Expanded Resume and Examples of My Work Product Since 2010


Jack Blog Picture 7-5-2014Hi, my name is James Huddleston, but people call me Jack. Thank you for visiting my website. If you would like to contact me, my email is jackhudd1@gmail.com, or feel free to call at 615-525-7592.

Please Note that Links to Examples of My Work Are on the Right Side of this Page: Click any of the links on the right side to go to that specific article.

Purpose of this Website. This website is an expanded resume where you can see examples of my analytical and financial modeling abilities. There are links on the right side of the page to examples of my work product from 2010-2013. I was employed in the first part of 2014, but that work product is confidential, so I can’t post any of it.

Summary of Qualifications (Details are Below the Summary)

– Links to examples of my work product from 2010-2013 and to articles I have written are on the right side of this page under “My Analyses & Financial Models” and “Published Articles”.

– Advanced skills in Financial Analysis, Accounting, Investment Analysis, complex financial modeling, analyzing assets and companies, Excel and PowerPoint (longer list below)

– Passing the 3 CFA Exams is proof of my knowledge and work ethic

– 4 years of experience as a Financial Analyst

– Completed the Chartered Financial Analyst (CFA) Program (passed all 3 exams – 2011, 2012 and 2013)

– Master of Accounting degree (3.46 GPA) and B.S. in Finance (3.92 GPA)

– Software – Certified Expert in Excel with Master-level skills. Advanced PowerPoint and Word. Proficient in Access. Familiar with SAP, SQL, Hyperion Planning, Essbase. I can quickly learn the software used.

– Expert at Financial Statements and SEC Filings. I have analyzed hundreds of companies and hundreds of financial statements, 10-K’s, 10-Q’s and 8-K’s.

– Team player, courteous, reliable, fast learner, self-disciplined, no bad habits, 25, single, and no dependents.

– My job is a priority and I don’t mind working extended hours into the evenings and/or on weekends, or last minute scheduling.

Examples of My Work Product. Links to examples of my work product from 2010-2015 (complex analyses and financial models) and to 6 articles I published between 2010 and 2013 are on the right side of this page. The articles were based on my work product. The Devon Energy Analysis is 31 printed pages and a good example of a complex analysis. The Richfield Analysis and Valuation is the most recent example and from it you can judge my skills in research, due diligence, financial analysis, valuation, scenario analysis, Segment Analysis, risk evaluation, and analysis of Financial Statements and notes for normalcy, misstatements, and accounting concerns.

Advanced Skills. I have advanced proficiency in: accounting and financial statements; financial analysis, corporate finance, financial modeling (over 1,000 hours in Excel), budgeting, forecasting, costs, revenues, and variance analysis; Excel, PowerPoint and Word; valuation, DCF, NPV, IRR, ROI, ROE, accretion/dilution analysis, peer comparison, industry analysis, scenario analysis, operational analysis, and risk evaluation; analyzing depreciation, working capital requirements, investment opportunities and investment performance. Expert skills in Financial Statement Analysis – I have analyzed hundreds of companies and read hundreds of financial statements, annual reports, 10-K’s, 10-Q’s and 8-K’s. If you want to see a detailed explanation of how I analyze and value companies, click the fourth link on the right side of this page titled “How I Analyze and Value Companies“. Expert in Excel – I have spent over 1,000 hours doing financial modeling in Excel. Examples are in the Analyses on the right side of this page.

4 Years of Work Experience.

   Punch Card Capital L.P. Financial Analyst for an Orlando investment fund. Reviewed over 100 companies and detailed analyses of two. Reviewed public filings, peer comparison, industry analysis, valuation and scenario analysis in Excel, forecasted future cash flows to assess default risk. Oct. 2013 to March 2014.

   Self-Employed Financial Analyst. Examples of my work product from this job can be found at links on the right side of this page. Between 2010 and 2013, I analyzed hundreds of companies and their financial statements, 10-K’s, 10-Q’s and 8-K’s, and spent over 1,000 hours preparing complex financial models in Excel. I used a fundamental analysis approach to analyze companies’ financials, operations, strengths, weaknesses, opportunities, threats (including competition, Porter’s Five Forces, and macro trends), and did a risk assessment. For the companies I liked, I did a DCF analysis to determine a valuation range. You can see the checklist I developed to analyze and value companies at the fourth link on the right side of this page. I worked for my parents, who paid me – we would discuss my progress every day, but the analysis was left up to me. This was great experience and I learned a lot because every company is different. Based on my analyses they bought 11 stocks, including China Mobile, Devon Energy, National Oilwell Varco, Berkshire Hathaway B, Apple, Wal-Mart, Johnson & Johnson, and Kraft. Examples of my analyses, financial models, articles I have written, and complex projects that I completed in 2010, 2011, 2012 and 2013 are at links on the right side of this page under the Categories “My Analyses & Financial Models” and “Six Published Articles”. March 2010 to Sept. 2013.

Education – Master of Accounting and B.S. in Finance. I graduated from the University of West Florida (UWF) in December 2011 as a Finance major (3.92 GPA on a 4.0 scale) and received a Master of Accounting (MAcc) degree in 2014 (3.46 GPA). From March 2010 to March 2014 I was also working and until June 2013 I was also studying for the CFA exams. I pursued a Master of Accounting degree for two reasons. First, as Warren Buffett said “Accounting is the language of business”. Second, UWF has a strong accounting program. In 2013, UWF ranked number 5 in the U.S. out of 266 small accounting programs for first-time pass rates on the CPA exam (source: the NASBA, which is the national accounting regulatory organization).

At the Berkshire Hathaway (BRK.A) annual shareholders meeting for the year 2013

At the Berkshire Hathaway (BRK.A) annual shareholders meeting for 2013

Chartered Financial Analyst (CFA) Program – 5 Years of Training in Financial Analysis. I have passed all 3 CFA exams – 2011, 2012 and 2013. To complete the CFA Program requires passing 3 very difficult exams, two of which are only offered once a year. I started studying for the CFA exams in 2008 and passed the Level 1 CFA exam in June 2011, passed the Level 2 exam in June 2012, and in June 2013 I passed the Level 3 exam. According to the CFA Institute, the worldwide pass rate was 39% for the Level 1 exam in June 2011, 42% for the Level 2 exam in June 2012, and 49% for the Level 3 exam in June 2013. The CFA Program has been referred to as a “gold standard” by The Economist and Financial Times. It has been described as “grueling” and “the equivalent of a master’s degree in finance with accompanying minors in accounting, economics and statistical analysis”. It is said that completing the CFA Program requires “ability, dedication, ethical grounding and hard, transferable analytical skills”. The CFA Program Curriculum consists of 8,000 pages in 18 volumes and covers topics such as Financial Reporting and Analysis, Corporate Finance, Quantitative Methods, Equity and Fixed Income, Economics, Alternative Investments, Portfolio Management, and Ethical and Professional Standards. I spent over 2,000 hours studying for the CFA exams and have spent an additional 1,000 hours doing financial modeling in Excel.

Software. I am a Certified Expert in Excel and have Master-level skills. I use Excel every day. I also have advanced skills in PowerPoint and Word, am proficient with Access, and familiar with SAP, SQL, Hyperion Planning, and Essbase. I am a fast learner and can quickly learn the software used.

Thank you for visiting my website.

James “Jack” Huddleston
Updated  March 24, 2015

Richfield Analysis and Valuation (2015)


Analysis and Valuation of Richfield International Limited

By James “Jack” Huddleston, January 19, 2015

Table of Contents

A. Introductory Notes

B. Investment Result

C. Analytical Procedures and Due Diligence Performed in the Course of Analyzing and Valuing this Company

D. Analytical Procedures and Due Diligence Not Performed

E. Description of the Company

F. Richfield Marine Agencies (“RMA”)

G. Speeda Shipping Co. (“Speeda”)

H. The Main Reasons Why I Think Richfield International is Undervalued by the Market

I. The Main Arguments for Buying Stock in this Company at Current Prices

I.8. Currency Risk

I.9. Analysis of Financial Statements and Notes for Normalcy and Material Misstatements, and Comments About the Auditor

J. The Main Arguments Against Buying Stock in this Company at Current Prices

J.4. Accounting Concerns

K. Valuation of this Company – Liquidation Value and Intrinsic Value (using Probabilistic Scenario Analysis)

L. After Weighing the Pros and Cons, Should Stock Be Purchased in this Company? Analysis of 4 Scenarios.

M. Since the RMA Business Appears to be Good, Why Not Buy this Stock as a Long-Term Holding?

A. Introductory Notes – This research was conducted in early December 2014. I found this stock using a screening program. This article is a compilation of my notes – it is not a polished article. I only post it here as a recent example of my work. From it, you can judge my skills in research, due diligence, financial analysis, valuation, scenario analysis, Segment Analysis, risk evaluation, and analysis of Financial Statements and notes for normalcy, misstatements, and accounting concerns (see I.9 and J.4 – my accounting knowledge is very helpful in this regard), and also my ability to undertake and complete a complex financial analysis in a fairly short period of time. I spent about 15 hours on this analysis.

B. Investment Result – I bought this stock for my own account on 12-15-14 at AUD 0.088 and sold it on 1-19-15 for AUD 0.165, an 87% return in 5 weeks. I do not recommend this stock at current prices.

