What Happened to Personal Responsibility?

Sometimes you really have to wonder why people do the things they do.  Earlier this week, Quest Resources (QRCP) announced the resignation of Jerry Cash, the firm’s CEO.  While details on the events that led to his resignation are unclear, it appears that an entity connected to Mr. Cash defrauded Quest Resources by approximately $10M.  While this is an insignificant amount in comparison to past instances of corporate fraud in American history, it still represents ultimate personal failure for Mr. Cash.  I find it impossible to understand why executives such as Mr. Cash throw away everything for a small short-term profit.  It is disappointing that the board of directors of publicly traded companies fail to weed out spineless, incompetent and selfish men such as Mr. Cash.  The fact that this happened to a company such, as Quest Resources, which should be printing money with its MLP structure, is frankly disturbing and incredibly disappointing.

If Mr. Cash had any intelligence at all, he would have simply slowed cap ex spending, allowed organic growth to continue for a few years and then proceed to sell the company after a full year of ‘normalized’ earnings.  If such a course would have been followed the company probably could have gotten close to $20 a share, netting Mr. Cash $36M in proceeds from his common stock alone.  Instead, Mr. Cash chose to throw his future away by trying to make a quick buck and hoping that the Oklahoma Securities Regulators and the investment community would not notice his deception.  I was never very impressed with Mr. Cash but I would never have guessed that he was a common thief.  

I would sincerely hope that the new management team and the board of directors would make every effort to regain from Mr. Cash the money that he stole.  In addition, I expect them to seek punitive damages to reflect the losses taken by the company’s shareholders and the damage that has been done to the company’s image, if they could collect interest on top of the base amount stolen I would view that favorably as well.  Mr. Cash controls 1.8M shares of Quest Resources and hundreds of thousands of options.  The new management team should file an injunction to prevent Mr. Cash from liquidating his stake in the company as it could go a long ways to repaying Quest Resources for the money that was stolen.  Frankly, I do not care how far the new management team goes in its efforts to collect from Mr. Cash.  I would hope that they would go after his financial assets, his personal property and his kid’s college funds if need be.  I am sick and tired of watching corporate executives abuse their positions of power.  Why they don’t realize that they have a responsibility to the shareholders and employees of their companies is beyond me.  If Quest Resources needs to assign Mr. Cash to work out his debt by mowing the grass around the company’s properties for the rest of his natural life that would be just fine with me as well. 

In trying to understand how Mr. Cash succeeded in defrauding the company there appears to be three avenues that he could have taken.  The first one, and the most likely, is that it was related to an outsourced drilling and/or servicing contracts awarded by Quest Resources to a company that Mr. Cash controlled.  Another possibility could be that it was related to all of the company’s recent M&A activity.  Earlier this year the company was working on an acquisition of Pinnacle Gas Resources (PINN), while the deal eventually fell apart because it would have been highly dilutive to current shareholders of Quest Resources the company did manage to ‘steal’ (legally) the PetroRidge properties earlier this summer.  Because of all this movement and the sizes of these transactions, I would not be surprised to see that Mr. Cash was paying his entity an outrageous M&A ‘consulting fee’ during the entire process.  The final possibility, and the one that we must hope for, is that Mr. Cash simply attempted to transfer money from the corporate account to his entity’s account as this would imply the least likelihood that the board of directors was looking the other way when it came to Mr. Cash’s inappropriate behavior.            

Quest Resources still has incredibly valuable assets and at these low levels, current and potential shareholders can legally ‘steal’ money.  The company’s 12.1M shares of Quest Energy Partners are likely worth in excess of $140M, while the company’s 4.9M units of Quest Midstream Partners are likely worth $90M.  In addition the company’s general partnership ownership interests are worth at a bare minimum somewhere north of $90M.  Over the last several years the company has been building its stake in the Marcellus Shale play, the company currently has 120K acres that I would value at a minimum of $240M and as high as $360M.  Once you factor in the company’s $44M in debt and the $15 million in cash that it should have, which has been reduced to account for Mr. Cash’s $10M withdrawal, you end up with a current book value of the company of somewhere between $365M and $489M.  If you divide these figures by the number of shares outstanding you’ll see that Quest Resources is worth somewhere between 11 & 15 dollars a share in buyout.  These figures don’t take into account the incredible growth that Quest Resources could have if it managed to fully leverage its MLP structure.  This is something that anyone with a dash of brains should be able to figure out how to do so I haven’t quite given up on the company yet as there is simply too much upside to the company’s investment story.  I have talked in greater detail on the company's valuation and that article can be found here.  

