Monthly Stock Idea Lab (MSIL) #5 - August 2023

Earlier this year, I started publishing my Monthly Stock Idea Lab on the last Sunday of every month. Today is the fifth edition. The idea behind this product is to improve the investment results by focusing the resources on better companies while eliminating businesses with “inherent” problems (no competitive advantages, no alignment of interests between key stakeholders, unsustainable earnings, poor returns on capital and capital allocation track record, weak balance sheets).

Since spotting a great business is relatively easy, I prefer to look for companies that temporarily face issues that can mask their inherent strengths and make them look just like ordinary businesses. In an ideal case, there are two drivers for the future upside: 1) improved financial performance and 2) rerating of a stock once the market becomes aware of the operational progress.

Looking for ideas in less crowded places (e.g. small caps) or out-of-favour markets (e.g. resources, emerging markets) can increase the odds and allow one to purchase good businesses priced as mediocre ones.

The flip side is that it can take longer to fix the problems or that these problems become permanent. The fact that a company joins the list does not mean it is an automatic BUY signal. It suggests, rather, that a company is worth researching further since it has the necessary attributes to make it a successful investment.

In today’s issue, I present five new ideas, one of which I bought this week. All of these companies have a net cash position (one has zero net debt) and offer double-digit shareholder distributions. I also share my thoughts on Watches of Switzerland following its 21% collapse on Friday. I profiled the company in last month’s edition and opened a 1.7% position in the stock.

So, let’s get started.

This Friday (25 August), the stock plunged almost 30% before recovering slightly to close at 548.5p (-20.9%). This was caused by the unexpected announcement that Rolex (Swiss-based producer of the legendary watches) decided to acquire one of its authorised retailers, Bucherer. Bucherer was founded in 1888 in Switzerland. The founder’s sons partnered with Rolex in 1924. There are over 100 stores today, mainly in Switzerland, the US, Germany and the UK. Bucherer does not disclose its financial performance. It says that Rolex remains its most important brand, sold in 53 stores.

Rolex is one of the most popular luxury watches, yet it remains a highly secretive company with no public financials. The business is run by a foundation. One of the critical features of the company’s strategy had been a pure focus on manufacturing. The sales are carried out by authorised retailers.

This acquisition of Bucherer appears to be a step out of its tradition as Rolex enters the retail market.

However, both Rolex and Watches of Switzerland have confirmed that this move was the reaction to the succession situation at Bucherer rather than a strategic decision to start the retail operations. Jorg Bucherer, an 86-year-old grandson of the founder, Carl Bucherer, exclusively owned Bucherer.
Mr Bucherer has no family succession, and his wishes are to form a legacy foundation with the proceeds from the sale of the company.

According to Watches of Switzerland, Rolex will not be involved in the operations of Bucherer, nor will it change product allocation or distribution. Rolex will appoint non-executive members to the board of Bucherer, planning to keep the business independently run.

My take and course of action: I see the reasons for market concerns. Even if Rolex has no serious intentions to expand in retail now, things may change later. The management of Bucherer may try to persuade Rolex to expand the partnership, get better access to its products or get other benefits. However, I also think this would be a slow process, and such a scenario is not given.

The success of Rolex depends on the image of exclusivity, any disruption or bad PR will hurt the brand. So, it is unlikely that the company will suddenly start to rock the boat. Bucherer is big in Switzerland and the US but much smaller in other markets. Watches of Switzerland has a more prominent presence in the UK (roughly 10x store count and sales), US (47 showrooms vs 30) and some other countries.

Most luxury watch retailers have been operating for 100+ years. It takes time to build relationships and trust. I see no point for Rolex to change their successful relationship with Watches of Switzerland.

With about 7% market share of the global market for Rolex products, Watches of Switzerland is a vital partner for Rolex. Even customer reviews are higher for the company and its other brands (e.g. Goldsmith) than its rivals, including Bucherer. Watches of Switzerland has an average customer rating of 4.5 (4.8 for its online site), while Bucherer has only a 4.2 rating.

