Portfolio Update, PBR, odd lots, and pitches

Provided to subscribers August 8th.

Here is the latest from Canadian Value Investors!

• Portfolio update

• PBR update

• Another odd lot TNET

• Quick pitches from around the web

• Other bits - Short selling is getting more dangerous, Canadian accounting shenanigans, and some investing history

Portfolio Update

There have been a few changes since the last update:

PBR Dividend Policy, Credit Rating Upgrade

Disclosure: We remain long PBR.A.

Since our last update, Petrobras has announced a few things. Most importantly:

1)  Their highly anticipated new dividend policy. It sounds just fine; a middle ground we expected and not the dire outcome some expected. The new shareholder remuneration is based on 45% of Operating Cash Flow minus investments vs 60% of Operating Cash Flow minus capex. The quarterly distribution model is maintained and Q2 has been announced (see table). They have also incorporated the ability to now repurchase shares and these repurchases would be considered as part of shareholder remuneration. We are fine with some repurchases at current multiples, but would not want to see the dividend replaced exclusively by repurchases (which does not appear to be the plan). The buyback program will be done under a pilot of the net twelve months and expected to buy back 157MM preferred shares or 3.5%.

2) They also announced their sustainable capex target. Again, in line with our assumptions (assumed 20% FCF disappears, actual number 6-15%). These investments are supposed to be profitable per their guidelines, but we assume they will not be and hope to be wrong. As a side note, we expect Canadian large cap / integrated oil companies will ultimately spend similar levels (just look at the Pathways Alliance CCS budget, never mind other initiatives) and do not think this is fully priced in by the market yet.

3) S&P changed the outlook of its credit rating from stable to positive as a “reflection of the improved outlook of the Federative Republic of Brazil”.

Here’s the new plan, and the new dividend policy.

“Rio de Janeiro, August 7, 2023 – Petróleo Brasileiro S.A. – Petrobras, in relation to the news released in the media and as disclosed to the market on 06/01/2023, informs that the Strategic Plan 2024-2028 will have as a driver, among others, the forecast of low-carbon CAPEX for the range between 6% and 15% of the total CAPEX for the first five years of the new Plan, in compliance with current governance practices, the commitment to value creation and the Company's long-term financial sustainability.

This driver is aligned with the strategic elements that should be included in the plan, allowing the Company to (i) act in low-carbon businesses, diversifying the portfolio in a profitable way and promoting the perpetuation of Petrobras; (ii) operate in our businesses in a safe and sustainable manner, seeking decreasing emissions, promoting diversity and social development, contributing to a just energy transition and to the training of sustainability experts; and (iii) seek innovation to generate value for the business, supporting operational excellence and enabling solutions in new energies and decarbonization.”

For those keeping track, dividends are ~18% yield so far this year if you bought in the spring like we did while the stock is up 20-40% depending on the purchase. We still like the company at the current price.

For context, even with the increase in share price, this is how it is trading relative to a few well-known names using recent analyst estimates available to us. They have different assumptions than we do, but directionally it provides an indication of how they are being priced relatively using similar analyst assumptions for oil prices. Should PBR trade like Saudi Aramco or Chevron? Probably not, but maybe not so relatively cheap either. The key concern remaining for us is will their domestic diesel/etc pricing remain profitable, or will political pressure crush margins?

Maybe Lula isn’t so bad. “Brazil’s Leftist President Is Getting Things Done. The Markets Love It.” https://www.marketwatch.com/articles/brazils-leftist-president-is-getting-things-done-the-markets-love-it-9124bffa

Another odd lot - TNET

Disclosure: We do not currently own this but might purchase.

TNET is repurchasing shares at $107 vs ~$105.50 currently and they have an odd lot provision. Upside is ~US$149, closing by as late as September 13th. ~17% IRR. Do your own due diligence. We are on the sidelines due to account rebalancing and transfers. Details here: https://www.bamsec.com/filing/110465923086012/2?cik=937098

Quick Pitches from around the web

These are ideas we are evaluating, but currently have no position.