Even with the fraud perpetrated by Mr. Cash, the underlying operations of the company are still strong.  Quest Resources will still receive nearly $25M in distributions from its subsidiaries and still likely has nearly $15M in cash in its bank accounts.  At below $5 dollars a share Quest Resources is one of my top speculative buys.  Given the stocks low price I would not be surprised to see a company like Atlas America (ATLS) come in and make an all cash offer for the company.   

I sincerely hope that the board of directors of Quest Resources attempts to make an example of Mr. Cash.  Mr. Cash is emblematic of a wider problem in corporate America in that our executives are no longer able to tell right from wrong.  While such a failure could be attributed to how men like Mr. Cash were raised, I believe that they are more a product of the culture that are a part of.  It is my opinion that all C-level executives of publicly traded companies should be required to take ethics classes in a manner similar to how all lawyers are required to take C.L.E. (continuing legal education) courses.   

Disclosure: Long QRCP

 

Short Thesis Intact at FirstFed Financial

I have been bearish on FirstFed Financial (FED) for sometime and despite the stock’s recent run up and what would appear at first glance to be a slight improvement in the company’s underlying fundamentals, I believe that the short case for the company bears reiteration.  FirstFed, like all California mortgages lenders, has been absolutely devastated by the terrible events out in California.  The company specializes in ARM mortgages and has only recently been making an effort to move into the traditional mortgage market in scale.  While this has definitely been a good decision on the part of management, I am not sure that it will be enough to prevent the company from being forced to do a massively dilutive share offering in the near future.  Such a transaction would be in the best interests of the depositors of the bank and I cannot imagine why management has not already tried to sell shares of the company into the recent strength shown by the company’s stock.

The management of FirstFed, in stark comparison to that of other banks, has been brutally honest with its shareholders and the investment community.  In a commendable act of baring it all to the investment community, management releases monthly updates on the health of their company.  In the most recent report, the bank at the end of July showed that it had $123.3M in loans 30-59 days delinquent as opposed to $126.2M in loans delinquent at the end of June.  This brief bit of news, coupled with a decline in loans that were regarded as non-accrual from $491.6M in June to $437.1M at the end of July sent the stock soaring, as investors believed it would be capable of surviving the current turmoil in not only California but also in the financial and credit markets as a whole.  Nevertheless, the company’s July report leaves out critical data points that are needed to analyze the company properly.  Some of the more important number’s left out was the level of the bank's capital base, the amount of charge offs taken during the month, the number of impaired loans and the amount of real estate held on the banks book’s as a result of foreclosure proceedings.  In addition, I believe that a more detailed discussion of the bank’s deposit base would be warranted given the dramatic change in its composition.  Some of these concerns and the metrics that support them can be found in the company’s quarterly report, which came out slightly before the July update. 

For me the two most glaring numbers that showed up in the company’s second quarter report were the number of loans that had become impaired and the surge in the bank’s real estate owned portfolio.  At the close of the second quarter the bank had $332M in impaired loans and $96M in it’s real estate owned portfolio.  In comparison, in the first quarter the bank had $131M in impaired loans and $45M in it’s real estate owned portfolio.  To me this is emblematic of the sharp deterioration that is occurring in the bank’s loan portfolio and I would imagine that the dollar value of loans that are delinquent should begin to rise again going forward. 

In addition, the company also provided information in its most recent quarterly report related to the losses that it has realized in its ARM loans that have reset over the last six months.  According to the company, the bank had $648.6M of loans reset of which $308.7M were modified by the bank.  It appears that during the modification process the bank took a loss of $26.3M or about 4% on the total value of the loans that reset during the first half of the year.  If this trend were to hold steady the bank should expect losses of $10-12M because of the modification process in the second half of 2008 and $25-30M during 2009.  This will have a significant impact on the company’s equity base.  The holding company currently has a book value of $550.8M so an additional $35M in losses would add further strain on the company, especially given its current loan portfolio. 

Two additional questions that I had relating to the July report were the amount of charge offs that that the company will be taking going forward on its loan portfolio and what exactly happened to it's deposit base.  A good portion of its non accrual loans will likely need to be charged off going forward as banks typically begin to aggressively charge off loans 120-180 days after they go non-accrual.  By my best guess, I would say that a good-sized portion of the bank’s non-accrual loans would be eligible sometime in the third quarter.  Typically, bank regulators do not like to see banks with an overly large non-accrual loan portfolio so I would not be surprised to see charge offs growing significantly going forward.  The second concern that I had with the bank’s July update was their deposit base.  According to the company, the number of wholesale or brokered deposits jumped to $1.247B in July from $691M in June, while retail deposits declined from $3.169B to $2.912B in the same period.  As a result of this action, the bank likely has a high level of uninsured deposits.  This has been a trend at the bank and I am disappointed to see it continue.  As a reference, at the end of June the bank had over $800M in uninsured deposits, I would not be surprised to see this figure grow in the next quarterly report.  Such an unsteady deposit base will likely make the bank prone to liquidity issues going forward should its wholesale depositors ever get nervous.  

