Market Position May 15, 2013

I have had some big successes in the market lately. The short yen position has been yielding truly incredible profits lately. Almost simultaneously, the long position in Tesla (TSLA) has nearly doubled. Nearly every day after the earnings announcement has given us a new breakout to higher prices. This signals that there is a big money position being established in the stock, or that short covering is occurring now. If the huge money behind these moves are capable of mobilizing so quickly to positive news, this signals to me that they will be equally quick to mobilize in reaction to negative news.

I am not sure how long this continuation move will last. Eventually there will be a pullback – that is almost certain. But I still suspect we are only in the early phases of this boom for Tesla. I expect Tesla to generate more buzz and excitement as the year goes on.

In addition, I re-established the position in 3D Systems (DDD), according to the logic outlined in my article. Events are playing out as I had expected, with upgrades in the stock, and higher prices. This lends credence to the idea that we experienced a test phase from January to March, and we are now in a phase 4 type boom. Therefore, there should be additional room to go with the DDD long.

C & J Energy  (CJES) continues to be a dead weight in both the portfolio. The bad news about the state of the hydraulic fracturing market is out, and I believe it has been priced in. I think we have put in a bottom in this range (~$18). I dont expect the stock to dip below $17 unless the market turns worse.

I expect the market to improve as the year goes on and higher natural gas prices lead to renewed excitement in dry gas plays.

I am working up a position in some dry gas E&P companies as we speak. I do not want to reveal names and tickers, as they are tiny companies, and I have to be very cautious to establish a position at the prices I would like. I have been able to find several that are trading well below book value currently, and I have reason to expect that the book value itself is artificially low, because it is based on a past price environment, where natural gas prices were much lower than today. I will write an article soon explaining the logic.

I am using my unleveraged portfolio to purchase the dry gas companies. I am selling off a previous purchase of Halliburton (HAL). Halliburton has also come to a fair valuation in the current environment. After the settlement of the Deepwater Horizon litigation, the shares have been relieved of the pressure that was depressing them. I suspect HAL will benefit if the activity in the North American gas market picks up, but I believe the benefit will be more pronounced in CJES, so I prefer an investment in the latter.

I also sold my shares in Petroleum Geo Services (PGSVY). It is a shame to sell off such a well run company, with such growth potential. It is still undervalued, and I expect that investors at these prices would do reasonably well holding this for the long term. 3D and 4D seismic technology is only becoming more and more important, and PGS has already accumulated the Multiclient studies for the vast offshore Africa fields. However, I think there are better opportunities, like BBBI.

I am slowly accumulating more shares of Birmingham Bloomfield Bancshares (BBBI). It is currently trading at a price to book of .5, and it seems to be generating earnings at a comparable pace to BNCCorp (BNCC). The deep discount offers a considerable margin of safety, and the growth, fueled by the automotive industry boom, is bound to continue for the foreseeable future.

Overview, part 1

My funds are up significantly to-date, but so is the market.

The market feels overheated, so I am cautious, and looking to reduce my exposure where I can. Any securities that I had been holding as value investments may be approaching correct valuation, so I am going to have to re-evaluate.

Core Labs (CLB) is a position that has been great for my portfolio. Up until now, there has been a two-fold case for the investment – the undervaluing of its shares, and its position as THE dominant player in reservoir analysis and management. In addition, its perforating products had been selling like hotcakes to many of the shale E&P companies. However, there is evidence that growth in the latter is slowing, and recent reports of drilling rigs being pulled from dry gas areas may negatively impact these products performance. Core’s management has even stated that they did not expect the past levels of growth in these products to be sustainable.

Core is also approaching a good valuation for the shares. I would place a good target price at $140/share. However, the whole oilfield sector is due for major appreciation, as geopolitical risks show no signs of cooling down, and oil prices continue to rise, and a rising tide tends to lift all ships. Core will likely appreciate along with the likes of Halliburton and C&J.

