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China Nort East Petroleum (NEP) revisited II

October 11th, 2010 · No Comments

Difficult to argue with this, although we can’t confirm the events that are supposed to happen soon..
What we like is that unlike many other Chinese smallcaps trading in the US, this one had it’s tyres seriously kicked and came off near damage free. So, one could argue that it should trade at a premium to these other Chinese smallcaps, an asset class where accounting errors seem to be rife.

But in fact, it still trades well below where it was before those ‘events’..

China North East Petroleum: Investing Made Easy
Atticvs Research Oct 7

We live in a period of low expected returns from investing across all asset classes. In this tough environment life is difficult for stock pickers. But life will surely not be tough for recent buyers of NEP.

China North East Petroleum (AMEX: NEP) is a low-cost, high-margin, cash-generative oil producer in northeast China. For more about the company, refer to earlier Seeking Alpha articles here and here.

There are 5 major catalysts in place to drive NEP’s stock price substantially higher:

  1. The Bernanke Put: Ongoing economic lethargy will lead to more QE, with consequential devaluation of the Usd and large quantities of money moving into safer-haven commodities such as oil. Alternatively, if economic activity actually improves, we get higher oil prices via demand. Either way, a win-win for investors in the oil sector.
  2. Acquisition: A significant cash acquisition of new oil properties by NEP is likely to be announced between now and summer 2011. This will be a game-changer for the company. NEP is building cash reserves and will have about $68 million cash at December 2010. The company has already announced its intention to acquire new oil leases and it owns drilling rigs which it can quickly deploy to profitably exploit new acreage. Everything is in place.
  3. Recovery from quote suspension: NEP’s stock quote was suspended for over 3 months in 2010 whilst the company corrected accounting mistakes in 2008 and 2009 SEC filings. The stock had been trading in the $9-10 range in spring 2010 and, not surprisingly, fell hard in the run-up to suspension, finally closing at $5.50. Now, with all filings corrected and up-to-date, with the company’s finance functions and controls improved, and with the 2010 SEC filings confirming that the corrections do not have any material adverse effect on NEP’s expected profits going forward, NEP’s stock price is positioned to recover lost ground. This recovery is likely to be step-like in tandem with NEP proving to investors that good operational progress continues to be made. One such development has already occurred; NEP announced on September 28 that its drilling subsidiary had won a contract to drill 100 wells over a 2-year period with an independent oil producer. Without doubt other positive operational developments will be announced in the near future with corresponding positive effects on the stock price.
  4. CFO position: As a consequence of the discovery of the accounting mistakes in the 2008 and 2009 SEC filings, NEP made changes to its finance function. The old CFO had some of his responsibilities modified, an interim CFO was appointed and, as yet, the company has not appointed a permanent replacement to the CFO position. In time this position will be filled.
  5. Analyst coverage: During the period when the stock quote was suspended, NEP’s sole analyst predictably dropped his recommendation from buy to hold (investors could hardly buy the stock if it wasn’t quoted!). This hold rating remains in place as of today. Over time, when NEP continues to deliver strong operating profits and files pristine SEC reports, it is highly likely that NEP will regain its buy rating, unless the stock price balloons in the meantime of course. So long as NEP’s stock price remains deeply undervalued it is very likely to attract buy coverage.

What makes NEP a particularly attractive investment opportunity is that all 5 of the above major catalysts are likely to occur and that, ahead of these events, the stock price is deeply undervalued.

The following P&L and Balance Sheet summaries are built using conservative oil price assumptions; $70 for Q3 and Q4 2010, $75 for 2011 and $80 for 2012. Yes, these are low-ball estimates, especially considering that oil has recently been trading above $80, but it is always best to base investment decisions on conservative assumptions.

