12/30/2018 Views- Not Particularly Cheap

I did almost no trading in December, and very little in November. On 10/28/2018 I wrote: “Now that I'm sitting on more cash and bonds than I have stocks, I'm almost cheering when the market goes down“. I still feel the same today. 

The problem is even after the market down turn, most stock valuations are only fairly valued if you assumes no recession in the next 3 years or so.

For example I am considering buying Goldman Sachs, which trades at about $160. Using consensus 2019 EPS, this trades under 7x earnings. Neither does that EPS look particular peakish. Over the past 10 years pretax profit actually held fairly steady, and the explosive EPS gains mostly came from lower tax rate and much lower share count.

So is GS cheap or what? The problem is about 20% of their revenue comes from the “Investment and Lending” segment, with the majority of that being gains from equity securities. In fact, from 2015-2017, this segment contributed 28% of GS’s pretax earnings! 

In estimating a conservative “normalized” earnings, I assumed 0 on those equity gains, and $160 stock price would represent under 12x P/E. This is a good valuation, but not a huge bargain for a highly leveraged, cyclical company prone to political attacks.

In a down cycle, that Investment & Lending “revenue” might not just be zero, it could be negative. Then this $160 price tag might be outright expensive.

Portfolio Positioning and Asset Allocation
Given my inaction, my stock exposure will likely maintain at the current level of 40-50% of liquid portfolio (basically my entire net worth minus home equities). I'm open to more if I see truly compelling value.

The 40-50% equity level is really more about how much cash I want, and less about how much equity exposure. As a full time individual investor, I don’t have regular income and have always maintained plenty of cash reserves. I also wanted to maintain plenty of “dry powder” to go in big in case there’s a recession.

I'd like to think the 40-50% allocation to equities implies a neutral view regarding the stock market. If stocks goes up I would have more than half of my portfolio invested, “net bullish” if you will. If stock goes down I will have ever decreasing exposure while keeping my dry powder high.

Wow That Was Rough! (BCEI, Continued)

Everything about Bonanza Creek Energy (BCEI) played out differently from what I expected.

I expected both Colorado Propositions 112 (ban fracking) and Amendment 74 (just compensation) to pass. They both failed.

I expected BCEI and HPR stocks to pop after the fracking ban was defeated. So I loaded up on them pre-market. I bought BCEI at $32.5. HPR I bought at $5.4.

HPR is just play money. But BCEI is a big position. I didn’t buy BCEI to make 20% or 40%. I bought because I think this could be a double or even triple. The removal of an existential risk in Prop112 prompted me to go big.

I chose to ignore the obviously weak price action in WTI oil prices. That was a mistake. Oil prices accelerated downward the past few days, and it’s broken some key support levels. Someone commented today that it’s the longest losing streak in history.

It's official. Crude Oil closed lower for the 10th day in a row, the longest streak in history. Down 23% in the past month, giving back all of its gains on the year. $WTIC pic.twitter.com/2Q8lj3r72h

— Charlie Bilello (@charliebilello) November 9, 2018

So instead of the pop I was looking for, both stocks got faded right after I bought, and now I’m sitting on big losses. After what I bought this week, and even after the price drop, BCEI is almost 7% of my portfolio.


Wow, that was rough.


I’m always hesitant to say the market is wrong, but the market seems a bit confused. These E&P stock tend to move with WTI futures on a day to day basis. But most hedge their productions for the next year or two. So what really matters is how much BCEI can sell their oil for, over the next 10 years or so (which is about the length of their reserve life).

So oil stocks should move relative to long dated oil futures, not spot prices – and WTI futures for 3 years out actually have not moved that much.


Floor Value and Calculations

At $27.9/share now, BCEI has a market cap of ~$580mm. Let’s do some rough calculation of floor value. We’ll assume liquidation.

Assume WTI averages out to $50/bbl for the next decade, knock back $6-7/bbl for location discount, you get ~$43/bbl for realized oil prices. Take into account non-oil products, BCEI can probably still fetch total realized price of $30/bbl, across all products. Operating cost (lease operating expense, midstream cost, taxes and G&A) are declining and can get to ~$15/boe. That would leave $15/boe of EBITDAX.

