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Introduction

Back in early March 2013, I wrote two articles wherein I discussed why I was strongly bearish on ten companies from several sectors of the U.S. and Canadian market. All these bearish recommendations have played out extremely well. In fact, the success was 100%. All those bearish bets dropped lower than their March 2013 levels during the period from April 2013 until December 2013, despite the fact that S&P has risen ~20% since then. My two bearish articles are here and here.

I did not follow the pack and this helped me identify this tsunami of red. I also look for stocks the market has walked past and forgotten about, that have inherent value, but a share price that indicates nobody is looking yet. And when the market catches up, big things happen.

Quick Overview Of My Hypothetical Bearish Portfolio

S&P performance is shown below:


(Click to enlarge)

Now let's check out the performance of those ten stocks, as illustrated at the table below:

Company

March 3-5, 2013

August 2013

Yield 1

December 2013

Yield 2

GMX

Resources (OTCPK:GMXRQ)

$2.53

$0.30

-88%

$0.11

-96%

Cobalt

International

Energy (CIE)

$24.9

$24.9

0

$15.33

-39%

BPZ

Resources (BPZ)

$2.68

$2.26

-16%

$1.60

-40%

Avalon

Rare Metals (AVL)

$1.07

$0.87

-19%

$0.55

-50%

Rare Element

Resources (REE)

$2.13

$2.13

0

$1.31

-38%

Uranium

Energy (UEC)

$2.34

$2.34

0

$1.81

-23%

Africa Oil (OTCPK:AOIFF)

$7.42

$7.07

-5%

$8.52

15%

Capstone

Turbine (CPST)

$0.98

$1.16

19%

$1.24

25%

Bon-Ton

Stores (BONT)

$11.38

$12.68

12%

$18.16

58%

AK Steel

Holding (AKS)

$3.54

$3.4

-4%

$6.17

74%

The table below is also reflecting the excellent performance of that hypothetical portfolio:

March 2013 -

August 2013

March 2013 -

December 2013

Average Yield Per Stock

-14.29%

-12%

So I really regret that I did not short all these ten stocks above, but my cash resources are limited of course. In this article, I update on three of the ten aforementioned stocks. I plan to detail on the remaining ones in my future articles.

Cobalt International Energy has imploded substantially lately because "The King has been swimming naked". AK Steel Holding and The Bon-Ton Stores are also swimming naked, and this is why they are two great short candidates at the current levels, as explained in the next paragraphs.

Cobalt International Energy

Cobalt's story has not convinced me thus far. Cobalt's study case is typical of market psychology. When times are good and money is freely flowing, some E&P stories often start incorporating "risked value" in order to justify their valuations. At times, this risked value can become absurd and some energy plays attain huge market caps on the very possibility that their acreage may hold the next big discovery.

If I wanted to buy a grossly undervalued energy company, I would buy either Chinook Energy (OTC:CNKEF) or Arsenal Energy (OTCPK:AEYIF), or Salamander Energy (OTC:SALDF), to name a few. The reasons that I pick these companies are discussed in my PRO-articles here, here and here.

Cobalt has been capitalizing on so-called Angola's pre-salt formations, due to the fact that some highly publicized campaigns have been saying that Angola's offshore geology mirrors that off Brazil. Thus Angola is considered to have Africa's biggest pre-salt potential, but any prudent investor had better take this with a grain of salt. The market perception and the reality converged finally and Cobalt's stock plummeted recently, as illustrated below:


(Click to enlarge)

Firstly, let's have a quick operational update:

1) The Ardennes #1 exploratory well in the Gulf of Mexico didn't find any commercial hydrocarbons.

2) The commercial development of North Platte is another big unknown. The best case scenario does not show any first oil before 2018-2019, according to the company's presentation.

3) The first oil from Heidelberg field is expected in 2016. However, it must also be pointed out that Cobalt has only 9.75% WI of that field.

4) The first oil from the Shenandoah prospect is expected in 2017 (best case scenario). Cobalt has just 20% WI in that project.

5) Gabon's pre-salt potential is also highly questionable. Diaman #1B well, drilled on the Diaba block in offshore Gabon, was temporarily abandoned pending further technical and commercial analysis.

6) The first oil from Cameia-1 (Block 21, offshore Angola, 40% WI) is expected in 2017, assuming an FPSO is developed and installed in a timely manner. The alignment with Cobalt's partners and Sonangol is a prerequisite on this project. Meanwhile, the testing of Cameia-2 was disappointing as no commercial hydrocarbons were found.