Watches of Switzerland offers more value than just a watch re-seller. The company has been expanding in the pre-owned, repair&servicing, and jewellery segments.

The company’s latest guidance points to 8-11% sales growth in FY24 with adjusted EBIT margin of 10.7% (“in line with FY23”). This translates into £179mn adjusted EBIT and £112mn net income (an EPS of £0.47). Assuming no dramatic changes to macro, FY25 profitability should improve as the company finishes renovations at some flagship stores. The consensus FY25 EPS estimate is £0.6.

At 550p market price, the company’s shares are currently valued at 11.7x and 9.2x PE based on FY24 and FY25 estimates, respectively.

I had a relatively small position of 1.7% (at cost) and decided to buy on Frisay’s weakness to maintain the same weight. In the near future, the risks lie with the economy and normalisation of watch demand following the COVID boom. Expanding online marketplaces and shifting demand into the pre-owned segment are also severe risks in the medium term. Taking this into account, I do not plan to increase my position aggressively.

The next big event for the company will be in a couple of months when management will provide an updated long-term strategic plan and key targets.

This month’s edition focuses exclusively on the oil & gas sector. There are two reasons for that. As I wrote earlier, the sector benefits from three structural drivers: ESG, Energy Transition and Capital discipline. It is much harder to raise capital or sanction new projects, which limits supply and helps companies generate better returns on capital. Energy Transition limits future demand visibility, reducing willingness to invest in large-scale projects. Finally, for the first time in twenty years, oil executives prioritise free cash flow (FCF), Balance Sheet strength and shareholder returns compared to production growth and capex spending.

The second reason for taking a closer look at the sector is my two recent positions: Kistos and Occidental Petroleum.

Just because an oil company is cheap on traditional metrics (e.g. FCF yield), it is not enough to buy it if the whole sector trades at bargain prices. To understand the relative valuation context and how my investments compare to alternative options, I have taken a quick look at some of their peers. One of them I purchased on 24 August.

Ticker: HBR LN
Price: £2.34
Mkt Cap: £1,872mn
EV: £2,072mn

I opened a new position on 24 August (1.5% weight), but having done some additional analysis over the weekend, I decided to exit it next week. Probably the most speculative action I have taken in many years.

Harbour is the largest independent UK offshore E&P company with c. 190kboe/d production and 2P reserves of 410mn boe (+455mn boe of 2C resources). Its production is roughly equally split between gas and oil. The company has a reasonable cost structure with lifting costs at $16/boe and less than $30/boe total costs, including development and decommissioning capex (excluding exploration).

The company has reduced its net debt by $2.9bn since Q1 ’21, when it completed the acquisition of Premier Oil to zero by 1H23. Management guides for $0.2bn Net Debt by the end of ’23 (due to cyclical pickup in capex during H2, higher tax payments and working capital reversal). This estimate does not include proceeds from the sale of the Vietnam assets ($84mn), expected before the year-end.

At 190kboe/d production and $80/bl and 100p/therm (NBP gas price), the company should generate $3.7bn operating cash flow before taxes. With capex at $1bn, Harbour can generate $2.0-2.7bn of FCF pre-tax.

Fiscal payments are the most critical item. Following tax hikes introduced by the UK government last year, the effective tax rate for the sector has increased to 75% (from 40%). This windfall tax is scheduled for five years (until March 2028). Investment allowances can reduce effective tax liabilities. Initially set at 80% (in May 2022), they were later reduced to just 29%. However, decarbonisation expenditure enjoys an 80% investment allowance. So companies, for example, can claim 80% of the costs to modify an oil platform to use wind power.

In June 2023, the government introduced additional changes reducing companies’ tax liabilities if energy prices fall. Specifically, the tax rate will return to 40% if both oil and gas prices average $71.4/bl and £0.54/therm for two consecutive quarters.