BCEI could ramp to 10mmBoe of production by 2020. That’s $150mm a year of EBITDAX. They’ll probably have still over 80 mmBoe of reserves, so call it 8 years of reserve live. This means total liquidation cash flows would be $150mm*8 = $1.2bn. You’ll want to discount that stream of cash flow, but the result is sure to be more than $570mm.

Let’s look at it another way. What WTI prices are BCEI stock prices implying? i.e. do the above calculation backwards. Shown below is my back of the envelope calculation. I believe that at <$28/share, BCEI’s stock price implies longer term WTI of about $40-$45/bbl.

Elsewhere in my portfolio

Bojangle (BOJA) got a buyout bid for ~$16/share. Basically $0 premium. As I bought it around $13 this is at least profitable. Still, as I tweeted out, it was very disappointing.

very disappointed in $BOJA sale. The company has options: strong brand name, strong balance sheet, possibility to go capital light by turning company stores into franchises...Time is on their side!! and board gives away those upside options for no premium!

— mspacey (@mspacey4415) November 7, 2018

This is all pretty demoralizing. Investment just hasn’t worked out this year. I’m now losing money. At least it's just my own money. I'm glad I'm not managing someone else's.

What I’m Still Holding and Why

In light of recent market moves, I went through my portfolio and gave myself a quick reminder of why I still hold some of these stocks. 

I took a hit in early August, during 2Q18 earnings. Since nothing I did was working, I had to cut exposure. The upshot of that incompetence is that I reduced my portfolio even before the latest market downturn. Then I cut more in early October. 

Now that I'm sitting on more cash & bonds than I have stocks, I'm almost cheering when the market goes down. 

I still have the below stocks though and I don't plan to sell them. If a year from now I might be proven as a bag holder, at least I can look back and understand why. Here they are.

FNF @ $32.5 

I wrote about FNF here and here. This is my biggest position at about 3.5%. The stock got crushed the past month due to market wide concerns about housing. I thought FNF actually held up relatively well despite the housing carnage (compared to say, homebuilders)

My views on housing remain the same – short and intermediate term cautious and long term bullish. In the intermediate term (within 3 years), we have an demand issue driven by lack of affordability, and housing prices have to come down.

However, the long term view is decidedly bullish, due to demographic tale winds I have outlined here. And I do think at <$33 a share (low teens PE), this is cheap enough for me to hold long term. 

Recent events:

• FNF just reported 3Q18 results. Open orders were down -9% yoy, and showed worsening trends each month throughout the quarter. Most of the damage is on the refi side though, which does not contribute that much to margins, so overall pretax profit actually went up. 
• The Stewart acquisition is scheduled to close 1H19. The housing market will probably still be in a slump at that time. This may not be a bad thing, as FNF will have plenty of opportunity to cut cost and bring STC’s margin up to FNF’s level. 
• Within a year, they will be able to offset the shares issued in the transaction through share repurchases. 
• FNF generated $320mm of cash flow from operations in 3Q18 alone, annualizing to over $1bn of cash flows from ops. That compares very well with market cap a little over $9bn. Mind you this is a business that does not require a ton of capex. Oh, and they pay nice dividend.

Bonanza Creek Energy (BCEI) @ 29

When I wrote about BCEI last time, I was aware of an initiative to effectively ban fracking in Colorado, but did not think that will gain traction. Unfortunately it did and now it's on the November ballot.

Here's the situation. There are 2 related items on the ballot - Proposition 112 (which effectively bans fracking) and Amendment 74 (which calls for just compensation if government actions hurt property value). 

What kind of probabilities and scenarios are we looking at? The latest poll numbers I read suggest both will pass. Both measures have found great support (Proposition 112 leader 52%, while Amendment 74 leading with 63% support). The 2 have different threshold though. Proposition 112 only needs 50%, while Amendment 74 needs 55% of votes to pass.

