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  • Southern Pacific Resource Corp: the next Suncor?
    Southern Pacific Resources (STP CN or STPJF) is a dirt cheap (0.45X NAV) early stage oil sands company based in Alberta, Canada with 208 mmbbl of 3P reserves and 667 mmbbl of 2P+2C resources, a debt-free, cash-rich balance sheet, and a very near-term high probability catalyst: regulatory approval and financing for Phase I of its crown jewel McKay project, expected within a few weeks. I believe this idea is off the radar screen in the hedge fund community, and it is not well followed on the Street. While difficult to gauge timing on regulatory approvals, the company has received good feedback that their target of 9/30/10 is in the right ballpark. The company is particularly confident because 100% of Canadian oil sands projects have gone on to receive approval once they have reached this stage. As for the financing, they are looking to launch a high yield debt offering in the C$300M range immediately following regulatory approval, which should comfortably close the funding gap for the project. Given the strength (bordering on frothiness) of the high yield market right now, I have high conviction that there will be good appetite for the paper. A good comp is Connacher Oil and Gas (CLL CN) 10.25% bonds due ’15, trading at par for a 10% yield. This should provide a strong derisking catalyst for the stock, and I think the discount to NAV should narrow considerably. My price target is C$2.00, which equals 0.9X NAV and provides 80% upside. With roughly $50M per year in highly visible free cash flow (FCF) at $80/bbl WTI and $6/mcf natural gas from the currently operating Senlac asset (reserve life of 11 yrs), I believe downside at the current enterprise value of C$300M is quite limited.

    Senlac Project: 
    In November 2009, Calgary-based Southern Pacific acquired the Senlac SAGD (steam assisted gravity drainage) project from Encana (ECA CN) for C$95M, net of working capital. The project had been operating for over a decade and was primarily used by Encana to develop new technologies and best practices that could be applied to its more significant projects like Foster Creek and Christina Lake (which are now considered among the best commercial SAGD projects in the industry). All of the 20 key field employees who worked on Senlac were retained, providing a wealth of transferable knowledge and experience that are now being applied to the McKay project.


    What’s more, as this project was run as an R&D center, its full economic potential was never realized. Southern Pacific is now running it for cash flow. It is producing about 4.5 mbpd at an average operating netback (after royalties, opex, etc) of $41/bbl, which equates to about C$65M in cash flow per year. It has about 11 mmbbls of 2P and 20 mmbbls of 3P reserves. Not bad for a C$95M acquisition. With C$25M of capex earmarked for Senlac, and average production of 4.75 mbpd, free cash flow from this project should be about C$50M (see assumptions below), which will be used to help finance the McKay project. The enterprise value of STP CN is about C$300M (net of C$90M in net cash post equity offering). One could argue that the company is cheap on Senlac’s free cash flow generation alone, which should last at least 10 years.


    McKay Project: 
    STP-McKay will be Southern Pacific’s first commercial project in the Athabasca oil sands region. The company in May 2009 submitted an application to the Alberta Energy Resources Conservation Board (ERCB) and Alberta Environment for the development of its first 12 mbopd phase and is expecting regulatory approval by the end of 3Q10 (announcement is expected any day). Typically these approvals (of which there has been plenty of precedent, not just by Southern Pacific but by Suncor and Petro-Canada, which was acquired by Suncor, among others) typically take 14-16 months and we are now at month 17 so it really should be any day.


    Phase I’s total project capital cost estimate is C$430M. In April 2010, STP issued 84M shares of stock at C$1.20 per share, raising C$101M in gross proceeds (ultimately enabling STP to graduate from the TSX-V to the TSX in June 2010). This removed the equity overhang related to the McKay Phase I financing, and STP plans to finance the remaining portion through cash on hand, free cash flow from the Senlac project, and a debt financing to be completed immediately following regulatory approval. Bid packages on major drilling equipment and supporting infrastructure are currently being issued, so the company should be able to move quickly upon receiving financing. The current timeline envisions application approval in September 2010, civil construction starting in October 2010, plant construction in December 2010, commissioning in October 2011, and first steam in Jan/Feb 2012.


