Thursday, September 29, 2011

BP - Is it Cheap?

I have found out I really don’t like to disclose my research, particularly because people are lazy and don’t share their own (or don't perform any).  Since I have a blog I had initially wanted to share value ideas monthly, so I will share this one. BP is a British integrated oil company that has fallen on hard times. I noticed a few high profile investors, like Seth Klarman, recent took a position so I decided to take a look. BP has come under extreme pressure due to the blowout failure in the Gulf of Mexico. The subsequent oil spillage was difficult to contain but it appears that they are doing much better keeping costs associated with the blowout contained.

Because of the spill many investors will not touch BP. Investors hate uncertainty, just look at Bank of America for instance. Moreover, investors don’t care if the lawsuits have any merit or not. It’s guilty until proven innocent.

Now BP did set up a $20 billion fund to pay for any damages that arose from the oil spill. The basically took the earnings hit in 2010 (non cash) and committed to fund the $20 billion through the end of 2013. They contributed $5 billion in 2010, and will contribute $1.25 billion/quarter or $5 billion annually for years 2011, 2012, and 2013. I will attempt to put some numbers on that liability below but let’s first determine the normalized earnings power of BP.

Normalized Earnings Power

To analyze the normalized earnings power I first determined the earnings before interest and taxes for the last 5 years and took the average. I adjusted the numbers for 2010 to exclude $40 billion (pretax) hit they took that year (non cash).

5 Year Average EBIT = $32.9 billion (EBIT = Earnings before interest and taxes)
5 Year Average Interest = $1.3 billion (debt to equity is very constant)
5 Year Average EBT = $31.6 billion (EBT = Earning before taxes)
Taxes at 35% = $11.0 billion

5 Year Average Earnings = $20.5 billion

Given that there are 3.2 million American Depository Shares (ADS) equivalent, the normalized earnings = $6.45/ADS. BP normally pays 40% of their earnings as dividends so that would be $2.58/ADS.

If you take today’s price of $37/ADS, the normalized earnings yield is 17.5% and the normalized dividend yield is 7.0%.  Definitely Cheap.

Trust Claims Analysis

Emergency Trust Claims

There were approximately 169,000 emergency claims and 99.8% have been settled for a total amount of $2.6 billion (average claim = $15,400). There are 273 remaining claims in this pool and assuming each of these claims pay out 2 times the average, for a cost of $30,800/claim, that would be an additional $8.4 million to be paid out.

Regular Trust Claims

There were approximately 308,000 regular claims and 81% have been settled. Claims were either paid (49%), denied (29%), or withdrawn (0.2%). The total amount paid for claims were $1.7 billion to the end of Q2, 2011 (average claim = $11,300). There are 59,232 remaining claims (19%) in this pool and assuming each of these claims pay out 2 times the average, for a cost of $22,600/claim, that would be an additional $1.3 billion to be paid out.

Government Claims

There were 965 government claims and 83% have been settled for a total amount of $1.3 billion (average claim = $1.6 million). There are 168 remaining claims in this pool (17%) and assuming each of these claims pay out 2 times the average, for a cost of $3.2 million/claim, that would be an additional $0.5 billion to be paid out.

Claims Summary

There has been a total of $5.6 billion paid to the end of Q2 2011. Using the assumptions above of 2x historical payouts BP would be on the hook for an additional $1.9 billion bringing the total to $7.5 billion. Obviously this would leave $12.5 billion in the fund for other liabilities or lawsuits.

What if we are ultra pessimistic and believe remaining claims will be paid out at 10 times historical payouts? Additional payouts would then total $9.5 billion and combined with $5.6 billion already paid, the total would be $15.1 billion. That would leave $4.9 billion left in the fund for other liabilities or lawsuits.

Obviously it appears the company has the liabilities well under control and has some buffer. If the partners on the well are forced to pay their fair share of the cost BP’s contributions to the fund may be complete be the end of 2012.


BP appears to be in decent shape to rebound from the recent oil spill. BP typically earns lower than average net profit margins on its production, but the stock appears cheap. Please note the 5 year average realized price for BP is $69.31/bbl, as this is the most important factor. Oil prices have come down recently to sub $80/WTI, and I feel it may go down quite a bit more. Net speculative positions in oil are quite high, and if China implodes oil it will go way down.

It appears the company has a good handle on the claims from the oil spill.

