Sometimes investing requires a lot of patience. You can identify horribly mispriced assets, but if there is no catalyst to realize that undervaluation, the price of those assets can stay depressed for a long time.
Other times a catalyst emerges quickly, and your returns are amplified by the shorter holding period required to realize value.
On September 20, 2011, I wrote this article for Seeking Alpha which detailed the fact that Connacher Oil & Gas owned some assets that were selling at a seriously discounted price because of the company’s heavy debt load. Here was the basic thesis:
The cash flow statement and balance sheet for Connacher are ugly. A quick look at the most recent cash flow statement reveals that the company is spending virtually all incoming cash on paying the interest expense on its debt. That means there is little cash left over for funding capital spending. The company has dug a big hole for itself to get out of.
But what Connacher does have is an asset base that is valuable in a world of high oil prices to a company with the cash to develop it. And that asset base at a fair (not an attached to an overleveraged balance sheet) price is far in excess of what the current share price implies.
Here is the value of what Connacher has:
- PV10 of proven and probable oil reserves - $3.1 billion
- Best estimate value of contingent reserves - $570 million
- Other assets - $140 million
- Total assets - $3.8 billion
- Less net debt - ($880 million)
- Net asset value, pre-tax - $2.9 billion
Value On a Per-Share Basis:
On a pre-tax, per-share basis, this equals $6.54 per share. On an after-tax, per-share basis, this equals $4.98 per share. Excluding the contingent resources, this equals $3.71 per share. Did I mention the current share price is $0.56 ?
In my article I also suggested that if I ran a well capitalized oil company my business plan would involve the following:
Stop all exploration spending where the rewards for the spending are uncertain;
Instead, start hunting for oil reserves on Wall Street or Bay Street;
Target reserves that are heavily discounted because they are attached to overleveraged balance sheets;
Start using my reasonably valued shares and cash not spent on exploration to add these reserves at bargain prices by buying smaller, overleveraged companies.
And I might start with Connacher Oil and Gas.
Fast-forward to this week, and what do you know? Connacher has received an unsolicited offer to acquire all of its outstanding shares. On the news of the takeover offer, Connacher’s share price jumped over 50% to almost $1.00, which is almost a double from when I wrote about it only a couple of months ago.
At this point investors don’t even know what the amount of the offer is, but the important thing is that the company is now in play. Even if management doesn’t go along with the offer, if the would be acquirer takes a $1.00 per share offer to shareholders I don’t think there is much doubt the company ends up being sold.
Unfortunately for me, I own no shares of Connacher as I was afraid of the debt level and what might happen should oil prices fall in the short term. But don’t feel bad for me. Offers like this for Connacher or the Sinopec (NYSE:SHI) offer for Daylight Energy (OTC:DAYYF) a few weeks back let me know I’m on the right track.
Find heavily discounted assets that you feel you can value reasonably accurately. Then wait until Mr. Market figures it out. I’ve got a portfolio loaded with undervalued oil producers. I expect that some of them will get taken out in the next couple of years which will accelerate my returns. Others will continue on developing properties and growing value per share.
Seeing Connacher and Daylight attract interest helps me believe I’m invested in the right sector at the right time. Why drill exploration wells in a risky location when you can drill for oil on Bay Street? There is no risk of a dry hole and the price is likely better.