For 2023, Harbour guides for $1bn of FCF (after-tax), assuming $80/bl oil price and £1.0/therm gas price ($12.5/mmbtu). The company also plans to spend $1bn on capex (60% on production & development and 40% equally split between exploration and decommissioning). This suggests that management expects c. $2bn of operating cash flow after tax in 2023.

In H1 ’23, it already generated $1bn of FCF but paid zero taxes, and its capex was $434mn (43% of the annual target). For the full year, management expects over $400mn of tax payments and $1bn capex, implying $1bn of outflows on taxes and capex in the second half of the year and zero FCF.

However, at a 75% tax rate, I estimate the company should generate around $1bn of operating cash flow on a normalised basis (at spot prices), which leaves FCF at zero if capex remains at $1bn. Of course, working capital movements and timing of tax payments may temporarily boost FCF. Harbour had $1,097mn tax losses and allowances at the end of H1 ’23. This should help the company reduce its near-term tax liability and generate better FCF.

The company also has about 260mn 2C resources outside the UK, primarily in Indonesia and Mexico. They can potentially be brought into production in the medium term, reducing the company’s effective tax rate.

The company estimates that its FCF has the following sensitivity to energy prices:

• A $5/bbl change in 2023 Brent impacts 2023 FCF by $90m
• A 10p/therm change in 2023 NBP impacts 2023 FCF by $50m

Apart from the extreme tax burden in the UK and increased uncertainty over future unit economics of the core assets, another serious issue is the short reserves life. Daily production of 190kboe/d translates into annual output of 69mn boe. With 410mn boe of 2P reserves, Harbour’s reserves life is just 5.9. Unless new assets are launched into production soon, its current output will fall quite significantly (by 15-20%) and will remain on a declining trajectory without new discoveries or M&A deals.

Insiders were mostly net sellers in the company, and there is no high ownership by management or Board members.

Management targets $200mn annual dividend distributions with plans to increase these distributions regularly. On top of this, the company carries out a buyback programme using surplus cash resources.

The company repurchased 64mn shares (£166mn) since the start of the year, reducing the share count by 7.4%. In 2022, Harbour spent $361mn on buyback. It has returned $1bn to shareholders in the past 18 months (dividends + buyback) in addition to a $2.9bn reduction of net debt.

Having done an additional analysis of the company’s H1 ’23 results and taking into account that without additional allowances, the company hardly earns sustainable FCF, I decided to exit my small speculative position, which I opened on Thursday (24 August).

Ticker: SQZ LN
Price: £2.35
Mkt Cap: £906mn
EV: £709mn

Serica is a mid-sized UK E&P producer founded in 2004. It has grown through the acquisitions of several mature offshore fields from BP and, more recently, an acquisition of a UK offshore independent Tailwind.

As you can expect, the company is cheap. Before the latest acquisition of Tailwind, Serica had a net cash of £403mn (as of 31 December 2022) and a market cap of £764mn (273mn shares with a market price of £2.8 per share). The company’s EV was just £361mn. It earned a net income of £178mn in 2022 and outlined 79-89p potential EPS for 2023E (£232mn) in its announcement on 9 January 2023.

Serica was valued at 4.3x P/E (2022) and 3.3x P/E (2023E) at the beginning of the year. Excluding the cash pile, its operating P/E was 2x and 1.6x for 2022 and 2023, respectively.

Following the acquisition of Tailwind, its proforma production should be at 40-47kboe/d, 41-48kboe/d and 42-49kboe/d for 2023/24/25 (based on management guidance).

At the beginning of 2023, Serica estimated pro forma 90-100p EPS for 2023 and 100-111p of operating cash flow per share (c. £400mn).

The company’s operating costs are relatively low at $17/boe.

Serica was approached by Kistos in 2022. First, Kistos offered Serica shareholders $1.23bn (£3.82 per share) in the form of cash and Kistos shares. Later, Kistos raised its offer to £4.25 per share, including £1.46 cash, £0.67 cash distribution and 0.4 new Kistos shares per Serica share (c. £2.1 equivalent).