At a 17.5% normalized earnings yield (normalized P/E = 5.7) BP appears to be cheap, however the past 5 years has included some very high prices for oil. The company is selling for a little more than 3x EBIT. If dividends return to normal levels and oil drops off a little more from here BP offers better price protection than most oil producers.  However, given the state of affairs in China I wouldn't touch anything commodity related.

Price is what you pay, value is what you get - Warren Buffett

Best Regards,
Kevin Graham

Disclosure - Long BAC and BAC.wt.a (both personally and for family)

Wednesday, September 28, 2011

Petrobakken - Dividend about to be Slashed?

I haven't commented about PetroBakken (PBN) or Petrobank (PBG) for a while so now might be a good time.  Why?  The stock got crushed today down over 12%.  I would be willing to bet the dividend is slashed over the next couple days.  PBN is currently yielding 11.7%.

Insiders are giving their friends an opportunity to sell before the news hits the steets.  Since the insiders don't own any shares, they don't need to sell. 

You can read about my thoughts on PBG and PBN: Here, Here, and Here.

Not to crow, but I did get a lot terrible reviews over at gurufocus on my article (the first link).  I have stopped writing articles over there because it speaks to the intellectual quality of the readership.  The second post talks about how they don't have the earnings to pay for their dividend.  The last link above was a scathing review of their 2010 results.

I may have to write another article for gurufocus on the anniversary of my article.  At this point and given my pessimism for oil prices going forward I think this one may just go to zero, given their debt levels. 

Best Regards,

Disclosure - I am not short and have never been short PBG or PBN (but I sure wish I did). 

Monday, September 26, 2011

Berkshire Hathaway Share Buyback

Well Berkshire Hathaway finally decided that a buyback was warranted because of the low price of the shares (Read Here).  Recently the stock has been selling for around book value. 

In some recent posts (Here and Here) I discussed the business and the assets and gave an estimate at how cheap they are. 

If and when Mr. Buffett ever decides to buy back a share of Berkshire, he effectively is buying his own businesses.  He is buying another Geico, Burlington Northern, National Indemnity, Mid American, Benjamin Moore, International Dairy Queen, See's Candy, Nebraska Furniture Mart, Netjets, Clayton Homes, and many more. 

Many of these companies are worth much more than book value.  Given they have grown their earnings by 20% for several decades these businesses are fantastic.  Demand for their products or services is the evidence. 

To me the bigger value is in Berkshire's common equity holdings that are selling for multi-year or decade lows relative to the underlying business performance.  Many of these companies are the cream of the cream that can earn very high returns on equity. 

Best Regards,

Disclosure - Long BRK.b

Sunday, September 25, 2011

Peter Schiff's Testimony Before Congress on Jobs

"Government stimulus will never grow this economy. It will never create jobs. It is the equivalent of trying to put out a fire by pouring gasoline on it. We have to understand that the housing bubble, the financial crisis of 2008, were the consequences of government stimulus." - Peter Schiff

While I agree with most all of what Mr. Schiff says in the videos.  My only point of contention is the effect of stimulus.  The stimulus is put into effect to lessen the depth of the recession.  It does not take money from Peter to pay Paul because the government borrows the money and doesn't require taxes from anyone TODAY.  That said their is no free lunch so future generations will have to pay for it eventually. 
Of course the government could step back and let the market correct itself the from imbalance and over-investment in housing.  The recession would be far deeper and hurt far more people.  By "floating the boat" and keeping some marginal industries afloat during this time will allow more businesses to survive after the correction.  The stimulus does draw out the recession no doubt but it does buy time for this restructuring to occur.  The hope is that the eventual recover is greater as businesses don't have to start from scratch and the infrastructure investment will make the nation more productive.   

Now, it is immoral how many members of congress used the stimulus bill to fund pet projects and give tax breaks to select lobby groups and friends, especially in their jurisdictions.  I can provide examples if you would like. 

As for the comments by Mr. Cummings, I believe, that education needing more funding couldn't be further from the truth.  Young people believe that money grows on trees.  They believe hard work isn't required to get ahead.  They think that government can answer all of our economic problems and that the government can magically shower money from the heavens.  Young people need to be educated in how capitalism works, how to savings not consumption drive economic growth, and that you cannot legislate yourself to wealth. 

I encourage you to try this experiment if you wish.  Walk up to 10 random strangers and ask them why we live in a wealthy nation?  Nobody has a clue.  Perhaps "The Wealth of Nations" by Adam Smith (from 1776) should be mandatory reading for high school students...  And after they finish that one they should read "The Road to Serfdom" by FA Hayek. 

