Pakiya's  Instablog

Today Caraco announced they have reached a consent decree with the FDA. From the announcement:

Caraco Pharmaceutical Laboratories, Ltd. (NYSE Amex: CPD) announced today that it has entered into a consent decree with the U.S. Food and Drug Administration (FDA) regarding the company's drug manufacturing operations. The decree provides a series of measures that, when satisfied, will permit Caraco to resume manufacturing and distributing those products that are manufactured in its Detroit area facilities. The Company is working expeditiously to satisfy the requirements of the decree and has already retained independent cGMP experts for review of the Company's operations and to facilitate a successful result.

Caraco now has an approved plan for getting back into FDA compliance and commencing manufacturing. It is now a matter of management executing the plan. The company's consent decree was expeditious and much quicker than I expected. 

It will still be a while before the company can start manufacturing but this news places a path that can be followed to get back into compliance.

The press release regarding the decree:
phx.corporate-ir.net/phoenix.zhtml?c=989...=


Pakiya Funds
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Disclosure: Long CPD

A small-cap natural gas pure play that is selling for 23% of its Net Asset Value (NAV). The opportunity provides a huge margin of safety and an extremely compelling upside.


Company

Constellation Energy Partners was formed by Constellation Energy Group in 2005. In Nov 2006 CEP was taken public. Constellation Energy Group still owns 28% of CEP, although they are looking to divest and looks like will sell their stake.

The company’s current assets include natural gas and oil reserves in the Black Warrior Basin in Alabama, the Cherokee Basin in Oklahoma and Kansas, and the Woodford Shale in the Arkoma Basin in Oklahoma. NatGas accounts for 99% of its reserves.

For tax purposes the company is a MLP.

Industry

Everyone has read the headlines about NatGas selling at 7-year lows. Although if you listen to the management team of most NatGas companies, it is clear that prices will rebound into the 7-10 range in 2010 and even higher in 2011.

From the EOG's most recent conference call:

Mark Papa [CEO]:
"Our view of the North American gas and oil markets is consistent with our previous earnings call, except that we've become more bullish regarding 2010 and 2011 gas prices. We still expect North American gas prices to remain quite low through year-end.

As you know, we've historically devoted a lot of work to developing domestic gas supply models and we think our current model is the most granular and best we've ever built. It's telling us that December 2009 domestic production will be 4.8 Bcf a day lower than year-end 2008 and this deficit will deepen further throughout 2010. When added to the Canadian supply drop of at least 0.8 Bcf a day, we expect the gas market to turn sometime early in 2010 almost regardless of what happens to LNG imports.

Everybody seems to be focusing on the supply growths from new horizontal plays, but the 800 pound gorilla in the room is Texas vertical gas production. This represents the largest single block of production in the U.S. 16.3 Bcf a day in December '08, and the rig count here has fallen from 450 rigs in January 2008 to 145 rigs today [Aug 4 '09].

Our model shows production from this large segment of domestic production will fall from 16.3 Bcf a day at year-end '08 to 13.2 Bcf a day by year-end '09 and then 11.6 Bcf a day by year-end 2010 down 4.7 Bcf a day over two years. In my opinion, this is the most important well population that people should be focusing on if they want to understand what's going to happen to gas supply over the next 24 months."

In order words, NatGas prices are bound to go up in 2010 and 2011. All the near term concerns about storage don't impact NatGas' future prospects.


Reserves

As of Q2 '09, CEP has total proven reserves of 232 Bcfe, with 99% of it as natural gas. It owns 3 reserves: Black Warrior Basin (111.6 Bcfe), Cherokee Basin (115.7 Bcfe), and Woodford Shale (5.1 Bcfe).

As of Q2 '09 the average daily production was 48MMcfe. So the company is producing 18.25Bcfe per year. At that rate the company has over 12 years of production reserve. This is definitely not a growth company, but it has plenty of years left of production.

The company does not into to spend much capital on new drilling, not until the commodity market recovers. This will allow the company to redirect the cash flow to pay down debt.

Production Costs

The company's production costs is about $3.1. The company is not the most efficent in production costs but it is right around average w/ the industry. At current NatGas prices the company is at a loss with its production costs. The hedges that the company has protects it in the current market. As the market rebounds their non-hedged production will be profitable and increase cash flow.

Hedges

The management has shrewdly hedged its production for the next 5 yrs. The hedges are in the $7-8 range, allowing the company to create stable cash flow. The company hasn't hedge its entire annual production but a large chunk of it is hedged for the next couple of years

2009 - 6  Bcfe - $8.39
2010 - 12 Bcfe - $8.19
2011 - 10 Bcfe - $8.46
2012 - 9  Bcfe - $8.34
2013 - 8  Bcfe - $7.33
2014 - 6  Bcfe - $7.03

With the annual producton of 18 Bcfe, the company is likely to produce 9 Bcfe in the last 6 months of 2009. The company has hedged most of that production in the $8 range. So the company's cash flow for the rest of 2009 will be extremely stable. With the annual production of 18 Bcfe, the company has hedge over 50% of its production in 2010 and  2011. This should allow the company to easily ride out the currently low NatGas prices and wait until more realistic market prices. The management team has stated that it purchase more hedges at the right price. We expect the company to hedge more of its production as the market prices recover.