In a previous article, I talked a little bit about the “Texas Ratio,” which was developed by Gerard Cassidy and the “California Ratio” which I came up with a while back in an effort to try to have an even earlier warning system for distressed banks.  A description of the Texas Ratio and what goes into calculating it can be found here.  My article on the need for a “California Ratio” can be found here.    

Cassidy defines the “Texas Ratio” as the following:

“The ratio is calculated by dividing a bank's non-performing loans, including those 90 days delinquent, by the company's tangible equity capital plus money set aside for future loan losses.”

At of the end of the second quarter FirstFed Financial by my calculations (which you might want to double check) had a “Texas Ratio” of 60.7%.

I have defined a “California Ratio” (and its still a very rough metric) as the following:

“Calculate the California Ratio by dividing the bank’s non-performing loans (including those less than 90 days delinquent) by the company’s tangible equity capital and the money set aside for future loan losses.  The tangible equity capital should be marked down to account for a reduction in value for the bank’s real estate owned portfolio and its impaired loans.  The bank’s real estate owned portfolio should be marked down to 50% of its stated value while the bank’s impaired loans should be carried at 80% of their stated value.”

At the end of the second quarter FirstFed Financial had a “California Ratio” of 101%.

While FirstFed has not quite yet hit the “danger zone” set by IndyMac’s failure, where the firm failed shortly after it's “Texas Ratio” hit 150%, the company is nevertheless in a precarious position going forward.  I would expect that the firm’s charge offs will begin to take a toll on FirstFed’s capital base over the next several quarters causing its capital ratios along with it’s Texas and California Ratio’s to deteriorate.  In addition, the firm’s large level of wholesale deposits could also cause the bank to take rapid loses should these depositors begin to flee the bank with their uninsured deposits and force the bank to sell parts of its loan portfolio at a significant discount to face value.  The bank is simply in the wrong market at the wrong time.  The stock is clearly one that should be avoided and for those adventurous souls I would advise shorting the stock at these levels.       

For Further Review:

FirstFed's recent 8-K

The Company's Most Recent Quarterly Report

Disclosure: None

Cramer Greatly Underestimates Atlas Energy Resources

As many of you know I have been a long time fan of the Atlas family of companies.  For those that are interested you can find a brief write up of mine of the parent company, Atlas America (ATLS) here.  Of the Atlas America subsidiaries, Atlas Energy Resources (ATN) has been catching the eye of members of the investment community of late.  One of its more vocal proponents has been Jim Cramer.  

Mr. Cramer’s involvement and discussion of the stock means that the investment thesis behind Atlas Energy Resources is becoming increasingly understood by mainstream investors, which is a great thing for those shareholders that got into the stock long ago.  Nevertheless, market pundits such as Mr. Cramer are still failing to differentiate Atlas Energy Resources from its peers.  Regarding Atlas Energy Resources Mr. Cramer recently stated that, “Atlas Energy is criminally undervalued" and that at its current price it is an absolute steal.  According to Mr. Cramer, the company is a steal because it has 6 trillion cubic feet of domestic natural gas reserves, which give it a $19 upside from its current levels. In addition, Mr. Cramer correctly states that Atlas Energy Resources manages an additional 900 billion cubic feet for other companies, and that it has identified 4-6 trillion more cubic feet of natural gas in Appalachia.  Mr. Cramer would have you buy ATN now and cash in on the 7.5% dividend "while you are waiting" for The Street to catch on.  In doing so, you are in fact getting a steal as Mr. Cramer suggests but you are at the same time dramatically underestimating the stocks future potential. 

Mr. Cramer's primary reason for recommending Atlas Energy Resources is the company’s substantial Marcellus Shale acreage.  If you have read my previous article on the Marcellus Shale companies you will remember that Atlas Energy Resources has the second most exposure to the Marcellus of any publicly traded company.  That article can be found here.  I believe that in order to properly understand the Atlas Energy Resources story you must first understand the company’s competitive advantages over its peers. 

If you can achieve this you will not be tempted to sell out on the stock’s next short term advance and will instead be more willing to hold on for the security's likely long term gains.  Development of the Marcellus Shale has been slow, even with heavyweights involved in the play such as Range Resources and Chesapeake Energy.  The two biggest challenges in developing the Marcellus Shale is the lack of pipeline infrastructure and the limited access to water that is needed to frac the wells. 

