Sunday, November 7, 2010

Why I'd avoid ATP Oil and Gas

I was asked by a comment on my blog by someone named Jason to comment on what I think of ATP Oil and Gas (ATPG - Nasdaq). I honestly don't know anything about the company other than one of my holdings, General Electric (GE), has had some dealings with them. I have never read any analyst reports nor have I read any comments by CanadianValue (a blogger was mentioned in the comment by Jason). I have read some of Canadianvalue articles but they contain little substance regarding returns on capital.

I took some time reading ATPG's 10-K and here is my quick and dirty.

1) ATPG hasn't earned a dime in profits as a corporation.
2) Their business model is feeding off the leftovers of the majors.
3) They have ran into some major financial difficulty (and the BP issues hurt them big time in GOM hasn't helped).
4) They are hugely leveraged as debt to equity is something like 5:1.
5) They borrow money at 12.75%. If that is what the bankers demand the company is basically up against the wall with a gun to their head.
6) If oil prices fall this company is toast.
7) It doesn't take long to see why short interest in the stock tops 50%.

I personally hate losing money more than I like making it. Now that makes me ultra conservative so I wouldn't touch ATPG with a ten foot pole. If oil prices fall you will lose your entire investment (even if they are hedged). I would never take such a risk.

To be fair I asked an opinion of a fellow blogger who is long and this is what he wrote me in an email.

I'll just bullet a quick rundown of all the positives and negatives for ATP now:

Negatives:

- Very high long-term debt with a high interest rate that gives them high fixed costs, and an even higher rate of future borrowing.
- Management is continually over promising and under delivering. The good news is they have become aware of this finally, and have begun to withold projections. If you say a well will be 7-10K barrels and it's 6.5K the market gets mad. If you say 5-7, that is a surprise; I believe the light bulb went on based on recent conference calls.
- At the mercy of Washington and future regulations. (Their drilling rig the Titan is state of the art, their management spent most of the summer in Washington teaching the politicians things about safety, and new regulations have been based on the Titans structure).
- If one of their wells turns out to be less than desired stock will sell off really quickly (98% success rate in developing their wells).

Positives:

-Daily production started the year at 13.5K barrels per day and it's currently around 30K (will find out more at tmw's conference call at 11 AM).
- A couple smaller wells are expected to be brought on prior to year end.
- When they receive permits to drill their next two Telemark wells that will be a catalyst, and there will be some short covering.
- Have hedged 1/3 of next year's oil production in the low 80s. I expect/hope that they have hedged a lot more since oil has entered the mid 80s.
- They have about a 65-35 mix of oil to natural gas in their wells; natural gas prices are finally rebounding.
- Entrada: They bought this for about 200K which judging by the excitement in management's voice should be a location for future production growth sometime around 2012/2013.
- Their Octabuoy right is already monetized which will give them new production in the North Sea in 2012.
- No financial covenants on their most recent debt.
- Capital expenditures are fully funded for 2011 based on the Titan Monetization: They do not sound as if they will need to take each of the last $50 million draws, but the money is there if they are short on cash.
- I have them cash flow positive with 32K barrles/ day at $80 oil and $4 natural gas; I feel like they are there, and have the production growth to stay there and in 2012 start to pay down that debt.


The only point of Kyle's that I wouldn't agree with is the point on the finacial convenants on the debt. They actually have a number if you read the 10-K. I quote from page 48 of the 10-K.

Covenant Requirement during the
Amendment Period (4)

1. Minimum Current Ratio (1)(5) Greater than 0.8 to 1.0
2. Ratio of Net Debt to EBITDAX (2)(5) Less than 4.0 to 1.0
3. Ratio of EBITDAX to Interest Expense (5) Greater than 2.0 to 1.0
4. Ratio of PV-10 of Total Proved Developed Producing Reserves based
on future prices to Net Debt (3) Greater than 0.5 to 1.0
5. Ratio of PV-10 of Total Proved Reserves plus 50% of Pre-tax Probable
Reserves based on future prices to Net Debt Greater than 2.5 to 1.0


If you read the 10-K it also explains how they are just barely keeping these amended convenants. Secondly, guys like CanadianValue might believe the total proved reserves don't matter but they definitely do to the bankers. To be a successful investor you must think like a banker.

My Summary

Now, I don't understand why so called "value investors" continually go for high risk investments like this. This one has red flags all over it. I have an investment checklist that I use and let me highlight a few on ATPG for the readers.

1) Is the business simple and understandable?

Definitely not. Now it would take significant time to breakdown what ATPG actually owns. They have sold off royalty stakes in all different areas of their business. It is definitely one big mess.

2) Does the business have a consistent operating history? NO

3) Does the business have favorable long term prospects? Not Easily Determined.

4) How much income tax was paid last year?

Now this one is interesting because oil and gas companies can shelter taxable income with drilling tax pools. If you do own an oil and gas company and they have never paid any income tax that is an immediate red flag they aren't earning any returns on capital. Now small startups can shelter income tax if capex continually creates tax pools, but you much be able to read the financial reports accordingly.

