to my knowledge nor do any close family, friends nor associates.

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.

Sepura – Drops off a cliff. Is it still investment grade?

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.


Sepura, a ‘global leader in the design, manufacture and supply of digital radio products, systems and applications developed specifically for business and mission critical communications’ is down almost 95% from the end of March 2016. Today’s market capitalisation is £50m at 14p per share. This is an almighty value destruction, this article looks at whether there is still value in Sepura at this price. So should you be bottom fishing or steering well clear?

What’s the reason for the sharp change in fortunes for Sepura?

As at the March 2015 year end Sepura seemed to be doing well. It was generating EUR25m of operating cashflow and even a small amount of Free Cash Flow. Back then it was capitalised at £206m(EUR 250m), zero debt and with profit growing 15% year on year. Sepura was even paying a small dividend and had a strong order book going into 15/16, it therefore looked decent value at just £200m. Not a major suprise to see the company continuing to increase in value beyond March to a peak of £300m(EUR 350m) towards the end of 2015.

The troubles seem to have started though with the May 2015 acquisition of Teltronic, a company offering similar products to Sepura but expanding the geographic reach into Iberia and Latin America, most notably Brazil. Sepura paid EUR127m in cash using a combination of debt and new equity to pay for it.

Amazingly Sepura also announced in September 2015 it was commencing a share buy back program for up to 1.8m of shares, bear in mind the share price was around £1.80 at this point in time, Sepura was therefore placing itself on the hook for upto £3.25m. Granted it isn’t the biggest share buy back programme in the world, but why did the company need to do this without at least waiting until the new acquisition had settled in? Sepura was/is in net debt so why should it be doing a share buy back at all?

Things really started to head south though with the release of the March 2016, announced on 27th June 2016, almost a full year after the Teltronic acquisition. Revenue was way up and this was almost entirely contributed by Teltronic, but operating margin fell through the floor and cash conversion was woeful, i.e. Sepura was not turning its working capital into cash. Trade receivables almost doubled from EUR47m to EUR88m, the question therefore is the additional revenue that Teltronic contributed, did any of the customers actually pay for it? Not only was the cashflow poor the company was now in a net loss position of EUR10m. See below for a breakdown of the key metrics:

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Fig 1 – Source: Sepura 2016 Annual Report

Sepura does not come out and say explicitly how Teltronic has performed at a cash generation/profitability level, but can we deduce the Sepura collapse in fortunes down to this acquisition? I can’t see the company has acknowledged this, but it’s no coincidence that Brazil and Saudi revenues grew in 2016, likely driven from the Teltronic acquisition. Brazil is going through it’s biggest recession in more than a century so is it any surprise its customers were late or non paying? In fact according to the notes of the 2016 accounts some EUR6.4 million of debtors were written off after acquisition, 15% of the total debtors balance. Anyhow no impairment of the Teltronic goodwill was made in the 2016 accounts, but I will be watching with interest when the 2017 accounts come out next year! I wouldn’t be surprised to see the whole lot gone.

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Fig 2 – Operating Revenue Segments – Source: Sepura 2016 Annual Report

 

After these dire results the company was forced into an emergency equity raise of £65m with net debt climbing to EUR119m. However, at this time management estimated assured shareholders of a record breaking net profit of EUR21 million in 2017 so all would be fine…

Surely it can’t get any worse then?

And then came a lunchtime trading update yesterday 14th September 2016…

Order intake in recent months has been lower than the Board’s expectations as a result of emerging delays in Device refresh opportunities in a number of key markets, primarily through budgetary pressures which are extending product lifecycles. At the same time, key contract awards in the Group’s Systems business have also been subject to delay. 

The latest sales pipeline and associated timing indicates that order intake for the full year will have a significant impact on the Group’s FY17 revenues. As a result the Board now anticipates adjusted EBITDA for the current financial year could be c. 60% lower than its previous expectations.

Obviously written by the PR people, but I can roughly translate to, ‘lower device sales and less new major contracts’. By the way it irritates me that they haven’t actually stated the expected EBITDA for 2017 now, instead investors have to trawl through the releases until they find the original guidance. From what I can see this was EUR27m, so now EUR10m.

Sepura were not done with that shite news though, two other bombshells; they warned they are likely to breach covenants on the borrowings from March 2017 next year. We are not told by Sepura what the current net debt position is though (another thing that riled me about this RNS). The final bombshell was saved for a separate RNS:

[Sepura] has been notified by Gordon Watling, its Chief Executive Officer, that he has received medical advice to take an immediate and extended period of absence, in order to recover fully from injuries sustained in an accident earlier in the year.