7) Do not also hold your breath with the Lontra-1 well and the Mavinga-1 well. On Block 20, the Lontra #1 well was heavily natural gas weighted (~60% natural gas) and the problem is that Cobalt cannot market gas under the existing Angola's production-sharing agreements. Regarding the Maving-1 well on Block 21, efforts to establish a sustained flow rate from a full drill stem test were not successful. Assuming these two wells get the green light finally, the first oil is not expected before 2018 at best.

After all, Cobalt's slump did not surprise me because all the bubbles implode sooner or later. Despite this slump, Cobalt trades at PBV=2.67 which is still sky high based on the company's discoveries and the time horizon for their development.

As I demonstrated in my linked article above, Cobalt had an irrational valuation, but many folks bit the bait of the company's contingent and prospective resources coupled with some analysts' speculative scenarios.

However, the contingent and prospective resources are a pie in the sky. Moreover, Cobalt's stock was fueled by thin air twice. It was in late 2012 when the first speculative rumors surfaced and pushed the stock from $20 to almost $30. Some analysts and fund managers claimed publicly that Chevron (CVX) would likely acquire Cobalt to face its longest slide in energy output in four years. These folks were trying to guess how Chevron could use its rich cash resources of $21.3 billion.

Cobalt has been burning cash for years and will continue doing so over the coming years based on the company's offshore findings as of today. Spending some billions for companies like Cobalt that burn cash fast and have significantly unproven properties, will be one of the biggest strategic mistakes that Chevron can ever make.

The speculation continued in April 2013, when some other analysts (from Stifel, Global Hunter, Tudor Pickering, Guggenheim etc.) were touting Cobalt's stock at 28$. They claimed that Cobalt was an acquisition target for Shell (RDS.A) (RDS.B), ConocoPhillips (COP) and Exxon Mobil (XOM). However, that speculation was a great gift to the prudent investors who unloaded their shares at those sky high levels.

Where are all these analysts today? This is why I have been always saying that the analysts seldom serve the individual investor. This is the primary reason I started writing for SeekingAlpha last year. Since 2012, I have been trying to help the self-directed individual investor profit from the stock market because he is so confused by many highly paid but incompetent analysts nowadays.

In fact, I strongly believe that if an E&P company acquires Cobalt at the current levels, Cobalt will be the next Red Back Mining of the oil and gas sector. Cobalt's acquisition even at the current price of ~$16 will be for the suitor's CEO as catastrophic as Red Back Mining's acquisition was for Kinross Gold's (KGC) CEO. To help you recall this story, Red Back Mining owned the Tasiast project in Mauritania, the Chirano mine in Ghana, and had exploration projects in both countries. Kinross Gold purchased Red Back for a remarkable $8 billion (including the purchase of the first stake) which was a pretty nice price tag for an asset that Lundin had only put ~$800 million into. That acquisition essentially set the CEO Tye Burt out of Kinross. He was fired in 2012. Red Back Mining was a grossly overvalued company at ~$8 billion, and that was a value-destroying acquisition.

Billionaire John Paulson also bought Cobalt at $28 - $29 last summer, increasing his stake in the company. Apparently, that was another awful call for Paulson after his failures with the gold stocks and the Greek bonds. Paulson's purchases are a good reminder that even the big guys are not perfect and that we should think twice before mindlessly following them. In fact, Paulson's big bets have been the ultimate contrarian indicators during the last years, as I discussed in my article here.

So how will Cobalt fare from now until 2016? Expenditures (excluding changes in working capital) for the quarter ending September 30, 2013 were approximately $290 million and for the nine months ending September 30, 2013 were approximately $671 million. Cobalt's updated 2013 expenditure forecast is $850 to $950 million. Cash, cash equivalents, and investments at the end of the third quarter were approximately $2 billion. This means that the company's liquidity will drop by approximately $300 million by year end.

Since Cobalt does not have any producing properties and the operating cash flows are negative, it will keep burning cash and the new placement will take place by 2015 the latest. I believe that Cobalt does not have funds to carry it well into 2015.

Last but not least, the following facts can help a potential investor realize how irrationally overrated Cobalt's "pre-salt" story is:

1) Harvest Natural Resources (HNR) has been looking to sell its 67% stake in the Dussafu Marine Permit PSC, offshore Gabon. Harvest was in negotiation with Vitol S.A. to sell this stake for $137 million.

