We recently read Shareholders Unite’s post on HUSA. We agree with the author’s conclusion on HUSA, but believe there are additional details that SU left out. We want to supplement SU’s post with our own thoughts:
Small-cap exploration and production stocks are like lottery tickets for investors. While most are failures, some strike it rich. Significantly higher risk appetite in the market has created an environment for small cap E&P story stocks to get egregiously ahead of themselves. We believe this is the case at Houston American Energy Corp. Most “lottery winners” in the E&P space are wildcatters who take enormous risk by trying to find undiscovered oil, with the hope of striking black gold and finding larger companies to farmout their interest to at high returns. HUSA is the opposite, in our view. HUSA’s business plan appears to leech on to larger oil companies then promote and hype their investments. For example, to justify HUSA’s current valuation, one has to believe that a $15 million investment made just a few months ago is now worth over $500 million. In addition, an investor has to believe one of the most sophisticated oil investors (Korea’s largest energy company) is willing to hand out winning lottery tickets for next to nothing. HUSA has made a spectacular run, but we believe it is coming close to an end. We believe investors are unaware or have overlooked prior indiscretions by HUSA’s management team at a bankrupted company. Given the issues with management and the overhype surrounding the company’s Colombian investments, we believe investors face greater than 65% downside from current levels.
HUSA has oil and gas investments in Colombia and the U.S. It was founded in 2001 and currently has three employees (a CEO, CFO and an assistant). With is most recent market cap of $620 million, the value placed by the market is roughly $200 million per employee. As of September 30, 2009, HUSA had invested a TOTAL of $19.8 million of capital—its market cap currently represents more than 30 times invested capital! Over the past six years, the company has generated "in total" roughly $31 million of revenue and lost $1 million of net income. We could only find one realized gain in the company’s history. It generated a gain of $7.6 million on a $4 million investment. The gain took place in June 2008, when oil was north of $125 per barrel.
HUSA has a history of a hyped stock (that ultimately does not deliver). In late 2006 the stock rocketed 160% over hype regarding its investment in the Cabiona prospect in Colombia. The company issued multiple press releases in the fall of 2006 regarding the progress on their Cabiona drilling project. In early 2007, management confessed that the drilling failed and the well had to be "plugged", sending the shares down 60%. In mid 2008, the stock rallied nearly 250% over three months over hype of the sale of its Caracara assets in Colombia. That sale generated the aforementioned gain of $7.6 million. The shares fell greater than 80% the following six months after the gain was announced.
The previous spikes in the stock pale in comparison to HUSA's most recent ascent. In July 2009 the stock was trading below $2.00 per share. In early December 2009, the company issued equity in a registered direct offering through the investment bank Global Hunter at $4.68 per share (2.89 mm shares or $12.8 million in net proceeds). Since that deal, the shares have quadrupled. The hype machine is currently in full force: momentum newsletters, small cap research shops, and chat boards (even pumpers on a chat board for a Chinese software company have helped drive the stock to irrational levels).
The shares have been such a huge outperformer due to excitement surrounding their October 2009 investment in CPO-4 in Colombia. To better understand the valuation of HUSA, we point to the sum-of-parts valuation from Global Hunter. While we believe Global Hunter is a respectable firm and do not believe that they are part of this pump and dump scheme, we take their research with a healthy dose of skepticism given their investment banking relationship with the company. Global Hunter provided the following sum-of-parts valuation to justify their recent $14 price target (the report has been published here.
$1.91 per share for 7 JV Colombian locations w/ Hupecol; ~12.5% interest
In September 2009, Hupecol LLC informed HUSA management that they hired an investment bank to explore the sale of six locations that HUSA has approximately 12.5% interest. The sale was originally expected to close on December 15, 2009 and has been delayed several times. The bid date has moved back numerous times, but a sale could possibly be announced at any time. We do not have a strong view on the valuation of these interests, but do not believe a value of $50 million to $65 million or $1.60 to $2.00 per share is highly unreasonable.
Clearly the largest piece of the sum-of-parts valuation of HUSA is their 25% interest in CPO-4. As way of background, in 2008 South Korea’s largest energy company, SK Energy, participated in an auction of 17 blocks covering 6.6 million acres in Colombia. SK Energy won the rights to the CPO-4 block (345,452 acres) with a very aggressive bid of 31% royalty to National Hydrocarbon Agency and a $2.3 million bonus payment (.pdf). SK Energy was very bullish about the prospects for CPO-4, as their bid was one of the most aggressive of any block.
Just a few months ago, HUSA announced a farmout agreement where it agreed to pay 25% of all past and future costs related to CPO-4 in exchange for 25% interest in the block (we believe this is actually a “farm in” agreement). HUSA management expects to spend $15 million over the next three years on CPO-4. Adjusting for the 31% royalty to the National Hydrocarbon Agency and the 8% royalty to the Colombia government, HUSA’s interest represents roughly 15% of CPO-4. In exchange for roughly a $10 million present value investment, we believe investors are now valuing this 15% stake at greater than $500 million just a few months later.