While both of these issues will be resolved eventually, most Marcellus drillers are seeing delays in their development plans and their stock prices are suffering as a result.  Atlas Energy Resources is different, although its unit price is also suffering, suggesting that investors are only following the story’s short-term hype instead of its longer term potential.  Atlas Energy Resources already has access to the substantial pipeline infrastructure of Atlas Pipeline Partners, which has been operating in the region for many years.  Even more importantly, Atlas Energy Resources owns its own water treatment plants so it has access to all the water it needs.  Unlike many other Marcellus drillers, Atlas Energy Resources' Marcellus Shale development plans are running full steam ahead.  The company is not limited by the lack of infrastructure or accessible water and as a result deserves a premium multiple.

I believe the most interesting part of the company’s story and something that Mr. Cramer completely missed is that Atlas Energy Resources uses other people’s money to fund its drilling operations in the company's Appalachians operations.  This provides the company with a much healthier balance sheet and allows it to explore other opportunities at the same time that it builds out its Marcellus portfolio. 

An ordinary natural gas well in Appalachia has an internal rate of return of about 20% at $8.50 gas, which is not too exciting.  However, Atlas Energy Resources rate of return is many times higher because of its use of a partnership drilling program in which it develops and contracts with investment partnerships composed of wealthy investors.  Atlas Energy Resources guarantees a rate of return to the investors somewhere below the return on the whole well and Atlas Energy Resources then pockets the excess return from the well that hasn’t been guaranteed to investors.  As a result, instead of Atlas Energy Resources paying for all of the drilling by itself and getting a 20% annual return, Atlas Energy Resources pays for a very small amount of the drilling costs and keeps a disproportionably large amount of the return.  This allows the company to achieve a 72% annual return on its investment.  This system works so well because the types of wells Atlas Energy Resources are drilling are very predictable and because the company is spreading the risk over many different wells in the Appalachians.  Below you will find a helpful chart courtesy of Deutsche Bank, it will come into discussion a little later on.

How many natural gas companies can get a 72% annual return on their investment you wonder?  Not a lot, but the ones that can do it do not do it with boring predictable Appalachian basin wells, they do it by being first movers on the hottest gas plays in the country such as the core Barnett Shale and the Haynesville Shale.  If you are not securing leases at the rock bottom prices that only a first mover can get you aren't going to be realizing annual returns on investment anywhere near Atlas Energy Resources levels.

With current lease rates, the Marcellus Shale has the highest return on investment of any known shale play with a whopping 86% annual return at $9.00 NYMEX gas (see chart above).  This is many times higher then what a typical Appalachian well would get that is not being operated through Atlas Energy Resources partnership program.

The rate of return in the Marcellus is the highest know internal rate of return because most companies do not have the needed pipeline infrastructure and access to water needed for large-scale development, with the notable exception of course being Atlas Energy Resources.  If an 86% return on Atlas Energy Resources' Marcellus wells is not exciting enough, it gets even better.  Atlas Energy Resources is soon going to start financing the development of its Marcellus wells using its partnership drilling programs.  As with Appalachian wells drilled under the partnership program, you can expect the annual return on Marcellus wells drilled under the partnership programs to be a few times more profitable than wells drilled on a standalone basis by the company’s competitors.  In my opinion, we are likely looking at an internal rate of return for the company of 200% to 300% on Marcellus Shale wells drilled under Atlas Energy Resources' partnership drilling programs.

Atlas Energy Resources continues to raise record amounts of capital from outside investors in its partnership drilling programs.  In fact, Atlas Energy Resources keeps increasing its own guidance for the amount of partnership capital it will be able to raise.  This is a good sign for the company’s unit holders as it means that management will be able to continue its history of delivering outsized gains for its stakeholders. 

More important than Atlas Energy Resources' significant Marcellus acreage is Atlas Energy Resources' ability to significantly enhance the rates of return on any oil or gas well via its partnership drilling programs.  This is an incredibly significant competitive advantage and something that Mr. Cramer should look into.  The fact that they have access to the regions best infrastructure only makes the story more exciting.

As Mr. Cramer suggests, I am content to cash in on Atlas Energy Resources' 7.5% distribution while I wait for The Street to catch on.  But Atlas Energy Resources seems to be even more "criminally undervalued" than Mr. Cramer realizes.

Disclosure: Long ATN, AHD, ATLS

FMD: Miracles Do Happen

Monday’s news that Goldman Sachs Capital Partners would be completing its deal with First Marblehead (FMD) should be viewed as a significant positive event for the company and its shareholders.  The deal is set to give First Marblehead $132.7M dollars in additional capital along with a much needed boost in creditability in the eyes of the credit and equity markets.  While the deal took longer then expected and will likely not allow the company to return to its former business model anytime soon, it nevertheless leaves investors with hope that the company’s fortunes will begin to turn around in the first half of 2009. 