C. Analytical Procedures and Due Diligence Performed in the Course of Analyzing and Valuing this Company

Approximate time: 15 hours

  • Read full annual report for 2013
  • Read Chairman’s letters for 2005, 2007, 2009, 2011, and 2013
  • Segment Analysis
  • Ratio analysis: profitability, credit, liquidity
  • Assessment of investment thesis via my net-net checklist
  • Assessment of corporate governance via checklist
  • Director compensation
  • Director backgrounds
  • Director independence and conflicts of interest
  • Assessment of accounting fraud via checklist
  • Income statement, balance sheet, and cash flow statement vertical and horizontal analyses
  • Balance sheet and cash flow accruals
  • Comparison of cash flow to accrual income
  • Auditor reputability
    • Contacted audit partner with a few questions regarding audit procedures performed (no response yet)
  • Auditor fee relative to assets and revenue
  • Regulatory requirements the company is under
  • Normalcy of accounting policies to IFRS and U.S. GAAP
  • Check for various things: presence of speculative derivatives, level 3 fair value assets, pensions, off-balance sheet items, related-party transactions, etc
  • Assessment of risk factors via my checklist
  • Various readings to gain basic understanding of business model
  • Browsed for all online articles relating to the company and its founder
  • Browsed company websites for any interesting information
  • Valuation, including both liquidation and capitalization of operating businesses
  • Historical multiple analysis
  • Probabilistic Scenario Analysis

D. Analytical Procedures and Due Diligence Not Performed

  • Comps comparison
  • Management assessment
  • Competitive advantage assessment
  • Industry economics assessment
  • Future growth assessment
  • Catalyst identification

E. Description of the Company

Richfield International Limited is a port service and shipping company. Its stock sells below net current asset value (current assets minus all liabilities) and net cash (cash minus all liabilities). In addition, the business is profitable and has no debt. The company is listed on the Australian Stock Exchange under the symbol RIS. This stock can be purchased via Interactive Brokers. Trading volume tends to be low and sporadic.

Richfield has two operating businesses: Richfield Marine Services (“RMA”) and Speeda Shipping Co (“Speeda”). The two businesses are described below.

F. Richfield Marine Agencies (“RMA”)

RMA offers a comprehensive range of port services to incoming and outgoing ships. Essentially, RMA’s business focuses on handling local complexities that would be difficult for a foreign ship to handle by itself, given how many ports and countries that such ships must visit. Its services include: shipbrokering (bringing together those who need cargo shipped with those who provide shipping services), crew handling services (hotel booking, transportation services, travel arrangements, medical needs, etc), supply services (spare parts, bunker fuel, fresh water, etc), storage services, assistance in obtaining port permits and licenses, customs clearance and forwarding (communicating with port authorities, completing paperwork and documents, etc), arrangement of marine and cargo surveying services, providing port and market information (such as freight rates), repair and maintenance services, and so on.

In many cases – perhaps most cases – RMA does not provide these services itself, but arranges for local contractors to do the work.

RMA focuses on ports in Singapore and Shanghai (the Shanghai office opened in 2007). RMA has a particular focus on ships owned by American companies, which explains why such a large portion of revenues, costs, receivables, payables, and cash is in U.S. dollars.

G. Speeda Shipping Co. (“Speeda”)

Speeda provides containerized shipping services to exporters and importers. The company operates a fleet of containers and fills container slots on ships. Speeda does not own any ships. This business was largely wound-down by the end of 2013.

Speeda used to be the focus of Richfield. The 2005 chairman’s letter states that, at the time, company’s strategy to grow was by (1) developing a fleet of ships, (2) expanding operations geographically, including Australia, and (3) creating a shipping service to Western Australian ports linking Southeast Asian ports.

It appears that the company originally listed on the ASX in anticipation of developing a significant business in Australia. However, the shipping industry subsequently entered a period of depression. Management changed its plans, and has almost eliminated the Speeda business line.

H. The Main Reasons Why I Think Richfield International is Undervalued by the Market

  1. No perceived catalyst.
  2. Declining revenues and a dismal reported financial performance since its IPO in 2005.
  3. Investors do not believe that the minority shareholder has, or will ever have, any control over this company.
  4. Over the past few years it has habitually traded below net current asset value (current assets minus all liabilities) and net cash (cash minus all liabilities). Even “net-net” (a company trading below net current asset value) bargain hunters avoid perceived “perennial net-nets.”

I. The Main Arguments for Buying Stock in this Company at Current Prices

  1. With a market capitalization of AUD 5.5 million at December 15, 2014, Richfield is selling for less than two-thirds of net current asset value (current assets minus all liabilities) and net cash (cash minus all liabilities). Current assets are almost entirely cash and cash equivalents. Therefore, you get $100 of value for about $66, plus the two operating businesses for free.
  2. The company was profitable in the last 8 out of 9 years and had positive free cash flow in 7 out of 9 years, in spite of the negative impact of the Speeda business.
  3. Both net current asset value and book value have increased since 2005 with some year-to-year consistency. Given the company’s historic profitability and positive free cash flow, it is probable that both net current asset value and book value will increase in the future.
  4. No debt. This fact, along with management’s stated attitudes and actions, seems to indicate a very financially conservative mindset. Liabilities are primarily composed of trade payables and tax liabilities. There is a small off-balance sheet operating lease obligation.
  5. The company should benefit near-term and possibly over the next 5 years from low oil prices, which will increase global trading activity as a result of lower bunker fuel prices, depending on OPEC’s actions.
  6. RMA is highly profitable and capital light, while Speeda is highly unprofitable and capital intensive. The company has been winding-down Speeda over the past few years, and by the end of 2013, Speeda had been largely wound-down. This fact may not be fully accounted for by the market. RIS has focused on RMA, which it has successfully grown over the years and which has achieved consistent year-to-year profitability. RMA has high returns on capital ex cash. It was profitable during both the financial crisis and the recent lean years in the shipping industry. The RMA business almost certainly has a positive net present value and will provide some assurance against NCAV declining.RIS 0 -- Segment results
  1. Given that Speeda has been largely wound-down, future results should predominantly reflect RMA’s results. Therefore, so long as RMA’s business continues as it has in the past, it should show stronger results over the next few years. This improvement in financial results could be a catalyst to gain greater market attention and spur optimism for the stock.
  2. Currency Risk – There is limited currency risk for a U.S. investor. Cash, receivables, and revenue are primarily in USD. Payables and costs are split about 50-50 between the USD and the Singapore Dollar.
  3. Analysis of Financial Statements and Notes for Normalcy and Material Misstatements, and Comments About the Auditor – It appears unlikely that the financial statements are materially misstated or fraudulent. The company is listed on the Australian Stock Exchange. It must adhere to Australian Accounting Standards and its financial statements are compliant with IFRS, according to the auditor (that is my opinion as well). The reported results do not look “too good to be true.” Cash flow and net income do not diverge significantly over a period of years. There are not significant net balance sheet or cash flow accruals over time. Cash and accrual taxes align over a period of years. Transparency and disclosures seems adequate. Overall, the accounts and accounting for the company are simplistic – there are no level 3 assets or speculative derivatives, for example, and there are not multiple corporate layers in the organization. The auditor, Stephen Moore, seems to be reputable. The auditor’s fee and total assets have shown a normal relationship over time. Assumptions used in goodwill impairment testing seem conservative. Depreciation policies seem conservative.

J. The Main Arguments Against Buying Stock in this Company at Current Prices

  1. Historically, RIS has sold at a discount to both NCAV and net-cash on average. The company has historically sold for much, much lower prices than the current price – as low at 20% of net cash (AUD 0.02 per share in 2012 versus AUD 0.09 per share today). The current price is relatively high when compared to average prices in the past.
  2. Corporate governance at the company is probably a farce. The non-executive directors appear to just be a rubber stamp body. 2 out of the 5 directors are executives. The board is probably dominated by the founder of the company, Chak Chew Tan, who owns 37.18% of outstanding shares and sits on the board. The non-executive directors have multiple other obligations and work activities, so it would be very difficult for them give much serious thought to matters at Richfield. It is questionable whether two of the directors (Steven Pynt and Andrew Phillips) even visit Singapore and the RIS’s operations during the year. The non-executive directors do not seem to be subject-matter-experts when it comes to the port services or shipping industries. In short, it seems unlikely that minority shareholders could ever have any influence on management or company policy, much less ever have the ability to replace management if it behaves poorly. Management is compensated with a fixed salary, regardless of the progress of the company or financial results.
    1. There are a few offsetting factors. First, the company is listed on the Australian Stock Exchange and must adhere to ASX corporate governance standards. Second, management has not done anything seriously contrary to minority shareholder interests so far. Winding down Speeda’s operations was a great idea, in my opinion, and prevented potentially massive value destruction for the shareholders. Third, senior management is not paid extravagant salaries. Fourth, the founder and CEO has a significant portion of his personal wealth in the company’s stock, which helps to align his interests more closely with the other shareholders. And fifth, the non-executive directors are not paid much for their services, relative to what the average director makes.
  1. Dividends and Shares Repurchased – The company has not paid any dividends since its IPO in 2005. No shares have been repurchased.
  2. Accounting Concerns – There are a few yellow flags and one red flag in regards to the company’s accounting:
    1. The company is far too small to support any significant system of internal control. There are just 28 full-time employees, including senior management. This risk is increased by the fact that the company has offices in multiple countries.
    2. The company had its IPO in a foreign country rather than its host country.
    3. It is unclear whether the auditor actually visited the company’s operations in Singapore (I have contacted the audit partner about this, but have not gotten a response yet as of December 28, 2014).
    4. The red flag is that there was a significant related-party loan at the time of the company’s IPO. The transaction is listed in the financial statements, but there is no mention of it in the notes to the financial statements, despite the loan being large. In any case, the loan was repaid and at a very high interest rate (Loan proceeds: 378,274 in 2005. Loan repayments: 456,795 in 2005 and 37,290 in 2006). Unusual related-party activities close to an IPO are one sign occasionally seen with fraudulent Chinese reverse merger companies.
  1. RIS has held a large cash balance since listing on the ASX. It is unlikely this will change in future. The company may, however, make an acquisition with the cash. While there is a risk of overpaying, RIS has so far exercised patience and discipline in waiting for the right candidate. The company has been actively looking for an acquisition since at least 2007 (that has been mentioned in the chairman’s letter in every annual report since then). An acquisition has not been made in 6 years, in spite of them actively looking. So they have demonstrated patience so far, especially considering that they were losing revenue and not highly profitable for much of that time.
  2. Management has indicated that it may expand its containerized business when conditions improve. The containerized shipping business, in my opinion, is not a good business, and management has shown poor judgment in the past when it comes to projecting market conditions for that business. RIS began investing in its shipping fleet right when the commodity boom was at its peak. Apparently, management thought this trend would continue. So they invested and a few years later it began crashing (starting in 2009). The investment has been a complete failure. It is possible, therefore, that management could make a hugely value-destroying mistake in the future with regards to their business decisions.
  3. Management has issued shares over time via secondary offerings to investors. I did not see an explanation as for why. This action is puzzling, because the company already had an enormous amount of cash, and the cash from the secondary offering has not been used since then.
  4. Given how small the company is, it could “go dark” and stop sending annual reports to shareholders, or it could delist from the ASX. Such an action would make it very difficult to sell RIS shares.
  5. Chak Chew Tan is clearly a key employee. Without him, it is unclear what value there is to the company or whether it could survive. He is age 57 now.