Can I still justify my investment in CLB, with HAL and CJES sitting at such ridiculously low valuations? Especially with C&J, the latest quarterly report has just confirmed the trend of earnings growth, and indicates a speeding up of growth, as three new fleets will be deployed in 2012. This is a 50% growth in its fracking business, which itself brings in over 80% of its revenues. C&J is also set to grow its coiled tubing business this year.

Further, C&J is a 100% liquids play now. They have moved their last fleet out of dry gas regions, and enter 2012 with all of their fleets in liquids rich regions. The only problem that seems to be occurring with the trend is a delay further upstream – there have been well delays because of constriction of supply in drilling rigs. When demand is outstripping supply, is that not a good thing?

With over 25% of my portfolio in this single stock, I am reluctant to commit to it further. Especially because its shares have appreciated so much since my initial buy-in – I feel I missed out, and now must wait.

This is probably foolish, but I should not ignore the effect of this emotion – does it have merit? If not, I can safely disregard it, hold my nose, and continue to load up.

But it is true – CJES does not represent the same value proposition that it once did. Buying it at $22 a share is much different than buying it at $17.

But how can I value this company properly? Because it is also a reflexive process – CJES is fueling its growth through share issuance – does my traditional value measurement even apply?

It has a 13.66% earnings yield, and a P/E of 7.32. From a return on my equity, it gives 64%, similar to its ROA of 42%, since it carries no debt. A price to free-cash-flow 4.83, almost all of which is used for the new fleets.

To value it from a PEG ratio, I expect anywhere from a 50%-100% earnings growth this year, which would translate to a PEG .14 to .07.

But can a GARP approach make sense here? There is a reflexive influence. It inflated the market cap by about 10% last year – this year we might expect something similar. If that were to occur, at today’s prices, CJES would still have a P/E of 8.05, still leaving significant margin for safety.

And the reflexive relationship may decrease over time – as CJES’s operating cash flow increases, it can increase the proportion of capital expenditures financed by operating cash flow and decrease the amount funded by share issuance.

Well, at least three questions remain –

1. At what price would I stop being a buyer?

2. At what price would I be a seller?

3. How much of my portfolio am I comfortable with allocating to this one stock?

1. I don’t have an exact answer, but I believe that a P/E of 10, it would cease to be such a screaming value. The stock does carry some risk – perhaps regulations, but more likely the ceasing of the trend, caused by decreasing oil prices (a resolution to the Iran crisis, Saudi Arabia flooding the market, or extensive oil finds outside of CJES’s core areas). The resolution of the Keystone pipeline could provide another risk to this stock, by flooding the United States with new, potentially cheaper, oil.
A P/E of 10 would give a top buying price of $30, which is still 36% higher than today’s price. Wow.

But that is my top purchase price. I get a feeling that buying at any price higher than $25 would not be prudent. If I want to allocate any more of my portfolio to this position, it should be at prices below this. If it so happens that I get a flood of capital after the stock has appreciated, I will have to evaluate the current market at that time – maybe there will be an abundance of great values by that point (i.e. maybe a crash will occur before then).

2. To gauge this, I would normally use the valuation of a current oil service major. But with much of the sector depressed, current valuations of BHI and HAL seem too low to correctly gauge. And SLB and CLB, with P/E’s of 22.6 and 32.9, respectively, are given high valuations because of competitive advantages that I don’t believe are present in CJES.
The growth rate will slow as the company’s installed base increases, at the same time that every other oil service major is increasing their installed base.

3. I would be comfortable below a max allocation of 50%. Anything more would be too much in one basket.

So that is an analysis of two of my holdings. Since CJES is below my stop-buying price, and provides significant upside from here, I am going to stick with it, and move over some funds from the hot CLB.

But what about the rest of my holdings? I want to make my allocation to CJES much closer to 50% than it is currently. I will have to do a follow up post on some other stocks that look less compelling that I am holding.