Gulf Island Fabrication turnaround

No Called Strikes Investing @NCSI_SA - $GIFI. Fabrication company that sold off an unprofitable shipyard division, made an accreditive acquisition, and is building a more robust backlog. All kick-started by a new CEO who I have a lot of respect for. Downside protection is a healthy cash balance and undervalued assets

CVI note: Market cap $57MM, but EV only $15.4MM considering net cash. New CEO (2019) turnaround three years in.

https://seekingalpha.com/article/4576264-gulf-island-fabrication-overlooked-unloved-and-undervalued

A quick look at the numbers.

Alto Ingredients ALTO– Jeremy Raper

Founder of Raper Capital is pushing for change at Alto Ingredients, Inc. (NASDAQ: ALTO), a producer and distributor of specialty alcohols and essential ingredients. On June 29, 2023, Jeremy published "An Open Letter to the Board of Alto Ingredients, Inc." on his website. An interview of the situation can be found here. https://youtu.be/yj3mg-r6q9E

Just yesterday, the CEO stepped down. Maybe something will come of this push indeed. https://www.globenewswire.com/news-release/2023/08/07/2719709/0/en/Alto-Ingredients-Announces-Executive-Leadership-Changes.html

Short selling is getting more dangerous

Another case study of the increasing dangers of shorting failing businesses. Yellow Corp declared bankruptcy, but not before its stock rallied 170% or so, reportedly due to “meme” investors. We continue to not short companies, maybe the odd put.

Example of what the discussions are like - https://www.reddit.com/r/DishTards/comments/15dwqp5/final_yellow_company_dd/

Background article - https://www.bloomberg.com/news/articles/2023-08-06/dan-loeb-surrendered-but-meme-army-still-hits-bears-for-millions

Accounting shenanigans overseas? How about right here at home in Canada

Hay & Watson has been blackballed. Thankfully, it is not the auditor of any of our holdings. We checked. In general, we are concerned about looser accounting and the regrowth of cancers like fifteen row “adjusted EBITDAs”. Maybe we are overdue for another big scandal and accounting standards overhaul.

TORONTO, August 5, 2023 – The Canadian Public Accountability Board has terminated the registration of Vancouver-based accounting firm Hay & Watson, Chartered Professional Accountants as a participating audit firm with the national audit regulator. The termination, which comes almost one year after Hay & Watson was banned by the CPAB’s counterpart in the United States, the Public Company Accounting Oversight Board, effectively bans the accounting firm from audit engagements of public companies.

https://www.canadian-accountant.com/content/profession/cpab-bans-hay-and-watson

A little bit of investing history

St. James Investment Company did a great quarterly letter covering a little bit of investing history.

https://stjic.com/wp-content/uploads/2023/07/STJIC-Adviser-Letter-2023-Q2-Final-3.pdf

If the S&P 500 was weighted equally, rather than by market capitalization, its performance over the last three years looks anemic. The equal weight index provides a better understanding of the breadth of the market and the economy. Of course, not all stocks are equal, as some hold greater significance than others. Some businesses are poised to benefit and grow more due to the ongoing AI revolution. One could argue that the aforementioned five companies provide substantial exposure to AI, potentially unleashing a wave of creative destruction. However, caution is warranted when 25% of the entire U.S. stock market capitalization is concentrated in just seven technology companies, trading at materially different earnings multiple of the remaining 3,687 businesses.