The board of Serica rejected all the offers and instead decided to go for the acquisition of Tailwind. This raised some concerns among shareholders. Management argued that Tailwind not only boosted per share reserves and provided exposure to oil away from gas but also brought significant tax losses that could partially offset future tax liabilities.

The major issue for Serica, just like for all UK-producing E&Ps, is the windfall tax, which puts the aggregate tax rate at 75% (compared to 40% before 2022). If Labour wins the next general elections next year, they could stop issuing new oil & gas licences.

Another issue is the requirement to obtain an OFAC licence for one of its assets, the Rhum project. The Iranian government holds a 50% interest in that project. Historically, Serica had no issues obtaining the licence to continue running the project.

Unlike Kistos, Serica has considerably lower insider ownership.

The company pays regular dividends. The full-year ’22 dividend was 22p.

Ticker: IPCO TO / IPCO ST
Price: C$ 12.39
Mkt Cap: C$1,622mn
EV: C$1,537mn

Internation Petroleum Corporation (IPCO) is part of the Lundin family. Adolf Lundin is a Swedish entrepreneur who got interested in natural resources and started a few ventures at an early age. His most significant success came in 1976 when he co-discovered one of the world’s largest gas fields - North Gas Field in offshore Qatar. Adolf Lundin passed away in 2006, and two of his sons (Lucas and Ian) continued to run the companies.

IPCO was spun off from Lundin Petroleum in 2017 when the company decided to separate its Norwegian operations from the international ones.

The Lundin trust owns 40.7mn shares of IPCO (31.2% interest).

Unlike UK E&Ps, International Petroleum has a superior reserves base and a solid organic growth potential. It has increased its 2P reserves by over 16x from 2016 to 487mn boe at the end of ’22. Its reserves life is exceptionally high - 27 years, 19 years longer than just six years ago. It has over 1.1bn of 2C resources.

The main producing assets are in Canada, including both heavy and traditional oil and Malaysia. Thermal crude represents 73% of 2P reserves, gas - 14%, traditional Canadian oil - 9%, and international - 4%. ’23 production is more evenly split, with Canadian oil and gas accounting for 53% and 33%, respectively, while international assets contribute 14%.

The company targets annual production above 50kboe/d during the 2023-27 period and plans to achieve cumulative 5-year FCF above $700mn (2023-27) at $75/bl oil price (over $1.4bn if oil price averages $95/bl). This translates into $140mn and $280mn annual FCF, representing 11.7% and 23% yield, respectively.

The company prioritises returning cash to shareholders and managing debt, select M&A deals and organic growth opportunities. As long as Net Debt/EBITDA is below 1x, management aims to distribute 40% of FCF to shareholders. The company repurchased 7.1mn shares at an average price of C$13 (5.5% of shares outstanding). It has repurchased 58.8mn shares from April 2017. With the growth project (Blackrod) entering Phase 1 development, its ’23 FCF is expected to be negative at $85/bl oil price, which means that buyback will resume only if the oil price exceeds $90/bl.

Blackrod accounts for 79% of the total ’23 capex ($365mn).

The company is a reasonably low-cost producer despite operating high-energy intensity assets with ’23 opex expected at $17.5-18.0/boe.

Mid-term capex is estimated at $14/boe and could fall to just $5/boe once Blackrod comes onstream in 2026.

IPCO targets 65kboe/d production during the 2028-2033 period compared to 50kboe/d currently.

Since its inception, IPC acquired five assets. It spent $875mn on four deals, generating a cumulative FCF of 635mn (at the end of 22). Assets were acquired during the 2018-21 period.

The key risks include operating heavy oil projects in Canada, which has generally higher CO2 intensity and requires significant energy to generate steam. Other risks relate to the development of the Blackrod project, which already saw cost increases and will drag FCF lower in the medium term, with the first oil expected in 2026 only. The risks of project delays and cost overruns are real.