    In June 2010, the company bought out Bounty Development’s (its partner’s) 20% working interest in McKay for C$33M giving STP a full 100% working interest in the McKay project (Phase I and surrounding phase expansion lands).


    Management believes that the STP-McKay project is analogous to Suncor’s (SU) currently producing, and highly successful Mackay River project, which has steam-to-oil ratios (SORs) that are among the lowest in the industry, averaging 2.5. Both projects target the same bitumen deposit – the McMurray formation. As shown below, STP-McKay stacks up well compared to other currently producing SAGD projects that have been deemed to be quite successful.


    Valuation: 
    With guidance from the company and directly relevant experience from Suncor and Connacher Oil and Gas, I have done what I consider a conservative, but realistic NAV model for STP which aggregates production from Senlac and McKay (Phase I and future expansions), and I come up with an NAV per share of C$2.58. This compares with Tudor Pickering’s NAV of C$3.00, Raymond James’ $2.47 and TD Newcrest’s C$1.66 (the only 3 estimates I’ve been able to find). I assume McKay ramps up to a max of about 40 mbpd by 2018 and Senlac peaks at 4.8 mbpd by 2012. Overall operating netback assuming $80/bbl WTI crude and $6/mcf natural gas works out to about C$33/bbl, with F&D $3.30/bbl and maintenance capex of C$40M. Sensitivities are shown below – clearly the price of crude is a huge swing factor here given the steep differentials and high operating costs of oil sands, so if you are not a bull on crude, this is not the investment for you.


    I’ve compared STP to its 2 closest comps, Opti Canada (OPC CN) and Connacher Oil and Gas (CLL CN), and on an EV/recoverable resource basis, the contrast is stark. The market is clearly applying little to no value for the McKay project despite all the positive reserve updates (on 8/19/10 the company upped its Best Estimate Contingent Resource from 256 mmbbl to 489 mmbbl. Total recoverable resources increased 62% from the prior estimate to 667 mmbbl). 
     

    Applying the peer group average EV/recoverable resource we get a fair value for the stock of about C$3.45. Assuming the C$300M debt is in place and funds capex the equity value drops to about C$2.55. 

    UPDATE:

    On October 18, 2010, STP received formal approval for its STP-McKay project.  Specifically it received the Order-in-Council approval authorizing the Energy Resources Conservation Board (ERCB) to grant approval allowing the company to proceed with development of McKay.  Alberta Environment (AENV) also has completed its Alberta Environmental Protection and Enhancement (EPEA) approval, so the company will move ahead with its roadshow to raise the C$300M in debt needed to finance the construction of the project.  I still expect no issues with this financing, which should be completed in the next month.  No change in my NAV estimate of C$2.58 - I believe the stock offers compelling value here and with the regulatory approval behind us, the 50% discount to NAV makes little sense.



    Disclosure: Disclaimer: Long STP CN
    Oct 18 11:53 AM | Link | 1 Comment
  • Southern Pacific Resource Corp: the next Suncor?
    Southern Pacific Resources (STP CN or STPJF) is a dirt cheap (0.45X NAV) early stage oil sands company based in Alberta, Canada with 208 mmbbl of 3P reserves and 667 mmbbl of 2P+2C resources, a debt-free, cash-rich balance sheet, and a very near-term high probability catalyst: regulatory approval and financing for Phase I of its crown jewel McKay project, expected within a few weeks. I believe this idea is off the radar screen in the hedge fund community, and it is not well followed on the Street. While difficult to gauge timing on regulatory approvals, the company has received good feedback that their target of 9/30/10 is in the right ballpark. The company is particularly confident because 100% of Canadian oil sands projects have gone on to receive approval once they have reached this stage. As for the financing, they are looking to launch a high yield debt offering in the C$300M range immediately following regulatory approval, which should comfortably close the funding gap for the project. Given the strength (bordering on frothiness) of the high yield market right now, I have high conviction that there will be good appetite for the paper. A good comp is Connacher Oil and Gas (CLL CN) 10.25% bonds due ’15, trading at par for a 10% yield. This should provide a strong derisking catalyst for the stock, and I think the discount to NAV should narrow considerably. My price target is C$2.00, which equals 0.9X NAV and provides 80% upside. With roughly $50M per year in highly visible free cash flow (FCF) at $80/bbl WTI and $6/mcf natural gas from the currently operating Senlac asset (reserve life of 11 yrs), I believe downside at the current enterprise value of C$300M is quite limited.