K. Valuation of this Company

I valued RIS using two approaches. The first is by estimating liquidation value.

RIS 1 -- Liquidation Value Table

The company is clearly selling for less than its liquidation value. However, the calculation of liquidation value is heavily dependent on the value of the company’s cash and cash equivalents. There is a possibility that management could destroy some of the cash value via poor investments or acquisitions.

Therefore, I also valued the company’s excess cash separately and add that cash value to the estimated earnings power value of the RMA business, subtracting for residual losses from Speeda and parent-level costs.

Total cash on the balance sheet as of September 30, 2014, was AUD 10,789,929. Assuming the company needs current assets to cover current liabilities 1.50 times, AUD 2,535,911 cash is required for working capital purposes. Therefore, excess cash is AUD 8,254,019. This is probably a conservative estimate.

Below is how I estimated earnings power for RMA:

RIS 2 -- Earning power calculation table

I estimated intrinsic value as the weighted average of four scenarios: worst case, pessimistic case, normal case, and optimistic case.

RIS 3 -- Intrinsic value estimation table

Clearly the market price cannot be justified based on the value of the RMA business alone. Therefore, the market is attributing some value to the excess cash and assets on the balance sheet. But the implied value for that cash given by the market price is at a tremendous discount from its book value.

The “normal” scenario capitalizes earnings at 8 times because that is the average multiple shown in market prices since 2005. My valuation for RMA is far below what management paid for it and what they estimate it is worth in the footnotes for goodwill impairment testing. Therefore, my valuation for the RMA business is probably conservative.

L. After Weighing the Pros and Cons, Should Stock Be Purchased in this Company? Analysis of 4 Scenarios.

I analyzed potential returns on investment based on 4 scenarios:

RIS 4 -- ROI estimation table

In the weighted average, normal, and even pessimistic case, the stock offers a strong possibility for market-beating returns. This is in spite of using, in my opinion, a conservative valuation and with a critical eye for risk and downside possibilities.

The fact that the company has on average sold at a large discount to net current asset value and net cash is probably a deal-breaker for most people, even bargain hunters. Some investors demand a specific “catalyst” for any investment of this type.

I think the risk-reward justifies investing a small amount of money in this company as part of a diversified portfolio. I think that the downside is largely protected by (1) the amount of cash on the balance sheet, (2) a profitable and cash-positive underlying business, and (3) reasonably intelligent and seemingly conservative management. If Richfield Marine Agencies continues to grow, then this investment could provide a reasonable return even if the price continues to stay at a discount to net current asset value. And if the market temporarily gets optimistic about the company, because the RMA business shows strong results or for some other reason, then there is a good probability of being able to sell this company’s stock near or above net current asset value.

M. Since the RMA Business Appears to be Good, Why Not Buy this Company as a Long-Term Holding? 

There is very little information available from English sources about the RMA business. Really, the only detail is from the company’s reports and its website, and the details available are vague.

Unless I can attain a better degree of understanding about what makes the business tick, I’m only comfortable paying a price that is based on the value of the assets of the Company. There is no way of knowing, for example, to what degree the success of the RMA business depends on Chak Chew Tan’s knowledge, connections, and reputation. If he left in the next 10 years, would the business lose half of its customers? I don’t know. Such an event would cause a huge impairment of the value of that business.

The earning power value of the RMA business provides a good cushion for the asset value and downside protection, but I’m basing my decision to buy stock on the asset value of the company rather than on the future of RMA.

In addition, the company’s stock presents a risk inherent in all of the Chinese reverse merger companies: no matter how much one studies the financial statements and notes, it is still possible that this company could be a complete fraud and the analyst could miss it.


Devon Energy Analysis (2012) – 31 Pages


Note: Based on this analysis my client bought Devon stock. This analysis is 31 printed pages.

Analysis of Devon Energy (DVN)

By James “Jack” Huddleston, June 27, 2012

Updated August 1, 2012, for Q2 2012 information (Posted 8-22-12)

Table of Contents

A. Format of this Report
B. Summary of Investment Conclusions
C. Basic Description of Devon’s Operations
D. The Peer Group
E. Production and Reserves
F. Merger and Acquisition Activities
G. Prospects for Growth
G.1. Expansion of Existing Locations
G.2. New Ventures
G.2.a. Description of the 6 New Ventures
G.2.b. Sinopec Joint Venture
G.2.c. Sumitomo Joint Venture
G.3. Canadian SAGD Projects
H. Financial Analysis
H.1. Accounting Adjustments
H.1.a. Impairment charges
H.1.b. Discontinued income
H.2. Financial Strength
H.3. Competitive Strength
H.3.a. Cost and Asset Efficiency
H.3.b. Profitability & Returns
H.3.c. Growth rate
I. Valuation
I.1. Free Cash Flow
I.2. Growth Rate
I.3. Discount Rate
I.4. Target Price Calculation
I.5. Special or Unusual Factors in the Valuation
I.6. Supplemental Valuation
I.7. Optionality Value
J. Worst Case Intrinsic Value
K. Worst Case Stock Price
L. Recommendation
M. Notes


A. Format of this Report

For the convenience of the reader, the sections of this report are numbered and the notes referenced in each section can be found at the end of that section or subsection, and these notes are set off from the regular text by a horizontal line. Notes to tables will be found at the bottom of the table. In addition, I have tried to use a text size that is easy to read on computers and mobile devices.


B. Summary of Investment Conclusions

Based on a study of the company, competitors, and future industry and economic expectations, as of June 27, 2012 Devon has a calculated midpoint target price of $98.47. Given a 33% range of value, the upper and lower ranges are $115.25 and $86.05. Using the midpoint target price as the decision rule for investment, Devon is recommended as a sound investment for purchase.


C. Basic Description of Devon’s Operations

Devon Energy Corporation (symbol: DVN) is an independent oil and gas company. It has an upstream exploration and production (E&P) business and a marketing and midstream (M&M) transportation business. In addition to pipelines, the M&M segment has compression and processing plants.

The M&M business’s purpose is primarily strategic, and it is not the main focus of the company’s strategy or capital expenditures. The primary function of Devon’s M&M business is to support its E&P business. The company was one of the first producers to begin drilling in certain plays. As a result, Devon has had to build the necessary transportation and processing infrastructure. As other E&P companies move in to drill, Devon allows them to use its infrastructure in return for a fee. In total the M&M business only comprises about 8% of Devon’s operating income, and accordingly it is given less attention in this article in comparison to Devon’s E&P business.


D. The Peer Group

Throughout this article mention is made of a peer group. The 15 companies in the Peer Group are listed below. These companies were chosen because they have similar economic characteristics to Devon in that: (a) most of their operations are in continental North America, (b) each of the companies has at least $1 billion in market capitalization, and (c) most of their business is in E&P. This Peer Group includes the following companies:

dvn 1 -- peer group

The Peer Group (1) has been split into subgroups based on the amount of reserves that are in natural gas. This is because the economics for oil and gas are different. I think one point that can be argued is that the mixed producers have a special advantage over the predominantly oil or predominantly gas producing companies. The advantage is that mixed producers can take advantage of price changes by shifting their production more toward the energy commodity that is most favorable. On the other hand, a company that has mostly oil or gas can do nothing more than wait until prices turn to their favor. This advantage, I think, translates into greater stability in earnings and returns.

Note that whenever the Peer Group is mentioned throughout this article – as it is frequently in the “Financial Analysis” section – it is referring to the aforementioned group of 14 companies. In addition, when a calculation for the Peer Group is shown, either the overall peer group average or the median of ratios, Devon is always excluded. Devon is shown in the list of Peers above just for convenience.

(1). See my article “Debt Servicing Ability of 15 Oil & Gas Companies” for more about this Peer Group


E. Production and Reserves

Reported total production (stated in million barrels of oil equivalent or MMBOE) since 2003 is as follows:

Devon’s Total Production from 2003 to 2011 (MMBOE)

dvn 2 -- dvn total production 2003 to 2011

A quick look at total reported production can give the impression that Devon has not grown at all over the past several years. The table above shows, however, that after excluding offshore and international operations – thereby isolating production to onshore North America – total production has increased 4.40% per year annually compounded. (Note: Devon currently only has operations in the continental U.S. It divested of its offshore and international operations over the past 5 years. See below: “Merger and Acquisition Activities”).

Reported proved reserves (MMBOE) since 2003 are as follows:

Reported Proved Reserves 2003-2011 (MMBOE)

dvn 3 -- dvn proved reserves 2003 to 2011

Continental North American reserves have roughly doubled since 2003. Canadian reserves have been relatively stagnant with the main advances being the Jackfish and Kirby-Pike steam-assisted-gravity-drainage (SAGD) projects (see the section “Growth Prospects” below for discussion on Canadian operations). U.S. onshore reserves have more than doubled since 2003, increasing 11% per year annually compounded since then.

Oil, NGLs and Total Liquids as a % of Total Reserves 2007-2011 (2)

dvn 4 -- ngls and liquids to total reserves 2007 to 2011

(2). Note: Oil + NGLs = Liquids

Below is a table from the company’s 2011 annual report, which breaks down reserves, production, and net acres by each major geographic area.

