I am sure that many folks also disagreed with the contributors who were bearish for ATP Oil and Gas (ATPAQ.PK), Delta Petroleum (DPTRQ.PK), Patriot Coal (PCXCQ.OB) or Uranium Resources (URRE). However, the performance of these stocks proved that the contributors were correct. The first three firms went broke recently, and Uranium Resources' chart has been very ugly.
I always like checking the reasons of an ugly stock performance or a bankruptcy. In most cases, the reasons for the steep drop are the same: the continuing losses and the rising debt/equity ratio, which means that this ratio is worsening on a quarterly or semi-annually basis. Some companies have also negative operating cash flow, which deteriorates the situation and accelerates the fall.
In these cases, the light at the end of the tunnel is sourced by two things: Either the sector is turning around and the tide lifts all the boats, or the company becomes an acquisition target although the premium is often negligible. If none of these two scenarios happens, substantial troubles will knock the door through severe dilution, additional long term debt and eventually bankruptcy. Although these troubles are always the same, the buyers are often overly optimistic, believing that this time is different.
All this being said, this is a heads-up article that more troubles are coming for the balance sheets of the following companies, which I call hot potatoes:
1) AK Steel Holding Corporation (AKS): I believe that AK Steel Holding is in a very bad position, in comparison to the companies of the steel sector. As I wrote in one of my recent three parts' series, there is an ongoing pipeline revolution that is going to transform North America in 2013-2014. Unfortunately, AK Steel has negligible exposure to this oil pipeline market, in contrast to United States Steel (X), which will benefit much from this investment boom in the North American energy infrastructure, as I explained in another series.
Additionally, AK Steel has to deal with its balance sheet which is not healthy at all. The company has negative equity (deficit) because the debt is bigger than the assets.
The bank debt has been growing the last five quarters, and I do not see any light at the end of the tunnel. Why? Because AK has both continuing losses and negative operating cash flow on a quarterly basis. Actually, the company has been losing money for four years in a row. The top line has been growing since 2009, but obviously this is not enough to cure the situation.
I know that some insiders bought in late November 2012, but this does not convince me to go long the stock. It also surprises me, why the management team is so richly paid although the company is facing severe problems with its balance sheet.
Despite all these negatives, the company has still a market cap of $520 million, which is too high for me.
2) Cobalt International Energy (CIE): This explorer is another hot potato, and I expressed my concerns about its valuation in early January 2013. It was the same article that warned about James River Coal too. Cobalt's stock has dropped more than 10% since then.
I also wrote another article in early December 2012, saying that Cobalt would need a financing because it ran out of cash. The company announced a financing just two days after my words. That financing was actually a debt of $1.4 billion that obviously impacted the debt/equity ratio negatively. The long term debt/equity ratio jumped from 0.07 in Q3 2012 to 0.44 in Q4 2012.
The company has also negative operating cash flows and continuing losses for four years now. Things get worse, when an investor realizes that the company has zero revenue. Nobody also knows when the first revenue will show up, let alone when the first positive operating cash flow will show up. In the meantime, the CapEx will keep eroding the liquidity of the company on a quarterly basis, and Cobalt will most likely have to add more debt or make a dilutive financing to replenish its cash.
From the operational front, the company has mixed results so far in Angola. Apart from the discovery of Cameia, things have not been encouraging in Angola.
Same mixed results come from the company's operations in the Gulf of Mexico (GOM), where the rigs did not encounter commercial hydrocarbons in some cases. Even when Cobalt had successful results in GOM, the company's working interest ranged from 20% to 60% and it was not 100%. It is also worth noting that some insiders unloaded part of their position in early January 2013.
The company still trades well above its book value (PBV=4). To me, what holds the company at the current grossly overvalued levels, is the speculation that Cobalt will find an ample quantity of commercially viable hydrocarbons in Angola and in the Gulf of Mexico. My conservative strategy is: "Please find and confirm the viability of these resources first, and turn the cash flow positive. If so, then I have plenty of time to go long the stock. These proved reserves, if any, will last for many years, won't they?"
3) GMX Resources (GMXR): It was captured in one of my articles in late December 2012. I did not recommend this energy player, despite its short term potential catalysts, but I warned the potential buyers of the company's balance sheet. GMX Resources has dropped from $7 in late December 2012 to $3.1 today.
GMX Resources' stockholder equity has turned negative since Q2 2012, and the long term debt stands at $380 million as of Q3 2012. The company has also continuing losses and negative operating cash flows for the nine months of 2012. I also estimate that revenues for 2012 will decrease by 40% in comparison to 2011. The annual report for 2012 has not been released yet.
This natural gas weighted company has been in a transformational period, and it has been trying to become oilier for 12 months now. This situation has brought the current market cap down to $15 million currently. However, there is likely more pain to come. I also believe a major restructuring is imminent. The company hired a financial advisor few days ago, to explore and evaluate options for its capital needs in 2013.
In my opinion, the company can get some breathing room for its liquidity constraints, if it makes a JV for its Niobrara acreage. It holds 100% WI in 40,000 net acres at the Bear Creek in Wyoming. Although the company has not drilled there yet to de-risk its properties, Bonanza Creek Energy (BCEI) has some promising oily results from the nearby Niobrara acreage. If GMX is lucky, its Niobrara acreage can be oily too.
4) Africa Oil (AOIFF.PK): It was in early December 2012 when I posted an article about Africa Oil, and how overvalued this explorer was at $10.50. I did not short it, but it seems that I must short more often because the stock is at $7.2 today, just three months later. This is a 35% drop.
The company has negative operating cash flows and losses for two years now. The continuing erosion of the company's cash resources resulted in a dilutive placement in December 2012. This is how the company avoided borrowing money, and this is why it does not have any long-term debt currently. However, it does not have any revenue, and eventually the operating cash flow will remain negative in 2013. Despite all this, Africa Oil trades at PBV=3.
The latest news also confirmed my belief that the positive operating cash flow is years away. The elections in Kenya carries a significant potential for instability. The current period through the elections is rocky and volatile, and the outcome can even cause a trade embargo.
Additionally, the commercial production is finally slated for 2017 in the neighboring Uganda, after being delayed almost a decade by rows over tax and infrastructure projects. Kenya also needs significant infrastructure, taxation and legislative improvement to handle any oil proceeds. Will Kenya avoid such setbacks? On top of that, commercial reserves have not been proven yet in Kenya.
From an operational front, the results from the company's core wells are mixed. Ngamia-1 and Twinga-1 wells found oil, but the initial shows from Paipai-1 do not look very encouraging. However, the final results from Paipai-1 have not been released yet, and they will be out during the next weeks.
5) Capstone Turbine Corporation (CPST): This manufacturer of microturbine energy systems has been losing money for four years now, despite the fact that the top line has been growing since 2009, and the gross profit has also been improving lately. However, the operating cash flow remains negative for many quarters.
The company does not have long-term debt, but is this enough to keep the company afloat for long? I think no, because the company's continuing losses reduce the stockholder equity gradually, and Capstone will have either to dilute or borrow money.
I also want to see an improvement at the accounts receivable, which have been holding steady with a slightly increasing trend lately. This is why I am not convinced why I have to pay such a huge premium (PBV=6) to buy Capstone currently.
I use the debt-to-equity ratio to identify the amount of leverage utilized by a specific company. The higher the leverage becomes, the riskier the companies are. If I add the continuing losses and the negative operating cash flows, the problem gets even worse often leading to troubles. This is why, I suggest the potential buyers to be very cautious, if they invest in the aforementioned companies at the current levels. I told you so.