Don't get me wrong education is very important.  In our global economy, if you choose not to get an education that is your individual right.  You just need to be aware that you will be competing with uneducated labor all around the world.  The growing divide between the rich and the "relative" poor in the USA proves this point as the US workforce is among the most highly educated.  Nearly one in every three people in the USA have four or more years of college, compared to one in thirteen in 1960. 

Now I say "relatively" poor because I have heard people from India say they would love to come to the USA, why?  "Because even the poor people are fat in America."  Moreover, if you earn the average annual wage (~50k/yr) in the USA you are in the top 4.3% (for wealth) in the world.  Imagine a line of one hundred people who represent the worlds richest to the poorest... you would be standing right next to Bill Gates or Warren Buffett at the front of the line. 

Best Regards,

Kevin Graham

Peak Oil - Ignores Market Forces

I wrote an article about a year ago about how Peak Oil ignores market forces (To read Click Here).  As price increases, more marginal reserves are exploited and technology allows us to access more and more previously unaccessable resources.  This in turn pushes the peak oil problem further and further out to the future. 

I recently came across an article in the Wall Street Journal that states many of the same points.  You can read it at the link below.

Best Regards,

Friday, September 23, 2011

Gold - Quote of the Day!

With Gold down 6% today and Silver absolutely crushed down 15%, I couldn't help but laugh when I read this quote.

When gold goes up, it's because everyone is increasingly realizing that it's the only true money.

When gold goes down, it's because everyone is increasingly realizing that dollars are the only true money.

There, I explained it for you.  (Ericopoly)

Have a great weekend!

Thursday, September 22, 2011

Here is the problem!!!

Here are some insights from an article on Globe & Mail.  You can read it here:

Mr. O’Rourke, a 47-year veteran of mining, insists long-term demand for copper is strong and other commodities is strong. Copper Mountain is the first major mine to open in B.C. since 1998 and is the third-largest copper mine in Canada. It was opened to capitalize on higher prices and was greenlighted on a feasibility study that rested on $1.80 a pound copper.

The price per pound fell on Thursday to about $3.50, from $3.75 on Wednesday, and an average of $4.20 in August, an extremely lofty level for copper. Mr. O’Rourke said his company would still make money at $2.50.

He also noted prices remain high. Copper is higher than it was a year ago and precious metals remain lofty, though off their peaks.  “Gold is still $1,730 an ounce,” said Mr. O’Rourke. “Silver’s $36. I mean, those are unbelievable prices for miners.”

Yes Mr O'Rourke...prices are high!  They are unbelievable prices!  So unbelievable that they are about to fall. 

As an investor I look for downside risk protection and those comments above are some huge red flags. 

Best Regards,

Brief Comment on the Market

It appears that many in the market today don't understand what is going on.  Let me give you my brief take and will be providing more info over the course of the weekend. 

1)  The bubble in Chinese real estate and construction seems to be popping.  Infrastructure and Construction combine for 40% of GDP, which is unheard of in any modern economy.  They implemented a massive 26% of GDP financial stimulus back in 2008 that gave the economy one last push.  The speculation over there in real estate is rampant.   

2)  Commodities are getting hammered.  China uses over 40-53% of the following commodities in the following order: Cement, Iron ore, coal, pigs, steel, lead, zinc, aluminum, copper, and nickel. 

3)  The CEO of Rio Tinto has hinted that demand is slowing.

4)  The Canadian economy (and Australian economy) depend heavily on commodities and economy will be effected heavily by this.  I would strongly suggest avoiding the broader market in Canada and anything related to commodities. 

Just to finish this isn't the end of the world, but during the last ten years many commodities have tripled, quadrupled, or even more.  Trees don't grow to the sky.  Even gold seem to have broken down and is selling off along side the broader markets. 

A number of very high quality companies are currently on sale.  I have commented on many of them them in the past.  Walmart is quite cheap. 

One benefit to this unwinding of commodity prices is that we will all be paying less for gasoline in the near future.

Best Regards,

Disclosure: I am looking to short commodities. 

Tuesday, September 20, 2011

Saturday, September 3, 2011

Bank of America - Comments on Lawsuits

Here are a couple of outstanding articles on the Bank of America/Countrywide lawsuits.  Since there is so much emotion involved in discussing Bank of America, it's refreshing to see some facts discussed.