Reserves and Production by Geographic Area, 2011

dvn 5 -- reserves by geographic 2011


Natural gas prices have declined in the past few years because of an oversupply of the commodity. This oversupply is often credited to the “shale boom” in North America, as prices in foreign countries have generally not experienced a decline of this degree. The largest exposure Devon has to low natural gas prices (and possibly decreasing NGL prices) is in the Barnett. Devon’s Barnett reserves in 2011 were 22.1% liquids. In 2011, 32.4% of Devon’s production came from the Barnett, 7.5% from the Permian, and 5.1% from Cana-Woodford.

A rate of return matrix in a 2012 company presentation shows that at $2.50 gas and $80 oil rates of return in the Barnett Shale are about 12%. After corporate taxes this would be 7.80%, which is not far from the ROIC seen for Devon as a whole and for the general industry in 2011 and 2010. (See below: “Profitability & Returns”).

The recent low gas prices will probably be temporary. Rates of return at recent prices are unattractive enough relative to oil projects that many producers have cut gas production and increased liquids production. Moreover, low gas prices have resulted in higher demand. The basic laws of supply and demand will most likely eventually cause gas prices to revert to some equilibrium price higher than the current price.

This equilibrium price reversion, however, probably will not occur within the next few months or even the next few years. Until this price reversion occurs Devon will continue to give a greater weight of production to oil and NGLs. In Q4 of 2011, 45% of sales came from oil and 36% came from NGLs. This kind of production obviously isn’t sustainable forever, given the reserve mix, but it can probably continue until natural gas prices increase.

The Barnett will benefit hugely if gas prices rise to a higher level. At a gas price of $3.50 and an oil price of $80, the Barnett operations are expected to have a rate of return of 30%. Cana-Woodford, which is 36.4% liquids, is expected to have a rate of return of 28% return at those same prices.

The Permian, which is mostly liquids (roughly 80%), has been not been much affected by the depression of gas prices. Out of dozens of competitors, Devon has the second largest acreage position (at 1,500 net acres) in the Permian next to Occidental Petroleum (2,400 net acres).


F. Merger and Acquisition Activities

Devon currently has operations solely in the continental U.S. (the lower 48 states) and Canada. In the past it had offshore operations in the Gulf of Mexico and subsidiaries across the globe, but from 2007 to 2011 the company divested of both. These divestitures are part of a strategic decision to focus on continental North America that was announced officially in 2009 by company management. Former CEO J Larry Nichols (now Chairman of the Board) explained this decision in his 2009 letter to shareholders:

“We had more high-quality development opportunities than we could simultaneously pursue. Therefore, in order to optimize the value of our overall opportunity set, we are relinquishing some opportunities and focusing our resources on others. This led to our decision to monetize our Gulf of Mexico and international assets and to focus our capital and human resources on our world-class assets onshore in the U.S. and Canada.”

Devon’s merger, divestiture, and acquisition activity since 1998 is presented below: (3)

dvn 6 -- m&a

(3). Note: The book value figures are calculated as the total selling price minus the sum of related capital gains.

It has been the company’s policy since the Ocean Energy merger to prefer internal investment over growth through mergers or acquisitions. Some investors worried that Devon might use the proceeds of the offshore and international divestitures to make poor acquisitions. The company, however, has made it clear that it does not intend to use those funds for acquisitions, and it will instead use the cash to repurchase shares and reinvest in itself. This course of action is based on the belief that its current opportunity set offers better rates of returns than a potentially overpriced acquisition.

It is interesting to note that, based on 2007 reserve data, offshore and international operations in total represented 8.9% of the company’s total reserves at the time. Yet these reserves were sold for in total $13 billion, or 57% of the company’s common stock market capitalization as of June 27, 2012. It would seem that either the market is acting pessimistically or the buyer of these assets was overly optimistic. It is more likely is that the resource potential is greater than the stated proven reserves, and that the value of those two divestitures as a percentage of the total company is significantly greater.


G. Prospects for Growth

There are three main known areas of prospective growth for Devon:

  1. Expansion of Existing Locations
  2. “New ventures”, including joint ventures with the China Petroleum & Chemical Corporation (Sinopec) and Sumitomo
  3. Canadian steam-assisted-gravity-drainage (SAGD) projects

These three topics will be discussed in some detail below.

G.1. Expansion of Existing Locations

While the scope of this report does not permit a detailed analysis of each individual play the company is involved with, a discussion of the general picture is warranted. Devon was one of the first companies to enter into some of North America’s recently discovered plays. That allowed it to acquire large acreage positions at a relatively low cost. As of June 2012, all of Devon’s locations are in North America.

Areas where the company was most actively expanding in terms of drilling as of 2011 and early 2012 are the Cana Woodford Shale in Oklahoma, the Barnett Shale in Texas, the Permian Basin also in Texas, and Lloydminster in Canada. Most of these plays are unconventional with the exception of Lloydminster, which produces heavy oil by conventional means. Not listed on the “Reserves and Production by Geographic Area” table above is another large acreage position in the Permian Basin that Devon only recently revealed known as the Cline Formation, which is a “liquids rich” play according to the company.

One way to evaluate Devon’s long-term growth prospects is by looking at its “risked resources”. In its 2012 Analysts Day presentation, Devon stated that risked resources as of April 2012 were 16,200 MMBOE and unrisked resources were 31,800 MMBOE, implying overall roughly a 50% chance of successful extraction. Based on 2011 production that means risked resources will take 67.5 years to extract. (Note: Risk resources figures include the “new ventures” described below.)

Management estimates should obviously be viewed with skepticism, as they could be overly optimistic, but even if one assumes that risked resources will be half of management’s estimate there is still an inventory of 33.75 years remaining. This does not include the exploration that the company will do over that period to find additional new resources.

Unfortunately, Devon does not define “resources” in its 2011 annual report or any other documents I reviewed. In addition, I cannot determine whether the definition of resources is the same as that used by the Society of Petroleum Engineers. It seems likely, however, that the company is using the standard definition of unrisked resources, which includes proved, probable, and possible reserves – reserves extractable given the best case scenario. Risked resources is likely defined as unrisked resources multiplied by the probability of ultimate extraction.

Chevron provides the following definition of “resources” in its 2011 annual report:

“Estimated quantities of oil and gas resources […] includes quantities classified as proved, probable and possible reserves, plus those that remain contingent on commerciality. Unrisked resources, unrisked resource base and similar terms represent the arithmetic sum of the amounts recorded under each of these classifications. Recoverable resources, potentially recoverable volumes and other similar terms represent estimated remaining quantities that are expected to be ultimately recoverable and produced in the future, adjusted to reflect the relative uncertainty represented by the various classifications.”

Max Petroleum PLC defined unrisked resources in a report titled “Resource Estimates of Exploration Potential on Blocks A & E from Ryder Scott Company, LP” dated July 12, 2012: (4)

“Unrisked prospective resource volumes are commonly categorized as Unrisked P90, P50, P10 or Mean Resources and are estimated before multiplying by the geological chance of success which assumes that the drilling of an exploration well is successful.”

And risked resources:

“Risked prospective resource volumes are commonly categorized as Risked Mean Resources and are calculated by multiplying the unrisked mean resources by the geological chance of success to account for the risk of drilling an unsuccessful exploration well.”

(4). http://www.maxpetroleum.com/uploads/10-07-12-rns-competentpersonsresourceestimates.pdf

G.2. New Ventures

This section describes the 6 New Ventures and joint ventures with Sinopec and Sumitomo.

G.2.a. Description of the 6 New Ventures

In addition to expanding on the plays where Devon already has substantial operations, there are multiple “New Ventures”, as the company calls them. Notable among these is a joint venture with Sinopec, a Chinese company that seeks to gain expertise in producing in unconventional oil and gas. The Sinopec joint venture includes five New Venture positions. A sixth New Venture is the Cline Shale. The Cline venture is close in proximity to Devon’s outstanding Permian Basin operations and will benefit from the infrastructure and economies of scale already present there.

Summary of Devon’s New Ventures as of Q1 2012 (5)

dvn 7 -- new ventures

(5). Note: (a) This data was originally shown in the 2012 Analysts Day presentation. (b) The “total” column figures are weighted by unrisked resources to Devon. (c) BOE/D = barrels of oil equivalents per day.

These plays are mostly unconventional, but some conventional wells will also be drilled. In the above table, the first month production rate is taken from a “type curve,” which shows expected production from a well over the life of the well. The type curve is almost always hyperbolic – that is, production decreases very rapidly near the first few years and then decreases very slowly for several years thereafter. For the type of projects comprising the New Ventures, the production by years 2-3 is usually roughly 20% of the initial production. Assuming production by 2013-2014 will be 20% of what it is by the first month, then BOE/D production per well is:

dvn 8 -- new ventures 2

Assuming the production in years 2-3 will be 20% of the first month production rate, then the wells that are planned to be drilled by the end of 2012 will add to production between 5.97 and 6.59 million barrels of oil equivalents (BOE). If these ventures turn out to be a success, it is likely more wells that can be drilled in each area with similar economics to the rest of the company’s operations.

If even 10% of the unrisked resources from the 6 New Ventures are eventually classified as proven reserves, this would add 79.52 million BOE assuming a 9.5% depletion rate (typical of Devon and the peer group historically) – as compared with Devon’s total 2011 production of 240 million BOE.

G.2.b. Sinopec Joint Venture

The terms of the joint venture with Sinopec are favorable for Devon. Devon receives $2.5 billion from Sinopec in exchange for a 33% interest in five New Venture exploration plays in the U.S. $900 million will be received during Q1 of 2012, and the rest will be paid incrementally over the life of the project to cover future drilling costs. The company expects the other $1.6 billion to be realized by the end of 2014. This $2.5 billion will, according to current estimates, cover 80% of total development costs until 2014. This significantly reduces the risk of the New Ventures, and it is almost self-funding, meaning it will not require relatively significant amounts of capital to be diverted to it.

If Sinopec did not overpay for the 33% interest, then that implies the total value of the joint venture is $7.5 billion. Devon’s $5 billion portion of the joint venture is 22% of Devon’s market capitalization as of June 27, 2012. Based on the June 27, 2012 share price of $56.20 and if one assumes that the market price is also correct, this implies the value of Devon’s current operations is $31.52, which is a 25% discount to stated book value per share (6).