    Senlac Project: 
    In November 2009, Calgary-based Southern Pacific acquired the Senlac SAGD (steam assisted gravity drainage) project from Encana (ECA CN) for C$95M, net of working capital. The project had been operating for over a decade and was primarily used by Encana to develop new technologies and best practices that could be applied to its more significant projects like Foster Creek and Christina Lake (which are now considered among the best commercial SAGD projects in the industry). All of the 20 key field employees who worked on Senlac were retained, providing a wealth of transferable knowledge and experience that are now being applied to the McKay project.


    What’s more, as this project was run as an R&D center, its full economic potential was never realized. Southern Pacific is now running it for cash flow. It is producing about 4.5 mbpd at an average operating netback (after royalties, opex, etc) of $41/bbl, which equates to about C$65M in cash flow per year. It has about 11 mmbbls of 2P and 20 mmbbls of 3P reserves. Not bad for a C$95M acquisition. With C$25M of capex earmarked for Senlac, and average production of 4.75 mbpd, free cash flow from this project should be about C$50M (see assumptions below), which will be used to help finance the McKay project. The enterprise value of STP CN is about C$300M (net of C$90M in net cash post equity offering). One could argue that the company is cheap on Senlac’s free cash flow generation alone, which should last at least 10 years.


    McKay Project: 
    STP-McKay will be Southern Pacific’s first commercial project in the Athabasca oil sands region. The company in May 2009 submitted an application to the Alberta Energy Resources Conservation Board (ERCB) and Alberta Environment for the development of its first 12 mbopd phase and is expecting regulatory approval by the end of 3Q10 (announcement is expected any day). Typically these approvals (of which there has been plenty of precedent, not just by Southern Pacific but by Suncor and Petro-Canada, which was acquired by Suncor, among others) typically take 14-16 months and we are now at month 17 so it really should be any day.


    Phase I’s total project capital cost estimate is C$430M. In April 2010, STP issued 84M shares of stock at C$1.20 per share, raising C$101M in gross proceeds (ultimately enabling STP to graduate from the TSX-V to the TSX in June 2010). This removed the equity overhang related to the McKay Phase I financing, and STP plans to finance the remaining portion through cash on hand, free cash flow from the Senlac project, and a debt financing to be completed immediately following regulatory approval. Bid packages on major drilling equipment and supporting infrastructure are currently being issued, so the company should be able to move quickly upon receiving financing. The current timeline envisions application approval in September 2010, civil construction starting in October 2010, plant construction in December 2010, commissioning in October 2011, and first steam in Jan/Feb 2012.


    In June 2010, the company bought out Bounty Development’s (its partner’s) 20% working interest in McKay for C$33M giving STP a full 100% working interest in the McKay project (Phase I and surrounding phase expansion lands).


    Management believes that the STP-McKay project is analogous to Suncor’s (SU) currently producing, and highly successful Mackay River project, which has steam-to-oil ratios (SORs) that are among the lowest in the industry, averaging 2.5. Both projects target the same bitumen deposit – the McMurray formation. As shown below, STP-McKay stacks up well compared to other currently producing SAGD projects that have been deemed to be quite successful.


    Valuation: 
    With guidance from the company and directly relevant experience from Suncor and Connacher Oil and Gas, I have done what I consider a conservative, but realistic NAV model for STP which aggregates production from Senlac and McKay (Phase I and future expansions), and I come up with an NAV per share of C$2.62. This compares with Tudor Pickering’s NAV of C$3.00, Raymond James’ $2.47 and TD Newcrest’s C$1.66 (the only 3 estimates I’ve been able to find). I assume McKay ramps up to a max of about 40 mbpd by 2018 and Senlac peaks at 4.8 mbpd by 2012. Overall operating netback assuming $80/bbl WTI crude and $6/mcf natural gas works out to about C$33/bbl, with F&D $3.30/bbl and maintenance capex of C$40M. Sensitivities are shown below – clearly the price of crude is a huge swing factor here given the steep differentials and high operating costs of oil sands, so if you are not a bull on crude, this is not the investment for you.