The deal itself gives Goldman Sachs a significant position in the company, although their voting power may never rise above 9.9%.  The majority of the firm’s stake will be in preferred convertible securities and the investment on average will have a breakeven point of $15 dollars a share.  This figure is substantially above the stocks current price and has likely caused Goldman to recognize a substantial short-term loss.  For this reason, I expected the deal to not go through and I am greatly relieved that I was proven wrong.  The members of the Goldman Sachs team are without a doubt always some of the smartest guys in the room so I am pleased that they are willing to sit on the short-term loss in favor of the potential for large long-term gains.  Goldman could have easily fought the agreement and their unwillingness to do so speaks volumes about their opinion of First Marblehead and its potential to succeed once the credit markets thaw.  In addition, I believe that the closure of this deal sets a minimum for any potential buyout of the company.   

The deal, by my calculations, leave First Marblehead with over $250M in cash and cash equivalents and $100M in short term investments, in addition to the value left in the company’s residuals and their wholly owned banks subsidiary, which I last talked about here.  Given the firms $57M dollar loss this quarter, which reflects a $60M dollar loss relating to the reduction in the value of the company’s residuals, we are clearly looking at a company that has made many difficult choices over the past year in an effort to reduce its costs.  The company has undoubtedly eliminated its large marketing budget and has scaled the company’s operations down to a level that reflects the current student loan market and the company’s reduced number of lending partners.  While losses are to be expected into 2009, I believe that the company will not have to do any subsequent equity offerings.  The company now has the ability to support well-secured student loans through its Astrive brand and a select group of regional banks who are still offering student loans to their customers.    

I believe that the deal was completed in part because the company agreed to bring back its cofounder, Dan Meyers.  While Mr. Meyers is taking no salary he has secured for himself a significant number of out of the money options that are exercisable once certain profit targets are met.   The options give Mr. Meyers the right to 3 groupings of 2M shares each with exercise prices of $6, $12 and $16.  While this will dilute future earnings and greatly expand Mr. Meyers stake in the company, it was money well spent by the board of directors.  In requesting Mr. Meyers to return, Goldman has ensured that a man who redefined the privately sponsored student loan market will be running its investment.  He is the perfect man and quite possibly the only man capable of leading the company through the current period.  

In looking towards the future of the company, I still believe that the company’s wholly owned bank subsidiary will be incredibly important to the company’s future.  While the bank is currently barred from boosting the number of student loans in its portfolio by the Office of Thrift Supervision (OTS), I believe that the company now has the capability to provide the bank with the additional capital that it needs to convince the OTS to lift its ban on the bank.  An increased capital base would make it easier for the company to expand its deposit base through the use of brokered deposits.  These deposits, which could be facilitated by Goldman, would then subsequently allow the company to expand its student loan portfolio. 

Another possibility would be for the company to go out and acquire a beaten up bank or bank(s) with higher quality commercial loans and a large deposit base that would be capable of supporting additional student loans.  Such a transaction would diversify the bank’s loan portfolio, which would appease regulators, while at the same time giving the bank the resources that they need to continue to support First Marblehead’s student loan activities.  As the loans age, they should begin to repay principal and interest in mass and with the average rate on the company’s current student loan portfolio in excess of 8% the bank should be able to generate significant net interest margins.  Overtime the bank ought to be able to ladder their portfolio so that it has a yield typical of a prime mortgage portfolio.        

By my calculations, First Marblehead could drop down all of its short-term investments, worth about $100M and spend $100 million going out and acquiring a handful of smaller deposit based lending institutions out of New England.  These transactions would boost the banks capital base to over $300M and give it the ability to support $3B in deposits and several billion dollars in student loans.  While there are regulatory risks to such an action, I strongly believe that the company could appease regulators by keeping a third of their loan portfolio in highly rated commercial loans.  If the company were to undertake such a plan it is my opinion that the company would be worth somewhere north of $1 billion dollars after accounting for the bank at 2 times book value, First Marblehead’s remaining cash and cash equivalents and what is left of the company’s residuals.  In addition, a fully leveraged bank of the size outlined above could potentially have annual earnings of 30-60M dollars.  When this is coupled with the profits that First Marblehead could potentially generate from a return of the securitization business it is clear that the company is significantly undervalued.  If management were to build towards a depositary model, while still keeping its securitization capabilities I would not be surprised at all to see the company post earnings within five years that would approach 450-500M dollars on an annual basis.  Such a figure, with dilution included, would support a stock price in excess of $70 dollars a share. 

