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We live in a period of low expected returns from investing across all asset classes. In this tough environment life is difficult for stock pickers. But life will surely not be tough for recent buyers of NEP.

China North East Petroleum (AMEX: NEP) is a low-cost, high-margin, cash-generative oil producer in northeast China. For more about the company, refer to earlier Seeking Alpha articles here and here.

There are 5 major catalysts in place to drive NEP’s stock price substantially higher:

  1. The Bernanke Put: Ongoing economic lethargy will lead to more QE, with consequential devaluation of the Usd and large quantities of money moving into safer-haven commodities such as oil. Alternatively, if economic activity actually improves, we get higher oil prices via demand. Either way, a win-win for investors in the oil sector.
  2. Acquisition: A significant cash acquisition of new oil properties by NEP is likely to be announced between now and summer 2011. This will be a game-changer for the company. NEP is building cash reserves and will have about $68 million cash at December 2010. The company has already announced its intention to acquire new oil leases and it owns drilling rigs which it can quickly deploy to profitably exploit new acreage. Everything is in place.
  3. Recovery from quote suspension: NEP’s stock quote was suspended for over 3 months in 2010 whilst the company corrected accounting mistakes in 2008 and 2009 SEC filings. The stock had been trading in the $9-10 range in spring 2010 and, not surprisingly, fell hard in the run-up to suspension, finally closing at $5.50. Now, with all filings corrected and up-to-date, with the company’s finance functions and controls improved, and with the 2010 SEC filings confirming that the corrections do not have any material adverse effect on NEP’s expected profits going forward, NEP’s stock price is positioned to recover lost ground. This recovery is likely to be step-like in tandem with NEP proving to investors that good operational progress continues to be made. One such development has already occurred; NEP announced on September 28 that its drilling subsidiary had won a contract to drill 100 wells over a 2-year period with an independent oil producer. Without doubt other positive operational developments will be announced in the near future with corresponding positive effects on the stock price.
  4. CFO position: As a consequence of the discovery of the accounting mistakes in the 2008 and 2009 SEC filings, NEP made changes to its finance function. The old CFO had some of his responsibilities modified, an interim CFO was appointed and, as yet, the company has not appointed a permanent replacement to the CFO position. In time this position will be filled.
  5. Analyst coverage: During the period when the stock quote was suspended, NEP’s sole analyst predictably dropped his recommendation from buy to hold (investors could hardly buy the stock if it wasn’t quoted!). This hold rating remains in place as of today. Over time, when NEP continues to deliver strong operating profits and files pristine SEC reports, it is highly likely that NEP will regain its buy rating, unless the stock price balloons in the meantime of course. So long as NEP’s stock price remains deeply undervalued it is very likely to attract buy coverage.

What makes NEP a particularly attractive investment opportunity is that all 5 of the above major catalysts are likely to occur and that, ahead of these events, the stock price is deeply undervalued.

The following P&L and Balance Sheet summaries are built using conservative oil price assumptions; $70 for Q3 and Q4 2010, $75 for 2011 and $80 for 2012. Yes, these are low-ball estimates, especially considering that oil has recently been trading above $80, but it is always best to base investment decisions on conservative assumptions.

Summary P&Ls

2008

2009

2010

2011

2012

Actual

Actual

Estimate

Estimate

Estimate

Ave Oil price

$94.29

$55.97

$72.73

$75.00

$80.00

Usd ‘000

Usd ‘000

Usd ‘000

Usd ‘000

Usd ‘000

Sales – Oil

58,572

51,081

61,086

69,375

63,000

Sales – Drilling

0

13,577

48,099

60,000

60,000

Sales – Total

58,572

64,658

109,185

129,375

123,000

Prod'n & Drill costs

3,848

7,730

23,152

28,400

28,500

Dep'n & Amort

8,621

9,815

10,198

11,400

11,400

Gov't Surcharge

11,105

4,619

9,355

10,638

10,631

Total

23,574

22,164

42,705

50,438

50,531

Gross Profit

34,998

42,494

66,480

78,938

72,469

Gross Profit %

59.8%

65.7%

60.9%

61.0%

58.9%

SGA expenses

16,820

18,105

5,052

4,950

5,600

Operating Income

18,178

24,389

61,428

73,988

66,869

Other, Int, Fin.

5,261

1,920

43

500

500

(G)/L Warrants Reval

(4,464)

27,399

(25,439)

0

0

Debt extinguish loss

0

8,261

0

0

0

Income before Tax

17,381

(13,191)

86,824

73,488

66,369

Income Tax

5,277

6,900

21,706

18,372

16,592

Minority Interest

1,583

2,018

5,052

5,750

5,250

Net Inc Ord Shares

10,521

(22,109)

60,066

49,366

44,527

Reported EPS – basic

$0.53

$(0.99)

$2.04

$1.65

$1.48

Reported EPS – diluted

$0.53

$(0.99)

$1.93

$1.57

$1.41

Earnings excl Warrant Revaluation

7,412

19,622

40,987

49,366

44,527

Normalized EPS – basic

$0.37

$0.88

$1.39

$1.65

$1.48

Normalized EPS – diluted

$0.37

$0.88

$1.32

$1.57

$1.41

Normalized Net Income %

12.7%

30.3%

37.5%

38.2%

36.2%

This very high % of Net Income to Sales is a key factor behind NEP’s ability to be strongly cash generative.

Summary B. Sheets

2008

2009

2010

2011

2012

Actual

Actual

Estimate

Estimate

Estimate

Usd ‘000

Usd ‘000

Usd ‘000

Usd ‘000

Usd ‘000

Cash

13,239

28,693

68,000

122,000

160,000

Other Current Assets

5,323

16,909

23,348

27,486

24,762

Property & Equip, net

56,726

62,312

57,705

51,000

45,000

Other Assets

4,640

9,814

10,043

2,145

2,145

Total Assets

79,928

117,728

159,096

202,631

231,907

Current Liabilities

18,210

25,340

26,520

28,500

28,000

Longterm Liabilities

25,527

44,403

13,909

0

0

Minority Shareholders

3,378

7,665

13,679

19,429

4,679

Shareholders Equity

32,813

40,320

104,988

154,702

199,228

Total Liabs & Shareholders Funds

79,928

117,728

159,096

202,631

231,907

Note again the large cash balances. Without cash acquisitions - which of itself would be positive news - cash at y/end 2011 would be $122 million and at y/end 2012 $160 million. Set against NEP’s total market capitalization of $200 million these cash balances are eye popping.

Summary

NEP’s stock closed October 6, 2010 at $6.83. For that price an investor gets a 2011 p/e ratio of 4.35 plus $2 cash per share, this using a conservative oil price assumption of $75 per barrel. At $85 per barrel, NEP would generate fully diluted EPS in 2011 of $1.70, equating to a p/e of 4.0.

There are 5 catalysts that will lift the stock price in the near to medium term. Just 2-3 of these catalysts would normally provide a good boost, but, in this case, all 5 are set to occur.

Against this positive backdrop it would be surprising if the stock price doesn’t trade comfortably into double digits by early 2011, especially as various catalysts kick in. A 2011 p/e ratio of 8 would put the shares at $12 and still leave the $2 per share cash in for free. This is inexpensive, and particularly so in a world of currency devaluations and investors moving funds into safe havens such as oil and other commodities.

A 75% increase on yesterday’s closing price of $6.83 is certainly not too shabby in a world of anemic returns across all asset categories.

Disclosure: Author is long NEP

Source: China North East Petroleum: Investing Made Easy