    I’ve compared STP to its 2 closest comps, Opti Canada (OPC CN) and Connacher Oil and Gas (CLL CN), and on an EV/recoverable resource basis, the contrast is stark. The market is clearly applying little to no value for the McKay project despite all the positive reserve updates (on 8/19/10 the company upped its Best Estimate Contingent Resource from 256 mmbbl to 489 mmbbl. Total recoverable resources increased 62% from the prior estimate to 667 mmbbl). 

    Applying the peer group average EV/recoverable resource we get a fair value for the stock of about C$3.45. Assuming the C$300M debt is in place and funds capex the equity value drops to about C$2.55.



    Disclosure: Disclosure: Long STP CN
    Oct 08 12:05 PM | Link | Comment!
  • APWR: Head Wind or Tail Wind?

    APWR is a provider of distributed power generation systems (DG) in China and is in the process of launching a wind power business. Its stock price has more than tripled this year as investors considered the company a proxy for the fast-growing alternative energy sector in China, especially the wind power market.  Additionally, most of the major Chinese wind power players are listed either in mainland China or Hong Kong, APWR enjoyed an extra tailwind due to its perceived scarcity value. However, a reality check of the wind power market in China suggested that APWR might be facing significant headwinds as it tries to jump-start its wind turbine business. Its current stock price has simply priced in too much of a blue sky scenario and significantly underestimates a wind chill factor of the execution risk in the current market environment.

     

    Reality Check

    Supply deficit of wind turbine market in China has given way to manufacturing overcapacity in 2009. Since 2005, the wind power installed capacity in China has experienced a triple digit growth rate. However, this explosive growth has quickly been surpassed by the manufacturing capacity as more and more companies jumped on the wind power bandwagon. Going forward, the demand growth is expected to gradually slow down.  According to the Global Wind 2008 Report prepared by the Global Wind Energy Council, “demand in the decade between 2011-2020 is forecasted to be 80 GW, or about 8 GW per year”.  This will be more than met by the existing manufacturing capacity in China – according to Chinese Wind Energy Association, the top four Chinese turbine manufacturers (Sinovel, Goldwind, Dongfang and Shanghai Electric) already have a combined capacity of 12GW now. APWR stated that it has the largest wind turbine production facility in China with 1125 MW capacity (according to its press release on January 11, 2009), however, in an industry with growing overcapacity, the utilization rate matters more than size.

     

    Wind turbine market in China is highly concentrated with limited incremental market share for new entrants.  There are currently 70 wind turbine manufacturers in China, but the top 10 accounted for a staggering 90% market share by the end of 2008. There is little market share left for new entrants such as APWR unless the demand grows significantly more than expected or the new entrants focus on the international market.  APWR may be able to mitigate some of this risk by selling 2.7 MW turbines as most of its competitors are selling 0.75MW, 1.5 MW and 2.0MW models. However, Sinovel, the largest wind turbine in China, has just started to manufacture 3.0MW (for offshore wind farm) in 2009 and other top manufacturers are also eyeing the high capacity turbine market. Direct exports may not be a solution for APWR as its technologies are all licensed from European companies which may have rigid geographic limits on the licensed products.  