The historic earnings and returns of the company, I think, do not at all justify any discount to stated book value. This same value of $31.52 when divided by the 5-year average of earnings per share (adjusted for impairments and discontinued operations) shows a P/E of 5.37. It seems likely that either the market is not giving much credit to the joint venture or has little faith in current operations.

(6). This is calculated as: the June 27, 2012 share price of $56.20 minus Devon’s share of the joint venture per share of $12.36 minus non-operating assets per share of $12.31 (for the calculation of non-operating assets per share. (See “Special or unusual factors in the valuation” below).

G.2.c. Sumitomo Joint Venture

Devon announced on August 1, 2012, that it will sell a 30% interest in its Cline and Midland-Wolfcamp properties to the Japanese company Sumitomo Corporation. The details of this deal are similar the Sinopec deal. According to Devon’s press release, the 30% interest will be sold for $1.4 billion. $340 million is expected to be paid by the end of the third quarter of 2012, when the deal is expected to close, and $1.025 billion is “committed” to funding drilling and completion costs over the next few years as the initial phases of the project are completed. This $1.025 billion is expected to be fully received by sometime in the middle of 2014. Devon will be the operator and “responsible for marketing.”

This deal is also favorable for Devon. According to the company the deal will cover 79% of drilling and completion costs. This has the two beneficial effects of (1) reducing the amount of capital expenditures Devon must commit and (2) reduces the risk of the project. The first few years of the venture will be the riskiest, and this risk will be substantially reduced when wells are actually drilled and producing. Until that time, Devon doesn’t have to commit much capital. It can be argued that a significant reduction in initial fixed investment increases Devon’s overall returns from the project. This factor combined with the lower risk makes the joint venture quite favorable.

As a side note, this joint venture along with the Sinopec joint venture gives credit to the notion that there is an advantage to a larger size just as there is a disadvantage. The disadvantage is potentially lower growth. The advantage, though, is that Devon is more likely to be a candidate for favorable joint ventures of this type.

G.3. Canadian SAGD Projects

In Canada, Devon has been investing several for nearly a decade in a steam-assisted-gravity-drainage (SAGD) project known as the “Jackfish.” The SAGD technology is used to liquefy crude oil so heavy that – according to Devon’s head of Canadian operations Chris Seasons – one can almost walk on it. Devon claims to be the first independent U.S. based company to operate an oil sands project in Canada.

After the success of the first Jackfish project, Devon invested in two more SAGD projects, and now has a total of three. Each Jackfish project produces approximately 35,000 barrels of oil a day, or 12.78 million barrels a year, and each has a lifetime of about 25 years. Jackfish 1 alone amounted to about 5.32% of Devon’s total 2011 production, and it has been in production since around 2008. Jackfish 2 was completed in 2011, but it won’t be at full capacity until 2012. Jackfish 3 achieved regulatory approval from the Canadian government at the end of 2011, and it probably will not be completed until 2013.

The cost structure of these projects is not made clear, but they are likely more expensive than conventional oil and gas projects. A rate of return matrix shown in a 2012 presentation for Jackfish 1 and Jackfish 2 shows an expected rate of return on Jackfish 1 of 29% assuming $80 WTI and $2 natural gas. Under the same price assumptions, the rate of return on Jackfish 2 is expected to be 22%. Returns for Jackfish 1 reach 39% at $120 oil and 29% for Jackfish 2. Another interesting feature of the SAGD projects is that the costs decrease as the price of natural gas decreases, since it is used as an input into the process. As a result, the rate of return on these SAGD projects decreases about 1% for every $2 increase in natural gas prices per mcf.

It seems that several more of these Jackfish-type projects can be developed within the next decade. For example, the Kirby-Pike Project is a 50-50 joint venture with BP and is similar to the Jackfish. Because Devon has gained an expertise in these kinds of projects, they are the operator. Chris Seasons estimates that at least six Jackfish-type projects will be operational before 2020 (2 projects at Jackfish, 3 projects at Pike, and a separate “Jackfish East” project), which will add about 52 million barrels of oil production per year in comparison to Devon’s total 2011 production of 240 million BOE (7).

Devon would have 2.20% volume growth over the next 10 years if its expansion were limited only to its Canadian SAGD projects. These projects have little risk in terms of exploration, because (1) the location of the oil is already known and (2) Devon has experience with the technology. Most if not all of this production will be heavy oil bitumen, and the economics of SAGD should provide a slight hedge to natural gas price declines.

The first Jackfish project took several years, but the SAGD technology at that time was relatively new. The knowledge Devon gained from Jackfish 1 has allowed it to now be capable of finishing a project within 1 to 1.5 years after Canadian regulatory approval, and Devon has been successful at quickly obtaining the required approvals. The economics should get better over time as the company’s expertise grows further. In addition, since all the currently planned Jackfish-type projects will be located in close proximity to each other, there will be economies of scale from transportation infrastructure, processing, personnel, and so forth.

(7). This is after subtracting out BP’s 50% interest in the three Pike projects.


H. Financial Analysis

The purpose of this section is to determine through objective analysis whether Devon is at least as good as the Peer Group, in terms of its financial strength, cost and asset efficiency, profitability, returns, and growth prospects (8). If this is the case, then Devon should sell for at least as much as the average company in the Peer Group has in the past several years. For the purposes of valuation, I am assuming that Devon will grow at a slower pace than the average for the Peer Group. The slower growth is offset to some degree, however, by the company’s financial strength and stability.

(8). The list of 14 companies in the Peer Group is near the beginning of this report.

H.1. Accounting Adjustments

Before analyzing the ratios themselves, it is necessary to discuss various items that have been adjusted and the reasoning behind these adjustments.

H.1.a. Impairment charges

In 2008 and 2009 Devon had two very large impairment charges against income termed “reduction of carrying value of oil and gas properties.” Companies in the oil and gas industry have special accounting standards, and the gist of this impairment charge is – although this is a gross oversimplification – that it is required when oil and gas prices decline by a significant amount. Many companies in the oil and gas industry recorded this kind of impairment in 2008 or 2009 as a result of the major price decline that occurred as a result of the recession.

The price of oil, measured by the “West Texas Intermediate” (WTI) spot price, started its plunge in July of 2008 at a price of $145.31[1], bottomed in December at $30.28, recovered to about $80 by the end of 2009, and steadily rose to approximately $100 by the end of 2011. By June 2012, oil prices had returned to the $80 range. It is definitely true that such price volatility affects cash flow. While the company’s derivatives protected its average sales price per barrel of oil equivalent in 2008 ($44.08), the average price received in 2009 was definitely affected ($24.71). Natural gas prices, measured by the “Henry Hub” (HH) spot price, dropped from a high of $13.31 in July 2008 to $2.06 in Sept. 2009, rose to $3.00 by the end of 2011 and were $2.74 by the end of June 2012.

Impairment implies a permanent long-term decline of earning power. Given these facts, the size of the impairment seems overstated. Once the prices are back up, the assets become economical again. A good portion of the impairment charge is justified – as the property and equipment were purchased at much higher natural gas prices than are expected in the future – but it is difficult to know precisely how much.

Inclusion of impairments for Devon and for the Peer Group companies reduces comparability. For the sake of simplicity, the adjusted ratios in the analysis below remove the total impairment from the income statement for Devon and the Peer Group.

H.1.b. Discontinued income

Since 2007, Devon has divested of its offshore and international operations. Besides a small amount of operational income, the sale created large capital gains in 2011 and 2010 and a lesser gain in 2008. In the table below, Devon’s net income is adjusted to exclude income from discontinued operations.

H.2. Financial Strength

Before a valuation can be made, the basic question of the Devon’s financial condition must be addressed. In addition, an analysis of the company’s competitiveness in comparison to competitors is warranted.

The table below compares Devon to the Peer Group on various ratios indicating financial strength:

Devon’s Financial Strength Compared to Peer Group (9)

dvn 9 -- financial strength

dvn 10 -- financial strength formulas

(9). Note: (a) No adjustment for discontinued operations is made for Devon as discontinued operations is reported below pretax net income. (b) For the years 2011 to 2007, the figure shown for the Peer Group is the median of ratios, and the average for those years is the arithmetical average of the ratios shown for the previous years.

These ratios, when taken in aggregate, show that there is little chance of the company being unable to pay its debts, and they show that Devon is generally in a stronger position in comparison to the Peer Group. Interest can be more than adequately covered by EBIT, and any debt principal can be repaid with normal operating cash flow. The ratios seen in 2009 are also strong given the circumstances. Management has voiced several times in the past few years its intentions to keep debt within safe limits.

As with any business, having free cash ready to take advantage of opportunities is a big advantage. Devon’s high cash levels in 2011 and 2010 are the result of its divestitures and, besides creating temporary extra financial cushion, will allow the company to make substantial investments without having to raise new funds from financial markets. As is discussed below, the current market price hardly seems to be giving any credit to this large cash position.

H.3. Competitive Strength

H.3.a. Cost and Asset Efficiency

The table below compares Devon to the Peer Group on various ratios indicating its cost and asset efficiency:

Cost & Asset Efficiency Comparison – Reserve Replacement (10)

dvn 11 -- reserve replacement

dvn 12 -- reserve replacement formulas

(10). Note: (a) For the years 2007 to 2011, the figures shown for the peer group are the overall average of the 14 companies in the Peer Group, excluding Devon. It is not the average of ratios but the ratio calculated if the figures for each company are summed. The reasoning for using an overall average rather than a median is to see how efficient the industry is on a whole on a barrel of oil equivalent basis. The average for those years is the arithmetical average of the ratios shown for the previous years (b) A ratio is calculated excluding revisions because for the most part these revisions are the result of changes in prices for oil and gas. Efficiency ratios are meant to analyze management’s ability to deal with things that are under their control, which does not include price changes.

The S&P Industry Survey for the “Oil & Gas: Production & Marketing” industry from March 29, 2012 shows that the “organic reserve replacement” ratio for U.S. producers is 2.07 on average for the three years 2010 to 2008 (11). Devon lags the Peer Group in replacing its reserves, but seems to be on par with U.S. producers in general.