Given the above information, I would put the probability of passing each at 80%. So:

• 64% chance that both measures pass (and effectively put BCEI in liquidation), 
• 20% chance they don't pass Prop 112 and BCEI shares pop, and 
• 16% chance that Prop 112 passes, but Amendment 74 fails. This would mean banning fracking without compensation, and BCEI shares collapse.

The base case then, is a sort of liquidation scenario for BCEI - no more new projects, but grandfather existing wells, and compensate them for property value damages. 

In that situation what is BCEI worth? Well if they get compensated on property value damages, then it's just worth the PV10 value right? That number is about $37/share. It's going to be more because the PV10 was done with $56 WTI, and now that WTI is around $67.

So I'm not selling this at below $30/share. I also think that between the upside scenario (no fracking ban) and downside scenario (ban without compensation), there's a higher chance for the former. 

I did switched some of my stocks to call options to manage the risk.

ASML @$158
ASML is the undisputed leader in EUV technology. If you’re too lazy to google, EUV is the most cutting edge semiconductor production process, needed as chips get smaller and smaller.

Here again, like FNF, I am medium term cautious but long term bullish.

Stock has been hit by general semiconductor sector meltdowns, as well as company specific factors. 

In the latest transcript, you can tell analysts are worried about the number of EUV units they might ship in 2020. Management guided to 40 units but they are saying that’s their estimate of capacity, which is not quite the same as customer demand. They also pointed out that “customers are not planning systems, they're planning wafers” – meaning as ASML’s machines get more productive, customers don’t have to buy as many machines. 

So I think 2020 estimates could be in danger.

But is the ASML bull case really about 2020 targets? I do not think so. I think it’s about ASML not only having a sole supplier position in EUV, but also showing success in the next generation product, high N.A. EUV.

Put another way, ASML will likely have a monopoly position through 2025 or even 2030, in the most cutting edge of semiconductor technology, and in the context of U.S. and China having a technology arms race.

Now that is a very enviable position. The company has net cash position so the question is not survival, but magnitude of success. 

The Others

• Digital Realty (DLR) and STORE Capital (STOR). I still have 2 REIT stocks. DLR owns data centers and STOR does triple net retail leases – I wrote about them here and here.

• Alibaba (BABA) @ $145 and Tencent (700.HK) @ HKD 270. Ugh.. as owners of these 2 stocks that practically goes down everyday, it's been absolutely brutal. And now they’re actually cheap relative to growth potential, with lots of unmonetized assets. BABA’s for example, hasn’t even started monetizing its cloud infrastructure business, its entertainment business…etc. 

• Google (GOOGL) @1150. I thought about cutting out on this one to protect my profit, but it’s now a 1% position that I’m just going to hold. Advertising is undoubtedly cyclical, and AMZN is encroaching on Google and Facebook’s duopoly there. Yet I take comfort that the technological expertise that Google owns will allow it to thrive beyond the current cycle.

• Quotient (QTNT). This is been a wild and frustrating ride, but I'm still in it. 

• Arena Pharma (ARNA). Biopharma companies have just about the least macroeconomic exposure of all sectors, and I like this one.

• CVS and UnitedHealth (UNH). I’ve held these for years. UNH is best of breed, and I believe the CVS/Aetna combination could challenge UNH for that status. 

• Bojangles (BOJA).  A legendary friend chicken brand, a conservative management that keeps leverage under control, and decent valuation. I like it. 

• P&G (PG) – I’ve had this for a while. 

I also have a bunch of tiny positions that are about 0.5% each. Collectively they add up to about 10% of my portfolio. It’s a bit of throw everything at the wall and see what sticks – I’ve got momo stocks like Amazon to some illiquid microcaps. There are a lot of unrealized losses here due to my habit of not exiting losing positions cleanly but retain a foothold for monitoring purposes. I’m not sure that’s a bad habit. 

Bonanza Creek Energy can Double or More

Let's try a new format today. I will start with a recent tweet of mine as a 10 second thesis/elevator pitch, then use the blog to flesh out more details.

