What About Those Recessions? (From STOR's 4Q18 Call)

I bought STORE Capital back in mid-2017, right after news came out that Berkshire/Ted Weschler bought it. I remember reading the news at 10pm that night and got so excited that I jumped out of bed, stayed up all night researching, just in time to put in a buy order the next morning.

Since then STOR has provided good returns. More than that, I learned quite a bit about the real estate business by following a good management team.

The 4Q18 earning call was educational. You know one of these moments of mental clarity, when some one says something that (you thought) you knew all along, yet a light bulb just goes off in your head? It's one of those.

I had been thinking about cycles quite a bit, and STOR's CEO Chris Volk says this:

"So the first thing I would talk about is cycle, the notion of cycle, and this gets - a lot of analysts focus on the expansion cycle that this economy has been in for a long period of time and...somehow we must be getting near the end of the cycle..."

"...I think that this economy can grow at 2% to 3% at a margin, but inside of that 2%, 3% there's plenty of recession activity that's happening."

"...So if you were working for Sears Roebuck you might have thought you were in a recession, if you are working for Radio Shack you would have thought there was a recession.

Payless shoes I mean any one of the 9,000 retailers price closed toward and you would have felt pretty bad, right. A fewer in the oil industry, as oil prices plummeted in the Dakotas and elsewhere. And you are located in one of those states, you were thought there was a recession. 

So inside of that 2% to 3% growth there is a lot of kind of creative destruction that's happening that's buried in that."

Duh! Of course!

Instead of waiting/worrying about a big recession all the time, we're better off recognizing that mini "recessions" by sectors have always been with us. Its called creative destruction.

Sometimes real insight is simple and elegant, and right in front of you.

I'm not sure I can add much more without sounding banal. So I'll stop here.

Zillow's Endgame

Summary of my thoughts on Zillow ($Z, $ZG) and Redfin ($RDFN) as follows:

First, the real value of Zillow Offers is mostly about expanding target addressable market through adjacencies. Zillow is also positioning itself more at the center of transactions.

Second, I assess the threat that Redfin compresses the size of the commissions market, and there by hurting both companies.

Third, I think what's happening is Zillow is abiding its time. It's letting Redfin blaze the trail in disrupting the real estate market, but can eventually shift to Redfin’s model.


Quick Reminder of Business Model Differences 
• Zillow: Attracts buyer and seller to its website. Agents pay Zillow to advertise their services.
• Redfin: Home seller and buyers hire Redfin directly. Sellers pay Redfin 1-2% fee. Agents are employees of Redfin.


Zillow’s Upside – TAM expansion and Subtle Role Shift

Traditionally, Zillow’s Premier Agent serves as advertising for buyer’s agents.

With the Zillow Offers (their iBuyer offer), they now can expand to seller/listing agents. The idea is Zillow shows a low ball offer to the seller, and says “by the way, these listing agents here can help you get much higher prices, why don't we connect you?”

This doubles Zillow’s target addressable market. I think possibly more. Since listing agencies are more valuable jobs than buyer agencies, Zillow might be able to extract more value. (Listing agents are guaranteed to get his 3% commission, as long as the house gets sold. Buyer’s agents might pitch several houses to clients and end up getting nothing. Which job would you prefer?)

Zillow Offers also provides more opportunity to push the company’s mortgage offerings.

Not only did Zillow double its TAM, it’s also subtly shifting its role with consumers and agents.

On the sell side, the "Zillow Offers to seller leads" strategy let Zillow deal with home sellers before they get a listing agent, not after. On the buy side, Premier Agent 4.0+ includes lead qualification. Again, Zillow interacts more directly with consumers before handing off the job to agents.

By creating more touch points with consumers, Zillow is positioning itself to displace agents at the center of transactions.

Will Redfin Destroy Zillow and Itself?

Now let’s take a step back. At least for now, Zillow basically monetizes by taking a cut of agent’s commission pool via advertising and lead generation. So for seller listing, if seller agents make 3% commission, Zillow might be able to take 0.5-1% by providing leads.

The problem is Redfin compresses the size of the pie with their low fees. It's a big risk for Zillow. How can Zillow charge 1% for leads when seller agent only makes 1%?  They can’t.

Keep in mind Redfin is bleeding cash at these prices, yet they keep on doing it. In fact, they’re ready to ramp up advertising about the 1% fee service.

