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I want to give credit for this idea to Adam Wyden of ADW Capital. He is letting me publish this with his permission. I am only publishing it because I think this is one of the most compelling investment ideas out there.

Here is Adam's writeup:

Barnwell Industries (BRN) was founded by Morton Kinzler in 1956. Morton has devoted his life to growing this oil and gas producer into a decent-sized business that in a normalized (oil and gas is improving -- especially oil) pricing environment can earn $25-30mm of EBITDA. In addition, the company owns a portfolio of real estate in the most exclusive area of Hawaii.

Why does this opportunity exist?

Like many family run/closely-held public companies, BRN does very little in terms of public reporting (no conference calls, roadshows/presentations, research coverage).

Barnwell attracted the interest of Mercury Real Estate Partners (activists) in 2006, who acquired a 19.20% stake and filed a 13D letter expressing the view that the assets were worth at least $29.00 a share and requested the company to sell/spin off the real estate. As you can imagine, 80-year-old Morton Kinzler was not super-keen on splitting up his life’s work at the request of an activist manager.

Mercury realized it had neither the capital nor the wherewithal to go toe-to-toe with Morton. After investing in BRN, Mercury got tied up with illiquid real estate investments in late 07/08 and was forced to sell the stock in a hurry. Having owned nearly 20% of the outstanding shares with about half the float owned by insiders, Mercury was really responsible for driving the stock down from the mid-20s to the low teens.

Subsequently, the company’s conservative accounting practices forced it to take non-cash / GAAP write-downs to its oil and gas / RE assets during the liquidity crisis of 2008/2009 when oil prices were low. But, unlike normal wildcatters/RE guys who are producing/selling their assets at the bottom, the company took a long-term view. Being well-capitalized, BRN did not dilute shareholders during the recession and basically retained most of the “book value” that was written down during the crisis.

Today, you have a situation where the company will be provisioning for much lower taxes in an improving environment in both its industries: Oil and real estate.

Energy

The conservative way to value oil and gas companies is to take a PV10 (Discounted Cash Flow) of a company’s existing oil+gas resource and add a residual amount for its probable and undeveloped acreage. If we go back to the 2008 price deck (measured in 2007), with oil averaging lower prices and natural gas at higher prices, we get to a PV10 analysis of roughly $90mm a share. Oil prices have rebounded sharply although natural gas (not NGL) prices have languished.

We must also keep in mind that the company spent $75mm in the last five years on capital expenditures (growing resource) that may have been impaired or not reflected in the reserve amounts given the old price deck. The company has also shifted a great deal of its recent production to oil and will have some degree of effect on the true economic PV10 or DCF going forward. Because GAAP accounting does not let us “write up” the value of the asset when prices rebound, the value of these cash-flows does not get valued until they physically hit the balance sheet.

Even today, the on-balance sheet value of the PV10 is $50mm (assuming $70.00 oil and $3.90 natural gas). When we assume $250 a sq. foot for the company’s 95,000 sq. feet of undeveloped acreage, we get a minimum of $75mm or over $9.00 a share. I believe this is worst-case scenario (or value in liquidation/sale today). With a shift in future production to oil (higher average prices) and some semblance of a rebound in natural gas prices, we could get to a real PV10 or DCF of closer to $100mm. When we add in the undeveloped acreage at more competitive pricing (recent acquisition was made at $650 a sq foot) we can get to much higher values for the oil and gas resource: $150mm or close to 18.00 a share.

Real Estate

The real estate is a little trickier. The company really has the creme de la creme when it comes to Hawaiian real estate. Adjacent to Kona Village and the Four Seasons Resort, the company is entitled to royalties on 54 lots (“Increment I”). These lots are being sold by Westbrook Partners, and the company is entitled to payments of 10% for the first $300mm in gross sales and 14% for everything above. They have been averaging $5mm a lot, but could see substantial price improvement. Carol Bartz (CEO of Yahoo (YHOO) and formerly of Autodesk (ADSK)) recently purchased two adjacent lots and built a $50mm compound; this should be a substantial boon to pricing.

In my view, Increment I is worth at least $22mm and there is upside to this value if prices improve (in 2004-07 many of the lots were going for an average of $7-10 mm).

The company also owns two smaller lots outright that it thinks are probably worth $6-8mm combined. In addition, it owns two lots with spec houses that are listed for almost $16mm; the company recently priced them to move because there is significant upkeep in showing/maintaining these homes.

Other odds and ends include a 1.5% interest in Kona Village Investors, worth, according to management, $2-3mm; income tax receivable $2.5mm; a New York City co-op that functions as an office and sublets space to others, bought in distress at $4mm; a JV option due in December at $2.6mm -- all told, worth another $13mm.

Increment II, Lot 4C, and Mauka Lands are a little harder to value. Increment II is planned as a 400-unit development around the golf course to which Barnwell is entitled:

8% to 10% of the price of improved or unimproved lots or 2.60% to 3.25% of the price of units constructed on a lot, to be determined in the future depending upon a number of variables, including whether the lots are sold prior to improvement. Kaupulehu Developments is also entitled to receive up to $8,000,000 in additional payments after the members of WBKD – Westbrook Partners have received distributions equal to the capital they invested in the project.

If the lots sell for $1mm a pop today, that’s roughly $400m (.09 = 36m+8mm = 44m/8.2 =$5.4/share). The timing here is unclear, but I think it’s important to understand the dynamic of RE. The rapid sales of Increment I could buoy the prices and development of Increment II rapidly.

I think it is important to step away from a PV of future CFs here. This land is intensely valuable and will appreciate over time, so we should not be discounting its future value. Hawaii is impossible to get zoning permits in, and the executives at Barnwell have superb relationships with the state and local governments. Is it surprising that it has won the rights to develop all these great properties for pennies from the government? The government decides who gets what here, and executives at Barnwell know that’s a huge boon to value and a deep competitive moat.

I view this as like owning the rights in the late 1800s of undeveloped 5th, Madison, and Park Avenues. If one can look a few years in advance, the value is powerful. I think it’s fair to assume the three other parcels are worth at least $35mm, but could / should be multiples of that.

When you add all of these values up and subtract net debt of $16mm, you get to equity value per share of $14.00-29.00.

Variant View

This is a stock that is orphaned. A large activist blew out in a hurry and it has been since plagued by languishing GAAP writedowns and is finally about to benefit from an elevated pricing deck in oil/natural gas and accelerated RE sales, which will inevitably result in substantially higher earnings per share.

BRN

RANGE OF VALUES

Asset

Oil & Gas

50

100

Undeveloped Net Acreage

24

62

Increment 1

21

25

2 houses

13

16

2 lots owned

4.6

7

Condo in NYC

2

4

Increment 2, 4C

10

35

1.5% interest in JV

2.5

2.5

Tax receivable

2.5

2.5

Development option

2.5

2.5

TOTAL Value

132

256

Less: Net Debt

16

16

Equity Value

116

240

Shares O/S

8.3

8.3

Stock Price

13.9

29.0

Source: A Bright Future for Barnwell Industries