$BCEI looks interesting. post-bankruptcy oil & gas co ramping production. could see $10-15 EBITDAX/share by 2019/2020. With current price of $36 this could double or triple. PV10 of proven reserves alone worth $37/share

— mspacey (@mspacey4415) June 28, 2018

Bonanza (BCEI) is a small E&P based in Colorado, its main asset is 67,000 net acres in the Wattenberg field. There's a Seeking Alpha article here that provides a great overview.

Bonanza went bankrupt in Jan 2017 and emerged late April 2017, which explains the nasty long term chart. But the process also gave them a clean balance sheet. After wiping out one billion of debt, BCEI now has ~$6mm of cash and $15mm of debt.

With its strong balance sheet, the company plans to ramp production aggressively.

Upside: 2-3x

Here's a quick calculation that shows the stock can double or even triple. Stock was at $36 at time of tweet.

Management is guiding to ~18.2 MBoe per day of production in 2018 and 50% growth on top of that exiting 2019. This implies 4Q19 production rate of more than 27 Mboe/d, and annualizes to about 10mm barrels of oil equivalent (mmBoe).

Unit production cost is about $20 a barrel (excluding D&A and exploration costs). Realized price was about $42.5 per barrel in 1Q18. This works out to EBITDAX of ~$22.5 per barrel. WTI oil prices have gone up and unit costs will come down as they achieve scale, so let's call it $20-25 of profit per barrel.

With 10 mmBoe production for 2020, that's $200-250mm EBITDAX. Using 20.5mm shares, we're looking at $10-$12 of EBITDAX per share, maybe more.

Consider stock trades around $36-$38 range, this is plenty cheap! I would not be surprised if stock goes above $100.

The bankruptcy history probably turned away a lot of investors, hurt liquidity and analyst coverage. The latest conference call had 2 analysts asking questions. As earning power gradually resurfaces and new CEO establish credibility, analyst coverage could ramp up, and all the sudden you have value, growth, momentum investors all chasing a relatively thin 20.5mm shares. Anyways that's my upside case.

Why now? Here's a potential catalyst (from the latest presentation): "Company will turn online its first eight appraisal wells in its French Lake acreage by midyear; positive results from these wells could unlock significant inventory." Anytime now...

Here's another potential catalyst - Bonanza can sell its non-Wattenberg assets which are less productive and use that to fund Wattenberg developments.

Any Downside??
Ok so there's a ton of upside, but what's the downside? Arguably none!! PV10 of reserves is worth $37/share, and that's with $56 WTI! Bonanza also has a midstream asset (Rocky Mountain Infrastructure) that the company values at $103mm, or ~another $5/share.

Of course, that PV10 can swing wildly with oil prices, but as long as oil prices stay above $60 they will be more than fine.

About that failed SandRidge Deal, and SRC's recent purchase of Wattenberg acreage

Back in November and December 2017, Bonanza agreed to be acquired by SandRidge for $36/share, only for its top shareholders FirTree and Icahn, to kill the deal. The main reasons were 1) SandRidge was so cheap itself that the transaction would have been dilutive, 2) no clear synergies, 3) the merger was such a huge departure to SD's plans post bankruptcy that it came as a shock.

FirTree mentioned that Bonanza's DJ Basin assets are Tier II in quality and seemed to think SD's North Park assets are much better. Now, I'm no geologist, but just from googling around, I actually get the sense that North Park assets were inferior to Bonanza's DJ Basin assets. Bonanza itself clearly has no appetite for the North Park basin, as it dumped its acreages there in March 2018 for almost nothing in return.

While we're talking about attractiveness of land positions, there's a nice data point from SRC Energy's purchase of DJ Basin positions back in December 2017.

Here's the press release: SRC Energy Significantly Expands Core Greeley Crescent Development Area Through Strategic Acreage Acquisition

Greeley Crescent is not that far from Bonanza's fields. From what I can find this is around location 5N 67W.  Bonanza's fields are around locations like "5N 62W", "6N 61W"...etc. (p8 of presentation here)

SRC Energy bought ~30,000 acres for ~$570mm, or almost $19k per acre, this compares to Bonanza currently being valued at less than $12k per acre. 