Devon is one of the larger companies in the Peer Group, and typically oil and gas companies show a decrease in their reserve replacement ratio over time. This makes sense from a logical perspective (the larger a company becomes, the more it is expected to regress to the mean). For example, the average reserve replacement ratio for the 5 “super majors” (BP, Chevron, ExxonMobil, Royal Dutch Shell, and Total) was roughly 1.50 in the year 2000 and 0.75 on average from 2004 to 2007 (12).

Oddly, in spite of its lower replacement, Devon has lower costs. Typically a company with lower costs is capable of expanding at a faster rate – that is why the low-cost Marcellus producers and producers in similar plays are achieving such high reserve replacement ratios. This may be simply a matter of choosiness on Devon’s part and a desire to forgo costlier projects and thereby sacrificing growth for overall returns. Indeed, growth that results in lower overall returns can sometimes result in a decline of the overall value of a company. The company has emphasized many times its desires to maximize returns and debt-adjusted growth per share, so this is a reasonable explanation.

(11). The S&P calculates this ratio as: = (revisions + extensions and discoveries + improved recovery) / production. Few companies actually report a line item even resembling “improved recovery” (all in all, only 3 do: SM Energy, Berry Petroleum, and Denbury Resources); it seems for the most part to be aggregated in “extensions, discoveries, and other additions.” The S&P’s figure most likely includes offshore production as well.

(12). International Energy Agency data. http://www.ie-ei.eu/Club_de_Nice/2009/GUINOT_2009.pdf

H.3.b. Profitability & Returns

The table below compares Devon to the Peer Group on various ratios indicating its profitability and returns:

Devon’s Profitability Compared to Peer Group (13)

dvn 13 -- profitability

dvn 14 -- profitability formulas

(13). Note: (a) For the years 2011 to 2007, the figure shown for the Peer Group is overall average of the industry. The average for those years is the arithmetical average of the ratios shown for the previous years. (b) The HH and WTI data are calculated based on monthly figures from the U.S. Energy Information Administration. These figures generally correspond to the realized price for each company before the effects of derivative hedging.

In the above table, two figures are presented for Devon. The first (“Devon Energy”) are the ratios based on data as reported. The second (“Devon Energy Adjusted”) makes adjustments for three one-time significant gains from the sale of discontinued operations. These gains occurred in 2011, 2010, and 2008.

The gains had the second consequence of placing a large amount of cash on Devon’s balance sheet. In 2011, 17% of Devon’s total assets were in cash. Obviously, much of this cash is not needed for operations and could reasonably be excluded in a calculation of ROIC. Making this adjustment by excluding “non-operating cash” (defined as any cash in excess of 2% of total assets) increases the ROIC for 2011 to 10%. The same adjustment for 2010 increases ROIC to 10.3%. Making these additional adjustments causes the average ROIC to become 13.5%.

I think this shows that Devon slightly trails the Peer Group. Making adjustments for any similar gains to the Peer Group could cause its average to decline (Cabot and SM Energy, for example each had substantial non-recurring gains in 2011 and 2010). In any case, the difference does not seem large enough to state conclusively that Devon is definitely worse than the average company, but in comparison to the Peer Group it probably isn’t one of the better companies in terms of its profit margins and returns on invested capital.

H.3.c. Growth rate

Total proved reserves provides a basis for valuing oil and gas producing companies and is a reliable measure of growth. It is from proved reserves that companies draw all of their production and hence their revenue. Proved reserves also minimize the effects that oil and gas price changes have on growth, which weakens the value of information gotten from growth rates. Oil and gas price increases over the past decade were extraordinary, and it would be foolhardy to project similar increases far into the future.

As shown on the table below, from 2001 to 2011, the growth rate of proved reserves for the Peer Group was 11.20% while Devon’s growth rate was 9.5% (after subtracting offshore and international reserves). Devon’s 2011 reserves are understated because of its previous divestitures and the huge amount of cash – around $7 billion (including that amount of the proceeds temporarily placed in short-term securities as of the end of 2011) – has yet to be reinvested. Devon’s cash is about the same amount that it spends in capital expenditures each year. Under this theory, there is a potential 8% of growth (the growth of reserves over the past 5 years) that is not factored into the current reserve figure. If that cash had been reinvested, the theoretical growth rate over the period 2001 to 2011 would have been 10.36%. For a company that is relatively large in size and has done little in terms of acquisitions over the years, this isn’t bad.

Proved Reserves – Peer Group and Devon (MMBOE) (14)

dvn 15 -- peer group proved reserves

(14). Source: 10K statements for each company – 2003, 2006, 2009 and 2011.


I. Valuation

The way to value any asset is to project its cash flows out into the future and then to discount them at an appropriate rate. This section discusses all components of the valuation, including: free cash flow, growth rate, discount rate, target price calculation, special factors in the valuation, supplemental valuation, and optionality value.

I.1. Free Cash Flow

The cash flows have been calculated using the “scientific” or modeling method of calculating first revenue, which is sales price multiplied by physical volume, and then subtracting operation expenses and taxes (15). The operating profit margin approximately equals that seen on average over the past decade, which is a good indication of the margin assuming a “normal” oil and natural gas price level. Operating cash flow is then found by adding back non-cash items, including necessary working capital investments, and then a subtraction for “maintenance” capital expenditures is taken to find “free cash flow” (16). Finding free cash flow in the case of an oil and gas company is comparatively simple. I used two methods of calculating maintenance capital expenditures that ended up with approximately the same results. These are briefly described below.

Value for an oil and gas company (i.e., its dividend paying potential) should stay the same if its reserves stay the same and everything else remains equal. Thus one would subtract from operating cash flow the amount of capital expenditures necessary to replenish depletion of reserves from production. Historically, Devon’s average annual total additions to reserves have been double their production. The predominant expense in adding new reserves is capital expenditures (additions to property, plant, and equipment). It can therefore be concluded that “maintenance” capital expenditures are approximately half of reported capital expenditures (i.e., one half of capital expenditures are needed to replace reserve depletion and therefore keep value constant).

A second method of calculating maintenance capital expenditures is to adjust depreciation for inflation over time. My personal records show that the multiplier necessary to adjust depreciation, depletion, and amortization to its cost in today’s terms is 1.25. Again, this is based solely on my personal records, and I found this number by looking at several companies that have a high amount of long-lived depreciable assets. The major error in this method is that today it costs more to gain a barrel of reserves from unconventional resources than it did ten years ago, but the results using this method for Devon were very close as those obtained from the first method based on reserve replacement. Over a 9 year period, the result using this method was within one percent of the result using the first method

Over a long period of time, free cash flow does not differ substantially from net income. Its main benefit in historic analysis is to get around oddities of accounting that distort results, such as with the impairments in 2009 and 2008.

(15). Future oil and gas prices are assumed to be slightly less than today’s breakeven prices for producers, to take into account cost efficiencies that will most likely occur in the future. The logic underlying this method is that competition should ultimately cause prices to move to their equilibrium price set by the laws of supply and demand. A scenario analysis was done to test for a near-term “shock” to oil and gas prices, where both drop significantly, and the results of this method do not differ hugely from that assuming a constant breakeven price. The calculated value between these two scenarios differed by about $5 per share.

(16). Maintenance capital expenditures are those needed to maintain value. Subtracting total capital expenditures instead of maintenance capital expenditures will cause free cash flow to be negative in many years. A good portion of the capital expenditures of oil and gas companies is spent for growth purposes.

I.2. Growth Rate

The growth rate used to value Devon does not include any assumptions about price increases over time – only volume growth is considered. Volume is assumed to merely grow at a certain percentage each year based on the company’s historic results, the Peer Group’s experience, and the fact that growth rates typically decline as companies become larger and oil and gas resources become scarcer. The estimated production from the SAGD projects and the new ventures alone are enough to grow volume roughly 4% per year over the next 10 years. Those two factors in addition to planned expansion at outstanding operations (the Barnett, the Permian, etc) are also considered in the estimated growth of volume.

A long-term growth rate of 8% is assumed. This reasoning is most succinctly explained in the following table. This table assumes that, with the exception of changes to reserves outstanding, everything else remains equal. In addition, it assumes a depletion rate (production divided by average reserves of the beginning and end of the year) of 8%. Note that, given a constant reserve replacement ratio (RRR), the growth rate percentage will be different depending on the depletion rate.

dvn 16 -- rrr

The reserve replacement ratio for Devon is expected to be at least 2 over the next several years, and it will likely decline over time as the company grows larger. This decline in the reserve replacement ratio is also reflected in the growth rate over the next 10 years. The long-term growth rate, over the next 90 years or so thereafter, is very low at 2% to reflect (a) diminishing returns on scale over time and (b) the uncertainty of that future.

I.3. Discount Rate

The cost of equity is the opportunity cost of investing in Devon as opposed to a competing oil and gas company or some company of equivalent risk. This opportunity cost is determined from the 14 Peer companies mentioned many times above.

Since potential oil and gas price changes are not considered in future growth, neither are they considered in the cost of equity – conceptually similar to using a “real” (as opposed to nominal) discount rate.

The cost of equity is calculated using two separate measures. The first is to combine historic growth with the historic dividend yield received on average for the Peer Group over the past several years. As calculated above, the Peer Group growth rate is 11.20%. The Peer Group’s dividend yield in May of 2012 was about 1.04%. Combining these two forms of return yields a total return of 12.24%. This is what one would have realized on average from the 14 companies in the Peer Group over the past several years after excluding those gains that occurred as a result of increases in the price of oil and natural gas.

I.4. Target Price Calculation

Based on a discounted cash flow valuation, a Target Price is calculated as $98.47 per share. Adding roughly a 33% range creates an upper range of $115.20 and a lower range of $86.05.

Below is a summary of this discounted cash flow valuation for the price:

Discounted Cash Flow Valuation (17)

dvn 17 -- dcf

dvn 18 -- other assumptions

(17). Note: This valuation is not attempting to forecast precisely the net income for 2012 or 2013. Its purpose is to provide an estimate of the value that is indicated given all the relevant facts of the company. If you would like to see the valuation model I used I can email it to you.