Richard Smith, Chief Financial Officer, has been appointed Acting Chief Executive Officer with immediate effect in addition to his existing responsibilities.

What? So Gordon injured himself earlier this year, but he only needs to take time off now, just happens to be the same day as the company releases the Profit Warning from hell? What exactly did he injure himself on, did an angry investor repeatedly smash him over the head with a walkie talkie? And why has it taken so long for the symptoms to take effect? On a serious note, best wishes to Gordon but this stinks of some sort of PR cover up. Has he been pushed?

So should I be tempted to bottom fish?

The company based on its revised guidance is now expecting around EBITDA 10 million. At a net profit level this will likely be close to £nil. The big question will be whether some of the working capital in March 2016 can be converted into cash though.

The management has clearly made some shocking decisions over the past few years, the acquisition was a poor one and starting a share buy back scheme shortly afterwards whilst not material, wreaks of poor decision making. With the CEO Gordon Watling now out of the scene this gives the remaining management chance to refresh things.

The liquidity situation is not critical in that Sepura does not need a fresh funds today, but it will need to talk to its lenders in the next 6 months. I certainly don’t think it is the end of the road for Sepura yet, but the next 6 months will be critical to keep net debt levels under control and at least demonstrate an improving picture.

Sepuras current Enterprise Value is £50m Market Cap plus I estimate £80m of Debt, i.e. £130m, so if the business can restore itself to its former glory when it was generating CFO of EUR 25m then this valuation is cheap. The other real possibility is a hostile move from a rival, the valuation could now be attractive, there was a brief bit of interest at the end of July but the counterparty pulled out. Some of the major contracts Sepura have could be interesting and there may be synergies at play, the tax losses of EUR25m (and counting!) could be an attraction also. Even if you double market cap this still only gives you an EV of £180m, this doesn’t look unreasonable given £20m CFO a year and given what Sepura paid for Teltronic, i.e. £100m (although the later is perhaps not a great benchmark!). However, If this offer doesn’t come in the next 1-2 months then I expect any potential buyers will instead wait it out and talk to the bondholders instead down the line.

If no buy out offer comes and/or management fail to turn around the company then I can see a looming debt for equity swap. It is pretty much out of the question to do an equity raise to pay down debt, last time Sepura went to it’s shareholders it was at a 53% discount. What would it be this time, bearing in mind the size of the market cap now? Mega dilution…

Verdict

SPECULATIVE BUY – Target to Sell at 20p (42% upside)
On balance this is a high risk one but I believe there may be an opportunity to make a quick profit here as people pile on the expectation of a potential take over. However, if the offer doesn’t emerge after 1-2 months then it becomes higher risk as the price will likely drift on no news until we get the next trading update. The big downward pressure on the price could come if some of invested institutions start offloading there shares so watch out for TR1s. A potential strategy could be take a small tranche at tomorrows open and watch for major dips. Note, I only have one or two of these distressed plays on the go at any one time, so make sure you risk manage!

Disclaimer – I have a long position equal to 1% of my net assets in Sepura bought in at 13p. I have no further positions in any of the other stocks mentioned and to my knowledge nor do any close family, friends nor associates.

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.

CloudTag – up over 500% in 2016, are investors heads in the cloud?

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.


CloudTag is probably one of the most promoted stocks among private investors at the moment, particularly on Twitter. The company has seen a meteoric rise from the start of January 2016, rising from 2.5p to 11.75p as of writing, valuing it today at £44.2m. It is always pleasing to see private investors doing well, but should they now be thinking about selling at these levels? For pre revenue companies like Cloudtag I tend to use a screening tool and if the company passes the screening I then follow up with some analytics for good measure. This is the approach I will follow below.

Wh0 are CloudTag?

CloudTag is pre revenue United Kingdom-based company that offers CloudTag Track. “The Company’s CloudTag Track and its associated smart device application range, provides personalized, weight-loss and fitness programs based on the latest clinical-grade, wearable fitness monitoring technology.”

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This is a competitive space, but does the CloudTag Track have a Unique Selling Point?