Notes

• Does it make sense that the company could trade much above PV10 of $37? I think so. The company estimates "all-in finding and development cost of $7.46 per boe". If they can create reserves at $7.5/boe and monetize that at $20-25 per barrel (as shown above), that sounds like good value creation to me!
• For context, Whiting Petroleum also operate in the Rockies and their enterprise value is almost double their PV10 reserve value.
• As a sanity check, in 2017 Bonanza added 15.5 mmBoe to their reserves with $110mm in capex, so the $7.46/boe F&D cost looks reasonable to me.
• Now, they will have to take on debt to implement capex, but that's just for 2018 and 2019, as they become cash flow break even by end of 2019. Management estimate of 2018 year end leverage will be 0.5x debt/EBITDAX. I estimate year end 2019 debt level of ~1.5x EBITDAX. But in any case debt should be well contained.
• Given SandRidge's (failed) offer of $36/share back in November 2017, I would have expected the stock to hit resistance around $36 area. Sure enough, the stock topped out around $35-37 range in May, then went down below $32. Only in the past couple days did the stock seem to get past that resistance. Are we leaving the past behind and moving into a new chapter in the Bonanza story?

The Choreographed Trade War

The list is out.  So China will put tariffs on American fruit, wine, and pork.

Clearly, China is showing some real restraint here. If they really wanted to go after agriculture (a major American export), they would have went after corn and soybeans. Instead we have:

• Fruit and wine. These are major California produces. California is clearly on Trump’s shit list, so China is almost doing Trump a favor.
• As for pork, a Chinese company WH Group owns America’s largest exporter in Smithfield. So this is China offering to tax themselves.

It's starting to look like Trump and Xi had some sort of handshake deal, because this is looking very much choreographed. Talk tough, slap some non-punitive tariff on each other, then take some victory laps with political constituents.

Ironically, Emporer Xi’s total grip on power allows him more flexibility to extend concessions in the face of US demands. “Xi for life” is bad for democracy, but so far good for U.S. commercial interest.

If Trump is smart, he will take this olive branch from China, claim victory and call it a day.

The best case for markets is if Trump keeps his strategy of speaking loudly and carrying a small stick. The economy would hum along with little damage.  Meanwhile, the Fed can use this trade war thing as an excuse to get dovish and delay rate hikes.

Notes from 1Q18

I was 100% allocated to stocks coming into 2018, had an ecstatic January, then a crappy February that led me to cut exposure. I continued to cut exposure in March and now sitting on more than 30% cash.

The low volatility regime has decisively ended, which means all sorts of previously overvalued stocks can come down on the slightest negative news. Fundamental based investors need to watch out for value traps! 

Often these negative news are laughable and are just an excuses to sell stocks. The problem is “value investors” have a tendency to confusing these negative news as the actual cause of stock drop, find reasons to say it doesn’t matter (which it doesn’t), then proceed to buy. But often the negative news is just a catalyst for a hibernating bear case to resurface, and NOT the real reason, so these investors are led completely off track.

The Facebook/Cambridge Analytica scandal is one such example. Bulls are attacking a non-existent bear case that people will somehow stop using Facebook. This line of reasoning dominates the market today, and will likely prop up the stock for now. But I do not think that is the reason for the price drop! There are other legit, but dormant bear cases that runs much deeper.  But I will save this for another time..

Some notes on a few stocks I’ve been involved in recently:

Digital Realty Trust (DLR) – bought at around $105/share
Very simple thesis: 1) Positive industry trends, 2) valuation/dividend coverage/leverage all check out fine, and 3) timely technicals

• Positive industry trends. 1) Datacenters have plenty of runway from ever-expanding cloud adoption. 2) The race toward over-the-top video means companies will want their content physically closer to consumer locations, so the Google, Facebook, and Netflix of the world will need the physical proximities that DLR can offer. 3) Edge computing is the future (required by internet of things, autonomous cars, 5G…etc), and again that raises the value of physical proximity to end consumers

• Numbers check out fine. About $18.5bn of market cap versus ~$1bn of cash flows from operations. That CFFO is growing rapidly. $1bn of CFFO easily covers ~700mm of dividends. Debt to EBITDA is high at > 6x , but comparing debt to value of investment properties shows a manageable ~50% loan to value ratio.