Long-term oil and gas prices are obviously open to debate. My reasoning in choosing those prices was to choose a price that seems conservative and justified based on long-term supply and demand. In the case of natural gas, this is based on the significantly higher prices seen outside of the U.S. and historically. For crude oil, this is based on a collection of many expert opinions on what the economic breakeven price (18) for crude oil is – that is, the price that will offer returns high enough to incentivize companies to drill for oil. Both prices include a rough discount for cost efficiencies that will probably be realized in the future as a result of experience gained and new technology.

The amount of time it will take Devon to reach this Target Price is indeterminable and depends a lot on how oil and gas prices move – for oil and gas companies move systematically with oil and gas prices. The average time frame for a stock to revert to its target price is 2.5 years (19).

(18). For clarity’s sake, the word “economic” typically means a subtraction for the opportunity cost is made.

(19) This average number is based on Benjamin Graham’s records. See HarperCollins Publishers 2005 version of “The Intelligent Investor” (1949 edition) on page 39.

I.5. Special or Unusual Factors in the Valuation

As mentioned numerous times in this report, there is a large amount of cash and short-term securities sitting on Devon’s balance sheet that can be reinvested over the next few years. Rather than attempting to determine the time frame and the ultimate returns from these reinvestments, I simply added the book value of these net non-operating assets to the present value of cash flows.

As of March 31, 2012, Devon had $5.828 billion of cash and cash equivalents and $1.282 billion in short-term investments (mostly commercial paper and the like receiving very low interest). Most of this is a consequence of the divestitures and $900 million of it came from Sinopec as a result of that joint venture, which is discussed above. Most of this cash is not needed for basic operations, and several of the companies in the Peer Group carry cash balances far below 2.5% of their total assets for several years consecutively. For the sake of conservatism and possible sampling error, it has been assumed that Devon will carry 5% of its total assets in cash.

The assumed cash needed for operations using the 5% assumption is $2.13 billion. This is far more than Devon has ever carried historically except for 2010 and 2011. It is enough cash to cover all current payables as of Q1 2012. After subtracting this $2.13 billion, $4.98 billion is left over as “excess cash.” This equates to $12.31 per share and has been added to the intrinsic value of operating activities.

The value of this $4.98 billion could alternatively be estimated by assuming it is reinvested and then calculating the present value of the resultant cash flows. The present value of such cash flows would probably result in a value higher than $4.98 billion.

I.6. Supplemental Valuation

A supplemental valuation based on a multiplier approach was also calculated as a check on the discounted cash flow approach. Based on historic earning power of $2.586 billion from current operations (the average of net income over 5 years after adjusting for impairments and discontinued operations) and a multiplier of 13.50 on these earnings, the value of current operations is found to be $86.39 and $98.70 after adding the value of non-operating assets.

The price to earnings multiplier was found by calculating for the average peer group multiple over a period of roughly 10 years, which was found to be around 15. The multiple was adjusted downward to 13.50 as analysis shows that Devon has slightly lower growth prospects than the Peer Group average. The multiple is also adjusted simply as a matter of healthy conservatism by assuming a general regression to the mean economic performance on an industry-wide scale over the long-term.

I.7. Optionality Value

Optionality value, simply stated, is that value that will become possible when some contingent event occurs. Technically, optionality value should already be included in an intrinsic value calculation, with the optionality component being equal to the total value multiplied by the probability of occurrence. In many cases, though, it is impossible to estimate the probability to reasonable range. Including it essentially adds a speculative component and basing an investment decision on that component when the investment would otherwise be unsound seems imprudent. For that reason, optionality value is not included in the calculation of the target price, but I think it still warrants discussion.

There are two prominent forms of optionality available to Devon that may become active and increase the intrinsic value calculated above. The first of these are additional opportunities that will become available as oil and gas prices rise. A clear-cut example of this is the North American oil and gas boom in the past few years, which has been made possible only because higher prices justified the increased costs of horizontal drilling and hydraulic fracturing.

The second relates to the Devon’s marketing and midstream (M&M) business. The annual report for 2007 states that the company was considering selling a minority stake in its M&M business in the form of a master limited partnership (MLP). The company felt the market was undervaluing it and an the M&M having its own securities would force the markets to value it independently with the high capitalization multiple generally given to MLP’s. This was in 2007 before the financial collapse, when MLP’s sold at an especially high multiple. Devon again discussed selling the M&M business at the 2012 Analysts’ Day. To quote current CEO John Richels (20):

“. . . the investment thesis at that time was these assets trade for, these MLP assets trade for 12 times EBITDA and you’re trading it at 6 or wherever we were at that time and take advantage of that. But what we found is the assets that are in our midstream and where we generate our EBITDA and our operating profit through our midstream operation is subject to commodity price fluctuations because they tend to be percentage of proceeds liquids contracts. And so as we got more into that, it became obvious and our advice from our investment bankers was that those assets, because they have commodity price exposure, trade more like 8 times rather than the 12, and we have very low basis in those assets. So we’d have to pay a big check to Uncle Sam, and frankly, it ended up — we’re given up the strategic assets and all of us the shareholders wouldn’t have seen it. So we decided not to go ahead with that. It’s something we revisit from time to time to see if those circumstances change, but at this point in time, it just doesn’t make sense.”

Essentially, the company believes that its M&M business has a “strategic” value created when combined with its normal E&P business, and that this synergy value plus the low market valuation end up exceeding the market valuation if split off as an MLP with its own securities and sold at a higher multiple. In regard to Mr. Richels’ comment about “commodity price exposure,” note that MLPs are often preferred as investments when oil prices are volatile, as those companies have a tendency of being more isolated from the short-term impact of price changes; hence the statement that Devon’s M&M assets have “commodity price exposure” was used as support that it would sell at a lower multiple.

It seems possible that if the multiples of MLP companies reach a high enough level, it may be possible for Devon to unlock greater value by selling a portion of its M&M business. This optionality value is somewhat small and the probability is most likely small as well. The value of Devon’s M&M business if it became an independent MLP is calculated to be $1.518 billion at the midpoint, $1,822 billion at the upper range, and $1.215 billion at the lower range. These values imply a P/E for the business of 13.93, 16.72, and 11.14, respectively.

(20). Credit to seekingalpha.com for the transcript of the whole event.


J. Worst Case Scenario

I have calculated separately on the assumption of a “worst case.” The intrinsic value under this scenario is calculated as $80.21. The valuation calculations are shown below.

The worst case assumes the following:

  • After most hedges on the price of oil and gas expire by the end of 2013, there is assumed in 2014 to be sudden and severe decline of oil, natural gas liquids, and natural gas prices – similar in degree to that seen in 2008-2009. For example, Western Texas Intermediate (WTI) oil prices bottomed in 2008-2009 at about $40, and that is close, I think, to the most extreme case. Effectively this means I am assuming that in the worst case there will be a price drop in 2014 to 50% of its long-term average price. Prices thereafter rise linearly to their long-term average in 2016. The long-term average price for oil is assumed as $80 per barrel, for natural gas $3.25 per million cubic feet, and for NGL $20 per barrel.
  • Natural gas liquids (NGL) prices decline relative to WTI oil prices in a similar way that natural gas did in the past few years. Historically, the price of natural gas has been about one-sixth the price of oil, which is roughly the “energy-equivalent” ratio (on a British thermal unit basis, 6 thousand cubic feet of natural gas equals 1 barrel of oil). Natural gas prices in 2012, though, have instead traded at about one-fiftieth of oil prices because of (1) a supply glut of natural gas in the U.S. and (2) the loss of excess production capacity of oil within the past decade. NGL prices have become depressed in 2012 due to oversupply – the same thing that has happened to natural gas. My worst case assumption is effectively that NGL prices will drop to 25% of the price of WTI oil instead of the historic average of 50%. The average price of NGL per barrel sold in Q2 of 2012 for Devon was $31.42 per barrel, and the average price of oil per barrel sold was $67.67 (this is before the effect of derivatives).
  • There is a slight decrease in production volume growth of 1% from the normal case.
  • EBT margins are reduced in the long-term to 32% instead of 38-40% as seen historically (after adjusting for one-time charges). This gives allowance for possible cost increases as unconventional projects increase in complexity (as the easier and cheaper “low-hanging fruit” are picked) and increased regulatory costs that may come as a result of public anxiety regarding fracking. Very rarely in normal has Devon experienced an EBT margin this low historically, and its margin is usually several hundred basis points higher – sometimes as much as 1,000 basis points higher.
  • EBT margins decrease during the oil and natural gas price shock to 20%, as there are short-term fixed costs.

These assumptions are shown in the valuation below.

dvn 19 -- valuation assumptions

dvn 20 -- valuation 2

dvn 21 -- valuation 3


K. Worst Case Stock Price

In my opinion, the price of Devon Energy’s stock is highly unlikely to go below $40. I would say that the worst case stock price is between $40 and $50 in the near future. The circumstances that could cause the stock price would go that low would be: (1) if a recession occurs (in which oil, natural gas, and stock prices will probably plunge for a short while), (2) if natural gas prices fall independent of the general economy, or (3) if oil prices fall independent of the general economy. I will address all three in that order.

1. Occurrence of a recession

$40 is roughly the price Devon bottomed at during the 2009 stock market crash (at $39.92). Since 2009, the company has increased its intrinsic value. In addition, with the exception of the 2009 bottom, Devon’s stock price has not fallen that low within the past 5 years. The stock price declined considerably within the past few months (as of September of 2012), but it seems to have hit a “resistance level” of around $55.

2. Natural gas price decline independent of general economy

Part of Devon’s stock price movement is caused by natural gas prices, which are one of several inputs constituting Devon’s total revenues. From January 2009 to August 2012, natural gas prices declined by 51.37% from $5.83 per thousand cubic feet (mcf) to $2.84 per mcf (these are the monthly average prices). During the same time frame, Devon’s stock price fell from about $75 to about $58 – a decline of 22.67%. The decline in natural gas prices were caused primarily by overproduction, and subsequently a “glut” formed in supply.

