Western Refining, Seahawk Drilling: Reconciling Valuation to Expected Future Outcomes

Includes: C, HAWKQ, S, WNR
by: Amit Chokshi, CFA

Kinnaras Capital Management ("KCM", "Kinnaras", or the "Firm") Separately Managed Accounts ("SMAs") returned -9.4% in Q2 2010. Table I presents KCM SMA performance relative to key indices. Investors should note that individual returns will vary based on the time one invested and that the composite return presented below is net of fees and is the time-weighted return ("TWR") of Kinnaras SMAs. TWR is one of the most comprehensive and accurate ways of gauging investment performance for managed accounts but can be skewed at times due to the timing of new portfolio openings. As a reference, SMAs that were open since the start of the year are down approximately 7.5% through Q2 2010.

Table I excludes performance of smaller, highly concentrated SMA portfolios. Exclusion is based on two main factors. The first is that these accounts are not reflective of the total deep-value framework used in the main strategy. Some of these accounts literally hold 1-3 stocks which can lead to results that do not accurately reflect the performance of the main strategy. These portfolios were not included in Q1 2010 figures because they skewed performance upwards to a degree not reflective of the overall strategy and are excluded in Q2 2010 for the same reason (albeit because the results in Q2 2010 would skew downwards).

TABLE I: 2010 Managed Account Performance

The first half of 2010 could be characterized as manic-depressive with sharp rallies and drawdowns occurring in nearly every month. Similar to Q1 2010, Q2 2010 started off nicely for the first few weeks with equity markets possibly impounding a V-shaped recovery only to quickly reverse course as market participants questioned valuations in the context of expected outcomes for the economy. Perhaps more importantly, the market eco-system received a massive shock during the "Flash Crash" in May which coincided with the European sovereign debt crisis. We also were faced with the BP disaster which understandably would add to our collective negative psyches. By the end of the quarter, expectations for a double-dip recession were beginning to be broadly discussed by a number of economists and market observers.

These fears continue to manifest themselves in fund flows. According to Trim Tabs, $10.7B fled US Equity mutual funds through July 2010 (at the time of the report, July was still in progress), following $3.8B that was liquidated in June. Those funds are stampeding into the perceived safety of bonds with $27.8B of inflows through July and $25.7B in June. While retail investors are doing this, PIMCO's Bill Gross is launching a set of equity mutual funds. In a recent Bloomberg article, Gross noted that he felt that the thirty year bond run may be coming to an end and equities may be a better place to be.

Without question, there are many challenges confronting the global economy. Every item I read and every person I speak with can present a litany of obstacles. However, since everyone knows about these problems and fund flows are mainly headed towards bond funds, I feel a bit more constructive about investing. In Q2 2010, a lot of good news was snuffed out of certain stock valuations and that gave us the chance to add to existing positions as well as establish new ones.

For example, Kinnaras did well in 2009 through investing in various consumer discretionary companies, particularly some mall-based retailers. These retailers were able to rapidly close underperforming stores, bargain with landlords for rent relief, achieve lower sourcing and transportation costs (cotton, oil, etc.), and aggressively rationalize their workforce. These cost controls led to positive cash flow and earnings surprises despite a massive drop in sales - and those earnings propelled shares.

Heading into 2010, I felt the consumer discretionary space was played out/fairly valued and spent my time on other opportunities. However, in Q2 2010 a few of these consumer discretionary companies had 50-60% of their market capitalization wiped out in a matter of weeks. We started to buy one of these in Q2 after the majority of its decline (knock on wood) and also have been nibbling on another in Q3.

The first retailer ("Retailer 1") is a $400MM market cap mall-based women's retailer catering to a specific age demographic. One of its competitors has been shifting its focus to a younger age group which actually improves Retailer 1's competitive dynamic and opportunity set. Kinnaras actually owned its competitor in 2009 so there was some good familiarity/sector intelligence that could be leveraged, and it didn't take long to get up to speed on Retailer 1.