In times like these, when companies like First Marblehead are faced with the obsolesces of their business models it makes perfect sense for management to embark on radical change.  In founding First Marblehead, Mr. Meyers created a completely new category in consumer lending.  I would hope that in leading the company’s revival efforts that he has the foresight to revolutionize the very market in which his company participates.  Companies like CapitalSource (CSE) are already leading the efforts to create specialty lending focused banks and I see no reason why First Marblehead can’t jump to the forefront of this exciting new area of finance.   

For Further Review:

GS Purchase Update from FMD

Disclosure: Long FMD

Penn Octane: Micro-cap with Incredible Upside

Penn Octane (POCC) is a micro-cap company whose upside will be driven by the migration of U.S. oil and gas properties into the MLP structure.  Penn Octane owns 75% of Rio Vista Energy Partners' (RVEP) general partner, entitling Penn Octane to an ever-increasing share of Rio Vistas’ distributions.  Upon first glance, making an investment dependant on growth in the distributions at Rio Vista Energy Partners may seem like a bad idea given Rio Vista;s performance since its IPO in 2004.  For years, Rio Vista languished under management that did not seem to know what they were doing.  However, Rio Vista seems to have found a path of growth under its new CEO who took over in November of 2006.  Since November 1, 2006, Penn Octane has risen from $0.44 to $2.31 while Rio Vista Energy Partners has risen from $3.91 to $12.31.  Over this period, Rio Vista has also paid out $3 in distributions.  If you have read any of my past articles on MLPs you will know that general partners are levered to growth at the limited partner through their ownership of incentive distribution rights (IDRs).  As a result, it would be fair to conclude that Penn Octane will grow much faster than Rio Vista Energy Partners will.

Over the last 18 months, Rio Vista's growth has been due to acquisitions.  Going forward Rio Vista's growth looks to be levered to a combination of acquisitions and an aggressive drilling program.  This is similar to other, mid-cap MLPs.  Rio Vista has been able to grow significantly over the last several years due to the premium valuation given to oil and gas properties under the MLP structure when compared to the valuation given to them when they are in the standard corporate structure.  This premium allows the limited partners, such as Rio Vista, to easily sell new units to fund future growth possibilities.  This difference in valuation is caused by the tax efficient nature of the MLP structure (it avoids double taxation) and the appetite for tax-deferred MLP income by members of the investment community. 

Because oil and gas properties are given a premium valuation when they are owned by an MLP it gives management an opportunity to arbitrage this valuation difference to add value.  This process can be repeated as long as the valuation difference continues to exist.  As less than 3% of oil and gas properties in the US are under the MLP structure there are plenty of properties available for companies looking to expand their footprint.  For a company of Rio Vistas’ size they have the opportunity to profit from every opportunity that comes their way, with Penn Octane’s IDR ownership the company should benefit immensely from Rios Vistas’ opportunities.  Demand from the investment community for investments in oil and gas properties continues to increase as energy prices rise, when coupled with the fact that many baby boomers are transitioning their investment portfolios away from common stocks into income producing assets, such as MLPs, the demand for these securities should be insatiable.  This will support these companies access to the capital markets and their growth ambitions, which will subsequently help their general partners tremendously. 

If these future prospects were not enough, there is an enormous discount between the company’s near term valuation and what the market is assigning it.  Most exploration and production MLPs trade at yields of around 11%.  Due to Rio Vista’s higher growth rate, the company trades at a yield of 8.2%.  To give you an idea of how accretive future growth can be for Rio Vista, recent transactions in the sector have been at an EBITDA multiple of 4.5x or about 22%, well above the company’s current yield.  Generally, the smaller the property the cheaper the valuation and even the smallest acquisitions are meaningful to Rio Vista Energy Partners and Penn Octane.

Over the last 18 months, Rio Vista has made $39.4 million worth of acquisitions.  If Rio Vista behaves similarly over the next 18 months the benefit of such a level of transactions could look something like this: 

	Prior to Potential Acquisition
Current Units Outstanding	2,515,518
Unit Price	$12.25
Current Distribution Per Unit	$1.00
	After Potential Acquisition
Hypothetical Acquisition Price	39,400,000
Units to Pay for Acquisition ($12.25)	3,216,327
EBITDA (4.5x multiple)	$8,755,556
Annual Cost of New Units	$3,216,327
Accretion to EBITDA	$5,539,229
Maintenance Capex	$1,107,846
Additional Distributable Cash Flow	$4,431,383
Total Units After Acquisition	5,731,845
Increase in DCF Per Unit	$0.77

If Rio Vista simply repeats its past acquisition performance over the next 18 months, it could easily create an additional $0.77 in DCF.  This significant growth at Rio Vista will produce tremendous returns for Penn Octane, as Penn Octane will be getting incentive distributions on the new units issued by Rio Vista Energy Partners along with distributions from its current ownership stake.  Penn Octane’s leverage to the future growth of Rio Vista, especially given its small size, allows for shares of the company to potentially be an incredibly successful investment for those willing to deal with its speculative nature.