Debt

The company has $220M oustanding on its $225 of its borrowing base. The company initially had a borrowing base of 265M. The base was reduced to 225M which caused the outstanding amount to be greater than 90% of the borrowing base. The company has been forced to place a temporary distribution suspension on its dividend.

The debt matures on Oct 2010. The company will likely generate 50-70M between now and Oct 2010. The company also has 16M of cash on hand. The company has made paying down the debt a priority. If the company redirects majority of its cash flow and the current cash towards debt paydown, the company will likely have around 150-170M in debt at Oct 2010. The debt load will be miniscule when compared to the company's expected proved reserves of 210 Bcfe at Oct 2010. The company will easily able to refinance and rollforward its debt. Although the interest rate on the debt might go up, we don't expect the higher interest rate to have much impact on the cash flow. We expect the lower principal amount to easily mitigate any increased interest rate.


Cash Generation

Compared to the company's cash generation, the company is extremely undervalued. The company had adjusted EBITDA of 17M in Q2 and 17.3M in Q1 of 2009. The adjusted EBITDA in the most recent quarters:

Q2 09 - 17M
Q1 09 - 17.3M
Q4 08 - 18M
Q3 08 - 18.8M
Q2 08 - 20.5M
Q1 08 - 17.5M

The 2008 numbers are higher than 2009 due to non-hedged sales at much higher prices. For Q3 and Q4 of 2009 we expect the company's EBITDA to keep decreasing because of the non-hedged sales will be at depressed values. Although given that it has most of its 2009, 2010, and 2011 production hedged, we expect the company to still make mid-teens in cash flow per quarter.

As for CapEx, the company spent 25M this year on getting new rigs placed. We think the CapEx will be less this coming year since with low NatGas prices it doesn't make sense for management to increase or keep production at current rate. Even if you expect 25M in CapEx, you are looking at around 35-50M of FCF


Valuation

Based on the company's 232Bcfe of proven supply, the company's NAV is $13/share. At the current share price of $3, this is a huge margin of safety on a company w/ hard assets. If we expect the NatGas prices to hit $6-7, you are getting the company for around 20% of NAV. Talk about dirt cheap.

There is plenty of talk about storage running low and it might cause NatGas prices to go well below the $2.80 range. This is absurd irrational 'noise'. Also the $13 NAV.

The likelyhood that NatGas stays below $3 is a worst case scenario: depression economy + storage of NatGas stays at a high + production stays at peak levels + commercial/residential demand doesn't rebound. I think the worst case scenario is unlikely to happen or presist for a long period of time. CEP's hedges protect the company and buy time until the market rebounds.


Risks

Present value of reserves is calculated with the price assumption of current strips  for the future years (most of them at 6+). If gas stays at this level 3 years in a row they could be in problems or if strip prices fall of a cliff (depression scenario). With strips < $4 the NAV is negative.

The biggest fear w/ the stock is the debt level. The $220M of borrowing against the borrowing limit of $225 is scary. Although the debt is not due until Oct 2010. Also the company has $16M of cash in provide some cushion. Finally, the company can monetize its hedges or some of its NatGas reserve in a worst-case scenario where the company needs near term cash. We believe the extremely discounted share prices provide a huge margin of safety in a Yellowstone like scenario.

The temporary suspension of distributions is something income-sensitive investors will not welcome. Although for value investors we will happily exchange the company pays out dividends for using the cash to payoff its debt. Also, it is likely the company's suspension is temporary and that company will payout dividend in the near future. We expect the company to be well below the 90% of borrowings by Q4 of 09 (it can easily happen at end of Q3). The distribution payout doesn't impact out investment thesis (although it would be nice to get the dividends). At current share price to NAV, the shares are an easy 5-6 bagger.

Disclosure: Long CEP

Global Ship Lease (GSL) is a containership lessor that signs long-term lease contracts based on fixed lease rates. GSL was spun-out by CMA CGM, the third largest liner shipping company, in late 2008. GSL has 16 ships that it owns and leases out to CMA on long-term contracts. The lease rates to be received are fixed, so GSL gets a steady cash flow. Also GSL is not impacted by the drop in lease prices, due to the long-term nature of their contracts. CMA owns a 40% stake in GSL, so there is an incentive for CMA to ensure that GSL doesn't go into bankrupcy, more on this below.

Current Results

GSL's fixed long-term contracts ensures the company gets a steady flow of cash. The company makes about 15M of FCF per quarter. In the worst quarters the global economy faced and extremely tough quarters for the shipping industry, GSL grew its CF.