Retailer 1 lost about 33% of its value from April to early June before reporting earnings that outperformed Street estimates. However, due to some concerns regarding Q2 sale softness and market pressures in June, shares further sank another 40% or so from that point. Kinnaras began buying in mid to late June and we're still accumulating shares for managed accounts and the Fund, which is why I haven't unveiled its name yet.

Retailers can be interesting investments when they trade at high forward multiples. This may sound counter-intuitive but what happens is that the Street and investors tend to get very negative in terms of sentiment. When a retailer has current depressed earnings, investors sometimes extrapolate the growth expectations and persistently low margins are impounded into valuations. So for 2011, the Street may assume no sales growth and maybe even lower margins - 0.5% net income margins, leading to $0.10 per share. The stock may trade at 30.0x those depressed 2011 EPS estimates or trade at $3.00 per share.

Now if this retailer has a solid balance sheet and an investor can get comfortable with the company's competitive dynamics and strategy, there could be an interesting opportunity. As previously mentioned, I had followed and invested in this specific niche last year and I think the problems facing Retailer 1 are short-term in nature. This means there's a lot of room for earnings upside which could lead to impressive stock performance in the next year or two.

CHART I: Retailer 1 [click to enlarge]

One thing to note is that many mall-based retailers have largely made their IT infrastructure upgrades and supplier changes over the past two years, leading to streamlined corporate costs and supply chains. This means that the real driver for earnings lies mostly in merchandising and inventory management. Inventory management will probably be the biggest challenge facing discretionary-focused retailers for the next few years given the reining in of US households.

Order too much of a product and risk an inventory write-off which results in a charge against earnings in the following quarter. Conversely, order too little off a popular product and you lose out on crucial sales that can leverage earnings during a key selling period for the year. Retailers can be risky from this standpoint but if you buy them when there's a lot of negative sentiment and the valuation is attractive enough, they can make for worthwhile investments.

With our prior example, perhaps sales which are expected to languish in 2011 will actually move up 10%. This sales growth is leveraged through the company's tight cost structure leading to, say, 2% net income margins (which is still below this company's historical average). This would yield EPS of $0.44. With just a 10.0x EPS multiple, this company could be worth $4.40 down the road or nearly 50% above the current price. The challenge is riding out the volatility and being willing to be long potential good news.

This approach basically encompasses most of our holdings whereby an investment is made in companies and sectors with cheap valuations/negative sentiment and accompanying skepticism for the investment thesis ("yeah, there's value there but..."). While I think the broader market is fair to slightly overvalued, we've seen a number of sectors and industries decouple in terms of correlations. For example, while a number of technology sectors have been trading at 52 week highs, industries like refiners are not that far removed from their 52 week lows.

I like the refiners because they are cheap across a number of metrics. Refiners scrubbed their balance sheets over the past few years as oil prices declined. With the decline in oil prices, the carrying values of a number of their intangible and hard assets were impaired. Yet even with aggressive write downs of their asset values, share prices of some refiners are still very cheap. Reviewing the balance sheet of Western Refining (NYSE:WNR) can help illustrate this embedded value.

EXHIBIT I: WNR Balance Sheet

Exhibit I applies a Liquid Adjustment whereby WNR's assets as of Q1 2010 are written down similar to a liquidation scenario. It's important to note that like many refiners, WNR had already gone through asset write-downs in recent years due to the economic decline so the above liquidation value estimates may be a bit aggressive.

In addition, most of WNR's inventories are oil products. Oil products, like many commodities, are pretty liquid and can be sold at prevailing market values. It's unlikely in a liquidation scenario that if WNR had $460MM of oil or refined products like jet fuel and diesel in inventories, these assets would be sold at a huge discount. Nonetheless, I still assumed only 70% of the carrying value would be realized. This exercise yields about $4.36 in liquid book value yet the stock trades for about $5 per share right now.

There are challenges facing the refining industry but many of the stocks in this sector are at five and six year lows, suggesting that the market has more than impounded these problems into their valuations. This makes me feel optimistic about the longer term performance of stocks such as WNR. Further, with capacity continuing to be stripped out, eventually even a slight uptick in demand will yield outsized EPS results which can drive share price appreciation.

