Newsletter Value Investor Insight carried an interview March 30th with Cobalt Capital's Wayne Coooperman, whose fund has returned 25.7% after fees annually since 1995, versus 9.6% for the S&P 500, according to Value Investor Insight. Here's the excerpt from the interview in which he discusses Atlas America (ATLS), which was trading at $57.25 at the time of the interview (current price here):
Describe a few of the broader themes that appear to link some of your current ideas.
WC: For one, we believe that the price of oil is going to remain high – $50-plus per barrel – driven by the growth in global demand. Even if the U.S. growth rate slows a bit, if China is growing 10% per year and India is growing 8% per year and the marginal propensity to consume energy in those countries is much higher at their lower income levels, that drives a lot of demand. In terms of its actual effect on demand people can get too caught up on things like what the weather’s doing in the U.S. or whether our economy’s slowing a little bit.
How are you playing this particular theme?
WC: We own some offshore drillers, such as Transocean (RIG), GlobalSantaFe (GSF) and Noble (NE). I can’t tell you if we’ve reached “peak” oil or not, but it is pretty clear to us that companies are going to have to spend more money to get the same amount of oil out of the ground. More of the discoveries today are in offshore, deepwater sites in the Gulf of Mexico, the North Sea, Western Africa and Australia, requiring the big, expensive rigs owned by the offshore drillers.
As in any cyclical business, there was a very long time when nobody added drilling capacity, so rates skyrocketed when demand picked up. We know there are a lot of rigs being built and that at some point supply will catch up with demand, but that’s still a ways off. These drillers are earning huge amounts of free cash flow and the visibility on earnings for the next couple of years is quite good. When we break down the rental day rates to a more normal level and look at what these companies can earn then – giving them credit also for the cash they earn between now and then – we think the stocks are probably 50% undervalued.
That could be conservative, because we don’t believe day rates get to a normal level as quickly as we modeled them to. New builds are taking longer and demand keeps growing. Noble just announced a new contract to finish a rig to be rented out at $550,000 a day for two years starting in 2009, with another two-year option. So that takes them out to 2013 at $550,000 per day – we modeled a lot less than that to justify owning the stock.
Though the industry dynamics are basically the same for all the drillers, we also like them for company-specific reasons. Transocean, for example, has a bigger percentage of its fleet in more complex, ultra-deepwater rigs – where there’s more of a shortage and it takes longer to add capacity – so its positive cycle should extend longer than for the other guys. We think Noble is the best-run company in the industry and has done a tremendous job on cost control.
Consistent with your bullishness on energy, tell us why you’re specifically high on Atlas America (ATLS).
WC: The company is a bit complicated, which is one of the reasons we like it. The basic business is doing private-placement offerings – they’ve raised $200-plus million for this year – to raise money for natural- gas drilling programs on company owned land in Appalachia. Investors get tax-advantaged returns and the money goes for gas wells that have a 99.9% success rate and generally have stable production over 30 years or so. The business is only sustainable if investors are getting an adequate return, and we found that even at $3 [per million BTUs] natural-gas prices, investors were making money. At the current gas price of over $7, they do very well.
Atlas gets a cost-plus fee for drilling the well, a $400 monthly fee for managing the well over its life and a 35% carried interest in the gas from the well. It’s entitled to all that without spending a penny of its own money, which we think is a pretty good business. They just took part of this exploration and production [E&P] business public, called Atlas Energy Resources (ATN).
The company owns the smaller pipelines that take the gas from the wells, the assets of which also trade publicly as a master limited partnership, called Atlas Pipeline [APL]. Finally, Atlas America owns the General Partnership interest in Atlas Pipeline, which is entitled to 20%- plus of the cash flow of the pipeline business, in yet another public company called Atlas Pipeline Holdings (AHD).
WC: I told you it was complicated. Basically, Atlas America is a holding company controlling these other companies. We like the business model and the sustainability of the growth. The company is adding to its 500,000 acres and its reserve base and it has an excellent drilling success rate. Management has been very skilled in creating value and we trust them to do the right thing, even if it sometimes takes longer than we expect. Another interesting upside here is the potential from digging deeper on their Appalachian acreage into what’s called the Marcellus Shale. Based on data from other companies who have tapped into this and from two wells Atlas itself has drilled, the reserve and return potential from the Marcellus Shale is huge. They can drill for that themselves, or just expand the private-placement drilling programs. In either case, all the related companies will benefit.
How exposed is the company to changes in natural-gas prices?
WC: It is an E&P company, so part of the cash flow is clearly tied to the commodity price. Their strategy over time has been to lock in prices at reasonable rates. They have a great business at $7-9 gas, so they don’t take a lot of commodity-price risk. For example, they’ve hedged around 75% of their 2007 production at around $9.
How tough is it to value Atlas America’s shares, which now trade around $57?
WC: We use a sum-of-the-parts analysis, using our discounted cash flow estimates, not the public market values. You don’t have the space to detail all the modeling we went through, but we come to a fair value of around $75 per share. That’s just a static estimate, though, and this company is anything but static. They’re buying back stock, which should create another couple dollars of value. The publicly traded units now have currencies that they can use to do their own deals, which should benefit the entire system. They also just announced a joint venture with Lehman Brothers and Magnetar Capital called Lightfoot Capital, which is an open-ended investment fund to buy energy assets. This is a case where we know management very well and have a lot of confidence in their ability to create value. That’s why we own approximately 10% of the shares outstanding.