Summary P&Ls 2008 2009 2010 2011 2012
Actual Actual Estimate Estimate Estimate
Ave Oil price $94.29 $55.97 $72.73 $75.00 $80.00
Usd ‘000 Usd ‘000 Usd ‘000 Usd ‘000 Usd ‘000
Sales – Oil 58,572 51,081 61,086 69,375 63,000
Sales – Drilling 0 13,577 48,099 60,000 60,000
Sales – Total 58,572 64,658 109,185 129,375 123,000
Prod’n & Drill costs 3,848 7,730 23,152 28,400 28,500
Dep’n & Amort 8,621 9,815 10,198 11,400 11,400
Gov’t Surcharge 11,105 4,619 9,355 10,638 10,631
Total 23,574 22,164 42,705 50,438 50,531
Gross Profit 34,998 42,494 66,480 78,938 72,469
Gross Profit % 59.8% 65.7% 60.9% 61.0% 58.9%
SGA expenses 16,820 18,105 5,052 4,950 5,600
Operating Income 18,178 24,389 61,428 73,988 66,869
Other, Int, Fin. 5,261 1,920 43 500 500
(G)/L Warrants Reval (4,464) 27,399 (25,439) 0 0
Debt extinguish loss 0 8,261 0 0 0
Income before Tax 17,381 (13,191) 86,824 73,488 66,369
Income Tax 5,277 6,900 21,706 18,372 16,592
Minority Interest 1,583 2,018 5,052 5,750 5,250
Net Inc Ord Shares 10,521 (22,109) 60,066 49,366 44,527
Reported EPS – basic $0.53 $(0.99) $2.04 $1.65 $1.48
Reported EPS – diluted $0.53 $(0.99) $1.93 $1.57 $1.41
Earnings excl Warrant Revaluation 7,412 19,622 40,987 49,366 44,527
Normalized EPS – basic $0.37 $0.88 $1.39 $1.65 $1.48
Normalized EPS – diluted $0.37 $0.88 $1.32 $1.57 $1.41
Normalized Net Income % 12.7% 30.3% 37.5% 38.2% 36.2%

This very high % of Net Income to Sales is a key factor behind NEP’s ability to be strongly cash generative.

Summary B. Sheets 2008 2009 2010 2011 2012
Actual Actual Estimate Estimate Estimate
Usd ‘000 Usd ‘000 Usd ‘000 Usd ‘000 Usd ‘000
Cash 13,239 28,693 68,000 122,000 160,000
Other Current Assets 5,323 16,909 23,348 27,486 24,762
Property & Equip, net 56,726 62,312 57,705 51,000 45,000
Other Assets 4,640 9,814 10,043 2,145 2,145
Total Assets 79,928 117,728 159,096 202,631 231,907
Current Liabilities 18,210 25,340 26,520 28,500 28,000
Longterm Liabilities 25,527 44,403 13,909 0 0
Minority Shareholders 3,378 7,665 13,679 19,429 4,679
Shareholders Equity 32,813 40,320 104,988 154,702 199,228
Total Liabs & Shareholders Funds 79,928 117,728 159,096 202,631 231,907

Note again the large cash balances. Without cash acquisitions – which of itself would be positive news – cash at y/end 2011 would be $122 million and at y/end 2012 $160 million. Set against NEP’s total market capitalization of $200 million these cash balances are eye popping.

Summary

NEP’s stock closed October 6, 2010 at $6.83. For that price an investor gets a 2011 p/e ratio of 4.35 plus $2 cash per share, this using a conservative oil price assumption of $75 per barrel. At $85 per barrel, NEP would generate fully diluted EPS in 2011 of $1.70, equating to a p/e of 4.0.

There are 5 catalysts that will lift the stock price in the near to medium term. Just 2-3 of these catalysts would normally provide a good boost, but, in this case, all 5 are set to occur.

Against this positive backdrop it would be surprising if the stock price doesn’t trade comfortably into double digits by early 2011, especially as various catalysts kick in. A 2011 p/e ratio of 8 would put the shares at $12 and still leave the $2 per share cash in for free. This is inexpensive, and particularly so in a world of currency devaluations and investors moving funds into safe havens such as oil and other commodities.

A 75% increase on yesterday’s closing price of $6.83 is certainly not too shabby in a world of anemic returns across all asset categories.

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At $7.30, it’s slightly overbought already, as it has been rallying strongly. But in the medium term we expect the rally to continue, unless we get some kind of general market sell-off.

Tags: NEP