I thought long and hard about this one and actually I think the company may have a USP, based on CloudTags claims. My own experience as an Apple Watch user is that if I do gentle or moderate exercise then the watch seems to track calories and my heart rate fairly well, anything more vigorous and/or dynamic and the data is a load of codswollop. Looking at the fitbit range, they also seem to suffer from the same issue. The CloudTag allows you to get around this issue by wearing it on your wrist for casual use and chest for more vigorous exercise.

The CloudTag track also tracks activity and sleep automatically and claims to measure Heart Rate variability, this being a key measure of stress. I have to admit that these are all one ups on my apple watch. That said I can’t see any information on how the the Heart Rate Variability information is presented to the user from CloudTags website. Another concern is that the product is not yet released so we don’t know in reality how seamless the experience is. What concerns also is that I can see reviews here and here but none of them are a ‘hands on’ review, they both look like articles placed by PR people. Has the product been offered to any Tech bloggers? If so then why can’t I find any reviews? My final concern is that although I like the product does it ‘medical grade’ heart rate tracking needed for most users?

What’s the price? When is it available? 

The price will be £89.99 and was originally estimated to be available in summer 2016, we don’t yet have a launch date, the last news we have was the RNS here which quotes that the distributor Second Chance are looking to build an orderbook with ‘major retailers/etailers’. The cloudtag website still gives potential retail buyers no indication when the product will be available, other than ‘coming soon’. What are the reasons for the delay here? Are their teething problems with the product or is Second Chance struggling to fill orders? The following statement from the latest RNS seems a little ominous too, is this an attempt to drip feed investors to the possibility of things not being well? Perhaps I am paranoid, but I have been trading on AIM far too long!

Good progress is being made on all fronts but it should be noted that Cloudtag is entering a highly competitive market and faces many challenges commonly associated with such entry. Plans have been put in place to address such possibilities and we are confident that our team has the skill and determination to resolve any such possibilities should they arise.

Are there any other barriers to a successful launch here?

kantar-media-ad-spend-fitbitI think the product seems pretty good if all the claims are correct and for the price it seems competitive, the Fitbit Charge is the same price and yet the CloudTag has the advantage of the heart rate accuracy and potentially heart rate variability.I popped into Dixons though earlier before writing this article and I counted 15 different wearables, there is a lot of choice out there? Is the product sufficiently able to differentiate itself without a heavy marketing campaign. This is probably my biggest concern, can CloudTag really gets its product in front of enough potential customers?

The marketing budgets of the Top 20 wearable fitness companies are included to the left which illustrates how much they spent in 2014. Fitbit spent $21m (£16m) in 2014, where is CloudTag going to find the money to compete on this level and persuade customers that it’s product is different? This to me illustrates the challenges CloudTag face.

That said, Withings is a smaller company with a good selection of products that managed to get a buy out from Nokia this year and raise its profile enough on a shoestring marketing budget of $199k. However, Withings also was one of the earlier entrants to the wearables and ‘Internet of Things’ space (I hate hate that term) giving it a very big advantage, whereas CloudTag is much later to the party.

How does the Valuation look?

Let’s look at one of the potential competitors Fitbit, who in 2o15 managed to generate cashflow from its operating activities of $109m from $1.8bn of Sales, that is just 6% of revenue! This Cash from operations was subsequently eaten up by financing fees too, this really shows how tight the margins are, or in other words how competitive the market is and what an uphill task CloudTag has in front of it.

To justify Fitbit’s CFO multiple below it needs to make sales of $1.8bn or 54% of the market capitalisation. Let’s assume for a moment that CloudTag achieves the same margins as Fitbit. This would be £21m of sales equivalent for Cloudtag against it’s £43m capitalisation which all things being equal could generate £1.26m of CFO, giving a very generous CFO/E ratio over 30. I admit these are ‘back of fag packet’ type workings, but it does illustrate the level of sales needed to generate a return here to justify CloudTags market cap. Is £21m sales per annum, i.e 0.25m units achievable by Second Chance the distributor, when so far Sales are £nil? Even if it were to generate this level of sales, with just £2m in the bank this is a very tough working capital cycle for CloudTag to manage. We could of course assume CloudTag can get better margins, but given the lack of economies of scale available to smaller companies is this really realistic?

fitbit

To further compound the uphill battle, wearables is also a fast moving market sector, with pressure to keep new products coming. Even if against the odds the CloudTag product is a success, how long is the shelf life though? 2,3 maybe 5 years tops? The first couple of years post launch, even if CloudTag survives, are likely to be cash draining given some of the sunk costs needed to launch a product. Maybe by year 3 it could turn a profit and generate some cash? However, the R&D departments at some of the bigger players are vast and how long would it be before a superior product emerges from a competitor?