Here is a link to the State of Nevada lawsuit against Bank of America, filed Aug 30th, 2011.

General Comments

I have read the above lawsuits, California Judgement, and the opinion of the Stanford Law Professor (click here).  Limited liability laws exist to prevent these types of lawsuits.  The claims in the Nevada lawsuit will not fly as the judge in California has already rule on the claim "WITH PREJUDICE".  This means that state attorneys and others can't sue Bank of America for Countywide's liabilities. 

In the Stanford Law Professor's report under Successor Liability he states:

Generally speaking, a corporation which acquires the assets of another corporation is not liable for the seller’s debts. This is not surprising: when you buy a used car from a neighbor, you don’t have to start paying his mortgage as well. The corporate equivalent of this rule is well established and comes from the idea that corporations are persons and therefore liable for their debts and not the debts of others (not even of their affiliates). This rule is taught in every introductory corporate law class and relied on every day by business planners. Thus, it is indisputable that BAC would not normally become liable for Countrywide’s debts when it bought Countrywide assets.


Don't let all this noise about the Bank of America lawsuits scare you.  If these lawyers don't want to settle Bank of America will play their trump card and put Countrywide into Chapter 11.  Then the vultures can fight over the carcass. 

Best Regards,

Disclosure - Long BAC common and warrants. 

Friday, September 2, 2011

Answering a comment on Berkshire

I received this comment on my Berkshire post.

Hey Kevin, good post.

Do these positions account for the insurance float that is used in the investment portfolio, since the money is not really ours then? Also, the stock portfolio and the businesses that you refer to are all on the asset side of the equation, but we still have to subtract the liabilities right?

 I thought I would make the response into a post as it is much too long of a response for a comment. 

Hi Anonymous,

You are correct.  As for the float, here is what Warren Buffett said in the 2010 shareholder's letter. 

Insurance float – money we temporarily hold in our insurance operations that does not belong to us – funds $66 billion of our investments. This float is “free” as long as insurance underwriting breaks even, meaning that the premiums we receive equal the losses and expenses we incur. Of course, underwriting results are volatile, swinging erratically between profits and losses. Over our entire history, though, we’ve been significantly profitable, and I also expect us to average breakeven results or better in the future. If we do that, all of our investments – those funded both by float and by retained earnings – can be viewed as an element of value for Berkshire shareholders.

I fully agree that a full accounting of assets and liabilities needs to be done and I believe that the net difference makes the stock very attractive.  Berkshire owns also $35 billion of debt securities that I have added either.  I will leave the reader to do his or her own accounting, as I don’t want to do someone else’s homework.

Secondly, although the float is a liability it is not a $66 billion liability.  How can this be?  To answer that question, ask yourself the following.  What is the value of a $66 billion loan at 0% interest (and sometimes negative interest) for an indefinite term?  

Thirdly, the liability side also includes some significant deferred tax liabilities.  These aren’t really liabilities.  Berkshire has $13.4 billion in deferred taxes from capital gains in Coca-Cola, American Express and others.  So if Coca-Cola stock is never going to be sold the tax liability is really zero.  As of the end of the year the total deferred tax liability was $35 billion, although I wouldn’t use all of that. 

An Alternate Way of Valuing Berkshire (Quick and Dirty)

If you read on p.3 of the 2010 letter to shareholders Buffett openly declares the earnings power of Berkshire to be $17 billion pre-tax and $12 billion after-tax in a “normal” operating year. 

If you skip down to page 17, under investments, Buffett says that the undistributed earnings of the companies they own is currently $2 billion.  This would be about $3 billion pre-tax.  So the total earnings power of the company and investments is about $20 billion pre-tax and 14 billion after-tax. 

So if you apply a 12 times pre-tax and 18 times after-tax multiple to the "normal" earnings power, the value of Berkshire is somewhere between $240-250 billion.  Currently the company’s market cap is $173.5 billion, giving a 28-31% discount.


Why I really like Berkshire, besides the obvious discount, is that the company is very conservatively run and the assets are top quality.  Moreover, the exposure Berkshire give you to a number of very large cap stocks is compelling because I believe a number of them to be significantly undervalue.  The market for these large caps has gone sideways for the past decade while the earnings (per share) have doubled, tripled or quadrupled.  I expect Wells Fargo to double over the next couple years so that alone will add $10 billion to Berkshire.

Thanks for the comment.

Best Regards,


Disclosure – Long BRK.b