Although the deal did not materialize according to the company's latest press release, this deal proposal can be considered as a ball-park estimate of the Dassafu field's value, because the Dassafu license lies in the heart of Gabon's pre-salt play, as shown below:


(Click to enlarge)

Additionally, Dussafu Block in pre-salt offshore Gabon has the following positive developments and characteristics:

A) "2 for 2" exploration successes thanks to Ruche discovery in 2011 and Tortue discovery in 2013.

B) 49 million bbl oil discovered on block (contingent resources).

C) First oil production by mid 2015.

It is apparent that Harvest's pre-salt discoveries offshore Gabon are overall better than Cobalt's discoveries offshore discoveries in Angola and Gabon. Harvest was in negotiation with Vitol S.A. to sell this stake for $137 million, as linked above. This means that the total value of this Block (100% WI) is approximately $200 million.

Meanwhile, Cobalt's current EV is approximately $5.8 billion, after the stock's slump from $30. How many Dussafu-like Blocks does Cobalt own with 100% WI? The potential buyers of Cobalt have to answer this question first, before they buy Cobalt at the current levels of ~$15.5.

2) Alberta Oilsands (OTC:AOSDF) is a Canadian oil and gas company that owns an 85% interest in petroleum exploration "pre-salt" blocks 2712A and 2812A, located in the Orange Basin, offshore Namibia. The Namibia Licenses cover an area of approximately 2.7 million acres. Alberta Oilsands has currently a market cap below $50 million.

3) HRT Participacoes (OTC:HRTPY) targeted recently three wells in the Orange and Walvis Basins, offshore Namibia. The main objective of these wells was to test the resource potential of reservoirs, expected to be equivalent to the Brazil and Angola "pre-salt" reservoirs. None of these three wells found oil in commercial volumes. HRT's market cap is currently well below $50 million.

AK Steel Holding Corporation

After dropping to $2.8 in late April 2013, the stock has risen to $6.17 as of today. How can a company with negative equity, negative operating cash flow, an onerous debt and continuing losses rise from $3 to $6.17?


(Click to enlarge)

Two are the reasons behind this rebound. Momentum and expectations. As everybody knows: "A rising tide lifts all boats". Some firms have made some overly optimistic assumptions about the steel industry, and this is what has pushed AK Steel Holding at the current levels.

AK's recent rise is 100% industry-related. In November 2013, Goldman Sachs raised its rating on the unprofitable companies to buy from sell and said the outlook for the domestic steel industry is improving because of higher demand. Leading steelmakers have also become more optimistic on the outlook for the $500 billion-a-year industry, which is often seen as gauge of economic health. ArcelorMittal said its two-year slump was over and that prospects for 2014 were looking up. Tata Steel said performance in Europe had improved, though challenges remained.

The problem that most investors and analysts have failed to see thus far is that AK Steel Holding is a patient who suffers from cancer. This patient does not need aspirin treatment. Aspirin is not enough for this critically ill patient.

AK Steel Holding gets approximately 50% of total revenue from automotive market shipments. The company has also some of the worst raw materials costs in the entire sector, which have eroded any chance at a decent profit margin. In fact, AK Steel operates at a much lower operating profit margin than the sector average.

In H1 2013, AK Steel Holding announced a price hike by around $50 per ton for all of its steel products. At the same time, AK Steel also announced that their raw material costs dropped from the previous quarter. AK Steel announced recently some additional price hikes for some of its products. It is expected that the combination of increasing auto sales in conjunction with the decreasing cost of raw materials and a recovery of the selling prices will help AK Steel's bottom line.

To me, what matters at the end of the day is how this rosy outlook passes on AK Steel's balance sheet. This rosy picture has not been coupled with better results, according to the company's latest Q3 2013 report. In other words, AK went deeper into the red zone in Q3 2013, although several beneficial factors have been playing out since H1 2013.

As of Q3 2013, the net debt stood at $1.6 billion while the negative stockholder equity was $633 million. So despite all the macro improvements of the nine months of 2013, the company's long term debt has risen almost 15% while the stockholder equity has worsened by 25% since December 2012.

Additionally, the automotive industry and infrastructure spending have very limited margins for growth over the coming years. The oversupply in the industry, especially from China, the world's largest steel producer, does not seem to decline any time soon. China currently produces ~47% of total production, while the U.S. produces about 6% of the world's steel. Price gains will also be capped, as mills respond by increasing production. So the sustainability of some improvements across the industry is highly questionable, and the prudent investors must face any overly optimistic scenario with a grain of salt.