CJES – A Play on North American Unconventional Resource Exploration

Overview

In combing through the IPO filings this year, I came across an interesting company that looks significantly undervalued: C&J Energy Services (CJES). This is an oil and gas services company that specializes in hydraulic fracturing, pressure pumping, and coiled tubing services, all of which are experiencing massive demand currently because of the interest in service intensive North American shale plays. For more information on why these services are in demand now, click here: http://www.pttc.org/aapg/lafollette.pdf

About a year ago, it was near impossible for E&P companies to get someone to fracture new wells in certain high demand plays like the Haynesville in Louisiana. But now, oil services companies are ramping up the available horsepower in their hydraulic fracturing fleets. This is spelling big growth numbers for the major players.

CJES attracted me because of its Trailing P/E of ~10, and its forward P/E of ~5. Further, it is trading at 42% below its IPO price, suggesting that it is well below proper valuation. I believe this is due to a mix of factors: the markets decreased demand for IPOs (almost all of which are down sharply), the recent downgrading of several onshore oil and gas service companies on concerns over the capital expenditure budgets of the major producers, and the recent drop in oil and natural gas prices. I think that all IPOs should not be traded similarly, so this cause is moot, the concern over capital expenditures is overdone, and oil prices have recovered substantially from their recent lows. The low natural gas prices are a cause for concern, but perhaps not as large as the market assumes. More on this in following paragraphs.

Business description

CJES has “fracking” fleets and coiled tubing units in the following areas: the Haynesville, the Eagle Ford, the Permian Basin, and the Granite Wash. Currently they have 172,000 horsepower available in 5 fracking fleets. They will get 2 more fleets in 2012, providing them with a total of 7 fleets and 270,000 horsepower. This is a 57% growth in available horsepower, and, if demand is sustained, should translate into large revenue growth numbers. CJES can adapt its fracking fleets to conventional, vertical wells, or unconventional, horizontal wells, utilizing one fracking fleet to handle either one horizontal well or two vertical wells at a time. This gives it greater flexibility in case the interest in horizontal drilling decreases, and greater utilization in areas where vertical drilling is used more, like the Permian Basin.

CJES also has 15 coiled tubing units, and 26 pressure pumps.

Since becoming public, their net profit margin is approaching the level that I really like: 20%. Of course, this is a very cyclic industry, depending on the forecast pricing for oil and gas. The financial strength of this company depends on the capital expenditure budgets of CJES’s major customers, which include: EOG Resources, EXCO Resources, Anadarko Petroleum, Plains Exploration, Penn Virginia, Petrohawk, El Paso, Apache and Chesapeake, along with some smaller players.

Risks

There are several major risks I see. One is that if all the major suppliers of hydraulic fracturing services are ramping up their fleets, we could actually run into a glut of supply in the next few years. To acquire the two new fracking fleets, CJES had to issue significant amounts of debt, and without revenue growth from those fleets, CJES will be hard-pressed to pay that off.
The new fracking fleets were not the only reason CJES issued new debt. CJES recently acquired Total, the manufacturer of almost all of CJES’s hydraulic fracturing pumps. This could be a great thing – the vertical integration can help reduce costs, increase maintenance efficiency, and provide opportunities for new growth in research and development of hydraulic pumping technology.  However, if demand falls, or if a supply glut is reached, this only means more debt that CJES is saddled with.

Demand for natural gas drilling is probably not sustainable with natural gas prices below $4. And, as you can see, the trend is clearly down:

These low natural gas prices are caused by over-production of natural gas from unconventional plays. I will write more on this situation in a later post.

However, CJES’s management has been shrewd enough to focus on liquids rich plays; three out of the four areas they are in are liquids rich: the Granite Wash, the Permian Basin, and the Eagle Ford. The demand for liquids is still high, because it is linked to oil prices, not gas prices. And with WTI prices creeping above $90 once again, this demand should be sustained for a while.

Conclusion

Unless the supply of fracking fleets and coiled tubing units outpaces the rising demand, I believe CJES will be able to pay down all its debt, and grow its earnings at phenomenal rates. This could be a huge gainer.

Disclosure: I have no position in any stock mentioned, but I may purchase a position in CJES in the next 7 days.