     

    Table 1 Wind Turbine Market Share in China

      Manufacturers 2008
    1 Sinovel 22%
    2 Goldwind 18%
    3 Dongfang 17%
    4 Vestas 10%
    5 Gamesa 8%
    6 Windey 4%
    7 SHE 3%
    8 Mingyang 3%
    9 Hang Tian 2%
    10 GE 2%
    11 Nordex 2%
    12 Suzlon 2%

     

    Wind turbine manufacturing is not the sweet spot in the wind power value chain. A typical wind power value chain in China includes wind farm operators (usually the government owned utilities), wind turbine manufacturers, wind turbine components providers, and raw material providers. Wind turbine manufacturers have the least bargaining power along the chain and are potentially squeezed from both upstream and downstream participants.  The overcapacity has led to increased competition and price wars among turbine manufacturers, which has eroded their bargaining power against wind farm operators and weighed on the top line. On the other hand, there is a significant supply deficit for key turbine components as the explosive growth of manufacturing capacity has not been matched by the similar growth of qualified component providers in China. Consequently the pricing and delivery terms are more dictated by the component suppliers, which will eventually weigh on the cost structure of turbine manufacturers. APWR will have to face similar challenges, though its joint venture with GE will mitigate these pressures with respect to one component: gearboxes.

     

    Wind power business is very capital intensive. To build a wind power turbine business from scratch, it takes significant upfront capital outlays to acquire land, equipment, technology licenses and other necessary manufacturing facilities.  For example, Beijing-based wind turbine new entrant Shengguo Tongyuan recently invested RMB 460 million ($65million) in the first phase of a wind turbine project  with annual output of 1,000 units of 1.5MW wind turbines. The second phase will cost an additional $90 million. After the business is up and running, the ongoing working capital need is also high as there is a natural funding gap between current assets and current liabilities. For example, Goldwind Technology, the 2nd largest wind turbine manufacturer in China, has accounts receivable days of 96 and inventory days of 116 while the accounts payable days are 58.  For some small players with less bargaining leverage, the accounts payable days could be as low as 30.  APWR’s existing DG business has relatively low working capital requirements: both receivables and inventory requirements are minimal - its A/R days are 20 and inventory days are only 7. With the ramping up of its wind power business, its working capital needs will have to increase significantly to be more in line with the industry norm and its cash balance is likely to go down significantly.

     

    Valuation

    Buying APWR now is essentially buying its DG business and a call option on its new wind turbine business and its JV with GE.  It will make a great investment if its DG business is traded at a discount and the call option is free. Current valuation does not present a good entry point, however.

    ·      Distributed generation business. DG is APWR’s bread and butter business, where it has a good track record. Though it has a high growth rate, the business has relatively low operating margins (~10.6%) and is quite sensitive to the macro economic cycle (evidenced by its downward revision of 4Q08 earnings). We find it hard to apply a higher than 10x P/E on the company (that is assuming no discount factor for an emerging market small cap stock). Management’s earnings guidance for 2009 is $32 million, implying a market cap of $320 million vs its $430 million market cap on 6/15/09.

    ·      Wind turbine business. We are hesitant to assign any value to its wind power business as at this point as it is still in a very early stage and it is hard to forecast “normalized earnings” for that division. The company stated before that it has signed a letter of intent for 380 units of 2.7 MW, but during the first quarter earnings call on 6/16/09, it said it will only deliver 2 units by the end of July and potentially another 30 units of 2.7 MW (300 manufacturing capacity) as well as 40 units of 750 kw (420 manufacturing capacity) by the end of 2009. As we point out in the reality check section, APWR has not picked the best timing in launching its wind power business. It needs to prove that it has a viable business model and the capital sources to compete and grow this business in the increasingly challenging market dynamics. 2010 is more likely a make-or-break year for APWR. Until then, there should be no tail wind for its valuation.

    ·      GE JV – the JV makes long term sense for APWR.  As we mentioned in the reality check section, component providers are the sweet spot in the wind power value chain. Additionally GE will use the JV as a potential supplier for its business in Southeast Asia. 

     

    Near Term Catalysts

    ·      6/16/09 earnings release: as expected, not a lot of new information to support its current valuation, especially in regard to the order book for its winder power business and how APWR would fend off its more established competitors.  Current 2009 guidance does not include contribution from wind power business as the company is still working with its customers on pricing terms which for competitive reasons could not be disclosed.

    ·      20F filing possibly by the end of June 

    ·      July 2009: the deadline to deliver 2 units of 2.7 MW wind turbines

     

    Disclaimer: the author has no exposure to APWR.

    Jun 16 1:16 PM | Link | Comment!
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