The other option of course to realise shareholder value is a buy out from a competitor, this is a possibility and much more likely than CloudTag being able to go alone. Let’s though return to Withings above, the acquisition was for $191m cash, i.e. £150m. The product range of Withings is larger, offering some real innovative and stylish products, winning tons of awards on the way. When you consider CloudTag is already valued at £43m, i.e. 0.3x Withings then this valuation looks very full to me. CloudTag has just one product, which is differentiated but certainly no more differentiated than any of Withings offerings in my opinion. I therefore believe there is no further upside on the CloudTag current valuation.

Summary

SELL – Target 5p

I do like the product but at this stage there is so much potential downside here which is not factored into the share price. To sum it up this is David vs Goliath and whilst the patents and/or product could be attractive to a competitor I can’t see the valuation being as high as £43m when looking at the Withings deal. My target of 5p capitalises the company at £20m or so, this could give some upside in any deal scenario, until then I won’t be getting in here.

I fully expect to get trolled on Social Media and the bulletin board for this article but i’ve got thick skin so bring it on, constructive comments preferred of course…

Disclaimer – I have no positions in this stock and to my knowledge nor do any close family, friends nor associates. 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.

Screening Pre Revenue Companies

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.


Valuing some pre-revenue companies can be extremely difficult, particularly those in Tech and other new industries. The core issue is that a lot of smaller pre-revenue companies are not in a place where they can give reliable earnings guidance or NPVs (Present value of future cashflows generated from the company). It is therefore necessary to use a screening tool to quickly filter the potential cash cows from the dogs. I have included below something I developed some years ago to identify potential companies to invest in. The tool asks a number of questions and points are awarded based on your response. Please note this tool is not appropriate for resource companies, these companies are generally more straight forward to value, I have written a separate post on reserve based valuations here.

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Pick a pre revenue company and if you do receive 8, 9 or >10 pts then that is a great start, it shows potential but this does not make the company an automatic buy, good companies can still be overvalued, so close down your dealing screen for now. The first thing you should do is remember that the valuation of a company in the long term is based solely on how much money the investment generates for shareholders through dividends or share buybacks. You should then look to do some quantitative analysis to consider that point further.

The best way of really estimating the value of a company, i.e. the potential Free Cash Flows (FCF) the company can make and potentially return to shareholders is comparing the NPV to the Enterprise Value of a company. I have a detailed NPV calculation that I have built in a recent analysis of Hurricane here that you can take a look at by way of example. It is actually not overly complicated to prepare a NPV computation, I’ll look to do a worked example in the future but for now this guide is fairly useful, a gentle introduction to the concept. Once you understand the concept you just need to have fairly sensible assumptions for revenue, costs, CAPEX, financing etc. Some assumptions you can glean from company presentations, other assumptions you may need to look to competitors and for some you may need to come up with your best educated guess!

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The key is that you are looking for NPVs well in excess of the current Enterprise Value of the company,  this will allow plenty of scope for further derisking.

If you don’t feel comfortable with NPVs, you can do some more basic analysis, look at the competitors, what Price to Earning ratio are they on? So if your company has a market cap of £100m and competitors are on PEs of 20, is it realistic that your company can turn £5m of profit on a forward looking basis. If not then is the valuation of your company too high? If yes, can it keep growing its earnings going forward? It would take your company 20 years to generate enough earnings to justify its share price and how many years would that be in dividends for shareholders? I could go on and on but these are the sort of questions you need to ask yourself and remember the valuation of a company in the long term is based solely on how much money the investment generates for shareholders through dividends or share buybacks.

Summary

The screening test should enable you to filter companies fairly quickly, but make sure you do some number crunching and be as prudent as possible with your assumptions. Once you have developed an NPV for a stock on your watchlist there is always an opportunity to revise your assumptions. At some point you will find an entry level on a stock where you have a solid piece of research on.

No method is never infallible and you of course can amend some of the screening questions as you see fit, just make sure you are very honest and as prudent as possible with your costing and revenue assumptions.

Finally, If all of the talk of NPVS, CFOs and PE ratios scares you then not to worry, keep following my articles and generally I will use analytical methods where I can and I am always happy to answer questions…. And as always I welcome your feedback!

xCite Energy – ‘Residual Value’, the warning signs were there.