• Timely technicals. 10 year U.S. treasury yields got close to 3% resistance and backing off. DLR stock seem to bounce of $100 support level.

Arena Pharmaceuticals (ARNA) – bought around $41.5/share
I bought ARNA right after their March 21st secondary offering. ARNA has market cap of about $2bn, but it has two phase 3 assets that are potentially best in class, targeting multi-billion dollar markets. You really don’t need to be that smart to see this is good risk and reward here.

The 2 drugs are different mechanism targeting different indications. So success probabilities are uncorrelated. Etrasimod is an S1P modulator that is targeting ulcerative colitis, a $4-5bn market. Ralinepag is an IP receptor agonist going for the pulmonary arterial hypertension (PAH) indication, a $10bn market.

Phase 3 trials have about 50% chance of success, so that means only about 25% chance of failing both. I think the distribution of outcomes are follows:

• 50% chance they have 1 indication with peak sales 1-1.5bn; at 3x revenue, this thing is worth 3-4.5bn enterprise value; stock doubles 

• 25% chance that both Etrasimod & Ralinepag scores, then peak sales would be like $2-3bn. Again at 3x EV/revenue this thing is worth 6-9bn. Stock triples or more.

• 25% chance that both fail, so stock trades down to cash value, or down something like 80-90%.. But realistically they still have other early stage pipelines and that’s worth something. 

There’s actually more upside than this. First, another asset, APD-371, has its phase 2 readout coming in 2Q18. If successful we have not two, but THREE phase 3 assets. 

Second, Etrasimod’s real value is that it’s an S1P modulator, which has applications beyond ulcerative colitis. Novartis’ Gilenya and Celgene’s ozanimod are both S1Ps and can be used to treat rheumatoid arthritis, a much bigger market. 

The risk is time to market (will take at least a couple years) and cash burn before we get there. But ARNA just raised a ton of cash so we're somewhat de-risked.


A big loss in Melinta (MLNT), and lessons

I’m taking a big loss here. It was never a big position, but a 55% loss on a ~2% position still hurts.

I bought at about $17.2/share. Originally, my thesis was that at that price, MLNT has ~$500-550mm market cap. They have 4 FDA approved drugs hitting the market, and I estimated $250mm peak sales. So this is a great bargain given established pharma regularly trade at 4-5x EV/revenue.

So what went wrong? 1) too slow to adjust fundamental outlook, 2) failure to see that future fund raises are a form of leverage.

First, I was too slow to adjust my fundamental outlook. I watched happily as MLNT stock collapsed. Small cap biotech/pharma is notoriously volatile, so there’s nothing out of the ordinary. The company has a big pile of cash, so net debt is low, and I’m not worried. “This is the sort of stuff I can double down on!” Management talked about $1bn peak sales, so my $250mm peak sales is quite conservative. I cheered as the stock went down so I can buy more at lower prices.

It’s pure negligence. If I never believed management’s $1bn peak sales numbers, why should I think my much lower estimate is conservative? That's straight up anchoring bias. Only after the latest earning call did I revise my estimates. I dug deeper into competitor revenues and downgraded my estimate of peak sales to $200mm, then $150mm. Now I’m not even so sure about that.

Second, I failed to realize that future fund raises are a form of leverage. I falsely thought of MLNT as a low net debt kind of company, the sort I can double down on. The truth is that MLNT is burning cash, meaning at some point they will need to raise equity or debt. This means MLNT is way more leveraged, and stock valuation is way more sensitive to peak sales than I realized. I underestimated modeling error, and that led to overconfidence and negligence.