It used to be that making money in stocks was relatively easier. Father of value investing, Benjamin Graham, was known for his predilection of “cigar butt” stocks. That is, stocks which the market has thrown to the curb, forgotten, but which still might have at least “a few puffs” left in them. Harvest Natural Resources (NYSE: HNR), a small-cap oil and gas exploration and production (E&P) outfit focused on the development of known hydrocarbon deposits worldwide, may prove to be a classic example of such a stock.
With a market cap of $74.4 MM, and an indicated net current asset value (NCAV) very near that, Harvest Natural Resources, as a company, does not appear to be dead money. On the contrary, following an imminent sale of its Gabon asset for $32 MM, the company’s cash and receivable balance, less total liabilities, will exceed its market capitalization by $25 MM, implying that the market assigns a negative value to its expected future cash hoard. Worst case, investors could expect to get nearly all of their money back even after a 30% tax on a special dividend. However, if management can figure out a tax-advantaged means by which to utilize that sum, investors could benefit. A tax-free return of capital, which might be allowed under US tax law, implies a 33% short-term, low-risk return.
In Ben Graham’s day, the cigar butt strategy was simple — buy seemingly undervalued companies that were trading near or below their liquidation values, or NCAV, and wait for the market to realize its folly. Sometimes, the market would be justified in discarding a value destroyer. But usually, the pessimism would be overwrought. Moreover, accidental cigar butts could provide overwhelming returns — ten-baggers is the term, I think. Plus, there was a “margin of safety” in paying a low price. Now, with the advent of computer algorithms and the proliferation of databases and securities analysts, the market has become more efficient. Now, more often than not, apparent deep value plays are value traps — they appear to be cheap because they deserve to be cheap. While there may still be a positive expectancy from going long deep-value stocks which screen well, the alpha decay has been real.
However, with the large margin of safety provided by company’s pro-forma cash pile, it seems as though the value trap euphemism might not to apply in the case HNR.
Following its most recent asset sales, the company will have no remaining working assets, but will boast a net current asset value nearing $99 MM. In October of 2016, the company closed on the sale of all of its Venezuelan assets for a net sum of $122 MM, less fees. As a result, the most recent balance sheet for 4Q2016 showed a balance of $76 MM in current assets, and only $8 MM in total liabilities. In February, shareholders overwhelmingly approved the sales of its remaining asset off the coast of Gabon, from which the company is expected to receive a cash sum of $32 MM. The closing of this divestiture is pending approval by Government of Gabon (GoG). A successful closing indicates a pro-forma liquidation value of $99 MM, compared with the stock market capitalization of $74.4 MM.
Figure 1: Dufassu Block, Gabon
source: Harvest Natural Resources – Operations: Gabon – Dufassu
The recent balance from 4Q2016 and pro-forma balance following the closing is presented here:
|Cash & Equivalents||$63||$96|
|Other Current Assets||$1||n/a|
|Total Current Assets||$76||$108|
|Total Current Liabilities||$8||$8|
|Shares Outstanding (MM)||11||11|
|Value per share||$9.0||$9.1|
|Current Price (as close 3/10/2017)||$6.76|
|Implied Premium (Discount) to NAV||-24.9%||-25.6%|
It is significant to note that all outstanding warrants were cancelled following the October asset sale. No preferred stock is currently issued. The market capitalization thus presented likely reflects an accurate assessment of the company’s enterprise value.
That basically represents the end game… a classic Benjamin Graham style “cigar butt” stock idea. Worst case, investors are likely to get a large portion of their capital returned. Any potential upside is definitely not reflected in the price.
Now from there, a lot does depend on management’s forward execution. Based on management’s deep level of experience and past track record, it is not unreasonable to presume that it will figure out a tax-advantaged means by which return a large portion of capital to shareholders and, from there, put the remainder to work on the next prospect for exploration and development. There may be more puffs left to this thing than the market expects.
Far be it from me to look a gift horse in the mouth.
DISCLOSURE: I HAVE NO POSITION IN ANY OF STOCK MENTIONED HEREIN; I/WE MAY DECIDE TO TAKE A POSITION IN THE FUTURE.