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.


xCite Energy a company once capitalised at £500m released probably the most inevitable RNS of 2016 this morning, perhaps only narrowly behind that of Gulf Keystones Debt for equity RNS in July. The headline of xCite’s RNS which saw the shares crater was ‘statement of share price movement‘, but the real headline should have been ‘Shareholders left with crumbs’, the real news was the following buried at the bottom of the release:

Whilst terms of the restructuring have still to be agreed, the Company now believes that there will be a minimal residual equity stake attributed to the Company’s existing shareholders following the restructuring.

The shares are down 66% to 2.5p, capitalising the company at £7.7m. What is disappointing is a big jump in the share price on Friday, based on twitter rumour of an imminent farm out. Market abuse which will no doubt go unpunished, but it’s AIM so it’s ok.

The company though has claimed it’s Bentley project has an NPV of over $2bn, how could it have come to this?

xCite Energy used bonds to finance the appraisal of the Bentley field, this is its only significant asset, a heavy oil field reported to contain 267 million Boe recoverable East of Shetland.

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The terms of the loan are here but in essence were always a debt for equity swap waiting to happen, in summary the notes are secured and interest rate is 12% per annum with a Payment in Kind interest of 3% on top, which can be paid either in cash or additional bonds at Xcite Energy discretion. This translates to an effective interest rate of 15%, firmly a junk issue which reflects the perceived risk of the company and certainly not xCiteing for  equity investors (sorry!). These bonds were issued in June 2014 for two years and thus due for repayment in June 2016. This was delayed until September 2016 to allow Xcite to enter negotiations with the creditors.

Many companies issue debt without hope of repaying it when it becomes due but assuming the company is low risk then the company can reissue further bonds on the same, or perhaps even better terms in this yield chasing environment. However, when xCite’s bonds were issued the oil price was over $100,  so if this was a 15% per annum funding back then I can only imagine new noteholders would demand minimum 25% per annum now. This would obviously be totally unsustainable for xCite and in reality I doubt anyone would lend to xCite, without it being conditional on a substantial capital raise or farm out. Here comes the next issue for xCite, it has been trying to find a partner for Bentley since 2012 . The project requires $3.5bn of CAPEX and whilst the OPEX per Boe is relatively low at $13.2 per Boe you have to remember this is heavy oil project at 10-12 api. What does that mean? Difficult to produce, difficult to develop and oils fetching a significant discount to Brent. This is a high risk proposition for any investors.

The NPV of Bentley is stated by xCite at $2.3bn, with an IRR of 39%, however I have not seen the long term oil price assumptions used nor how sensitive the project is to CAPEX overuns and reductions to the oil price. Given that the data room has been open since 2012, what is it exactly is it that is putting potential investors off? Given that Hurricane Energy was able to raise £50m at a premium recently suggests to me it could be the that the Bently asset is unappealing rather than the market per se. So with no other method of raising funds all the cards are with the bondholders…

So can bondholders take everything from here and how much will be left for equity holders?

What many equity investors fail to understand properly is that bond holders demand lower returns than equity holders, but consequently also demand lower risk.  This requirement is the basis for the order of preference of creditors in the event of liquidation or administration, as defined by UK law. I’ve listed the order below and for avoidance of doubt I have underlined the category that xCite’s bond holders fall into.

  1. Fixed charge holders.
  2. Liquidators’ fees and expenses.
  3. Preferred creditors.
  4. Floating charge holders.
  5. Unsecured creditors.
  6. Interest incurred on all unsecured debts post-liquidation.
  7. Shareholders.

Once a company gets into default on their debt the bondholders can petition the high court for the company to be placed in administration. The administrators will then find try and recover as much value as possible in the order stated above. Under this process shareholders will typically get £nil. This process is time consuming and expensive though and therefore bondholders typically will prefer to offer equity holders a token, enough of an incentive to approve a shareholder resolution to increase the share capital by sufficient amounts to complete a debt for equity swap. However, the above is fundamentally why secured bondholders are always in the driving seat during a restructuring.

In terms oh how much ‘residual’ value equity holders will get, it usually is a good indicator to look at the levels the bonds are trading at, i.e. if the bondholders are expecting a haircut then equity gets nothing, it looks as though this bond issue is highly illiquid and I can’t see any bonds being traded in the last year. However, let’s look instead to the recent Gulf Keystone restructure, where existing shareholders received 4.5% of the enlarged share register. In this case I see between 2.5% and 5% at best.