Another item worth mentioning is the significant growth Rio Vista is projecting as a result of its drilling program.  Assuming Rio Vista Energy Partners meets its guidance, Rio Vista Energy Partners could generate $3.18 per unit in distributable cash flow during 2009, allowing for a substantial increase in distributions at Rio Vista and earnings at Penn Octane.  It should be noted that these results exclude any potential acquisitions by Rio Vista, which would create even more upside to the company’s guidance.  

	2009
EBITDA	17,800,000
Total Capex	9,800,000
DCF	8,000,000
Units Outstanding	2,515,518
DCF per unit	3.18

Rio Vista and Penn Octane are not without risk given the poor performance of the prior CEO and the company's micro-cap size.  I do not know if Rio Vista’s drilling program will return results as impressive as management is currently expecting.   However, the arbitrage opportunity available in Rio Vista Energy Partners and Penn Octane is significant given the companies’ small size and the growth possibilities at Rio Vista.  The benefits of acquisitions at Rio Vista for Penn Octane as a result of the IDRs that it holds leaves tremendous upside in the shares of Penn Octane.  If Rio Vista continues with its acquisitions Penn Octane’s small market cap should allow for an outsized benefit for the share price as a result of its IDRs in Rio Vista.  Management has stated that they intend to pursue expansions through more accretive acquisitions, and I expect them to continue once certain contractual agreements relating to the company’s most recent acquisition expire in the fourth quarter of 2009. Rio Vista Energy Partners and Penn Octane in particular have more growth potential than just about any other stock in my coverage universe.  I just hope management realizes the potential of their two companies. With these two stocks, it is important to keep in mind that as with all micro-caps they are likely not suitable for the typical investor. 

For Further Review:

RVEP presentation

Disclosure: Long POCC

Don't Discount Fee Income at Fannie Mae

The recent news that Fannie Mae (FNM) will raise the fees that it charges mortgage originators to assume the liabilities related to their loans will significantly help the company going forward. In raising the fee that it collects for buying and guaranteeing mortgages from .25% to .50% of the loan value, Fannie Mae has successfully expanded its fee generation possibilities. If the company can survive its current predicament, which is still very questionable, the company may just be able to drive earnings – excluding loan loss provisions and other charges – that will allow the company to create an asset and fee structure capable of supporting all of the dilution that has taken place over the last year.

In looking at the company’s May summary of its financial situation, we can see that the company purchased $182 billion dollars in mortgages for its portfolio during all of 2007. In addition to these purchases, the company also guaranteed the issuance of $629 billion dollars in mortgage backed securities for other institutions. What is probably an all too simple calculation reveals that these $800B dollars of additions to the balance sheet (which are cancelled out to a degree by runoffs) generated somewhere near $2B dollars in fees for the company in 2007. It should be noted that the annual premium payments put forth towards keeping Fannie Mae as the guarantor of the securities is not included in this figure. In the quarter ended 3/31/08 the company took in $1.752B in guaranty fee revenue.

The $800B in securities that passed through Fannie Mae last year is likely a good number to use for future years as the company, with what is now nearly an explicit guarantee of support by the federal government, has managed to monopolize the market in which it participates. While this has exposed the company to a greater deal to less healthy business segments within the mortgage market it could potentially allow shareholders, if they are not diluted to nothing, to reap substantial rewards should we begin to see a bottom in the housing market fairly soon. Going forward from October 1, when the fee increase is set to go into effect, we should expect to see Fannie Mae’s fee income related to its handling of mortgages that pass through its door’s to double from $2B to $4B. Management will welcome this extra $2 billion dollars as it will help to relieve some of the pressures being put forth by the company’s high levels of leverage. The elimination of the company’s dividend would add another $1.3B dollars to the company’s capital base over the course of the year, something the company desperately needs. These two steps could allow for significant internal capital creation over time.

The federal government’s near explicit guarantee put forth recently by the Paulson bailout plan will prevent Fannie Mae from blowing up on the financial community overnight because the debt investors of the company have been reassured that their principal will be taken care of by the federal government in the event of a liquidity inspired insolvency at the company. Such a belief has bought management time to pray that the housing market bottoms and to scrape together internal sources of capital in the forms of increased fees and savings from a potential dividend elimination to help smooth out the losses caused by defaults in the company’s portfolio.