This looks like a lose/lose situation. Redfin can end up compressing industry commissions to the point where Zillow, Redfin, and traditional brokerages all get hurt, while home buyers and sellers benefits.

But How Far can Redfin Go? 

There's a limit to Redfin's creative destruction though.

First, Redfin’s price is not really 1%. That 1% is their basic listing service. They have a more complete Concierge service that charges 2%. And that’s just for seller agents. If buyers have their own buyer’s agent, they get paid commissions as well.

So at the end maybe Redfin gets the total commission down to say 3%-4%. It’s not going to be zero. That’s still a huge cut percentage wise (20-50%) from the current 5-6% commission, but there’s a floor some where.

Second, unlike Zillow, Redfin is bleeding cash. They’re pushing a low cost strategy, but don’t really have the balance sheet to do it. How much lower can Redfin go? How long can they keep this up? How much longer can they convince investors to fund this strategy?

Investors are willing to fund loss making, cash flow negative companies because of growth and operating leverage. But operating leverage here is limited, because unlike a pure software company, Redfin’s costs are not truly fixed.

Each agent can only handle so many customers before Redfin has to hire another agent. Redfin's limited ability to scale will eventually make it hard for Redfin to fund their low cost strategy.

I think Redfin is in land grab mode right now, but any pricing pressure they exert on the industry (and Zillow by extension) will take time, and that pressure will eventually let up.

Online Platform Gains Leverage Over Agents

So it would seem that Redfin’s low cost push has a limit, perhaps say cutting industry commission to 3-4% of sales price.

Price cuts are only part of Redfin’s disruptive strategy though.

Just as importantly, it’s shifting the way people buy and sell homes. Instead of going to individual agents, and let them hash out deals with other agents, people use an online platform like Redfin and Zillow to not just get a price estimate, but also directly sell their homes, or let the platform assign an agent to them.

The online platforms, Redfin and Zillow, then become the center of the transaction, instead of a collection of agents.

The subordination of individual agents to online platforms is already under way. Redfin obviously already does this by interfacing directly with home sellers, with agents being mere interchangeable employees. As I mentioned earlier, Zillow is making a similar move with their seller leads business and Premier Agent 4.0+.

The explosion of the iBuyer model, by quickly providing sellers a “quote”, should further position online Platforms as the center of home sales transactions, away from agents.


Alternative Ending - Both Redfin and Zillow Wins 

This increased leverage over agents increases the likelihood that Zillow can further shift their monetization model in the future.

If Zillow can take control of seller listings, lead qualification, and decide which listing agents to connect with sellers, the next logical step would be just to hire those agents as employees.

That puts them not very far from Redfin's model.

The exact route of Zillow's shift will vary, but it's happening.

Redfin is at the forefront of industry disruption, but they do it in an unsustainable way. At the same time, Redfin's success helps Zillow’s hidden agenda – which is increasing platform power over agents.

Redfin is blazing the trail by burning cash. Zillow is following behind, abiding their time with a revenue model that leads to positive cash flows.

When the time comes, Zillow’s monetization model can converge to that of Redfins, and they settle at a 3-4% total commission while taking a much larger market share.

Thoughts on Cycles

Update 2/12/2019
In my original post below, I talked about the concept that fraud is cyclical. It turns out there are words for it - the "bezzle" and "net psychic wealth" - coined by John Kenneth Galbraith. He explains it much more elegantly than I can:

“Weeks, months or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s business and banks. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.” 

- John Kenneth Galbraith

So the "fraud is cyclical" thing is certainly not any unique insight of mine. In my post, I further distinguish between frauds perpetrated by management, frauds unknown to management, and unintentionally inflated results from murky data.



Original Post (1/19/2019)
I recently read Howard Mark’s “Mastering the Market Cycle”. It was particularly interesting to see how he reconciles common value investing believes like “can’t time the market”, “ignore the macro”, and so on with more acceptable topics like “where are we in the cycle”. I had always thought the differences are little more than semantics, but Howard Mark pointed out some subtle differences that I had not thought of.

Reading the book also had me thinking through cycles some more. Here are just some thoughts that I will elaborate in this post.

• Why credit cycles do die of old age, and how lack of new borrowings alone would lead to recession. 
• Instead of looking at asset prices and judge whether they are rich or cheap, look at capital provider’s behaviors. Are deals getting done at ridiculous terms? 
• Thoughts on inflated earnings. While most investors are well aware of natural cyclicality, what’s less well understood are various degrees of fraud and “pushing the envelope” behaviors. 