What is the future for xCite?

The Bentley asset has had little interest so far from third parties and clearly xCite is not in a strong enough position to raise the capital that it needs to go alone. The bondholders though will know it is a real risk that they are stuck with an asset they can’t develop, at least until oil is >$100. In addition by their very nature bondholders are unlikely to want to hold the equity long term. They will therefore be keen on crystalising whatever they can. I think therefore the best opportunity for xCite is a distressed sale post any debt for equity swap, in my view this will probably be most likely to private equity.

Again it is terrible to see private investors lose so much on xCite and I genuinely hope they get as best deal they can, my fear is this will be much lower than current share price…

SELL – Target 0.5p

Disclaimer – I have no positions in this stock and to my knowledge nor do any close family, friends nor associates. 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.

Hurricane Energy – Huge Potential at 38p

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.


Hurricane Energy plc (HUR.L) released a very exciting RNS this morning here, giving an update on appraisal drilling on its Lancaster development. The 60 day well confirmed all objectives were met, with the results coming in significantly better than prognosis. The key points from the RNS were as follows:

  • Hydrocarbon column: 620m, deeper than the 2014 well by 320m.
  • Assisted Flow Rate:11,000 confirmed vs 9,800 boe per day expected
  • Pressure: As prognosed.
  • Crude quality: 38 API, a light crude oil which should fetch a price fairly close to the Brent benchmark.

For those without a petroleum background, what does all this mean? The 2C, i.e. The mid case contingent reserves were 207mm Boe prior to the pilot hole being drilled (Note – if you are not familiar with reserves classifications please see my article here) with the best case reserves being 456MM Boe. The hydrocarbon column as mentioned above has come in significantly in excess of prognosis, therefore the best case of 456 MM Boe is likely to be well within reach. It is no surprise therefore that Hurricane Energy have today stated the result ‘materially derisks the plans for field development’. Hurricane Energy share price have responded accordingly, up a stonking 55% to 38p, capitalising the company at £377m as at market close.

What’s the background? What is the Lancaster Development?

The Lancaster development is an exciting Oil appraisal prospect West of Shetlands in the UK and 15km from the BP operated Schiehallion Field. The Schiehallion field is currently under a £3bn redevelopment after already producing 400 mm Boe since 1998. The field is expected to be bought back on stream this year with expected production at 130,000 Boe per day and an estimated remaining resource of 450 mm Boe. Even in a low oil price environment the West of Shetland basin is an extremely exciting area and the last part of the UK Continental Shelf to have its resources substantially tapped into. Hurricane are definitely exploring in an interesting area.

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Fig 1 – Source: Hurricane Energy 2015 Annual Report

Hurricane’s prospects are in fact in even more exciting. The company is exploring in basement reservoirs, a part of our geological history overlooked by the majors operating in the North Sea. ‘Unlike sandstone reservoirs that hold oil in the rock and have provided much of the world’s oil over decades, fractured basement rock is very hard and brittle, composed of rocks such as granite. Billions of cracks have been created when the basement structures moved through tectonic action, resulting in seismic scale faults and highly connected fracture networks’

‘For Hurricane it is these faults and fractures that are most interesting because that is where, under the right conditions, significant volumes of oil accumulate.’

Assuming the Lancaster project does now press ahead with the Field Development plan (FDP), the project is expected to be an FPSO with subsea infrastructure tied into two wells (see fig 2 below). This would be an estimated 20,000 Boe per day with Hurricane Energy stating they expect first oil to be Q3 2019 on this FDP.

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Fig 2 – Source: Hurricane Energy 2015 Annual Report


So what are the next steps for the Lancaster Field and what is the potential news flow?

It does look very promising for the Lancaster field, today’s announcement pretty much confirms commerciality and introduces a whole lot more potential further upside too. Hurricane will now immediately sidetrack into a horizontal well (see Fig 3 below) to confirm production rates and build up a deeper knowledge of the reservoir characteristics across the field.

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Fig 3 – Source: Hurricane 2015 Annual Report

More detailed lab results will also be gained from both the pilot hole and the sidetrack, once completed. We are then likely to see a revised CPR (the last one was done in 2013) and a need to rework the FEED (Engineering) studies, to devise the most appropriate FDP. My expectation is that the FDP could look a lot different to Fig 3 above. This FDP was developed with a 53 Million case in mind, as mentioned we could be looking at a field 10 times larger than this.