At its current price of $423, Nvidia is valued at forty times its annual revenue. If one heroically assumes that the company manages to compound revenue by 50% per year for three years, it will "only” trade at a multiple of twelve times hypothetical sales in 2026...hardly a screaming bargain. Of course, market history has an interesting way of repeating itself. The most exaggerated technology bubble occurred in 1928-29 when the Radio Corporation of America (RCA) captured the imagination of every speculator on Wall Street. RCA’s trading volume sometimes accounted for 20% of the total volume on the New York Stock Exchange. At the stock price peak in September 1929, the company was "valued" at $665 million. Sales increased from $65 million in 1927 to $102 million in 1928 to $182 million in 1929. Therefore, at the peak of the RCA stock buying frenzy, the company was "valued" at a multiple of "only" 3.6 revenue. Forty-five years later, in 1974, RCA’s annual sales were $4.6 billion, yet the stock price bottomed that year at $38, about one-third of its 1929 stock price high.2 While most rational investors consider Nvidia ‘slightly’ overvalued, market momentum could push fantasy valuations higher. Comparing the 1929 period of RCA and the current situation with Nvidia in 2023, one observes a similar pattern where most stocks experience decline while a handful of large companies powered the major indices higher. In both instances, unsuspecting investors maintained the illusion that the "market" was healthy.

Hemisphere Energy Corp (TSXV:HME) - Thinking about valuing oil and gas companies

Is a 20% free cash flow yield and ~8% dividend yield the right price for a growing oil and gas company?

We follow energy extensively but view commodity businesses from a tourist perspective. They are extremely cyclical, and we are extremely price sensitive. We like companies that are as close to no brainers as possible, and opportunities come up at times because of the volatility. At the moment, we hold shares in Suncor and Petrobras and still hold some MEG in our diversified portfolio (see previous articles), but have fully swapped out our remaining holding in MEG for more Suncor and Petrobras. We view Suncor and Petrobras as better bets vs MEG at today’s prices. The nudge was Suncor finally getting their new CEO, who we like. Time to hit that reset button on safety in the office and the multiple in the market. https://boereport.com/2023/02/21/suncor-board-announces-rich-kruger-as-new-president-and-chief-executive-officer/

But what about small cap energy companies? Surely there are opportunities there. Today we look at Hemisphere Energy, which is a small Canadian producer (~$130MM market cap, ~2,800 boe/d) and often talked about on Twitter. We do not currently own this (we might eventually), but wanted to share with our readers what we are doing in the background between posts.

The Challenges of Investing in Energy

The challenges with evaluating energy companies in Canada are:

• Guessing future oil and gas prices, obviously – We mitigate this by only making a purchase when our bet will work out alright even at prices much lower than strip prices. It is not very often that prices are right for us, but right now seems to be one of those times.

• Difficulty in understanding a company’s assets and potential future development opportunities with very limited public information. A producer might have drilled their best wells, have few good future locations, or many other issues. – We mitigate this by focusing on companies with relatively simple (from a reserves certainty standpoint) long-life assets like Suncor’s oilsands projects.

• Even if you get a low price and understand their assets, you still have to deal with their biggest risk: management shenanigans. The risk is cash flow is used for a bad asset purchase, a bad merger, or other capital bonfire parties. We think that, in general, the energy industry is almost as good at destroying capital as the airline industry has been historically. But this time... it’s different!

Energy companies also rarely generate positive free cash flows as the cash required to develop a resource play far outstrips the short-term cash flows received, especially if you are growing reserves and production quickly. The difficulty is figuring out which companies are profitably growing, versus simply just growing.  We believe the Recycle Ratio is the most important metric in assessing E&P companies (notwithstanding the shortcomings). There are many definitions of the Recycle Ratio, but in our view, the best definition is:  Recycle Ratio = [free cash flow per boe / PDP FD&A capex cost per boe]

Some quick definitions:

Boe - barrel of oil equivalent

boe/d - barrel of oil equivalent per day

WTI – West Texas Intermediate – The most commonly referenced oil price benchmark in North America. Companies produce oil that trades at a premium or discount depending on the quality. Heavy oil produced by Suncor and Hemisphere trades at a discount.

"probable reserves" are those additional reserves that are less certain to be recovered than proved reserves. It is equally likely that the actual remaining quantities recovered will be greater or less than the sum of the estimated proved plus probable reserves.

"proved reserves" are those reserves that can be estimated with a high degree of certainty to be recoverable. It is likely that the actual remaining quantities recovered will exceed the estimated proved reserves.