Quarter - NI    -  CF
3Q 08 -  (.3)M  -  12M
4Q 08 -  (43)M  -   13M
1Q 09 -  11M    -   15M
2Q 09 -   22M   -   14.8M

So basically in some of the worst quarters in decades, the company increased cash flow (net income is impacted by hedges for interest rate). So operationally the company can pay the current interest expense and still generates plenty of cash.

The company takes the FCF and gives it out as dividend to shareholders. In the last 2 quarter of '08 and first quarter of '09 the company gave out $.23 per quarter. For CMA, tax wise this works out nicely. 

GSL has quite a bit of debt. It has about 550M of debt. The company can easily cover its interest expense on the debt and still has tons of cash flowing in. Although the company's debt has a covenant about debt-to-ship value. If the debt-to-ship value goes over 100% the bank can cause default. Although given that the company can pay the interest expense and generates plenty of cash, the bank is highly unlikely to force bankrupcy. The current situation has caused the company to stop making dividend payout since Feb '09. Since Feb, the company's debt-to-ship value ratio is over 100%, although the bank has still not forced default. (The stop on dividend has forced investors who were holding the stocks for the dividends to sell out and has created an incredibly compelling investment opportunity).

The company has been working w/ the bank to amend its agreement. The contracts are still in discussion but it is highly likely an amendment will be worked out and the company will start paying out dividend.

The Bank's Perspective

From the bank perspective, it doesn't make sense to force the company into default. First, the company can pay the interest expense (about 4.5M per quarter). Second, by forcing default the banks will be stuck w/ ships in a market where the value of the ships is extremely low. So the banks would take a loss by selling the ship at these depressed values. Third, GSL has a steady stream of cash coming. With the long-term rates, GSL is not exposed to current market rate fluctuations. So I know what this company can make and whether it can keep making the interest payments. Finally, GSL makes plenty of FCF each quarter. So if I'm the banker, I'm thinking how do I force the company to pay me more. If I'm the banker, I work with this company to either increase the interest rate or force the company to make additional principal payments. In either case, it would be a mistake on the banks part to force default. Also since the bank hasn't forced default since Feb, that is clear indication the bank is not interested in bankruptcy.

To understand the bank's perspective, all you need to do is look at whats happening in the commercial real estate market. The big REITs are on the brink on bankruptcy because of the drop in occupancy and asset value. Although the banks have been working w/ the REITs to extend maturity on the loans or forcing the companies to raise equity. In either case, the REITs are surviving and the banks are not stuck w/ having to sell assets in a distressed market or writing down the assets on its balance sheet. In GSL's case, 'occupancy rate' does not drop due to long-term contracts. The asset values also don't drop, since the company is not really looking to sell its assets until after the contracts are over. I think GSL doesn't really need to raise equity, since it is not struggling operationally to meet its operational or interest expense.

CMA CMG Risk

I think GSL's biggest risk comes from what CMA is doing. As long as CMA can keep paying the monthly charter rates, per agreement, GSL will make its steady cash flow. CMA is a private company, so getting data on it is hard. The main concern regarding CMA is that it has tons of CapEx that it has signed agreements for. With the bad credit crisis and already having a ton of debt, people have concerns over CMA's ability to survive. Although CMA can get out of those CapEx agreements by paying a penalty and cutting back on other expenditures. Also, CMA roughly gets a huge dividend from GSL, so CMA would look to cancel lease agreements with other lessors first. CMA is getting the dividends, tax benefit, and has an equity stake in GSL. So CMA cancelling its contracts with GSL would be the last scenario that CMA would consider.

The shares of GSL has dropped substantially for mainly two reasons: the CMA concern (whether GSL's agreements will be honored by CMA) and the temporary hold on dividends payout has dropped the shares dramatically. The CMA concern are valid, although CMA has options to cut or control its CapEx. Also CMA has been buying back its debt in the open market at huge discounts, so management is taking the right steps. As for the hold on dividends, I think this is only temporary. The management definitely wants to pay out those dividends and CMA wants the dividends. Once the bank issues are fixed, I think the dividends will be reinstituted. Also there has been huge selling in GSL shares recently, I think this is because a major holder started unloading once the dividends were put on hold.

Current Valuation

The shares currently trade at $1.40, a market cap of 98M. Remember the company was paying dividends of $.23 per quarter, so you are getting a 70%+ dividend yield if the old dividends are reinstated. Most likely dividends will be cut. It is not clear what type of dividend payout will happen in the future, but you basically get a company making 60M in FCF for less than 100M. Plus the assets don't need to be sold in this distressed market, so GSL can wait until the market recovers to get a fair value on its assets. GSL doesn't have a single contract expiring until 2012, plenty of time for the market to recover and place historical values on the assets.