Many cyclical industries are characterized by over investment in boom periods and under investment and overzealous capacity reduction in bad times. During the peak oil years, refiners were making significant investments in more expensive refineries that had the ability to process sour and heavier crude. This was because at a certain price it was cost effective to refine what were typically less desirable classes of crude oil. However, since oil prices have collapsed, refiners have been closing a number of refineries including some of the most recent, high cost ones. The industry has been downsizing itself over the past two years and while there is still work to be done, I suspect that refiner executives have made the 180 degree shift to the view that ultra high oil prices are the "new normal" to the new "new normal" whereby demand will be so tepid there are far too many refiners out there.

Both cases are probably wrong, and what I anticipate is that the industry reduces capacity to the point where acceptable utilization rates are achieved based on the current, weak economy. This will lead to little excess capacity if the economy has even a slight uptick in the coming years, which will result in much higher capacity utilization - leading to big EPS figures which could result in meaningful share price appreciation.

The concept of having a solid level of asset protection and riding out some tough current times also led us to an investment in Seahawk Drilling (NASDAQ:HAWK). HAWK was spun off from Pride International (NYSE:PDI) in August 2009. Kinnaras investors know that I am a big fan of spin-offs, as are most investors that are familiar with Joel Greenblatt's 'You Can Be a Stock Market Genius'. Spin-offs can be excellent investment opportunities which is why I track upcoming spin-offs. Kinnaras has invested in its fair share of spin-offs over the years and once HAWK was spun out, I kept an eye on it.

HAWK is a shallow water natural gas driller in the Gulf of Mexico ("GOM"). Like many GOM drillers, HAWK saw its share price crumble once the BP disaster and drilling moratorium occurred. Shares peaked shortly after the spin-off at roughly $35 per share and commensurately lost about 50% before the BP oil spill. Once the BP spill and moratorium occurred, shares plunged from $18 to as low as the mid $8s. Shares are now at about $10 and Kinnaras began buying in the $10-12 range.

HAWK has attracted the attention of other value investors such as Corsair Capital but the best analysis of HAWK comes from Toby Carlisle, founder of Eyquem Fund Management. Anyone that wants to get fully up to speed on HAWK should check out his blog, which contains a number of excellent posts on HAWK.

The basic thesis with HAWK is that it provides tremendous operating leverage to an upswing in natural gas prices. Natural gas prices are low due to economic weakness and a lot of supply that has been discovered in recent years. Right now, the world is awash in natural gas due to weak economic activity and new gas discoveries. However, if one can look past a one year time period, HAWK can begin to look really exciting.

Dayrates - or what drillers charge for their services - are correlated with natural gas prices. So with natural gas prices so low, dayrates for drilling rigs are low. The cost of operating these rigs is fairly fixed, however, so assuming HAWK can make it through a weak economic period, there should be the potential for upside over the years. If natural gas prices increase, the drilling rates will as well.

The challenge is making it through a slow period. Right now, the GOM drilling market has been very depressed but there are signs of some life with more rig activity occurring and more inquiries regarding rig availabilities being made. But even in the event that drilling activity remains extremely poor in the Gulf region, HAWK should be able to make it through this slow period.

HAWK has a very attractive balance sheet with about $67MM in net cash. More importantly, HAWK's drilling rigs have considerable value but are being severely discounted by the market. In fact, the market value of drillings rigs has declined to levels below even 2004 market values. There have also been some recent transactions by Hercules Offshore (NASDAQ:HERO) and Ensco (NYSE:ESV) that suggest HAWK has much more value solely based on the value of its rigs than its current share price implies.

At $10 per share, HAWK's market cap is $118MM. HAWK has about $164MM in total liabilities so the market is saying HAWK's total assets are worth $282MM. Out of the $282MM in asset value implied by the market, $73MM is cash, leaving $209MM in implied asset value. Another $67MM is accounted for by current and other assets so that leaves $142MM in asset value for its rigs. HAWK has 20 rigs and its current share price implies that the average value of its rigs is about $7MM each. HAWK's CEO has mentioned in the past that the scrap value of a rig is about $8-9MM each and rig transactions over the past year have implied rigs similar to HAWK's support higher rig values.