We care most about PDP reserves or Proved Developed and Producing reserves that are volumes related to wells that have already been drilled and are in place; this is the most conservative number and companies generally hate using it for calculations.

For more definitions of terms (BOE, etc) we encourage you to check www.investopedia.com while Wikipedia has a decent background on types of reserves (like PDP being proved developed producing reserves) https://en.wikipedia.org/wiki/Oil_reserves

Analyzing Reserves

Hemisphere is a bit of a different company. They have been focusing one key asset for the last decade or so. It consists of heavy oil production with water/polymer flooding, which they say has been working well. Flooding, when it works, increases production levels, the amount of oil and gas you recover, and lowers decline rates. Their program seems to be working. You can read their year-end press release here. https://www.hemisphereenergy.ca/news/thu-02162023-1200-hemisphere-energy-grows-proved-reserve-value-309-million-and-proved-net

Oil and gas companies break down the year-over-year change in reserves in their Annual Information Forms, which can be found at www.sedar.com These reserves are evaluated by a third party engineering firm in a process that is somewhat analogous to accounting, but with a bit more art given the inherent assumptions that have to be made about future recoveries, realized prices, and costs. When combined with their financials, you can get a feel for how good they have been at finding profitable development opportunities.

However, it has limitations of course, and is often dangerous to simply extrapolate. In Hemisphere’s case, they are a mainly one trick pony working away on their asset. They have been able to increase reserves year-over-year. If a company is trying new things, in this case waterflooding their assets, the engineers will typically be more conservative until they have more data. Waterflooding is not a new technique, but it was new for their assets specifically. Reading the tea leaves, it looks like the third party engineers gave them credit for their waterflooding projects via a meaningful bump in technical revisions in 2019 as shown below.

They have also been able to maintain reserves. They originally financed this with some debt, but are now totally de-levered.

The Value of a Barrel

Netbacks are effectively the margin that an oil and gas company makes on what they produce. The table below outlines the breakdown. However, it does not include the capital costs to actually find that barrel of oil.

The Cost to Find That Barrel

The second key part is how much it costs to find that barrel and is it worth doing. If the capital cost to find a barrel is more than your netback, you are effectively a non-profit charity. We focus on the PDP recycle ratio, as 2P reserves still include unspent capital (such as future drilling) attached to them and more estimates, while PDP/1P reserves are typically related to wells that are already drilled. 1P also includes wells that are turned off or conservatively categorized as such (proven non-producing or PDNP), as well as reserves that are direct offsets to current production and reasonable certainty of production (PUD). 2P includes probably, which provides some indication of future opportunities, but requires significant capital to unlock that value. We do not want to pay for 2P and just use it as an indicator of if the runway is running out.

This is their own stated recycle ratio and it is pretty healthy. However, these numbers are very volatile year-to-year and we prefer to look over a longer period of time as we have below. This often does not work very well, such as when a company makes frequent acquisitions/dispositions or has many different assets and does not consistently drill each asset. Hemisphere is a single simple asset company, which we like. A few notes:

• 2012 - Year‐end reporting date changed to December 31. Major acquisitions of Jenner assets in 2012.

• Capex was limited in 2015-2017 given the price crash. 2018 normal. Debt issuance funded 2017+ growth, peaked at $32MM and now totally de-levered.

• 2020 - Large PDP positive/Prob negative technical revisions likely third-party engineers giving credit for previous waterflood work; moving prob/PDP

• 2021 - Capex incl only 50%/$6MM drilling and only 3 of 7 on in 2021, other incl new polymer skid at Atlee G pool, etc. F&D excl = ~$6MM

• Backed out Financing Warranty valuation change $6.1MM. 2017 warrants cleaned up.

You can also get a feel for the quality of their barrels by comparing realized prices vs benchmarks. In this case, the most important is WTI and their discount aligns with what you would expect for a heavy barrel at around ~$20 Canadian in a normal market (2018 diffs blew out due to egress constraints; a story for another day).