Why Cycles Do Die of Old Age

Bull markets die with the end of credit cycles, which die of old age.

Over the past 30 years debt to GDP ratio throughout the world has ballooned, meaning new borrowings drive an ever bigger share of spending.

Whenever someone take out a mortgage to build a new home - that stimulates the economy. You take out an auto loan to buy a new car, that stimulate the economy.

But how many mortgages and auto loans can I take on? How many houses and cars can you buy? TVs? If you just bought a new house this year, chances are you’re not about to buy another one next year. Not when you’re up to your neck in debt.

As time goes on we approach some natural limit on indebtedness, and new borrowing activity decreases. Instead of borrowing, we have to pay down debt. That means less spending in the economy, and less spending means less jobs are needed.

This may not be obvious to some – less borrowing and/or paying down debt may be prudent, but it causes the economy to contract.

So thus credit cycles do die of old age, and with that, spending and the associated bull markets die of old age.


Look at What Investors Do, Not What They Say. Oversupply of capital

Here’s maybe the most useful thing I learned from Mark’s book – in judging where we are in the cycle, it’s much better to judge investor behavior rather than asset valuation, or even investor sentiment as expressed through media.

Asset valuation is inevitably subjective (7x PE looks cheap but is that peak earning or not? Depends on if you think if a recession is coming soon right?).

Investor sentiment and news flow can also be misleading. News headlines and Twitter can be flooded with panicky takes, but if VC deals are still getting done at 20x revenue then it’s hard to say the market is in capitulation mode.

Much more reliable are investor actions, as expressed through lending terms, M&A terms, IPO terms.

What does this all mean for us now (December 2018)? The U.S. stock market has taken a beating; news flows are undoubtedly bearish (trade wars! Government shut downs!) And we have cyclicals like Goldman Sachs trading at 7x PE. Are we near bottom of the cycle? I would say hardly.

Masayoshi/Softbank’s Vision Fund is buying anything and everything with Saudi money. Companies are still doing large buybacks. Consumer staples are getting into marijuana space at high valuations. Amazon is still expanding into new industries everyday. These are not signs of capitulation.

Intuitively, ease of financing also implies lowers barriers to entry, excess capacity, and crowded competition in the underlying industries. This “creative destruction” is not good for investors.


Frauds (and false profits) are Also Cyclical

I think frauds are important triggers of financial crisis because the “you think you have money, but suddenly you don’t” effect triggers panics and sudden liquidity demands.

It’s no coincidence that scandals like Enron and Madoff get uncovered at end of the cycle. For one, eroding asset values force investors to take a cold hard look at their portfolio, and there frauds are uncovered. Second, the unveiling of fraud alert the market to huge losses, which leads to a more skeptical market and even more unveiling of frauds.

Frauds are cyclical. They may be discovered only after the fact, but some portion of an economy’s output will always be from questionable behaviors. More at top of cycle, less at bottom of cycle; less frequently discovered at the top, more uncovered near the bottom. 

Frauds may have nothing to do with management’s integrity. Frauds can take place while senior managers are blissfully unaware, or even explicitly forbids it. The Wells Fargo scandal from a few years back - where low level branch employees create fake client accounts to meet aggressive sales goals – is an example.

As the economy expands and firms fight for market share, the pressure to improve performance naturally incentivizes all sorts of fraudulent or “push the envelope” behavior that inflates revenues.

Nor does inflated revenue and data need to come from intentional fraud. Ellen Pao’s “it’s all fake” tweet has an interesting discussion here.

It's all true: Everything is fake. Also mobile user counts are fake. No one has figured out how to count logged-out mobile users, as I learned at reddit. Every time someone switches cell towers, it looks like another user and inflates company user metrics https://t.co/tk1PKuvLL6

— Ellen K. Pao (@ekp) December 27, 2018

Unlogged in devices can create confusion and inflate data. I personally have the experience of inflating advertising metrics recently. I played this videogame where I constantly have to play to level up my avatars. So I quickly learned the common practice of building a macro or bot to “auto-farm”. This game is free to play and depends on advertising revenue. So the company is likely selling overstated user metrics when pitching to advertisers (albeit unknowingly).

Nowadays entire business models are based on advertising revenue, which are based on unreliable user metrics. This inflated revenues and earnings will drop when the cycle ends - and not in a controlled, linear fashion that analysts tend to forecast in their models.

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?