Although U.S. Steel (X) has a better balance sheet than AKS, it said in October 2013 that it will permanently close parts of plants in the U.S. and Canada as it tries to reduce costs after four unprofitable quarters. AKS must also take urgent measures to improve its continuously negative cash flows, shrink its activities, dilute heavily its current shareholders, increase its declining cash resources and reduce the burdensome debt.

After all, I believe that AK Steel's stock is being rewarded prematurely and the stock will reverse direction, embarking on a new trend downwards soon. I believe that the brutal take down for AK Steel's stock will take place soon, because these improvements of the macro environment cannot move the needle on AK Steel's horrible balance sheet. From a fundamental perspective, AK Steel is currently in the Emergency Room and the aspirin cannot save it.

The first warnings signs also showed up recently. Wells Fargo noted that: "We expect pricing to weaken meaningfully in H1 2014 due to increasing levels of import competition and believe there is now greater risk to 2014 estimates".

JP Morgan also noted: "However, we don't think steel prices will move much higher in the near term and wouldn't expect much more outperformance from AKS and X. In our opinion, some of the drivers that increased steel prices since June appear to be running out of steam and could start to weigh on the market. Domestic steel mill supply could increase as 2H13 outages are nearing an end. Foreign supply into the U.S. market could also increase with higher imports as U.S. steel price premiums over Chinese prices are nearing a high".

The Bon-Ton Stores

Since early 2013, the stock has been bouncing up and down, while it is getting weaker fundamentally. This yo-yo performance pushed the stock down to $10 in October 2013, and the stock currently lies at $18.05, as shown below:


(Click to enlarge)

To me, Bon-Ton is the absolute short candidate at $18.16, and the complete lack of fundamentals can cause a vicious plunge at any time, devastating the buyers at the current levels.

The Bon-Ton Stores has a shattered balance sheet with a whopping PBV=7.65 and negative net tangible assets as of September 2013. The company is stuck with a net debt of approximately $900 million that has not been reduced since 2011. Since the net debt to stockholder equity ratio stands at 18 times, the company is fully dependent on its creditors.

Meanwhile, the company's top line is stagnant for several quarters now, and the bottom line shows that Bon-Ton is generating losses almost every quarter. Bon-Ton makes money only during the last quarter of its fiscal year, but "one swallow does not make a summer".

This lack of growth coupled with the continuing losses has been eroding the company's balance sheet which is deteriorating on a sequential basis. Moreover, the operating income has turned from an extremely low 2% (FY 2012 and FY 2013) into negative (FY 2014).

Although BONT has a stated goal to increase e-commerce sales by 50%, things do not move as planned on that front. Bon-Ton's e-business is just 4% of its total sales as of today. Apparently, the transition to the omni-channel is not easy and requires a considerable amount of money that Bon-ton cannot currently afford.

After all, the recent recovery and the short-term recovery during July-August 2013 remind me of a typical "dead cat bounce". Bon-Ton has to restructure its business sooner or later. With estimated cash flow for 2013 at just ~20 million (on average), the company is unable to produce substantial positive free cash flow to pay down debt.

The company entered recently into an amendment to the existing $675 million asset-based revolving credit facility that was scheduled to mature in March 2016. However, this amendment is a drop in the ocean.

A potential investor has to see the big picture. The big picture is that Bon-Ton does not have the luxury and the flexibility to change its business model substantially. Bon-Ton cannot sell its existing merchandise with a 30% operating margin. Can the company change its merchandise and switch to selling something else? Yes, it can. What can Bon-Ton sell to pocket a 30% operating income?

Since The Bon-Ton Stores is a typical department store retailer in a fundamentally weak position who faces a fierce competition. This fierce competition is restrictive for Bon-Ton's operating margins which are doomed to remain at extremely low levels. J.C. Penney (JCP) should be a study case for any potential buyer of BONT.

So Bon-Ton must come through a massive shakeout to survive, and I believe that the dividend will be suspended in 2014. Additionally, the company must decrease its SG&A by closing more stores, sell assets and shrink its activities substantially.

Conclusion

After Cobalt, I estimate that both AK Steel Holding and The Bon-Ton Stores will nosedive soon. Bon-Ton's and AK Steel's implosion will result primarily from the fact that these companies are extremely over-levered with debt and lose money. This debt has become too much of a burden for these companies to handle and they must restructure their operations substantially to survive and meet their future payments.

Source: Cobalt International Energy Is Taking A Bloodbath, AK Steel Holding And The Bon-Ton Stores Will Follow