China North East Petroleum: MBO Or Multi-Year Profit Growth A Win-Win

Oct.31.11 | About: China North (CNEP)

During 2010 and 2011 there’s been a deluge of reports about the dangers of investing in Chinese companies. We are at the point where almost every investor in the world must surely be aware that quoted Chinese companies often have lower financial reporting standards and/or ethics than their western peers. This tsunami of negativity toward Chinese companies has, not surprisingly, caused stock prices to plummet to exceptionally low levels. Unfortunately, and as happens when tidal waves hit, the good as well as the bad get drowned.

Inevitably, when company price tags fall significantly below fair market valuation, M&A enters the fray. As 2011 has progressed this is exactly what has begun to happen to Chinese companies. Already in recent months we have seen several buy-outs. These include China Security & Surveillance (NYSE:CSR), Harbin Electric (NASDAQ:HRBN), China Fire & Security Group (NASDAQ:CFSG), Shanda Interactive Entertainment (NASDAQ:SNDA) and others.

What these companies had in common was a deeply undervalued stock price that gave the core shareholder group – usually involving the Chairman/CEO/Management who knew and understood the business inside out - the opportunity to buy the remainder of the company for a not-to-be-missed price. This was an entirely logical response from those who best understood the business.

And with many Chinese stock prices remaining at exceptionally low levels it seems obvious that further MBOs will occur.

There is one Chinese company, above all others, which now stands out as an ideal buyout candidate: China North East Petroleum (NYSE:NEP).

NEP is an independent oil driller in Northern China. As of June 30, 2011, the company had net cash of $75 million; it generates $10-$12 million of cash from operations each quarter and this will bring net cash to $90-$100 million by year end. The current stock price is $2.70 giving the entire company a market cap of $96 million. Essentially, this market cap is the same as the net cash at December 2011, and the underlying business is valued at zero.

And yet, despite the very cheap valuation, NEP is highly profitable. During 2011 it is forecast to earn $0.94 per share with a further $0.90 EPS to follow in 2012 i.e. the stock trades on a p/e of 3. Whilst profitability will flat-line between now and 2013, production at its Durimu oilfield (NEP expects to recover 143 million barrels) comes online in 2013 causing profits to balloon.

This March 2011 Seeking Alpha published this article about NEP’s outlook for strong profits growth commencing in 2013. Whilst the numbers and time frame can probably be tweaked slightly over time, as with all companies, the overall thesis is still completely valid.

NEP stock has been hammered several times over. First, it’s been beaten and bruised by the Tsunami against all-things-China in 2010 and 2011. Then, in early 2011, this all-pervasive China negativity was used as the foundation for a damaging short attack on the shares. Finally, it caught further downdrafts in late summer this year from a US stock market in correction mode on fears of European sovereign debt problems and a global economic slowdown. Now, as we approach year-end 2011, the dust is finally settling across global stock markets but NEP’s shares have been forgotten and remain at levels that represent extraordinary value.

What makes NEP an ideal buyout candidate is a combination of factors. The super-low valuation and cash-rich balance sheet is readily apparent. But whilst most growing companies need to access financial markets in order to raise funds to help pay for their expansion, NEP is cash-generative and can fund all its growth internally. Refer back to the February 2011, Seeking Alpha article where this is explained in detail. Thus, NEP does not need a stock market quote in order to raise funds.

At the current low valuation NEP can be taken private at a stroke. The question is – at what price? This is difficult to say. On one hand a premium of 100% - say an exit price of $5.40 - would be great for anyone who bought shares during the summer of 2011. This would also be highly attractive buying price for the acquirer, representing an exit p/e of 3 for the business excluding cash. However, many longer-term shareholders, including some of NEP’s institutional shareholders, will have bought shares above this price threshold and they would undoubtedly push for a higher selling price.

It will be interesting to watch NEP to see if and when a buyout occurs. I consider it to be likely. Frankly, if I were part of the management group I’d certainly advocate it and, for my own exit strategy, I would seek to have the shares listed in Hong Kong at a later date and at a much higher multiple. However, as a long-term shareholder, which I am, I would prefer to sit tight and reap the benefits of the strong multi-year profits growth that commences in 2013. With the shares sitting on the shelf at cash value right now either outcome would be a win-win for new shareholders.

Disclosure: I am long NEP.