Is SK Energy dumb or was it in financial difficulty? We argue neither. SK Energy is a leading energy company in South Korea. In 2009, it had revenues of $32 billion and assets of over $19 billion, and had a tremendous amount of financial flexibility with its leverage below 3.5 times debt to EBITDA. SK Energy operates in dozens of foreign countries and recently highlighted their most desirable 2010 exploration opportunities in Vietnam, Brazil, and Peru (notice Colombia is not mentioned Earnings Results-Final(1).pdf).
In addition, the HUSA CPO-4 deal was announced after a number of positive high profile data points were announced in Colombia. This includes the $800 million acquisition of Emerald Energy by Sinochem in August 2009 and large success by Petrominerales Ltd. (PMGLF.PK) Corcel-A2 in September 2009.
Even stranger, according to Gulf United Energy’s 10-Q issued in January 2010, Gulf United “entered into a tentative letter of intent with SK Energy Co., Ltd to acquire a 25% interest in Block CPO-4 in the Llanos Basin of Colombia. This agreement is subject to completion of a definitive agreement which is currently being negotiated.” Gulf United entered into the letter of intent AFTER HUSA finalized its agreement with SK Energy. Gulf United Energy is another small cap E&P company with limited management team and a current market cap of $33 million.
So despite knowledge of success at Corcel-A2 and the lofty takeout valuation of Sincohem, very recently one of the most sophisticated oil investors in the world was looking to dump 50% of its interest in CPO-4. At the very least, this should be a massive red flag. At the very best, we believe there is a huge disconnect between the valuations of Petrominerales Ltd, who has proven success in Colombia, and the highly speculative investment in HUSA. We believe Shareholders Unite’s post does a good job of flushing this disparity out.
The quality of a management team is extremely important for any small cap company. But when your management bench is only two people, assessment of management is vital. We found prior indiscretions of HUSA’s founder and CEO, John F. Terwilliger, highly concerning. Terwilliger was the founder and CEO of Moose Oil and Gas Company, which filed for Chapter 7 bankruptcy in April 2002. As Moose Oil was heading towards insolvency, it was alleged that Terwilliger used Moose Oil resources and funds to start HUSA. According to a court appointed official, in “March of 2001, John F. Terwilliger began using the funds of Moose Oil and Gas Company to create a new corporate entity that became known as Houston American Energy Corporation.” According to the 2004 case of Alan Gerger, Trustee vs. John F. Terwilliger (case number 04-03187),
Moose Oil and Gas Company raised approximately $500,000.00 in contributions to the corporation that were deposited into the corporation’s bank accounts and, within a short period of time, appear to have been used not for the purposes represented.
In addition, Terwilliger transferred assets that the court official found were “made with actual intent to hinder, delay or defraud investors.” The acts “were committed intentionally, willfully, and/or maliciously, John F. Terwilliger committed acts constituting a breach of his fiduciary duty.”
In the settlement agreement in October 2005 (case # 02-33891), the trustee had evidence that showed
that John F. Terwilliger and Marlin Date Research [100% owned by Terwilliger] engaged in a scheme to hinder, delay or defraud creditors of Moose, that John F. Terwilliger intentionally breached his fiduciary duties.
In light of these findings, we found a number of items that should be serious red flags to any investor. For example, management has a poor track record of estimating or possibly inflating proven reserves. According the 2008 10k,
During the years ended December 31, 2007 and 2008, revisions to prior estimates resulted in significant negative revisions to our proved reserves. Negative revisions during fiscal year 2007 amounted to 57.7% of prior year-end proved natural gas reserves and 40.2% of prior year-end proved oil reserves. Product sales and negative revisions during fiscal year 2008 amounted to 86.2% of prior year-end proved gas reserves and 83.4% of prior year-end proved oil reserves.
Even more disturbing is the disclosure regarding related party transactions. Over the past two years, (page F-11 10k), Terwilliger and Director Orrie L Tawes received royalty payments of $256,018 and $253,467, respectively. This is highly concerning given the CEOs prior history of apparent self dealing. Also concerning, according to court documents (Case 04-031887 Document 1), prior to Moose’s bankruptcy, “all of the oil and gas properties and/or interests of Moose Oil and Gas Company being transferred to O. Lee Tawes and Marlin [owned 100% by Terwilliger].” Is it possible that Terwilliger is still benefiting from the potential “fraud” (the Trustee’s words) at Moose Energy, but now at the expense of HUSA’s shareholders? We have no opinion on this, but would feel more comfortable if not for the modest audit fees charge by their auditor GBH CPAs. We can only hope that the $78,335 audit fee is sufficient to provide proper oversight at HUSA.
In conclusion, we believe HUSA could be set up for a massive collapse. We believe investors face greater than 65% downside from current levels. Even a stock price that is 65% lower suggests a greater than ten times return on their investment in CPO-4 in a few months—which may understate the downside given SK Energy’s recent actions. With only 669,000 shares short (around 2% of shares outstanding), we believe the shares represent an undiscovered opportunity for the short community and a lottery ticket than may ultimately be worth nothing more than the paper on which it was printed.
Disclosure: Short HUSA