As with Retailer I, WNR, and HAWK, our approach is really about reconciling valuation to expected future outcomes. Sure, things are bad but if they remain status quo, then we still have a valuation cushion. But If things improve even slightly, we have the chance to make some pretty solid returns.

That also applies to our larger holdings like Citigroup (NYSE:C) and Sprint Nextel (NYSE:S). C has explicit government support whereby it cannot fail and still trades at a discount to its P/B and P/normalized earnings power. Trends continue to move in the right direction for C with net credit losses declining sequentially and on a comparable quarterly basis per C's Q2 2010 earnings report.

In addition, C realized a Loan Loss Reserve Release in Q2 2010. This is a point of criticism by some skeptics that will say the earnings are juiced to some extent by these reversals. These critics say the swipe of an accountant's pen is leading to these reserve releases which artificially boost earnings. This is an unfair and inconsistent criticism because these same skeptics in prior quarters would point to the high level of loss reserves these banks were setting aside in anticipation of future losses as a warning to investors.

What I had noted when Kinnaras first started looking at financials was that banks were likely over-reserving for future losses. For example, one regional bank that Kinnaras owns has about $100MM in non-performing loans ("NPLs"). However, $31MM of those NPLs were still current on principal and interest through Q1 2010. If one assumes that the period from late 2008 through 2009 was the zenith of the financial crisis, as the economy recovers, even at this anemic pace, those $31MM in NPLs could eventually be classified as performing. Basically, if those loans which are current on principal and interest did not kick out during the worst of the recession, they are likely good money.

What this means is that a number of loss provisions for banks could be reversed across the board. This is consistent with historical bank crises, whereby loss provision reversals are recognized as the realized credit losses come in well below prior expectations. This expectation was what led me in January to present the notion of a bank-only investment vehicle to some investors, with a specific emphasis on regional banks. While C is a money center bank, the same phenomenon of loan loss reserve reversals will occur throughout the year and have the most pronounced impact on regional banks. We own a few regional banks and I think we will be pleased with their performance.

S is also continuing its impressive turnaround. In late Q2 2010 it released its new phone, the HTC EVO 4G. I bought one, electing to pay the penalty to cancel my T-Mobile bill and drop my Blackberry to sign up for S and get the new phone. This phone is powered by Google's (NASDAQ:GOOG) Android Operating System ("Android OS") and is the real deal. It's a major iPhone competitor and I would know considering my household has gone through two iPhones.

S released its Q2 2010 results which were very strong. Churn was under 2%, with S reporting its best churn figures in its history. It added postpaid subscribers for the first time in three years and CEO Dan Hesse mentioned that this would be the case even without the EVO. The EVO was released late in Q2 so I expect the full EVO impact will likely be felt in Q3 2010. S continues to generate strong cash flow and has no significant near term debt maturities. In addition, its customer service metrics continue to improve. The company is doing just about everything right and I expect the stock to eventually reflect these positive developments, albeit with the typically high volatility associated with S.

These quarterly missives can sometimes be a challenge because the reality is three months is a very short time period. There may be a lot of noise within 90 days but not a lot of news. It's also difficult to reflect on what's happened over just a few months when most of your time is focused on the fundamentals of the companies and a 1-2 year time horizon for catalysts to materialize.

In addition, my sensitivity threshold to market volatility is pretty low whereby our holdings may swing heavily, but it doesn't really register with me. For example, June was a vicious month for Kinnaras but that was largely due to S, one of our largest positions, declining about 20% on no news. In fact, S reported impressive Q2 2010 results a few days before the end of July and the stock but sold off about 12% in the last two days of the quarter - which dinged what would have been stronger July numbers. S is doing the right things but short-term market fluctuations are part of the game.

Overall, I feel pretty good about what we hold. For marketing benefits I'd certainly love it if Mr. Market hurried up and assigned better valuations to our holdings but I feel that what we have is well positioned to do some great things for us. In fact, I would love to deploy more capital in some of our regional bank names as well as one very interesting microcap. I'll save that for the next quarterly letter.

Disclosure: Long C, S, WNR, HAWK