As for ATPG, I already mentioned they haven't earned a dime in profits over it's history. Enough said.

5) What is the EBIT/Enterprise value? Zero.

6) How much leverage does the company employ? Way, way too much. Personally I hate debt, both personally and in businesses I own.

Now I could go on but I don't feel it's necessary. Why do investors feel like they have to jump through so many hoops in order to justify an investment? As Warren Buffett has said, "degree of difficultly doesn't matter in investing." If you followed Buffett's policy of 20 spot punchcard for your allowable investments in your lifetime would you waste a punch on ATPG?

This investment can't be explained on the back of a napkin, doesn't earn outstanding return on capital, doesn't have any competitive advantage, and it has a terrible operating history.

I'm sorry I have to stick to my guns and toss this one to the too hard pile (and I would add not worth my time anyway). This is where I scratch my head and ask where are the true value investors?

I previously have posted nine stocks on my blog that should return 10-15% per year for the next 5 years quite easily regardless of factors like where oil price will trade in the next few years. I will add that some have moved up substantially this past week so use your own judgement.

If you feel you are a value investor and take Buffett's investment strategy seriously please comment as I am deperately interested in meeting some fellow value investor over the internet. Comment Below or send me an email.


Best Regards,
Kevin


To read Kyle's Blog Click Here

9 comments:

  1. I like your approach. If you stick to your guns and only invest in low risk situations at good prices you will do fine over time.

    I would say though that dumpster diving as I did with ATP can be lucrative. I've linked my first article below which was when we got quite long ATP under $6. Prior to the BP spill we were up 4x and are still doing pretty well with a $16 plus share price today.

    You will be interested to know that Einhorn was getting long at the time I wrote this article as well.

    http://seekingalpha.com/article/133082-atp-oil-gas-value-after-a-stock-and-commodity-collapse

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  2. Hi Devin,

    I agree that dumpster diving may be lucrative but is it also downright dangerous. If you like taking a coin and flipping for double or nothing that is your choice.

    Permanent loss of capital is what I try to avoid.

    Lastly please do not put any links in your comments. I will remove your comments next time.

    Good Luck with ATPG,
    Kevin

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  3. Kevin, just FYI -

    http://boards.fool.com/re-sa-article-quotwhy-id-avoid-atp-oil-and-g-28879719.aspx

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  4. This comment has been removed by the author.

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  5. Hi Kevin,

    Claiming that ATP doesn't have a ROIC, and an outstanding one at that, without delving into their oil and gas reserves, the most important part of an oil company's valuation, is completely rediculous. GAAP numbers are (next to) useless for reporting O&G E&P results. **Especially** since lots of companies use successful efforts accounting (ATP uses the full cost method). The successful efforts method would show MORE GAAP earnings than the full cost method.

    In gauging longterm results of an upstream oil and gas company, you have to take in the longterm change in liabilities versus the longterm value added by finding oil and gas. Once you have a range (this is naturally an imprecise science which you as a Canadian PEng clearly understand when performing any engineering projects) of value created over time you can then evaluate managements consideration for the use of debt. Then you take a haircut for risk employed on ROIC (since safety, operational, and hitting good wells are all potential liabilities), another haircut for the possibility of a huge environmental liability, another haircut for dilution due to options to retain employees, and you see a rough range of what the "expected" ROIC is. The nice thing about ATP is that as they build more hubs this should likely improve over time (40 year life but Titan payout is easily within its first few fields at mirage/morgus). Once you do all this, with my assumptions and following the company, I believe they earn roughly a ~25-35% after tax risk adjusted ROIC, which is partially due to fast rising oil prices in the industry and partially offset by much higher costs of doing business. I believe if both were to stay constant this after-tax ROIC would be in the neighbourhood of 15-20%.

    This means if they see the prospects for a hub like the Titan as viable and they issue debt at 12% pre-tax (8% after-tax) and some vendor financing at 20% pre-tax (13% after-tax) that I feel comfortable with them taking on that risk. As stated previously, I guess Einhorn feels the same way. I expect the highly value oriented management team of ATP will too.

    Their overpromising and underdelivering in the short run expectations-management theme doesn't bother me. Their longterm track record is great and there are very few other companies that can claim the same. As an engineer you surely know that they are trying to predict what they think will happen (as you would report to your boss) versus massaging the numbers and data (which they would be doing more of if they wanted/needed to issue more stock - but it is in their benefit for the price to stay low as long as possible now so they can buy back shares on the cheap).

    My opinion, and I do appreciate the debate

    Fellow Canadian engineering value investor
    Chris Bourque
    cb24@ualberta.ca (please delete email address after you've read this)

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  6. Chris,

    Thanks for your comments. In order to earn a return on capital you must earn a profit. ATPG hasn't done so in the past so their ROIC is zero. If ATPG is using full cost accounting that makes it even worse.