Ticker: THS LN
Price: £0.74
Mkt Cap: £222mn
EV: £132mn

$112mn net cash (40% of the market cap)

The company was founded in 2008 by Loucas Pouroulis, a Cyprus-born South African mining businessman. The Pouroulis family currently holds 56.5% of Tharisa, another 8.8% is owned by Fujian Wuhang Stainless Steel. The company was listed in 2014 on the Johannesburg Stock Exchange (and on LSE in 2016). Tharisa has raised $263mn from shareholders and received an additional $95mn from Fujian Wuhang and Hong Kong HeYi Mining in 2011.

Since its foundation, Tharisa has returned over $90mn in cash to shareholders and repaid over $202mn in debt.

Tharisa aims to distribute at least 15% of its net income as dividends. For 2022 and H1 ’23, its payout ratio was 17.7% and 16.4%, respectively. Its FY22 and H1 '23 dividends represent 7.8% and 3.2% yields, accordingly.

Its principal operating asset is the Tharisa Mine, located in the south-western limb of the Bushveld Complex, South Africa. The mechanised mine has an 18-year pit life and can extend operations underground by at least 40 years. Tharisa also owns Karo Mining Holdings and Salene Chrome, development stage, low-cost, open-pit PGM and chrome assets, respectively, located on the Great Dyke in Zimbabwe.

The mechanised nature of the open-pit operation has ensured that it remains within the lower cost quartile of PGM and chrome producers, with an ore body showing consistency over the past decade of production.

The Company provides China, the world’s biggest stainless steel producer, with some 10% of its annual chrome needs. Tharisa is expanding its PGM portfolio with the development of a new mine on the Great Dyke in Zimbabwe, looking to double its PGM output with a combined minimum life of both mines of 17 years, with the possibility of multi-decade-long extensions given the resource inventory at both operations.

The company spent $105mn and $106mn on capex in 2022 and 2021, respectively, while delivering revenue and EBITDA of $686mn/$596mn and $237mn/$224mn. FCF was $69.5mn in 2022 and $102.4mn in 2021.

It has been a net cash company since 2021, with the latest net cash position of $112mn (H1 ’23), which accounts for 40% of the company’s market cap.

Tharisa’s investment case largely depends on platinum prices. They, in turn, were driven mainly by demand from the auto sector (platinum is used in autocatalysts). The auto sector represents c. 40% of the total demand for platinum. Demand will clearly fall with the expansion of EVs. Industrial and jewellery sectors were two other major consumers of the metal, accounting for 30% and 25%, respectively.

Ticker: TGA LN
Price: £6.23
Mkt Cap: £855mn
EV: £567mn

Thungela is a former coal division of Anglo American, which was demerged from the parent and listed on LSE and JSE in 2021.

The company produces its thermal coal predominantly from seven mining operations in South Africa, consisting of underground and opencast mines located in the Mpumalanga province of South Africa. Thungela also holds a 50% interest in Phola, which owns and operates the Phola Coal Processing Plant, and a 23% indirect interest in RBCT - one of the world’s leading coal export terminals, with a design capacity of 91 mtpa.

The company’s dividend policy targets a minimum 30% payout ratio applied to adjusted operating free cash flow. Interim dividends for H1 ’23 were based on a 33% payout and amounted to R4.3bn (R10/share), less than half of what was paid in H1 ’22 as coal prices declined. The latest interim dividend represents a 6.9% yield.

For ’23, management targets 11.5-12.5m t of saleable production. The company is trading at about 3x forward earnings, based on consensus estimates.

The company has an offtake agreement with Anglo American, expiring mid-2024. Management is building its own export marketing capabilities.

33% of the company’s market cap is net cash (c. $363mn)

The company’s operating cash costs are $39/t, including royalties (on a FOB basis).

The primary issue for the company is its reliance on state rail operator Transneft Fright Rail, which carries its production to export terminals. Historically, the operator carried lower volumes than the terminal capacity, limiting Thungela’s production volumes. Five-year average rail transportation is 65mn t, while the key export port of Richard Bay has a capacity of 91mn t.

Management has undertaken steps to diversify the geography of its operations by acquiring 85% interest in Australia’s Ensham project for c. $150mn.

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