The important question, how much is Hurricane worth after today’s announcement?

It is still fairly hard to value Hurricane Energy. There aren’t any Lancaster project economics in the public realm so I have had to develop my own NPVs. My numbers are extremely high level but at the 20,000 boe per day base case and with 1C  resources of 58mm Barrels I estimate a conservative NPV of £271m. The numbers though get very interesting if Hurricane can get a FDP away with much higher production rate than 20,000 boe and a resource level towards the best estimate of 456 mm Boe. Based on todays result I believe this is a real possibility.

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Fig 4 – ShareInvestors.co.uk NPVs

If Hurricane can get a field development plan for Lancaster in place which can achieve 40-60k boe per day then the economics look splendid. This production rate I estimate would give an NPV between £800m and £1.2bn, significantly above today’s market cap. This is with only running the economics until 2026, the Lancaster field life is probably around 20-30 years if the best case contingent resources of 456MM Boe is achieved. I have also been quite conservative in my assumptions so potentially even more significant upside too on the NPVs. So in summary todays market cap of £377m looks pretty cheap given the potential upside.

Note, these numbers are very high level, you can find my workings for my NPVs stated above here. Please review carefully my assumptions before taking any investment decisions. 

Are there any other upsides?

Tons. According to the the CPR done back in 2013 the total 2C resources relating to prospects other than Lancaster were 237 mmBoe, nearby prospects such as Lincoln are quoted by Hurricane as being tie in opportunities to the Lancaster development. If this comes to fruition then all of a sudden Hurricane Energy could have on its hands major development, similar to the Schiehallion area mentioned above.

Hurricane previously also considered farming out part of the Lancaster area to a JV partner ahead of the current appraisal drilling programme. The farm out was delayed due to the partners not being able to fund a drilling programme this year. In hindsight this was a smart move for Hurricane as the shareholder value from any farm out now will be much greater. I wouldn’t even rule out a major sniffing around, perhaps BP making an approach for Hurricane given their local area expertise, or am I getting carried away?

Other upsides? In my model I don’t have the return of ‘$100 oil’ until 2026, if we do get back to higher oil prices quicker than this then we could see further significant upside on the NPV figures quoted above. I’ve also ignored any potential North Sea tax reliefs, I wouldn’t be surprised to see some sort of enhanced field allowance or other tax credits in the next budget, just to satisfy the political pressure to ensure continued oil production in the North Sea.

This feels like a ramp. There must be some risks?

I agree this is the most bullish article I’ve written for a while, but it is important to be balanced. If long term oil prices are substantially lower than that I have assumed in my model then the NPVs noted above in Fig 4 will drop significantly. For example, the 40k boe per day case mentioned above would result in an NPV of £360m on a 20% reduction in oil price each year, very close to the existing market capitalisation.

The NPV of Lancaster is also very sensitive to CAPEX, I have made some assumptions above on CAPEX figures but these are my estimates, even if I am correct with my estimates there is still a risk of CAPEX overuns. Laggan Tormore the last major West of Shetland project started production at 90,000 boe in 2016, but the project was 40% over budget. At FID it was anticipated to cost £2.5bn but it finally came in at £3.5bn and with a one year delay. In summary CAPEX overuns and lower oil prices could destroy all value for Hurricane.

There is also a risk that the current sidetrack discovers issues and subsequent appraisal brings the fields size and production profile down significantly. It is therefore important to understand that although significant derisking occurred today there is still a speculative side to this investment.

Summary

BUY – Target 55p

On balance still a buy, my target of 55p would capitalise the company at £540m, still leaving plenty of room for further derisking towards a 40k boe a day production scenario on Lancaster, i.e £850m of NPV. There would also still be plenty of further upside with a 60k+ boe day production case, with or without the other prospects nearby. Considering this then Hurricane could easily be a $1bn company ahead of first oil on Lancaster in 2019. Appraisal disaster, CAPEX overuns and lower oil prices could destroy shareholder value, but these are issues not unique to Hurricane. As long as Hurricane is part of a diversified portfolio then you have yourself a potentially very good investment here.

Disclaimer – I have a position equal to 1% of my net assets in Hurricane Energy. I have no further positions in any of the other stocks mentioned and to my knowledge nor do any close family, friends nor associates.

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.