    I know exactly what you are saying. The problem is most companies toot their horn on the economics of individual projects while not including a lot of other costs/overhead. What you see in the investor presentation never translates into the financial statements. You can choose to believe the company's investor presentation but I prefer to use the financials.

    What is their long term track record? Problems and debt at over 12% interest. That doesn't speak well. If they had an outstanding record they wouldn't be borrowing at 12% today, period. Listen, credit quality can tell me more about a company and in particularly the quality of the management.

    Please don't take my comments personally, I appreciate opposing viewpoints. However, I have a very direct personality (if you haven't noticed).

    I don't know how to remove your email. If you know, send me an email. You can find my email on the contact tab above.

    Best Regards,
    Kevin

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  7. Kevin,

    Yes, you do have to return a profit, of course we can agree on that. Let's take a simpler example to exemplify what I mean about making a profit and reinvesting it in your company. Then we can run through the financials to see how it would change reported results. When we look at ATPG they have massively (to the point of high leverage) reinvested in their company over the past 10 years.

    You are an apartment building owner that owns 10 apartment buildings in the year 2000. You look at three of your options (for simplification) over the next 10 years: a) pay all rent minus costs out to your shareholders as dividends b) you use all existing cash flow to build more apartment buildings or c) use all existing cash flow plus maximizing your borrowing to building more apartment buildings. If you are the owner of the company, which option will you choose, why, and how will the financials look if you are trying to maximize the value of your company over the long run?

    If you choose a), it's because you think there are better opportunities in other investments rather than building or buying more apartment buildings.

    If you choose b), it's because you think you can earn a return on capital above your cost of equity.

    If you choose c), it's because you think present investment will maximize long term value if your return on capital exceeds both your cost of equity and cost of debt.

    Let's compare b) and c), as that is generally what has happened for the mid-tier oil and gas companies (the large E&P's generally do a combination of a) and c) )

    If the company chooses b), to reinvest profits without taking on more debt, they will show profits during the next 10 years, but less than a) especially during the first few years due to increased costs for expanding, such as increased depreciation for the new buildings, lawyers and real estate evaluators to purchase the new sites, etc etc. This will show lower profits when in fact the company is preparing itself for larger profits in the future. At the end of 10 years, b) might own 40 real estate buildings which means that if it switches to paying out earnings as dividends it will have 4x the base of a) (roughly a 15% growth rate for reinvestment, satisfactory but not amazing).

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  8. Then we can compare option c) to option b), if they can leverage their equity at 1x with debt, reinvest profitably at 15% growth rate, have a weighted average cost of debt over the last 10 years of 10% after-cost, they could own 124 apartment buildings and would still carry 1x equity to debt in 2010.

    To evaluate whether b) or c) were more productive you would look at, in the year 2010, whether 84 more apartment buildings are worth that 1x debt, and you compare to the company that didn't use leverage to expand, and 1x the equity is 40 buildings so you could sell 40 buildings, pay off the debt, and you would have 84 buildings left over with the same amount of equity and debt as company b).

    The ironic part of this whole discussion is that even though company c) was blowing company b) out of the water in terms of capital structure for longterm results, the financials will look substantially worse. You will be opening up ~4x more buildings in the course of 10 years, which means much higher salary costs, searching for prospects, real estate costs, lawyer costs, building the apartments, etc. Full cost means that they would expense all of these on the income statement (depressing present "profits" that are actually being reinvested) so that would show much lower profits.

    As you can see, what they teach you in business school applies here, if a company is reinvesting its debt-laden capital at returns higher than its cost of debt over a full cycle than it is creating excess value for shareholders.

    I believe you are severely misunderstanding the economics of reinvesting. As a value investor, I am hoping you and the vast majority of others continue to do so as this presents the opportunity for me to make ridiculous excess gains.

    Thanks again,
    Chris Bourque

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  9. Hi Chris,

    I totally understand what you are saying. As to your options you must breakdown the returns for any future investment and decide accordingly.

    Chris, what is the average return on capital in the USA? How about for Oil & Gas? Buffett estimates the average company earns 12% ROE and ROIC is less if any leverage is used. ATPG must earn inexcess of 12.3% to create a real return. Like I have said, good luck. Not only must the project have superb economics, but only the excess would be the real return.

    I understand the economics of reinvesting. You must earn a full cycle return on capital in excess of your cost. It's crazy all the talk on the internet regarding CF and no focus on profits. Now in oil and gas you can shelter profits from income tax with tax pools. You will show a profit but not pay income tax.

    Full cost accounting in oil and gas does not mean they expense all exploration and development activities today to show lower profits. It means you capitalize all exploration and development activities and depreciate over time. In effect it does the opposite of what you think. Successful efforts means you only capitalize successful E&P activity. It will fully expense unsuccessful results today.

    I will you all the best with ATPG. You got the 50% shorts by the tail. Congrats on your opportunity.

    Regards,
    Kevin

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