While I would certainly not want to own Fannie Mae at this point in time, I am watching the situation closely as there is a small possibility in my opinion that an investment in Fannie Mae could be just as successful as an investment in Chrysler could have been immediately following its own bailout. If Fannie Mae has not been nationalized by the end of the year and if interest rates are still at 2% then I believe that it may just be appropriate to enter into a position in Fannie Mae. Internal capital generation coupled with an expansion of net interest margin (a result of low rates and inefficient credit markets) could create significant upside potential in the stock of this beleaguered company. While an expansion of auxiliary revenue sources will be key, strong net interest margins will be incredibly important and it something I first talked about in regards to Fannie Mae back in May. Another bullish indicator for the company would be the company’s announcement of a significant increase in the premiums that it charges other financial institutions to guarantee the mortgages that they have originated. Fannie Mae is still a wait and see story but the point is clearly coming when ultra deep contrarian investors must decide whether or not an equity position in Fannie Mae makes partial sense.

For Further Review:

May Financial Update Provided by Fannie Mae

Bloomberg Article on Fannie Mae's Rate Increases

Disclosure: None

Oppenheimer Finds Hidden Value at UAM

I have followed Universal American (UAM) ever since it was Universal American Financial (UHCO) and I even managed to own shares in the company from 2004-2005 during the stock’s great run up in preparation for the company’s entrance into the realm of Medicare supported insurance products for the elderly.  One of the key instigators in my decision to sell my stake was my belief that the businesses that it was getting into, namely the PFFS (private fee for service) segment of the Medical Advantage, while capable of producing dramatically higher top line growth rates would fail to achieve corresponding increases in the company’s net income.  For the most part, this assessment has proven to be correct and the stock has fallen dramatically from it’s all time high in the mid 20s.  Recently, I re-entered my position in the company as a result of its upcoming earnings reports (which was very positive), Universal American’s tremendously low P.E. at the time and the positive sector comments being made by Leon Cooperman of Omega Advisors in a recent Barron’s issue.  While these three all add various character lines to the Universal American story, I was greatly impressed by a recent analyst report put out by the analysts over at Oppenheimer & Company.

The most recent quarterly report shows a company that while not quite hitting on all cylinders has a lot going for it.  If Universal American can prevent costs for escalating too quickly and holdout for the next re-pricing of it’s Medicare products the company should find itself in good shape going into next year.  In holding the line on costs, the company should be able to produce a tremendous amount of cash in a manner similar to what Leon Cooperman believed possible for some of the large insurance companies namely United Healthcare (UHC) and Aetna (AET).  While I am not to particular on how they use their free cash flow, I believe that the company could potentially buy back in excess of 10% of its float each year for the foreseeable future just as Cooperman suggested United Healthcare and Aetna could.     

Oppenheimer’s informative call on Universal American follows this thought process, they suggest that tremendous amounts of cash can be brought up from the subsidiary level to the holding company level and still allow the individual insurance companies to meet all legal capitalization requirements. Here is their statement on the matter from their most recent report:

“Assuming Universal remains in all its products, it has to hold a minimum amount  of capital to keep the regulators happy. This generally amounts to about 200% to risk based capital (RBC), which for Universal American works out to about $390 million. Of course, it’s unlikely Universal would allow its statutory capital to fall to the absolute minimum, so at 300% of risk based capital, or $583 million. Relative to the $950 million currently held at the subsidiary level, this analysis suggests that Universal has the opportunity to transfer approximately $360 million in excess cash from the subs to the parent company. This would be additive to the $126 million that Universal currently holds at the parent company.”

The company could use these cash proceeds to buy back as much as half of the company’s outstand shares at current prices.  This would add tremendous leverage to the company’s business model in terms of EPS and allow for a significant expansion in the share price of the remaining shares as the company would be purchasing shares for well below book value. 

For those of you that are interested here is Oppenheimer’s sum of the parts valuation for Universal American:

Universal American Sum of The Parts Analysis

Multiple Price

Medicare Advantage - HMO             9.5x $4.35

Medicare Advantage - PFFS             7.0x $2.42

Medicare PDP                                     6.9x $5.94

Traditional Insurance                         8.0x $0.82

Senior Administrative Services             8.0x $2.31

Corporate                                     8.0x ($3.29)

Current stock price $12.55

Source: Company reports and Oppenheimer & Co. analysis. 

In looking at this table, provided by Oppenheimer, it is important to note that a buyout premium is not included.  This is especially important for Universal American as the vast majority of its Medicare related business is concentrated in just six states.  These states are New York, Indiana, Pennsylvania, North Carolina, Virginia and Texas.  Such a focus makes the company an attractive buyout by a larger suitor.  If you were to value the company at 10x the midrange of its 2008 guidance you would get stock price of 16 dollars a share if you bring the multiple up to 12x the mid range of 2008 earnings to reflect a buyout premium you would be left with a stock price of closer to 19 dollars a share.  Such a price would leave significant upside to the stock from its current levels.    

Disclosure: Long Universal American (UAM)