A natural gas price in the mid-$2s puts a lot of pressure on the profit margins of E&P companies. As a result of this decline in natural gas prices, many companies, including Devon, have switched their exploration and production activities largely if not completely away from natural gas and are now focusing on oil instead. I find it hard to imagine that the imbalance in supply to demand could be exacerbated any further (except possibly just briefly) or that the price would fall below a breakeven level, as these companies have shown themselves to be very nimble in shifting production in response to changes in prices. In addition, prices at the mid-$2s gives a big incentive for companies to invest in the expensive process of natural gas exportation, since natural gas prices in Europe and Asia are far higher than they are in the U.S., and major investments in this regard have been made at the time of writing (September 2012).

A further decline in natural gas prices is not entirely impossible, though. If gas prices fall an additional 50% from the mid-$2s, say $2.50, and if Devon’s stock price falls by 23% from a price of $60, then its stock price would still not go below $40.

3. Oil price decline independent of general economy

As for oil prices, there are two ways prices could decline (besides due to a decline in economic activity): (1) worldwide oil prices fall because of excess production capacity, (2) regional oil prices in the U.S. fall relative to worldwide prices (there exists a discount to worldwide prices or the discount widens).

In the past, (1) was the typical situation, as OPEC sought to stabilize world oil prices through increasing and decreasing production as necessary. It could do this because it had excess production capacity over demand. Within the past 10 years, though, OPEC has largely lost this excess capacity and absolute price control is no longer a possibility. Oil prices now are set by market forces. A decline in worldwide oil prices is certainly possible if a recession occurs, as demand would decrease. Absent of a recession, though, worldwide supply is unlikely to exceed demand for any significant period. Thus, there is no significant catalyst that I know of that would cause a significant decline in worldwide oil prices except for a recession.

The main danger is (2), and the primary culprit behind it is a lack of adequate pipeline capacity to handle the sudden increase in U.S. oil production from the oil sands in the northeast U.S. (Wyoming, North Dakota, etc) and Canada, and from other places as well (the Permian Basin in west Texas being a good example). A huge amount of capital, however, has been funneled into building new infrastructure over the past few years, and this infrastructure problem should largely be resolved within the next few years, say by the end of 2013-2016.

Before that capacity comes online, a further decline in North American oil prices – due to a widening of the discount – is possible. If that occurs, Devon’s stock price would likely decline as well, since Devon sells all of its oil production at U.S. and Canadian prices. The lack of capacity, though, is already largely reflected in current prices. West Texas Intermediate (WTI) sells at a significant discount to worldwide oil prices, and the price of crude oil from the oil sands sells at a further discount to WTI. For example, Devon’s average U.S. selling price of oil was $88.74 in Q2 of 2012, while Canadian oil (where its oil sands projects are located) sold at an average of $54.88.

I do not think increases in production of oil are going to outpace increases in infrastructure in the near-term – as the steep discount of U.S. oil prices to world prices disincentivizes rapid expansion of production, and new infrastructure is being built at a fast pace. A significant increase of the discount of U.S. prices to world prices does not seem likely (except perhaps for brief periods). Even if it occurs, it is unlikely to be more than a 20% drop (which would set Canadian oil to $44, based on Q2 prices). As with natural gas, oil at $80 (from its recent normal level of around $100) puts pressure on the profit margins of many unconventional companies. If that kind of drop occurred, and assuming Devon falls by the full 20% from a stock price of $60, then its stock price would still not fall below $40.

4. Final thoughts

It is for these reasons that I think Devon’s worst case price is between $40 and $50 in the near future. These reasons are entirely related to price, because I do not think Devon will fail on exploration and production matters or cost control in the near-term, and in fact Devon has been doing well in those regards.


L. Recommendation

Devon’s price as of $56.20 per share as of June 27, 2012 is far below my calculated intrinsic value. The decision rule on whether to buy is that the price should be at most two-thirds of the midpoint target price. At the current price, this ratio is 57.07%. I calculate a midpoint target price of $98.47. Based on a 33% range, the upper range is $115.20 and the lower range is $86.05. Using the midpoint target price as the decision rule for investment, Devon’s common stock is recommended as a sound investment for purchase.


M. Notes

Note 1: Sources of company data

Except where otherwise noted, data in this article is exclusively from company SEC filings. Market price data, however, is from Yahoo! Finance.

Note 2:

Technically speaking, a positive adjustment on the income statement for impairment or a negative adjustment for gains would necessitate an adjustment on the balance sheet. I failed to do this only because it does not change the overall conclusions as toward Devon’s relative position to the industry.

Disclosure: I am long Devon.

Copyright Jack Huddleston, 2012

You are allowed to copy all or part of this article as long as you credit:

James “Jack” Huddleston, copyright 2012, www.jamesjackhuddleston.com

Debt Servicing Ability of 15 Oil & Gas E&P Companies (2012)


Debt Servicing Ability of 15 Oil & Gas Exploration and Production Companies

 By James “Jack” Huddleston

Data as of July 2012 and earlier – Posted 8-22-12, Revised 9-2-12

Table of Contents

A. Format of this Report

B. Overview

C. The Effects of Oil and Gas Price Volatility on Debt-Servicing Ability

C.1. Average Monthly Oil & Gas Prices for 2011 to 2006

D. Comparison of Financial Condition

D.1. Financial Condition Ratios for 2011

D.2. Financial Condition Ratios 2006 through 2011 (6 year averages)

D.3. Financial Condition Ratios for the Year 2009

D.4. Debt Servicing Ability by Cash and Liquid Assets

E. Break-even Oil & Gas Prices and Break-even Costs

F. Relative Valuation

F.1. Valuation Multiples

G. Concluding Thoughts

H. Notes

I. Raw Data Tables

I.1.   Revenue, 2006 to 2o11

I.2.   Earnings Before Interest, Income Taxes, Depreciation, Depletion & Amortization, 2006 to 2o11

I.3.   Depreciation plus Depletion plus Amortization, 2006 to 2o11

I.4.   Interest Expense (excluding capitalized interest), 2006 to 2o11

I.5.   Interest Capitalized to PPE, 2006 to 2o11

I.6.   Impairments from Full-Cost-Ceiling Test, 2006 to 2o11

I.7.   Earnings Before Income Taxes, 2006 to 2o11

I.8.   Net Income (continuing Income where applicable), 2006 to 2o11

I.9.   CFO (continuing CFO where applicable), 2006 to 2o11

I.10. Cash & Cash Equivalents plus Short-term Investments plus Restricted Cash, 2008 to 2o11

I.11. Receivables, 2008 to 2o11

I.12. Total Debt, 2006 to 2o11

I.13. Shareholders’ Equity, 2006 to 2o11

A. Format of this Report

For the convenience of the reader, the sections of this report are numbered and I have tried to use a text size that is easy to read on computers and mobile devices.  Notes to tables can be found at the bottom of the table and general notes are at the end of the report.

B. Overview

This article compares the debt servicing ability of 15 U.S. oil and gas exploration and production companies (the “Peer Group”). These companies primarily derive their operating income from North America, from exploration and production, and from onshore activities.

Note: If for any reason the tables in this article are obstructed, right click the table and then select “view image.”

C. The Effects of Oil and Gas Price Volatility on Debt-Servicing Ability

In the U.S., the historical chance of a recession in any year is roughly 1 in 5, so it is important for a company to be prepared for that possibility. While oil and gas generally have inelastic demand, recessions are often accompanied by a decline in oil and gas prices and sometimes the prices collapse, as occurred during the last recession. This can be seen in the recent history of West Texas Intermediate (WTI) crude oil spot prices and Henry Hub (HH) natural gas spot prices.

Average Monthly Oil & Gas Prices for 2011 to 2006 (1)

debt 1

(1) The spot prices here generally correspond to the average price realized by each company before netting the effect of derivatives hedging. Some companies seem to continually receive higher prices than others, but the relative movement year-after-year is similar.

The preferred way to pay debt service is from operating cash flow but prolonged low sale prices can cause operating cash flow to decline after hedges expire. Marginal operating cash flow is not an immediate issue if a company carries an adequate amount of cash to service debt or maintain basic operations if oil and gas prices drop below the break-even point. (See ”Break-even Oil & Gas Prices and Break-even Costs” below). Some oil and gas companies, however, carry little of their total assets in cash and have little cushion to protect against adverse events (See table below: “Debt Servicing Ability by Cash and Liquid Assets.”).

A cash reserve deficiency can be countered by very stable operating cash flow. That is why utility companies, for example, can safely carry very large amounts of debt that would not be safe for the typical company. In the event of a major price decline, O&G companies that have inadequate cash reserves could be forced to service debt rather than replenishing reserves lost through depletion, which could result in an impairment of value. A more severe consequence would be a near-term funding shortfall. If debt service can’t be paid from operating cash flow or cash reserves, it may become necessary to sell long-term assets, but a decline of oil and gas prices would decrease the amount a company could liquidate those assets for. The result could be very problematic.

D. Comparison of Financial Condition

The tables below compare the ability of the 15 oil and gas companies (the “Peer Group”) to service debt interest and principal from cash flow, cash reserves, and liquid assets. The formulas used to calculate these ratios can be found below the first table, “Financial Condition Ratios for 2011”. The data seems to indicate that there are significant differences in the ability of the companies to service debt in the event of a protracted period of low oil and/or gas prices.


Financial Condition Ratios for 2011 (2) (3) (4)

debt 2

debt 3

(2) Chesapeake has the unusual practice of capitalizing nearly all (around 92%) of its interest charges from debt, making it appear much financially stronger than it really is. On average the other companies capitalize 25% of their interest charges.

(3) Newfield recently issued $1 billion of debt at a yield of 5.625%. This increases its 2011 debt to equity ratio to 102.2% (97% based on Q1 2012 data) and lowers its 2011 EBIT TIE ratio to 4.63 and its 2011 EBITDA TIE ratio to 7.95.

(4) The “overall Peer Group average” calculates the same ratio for its column except it uses the sum figures of the group (rather than taking the arithmetical average of the ratio calculated for each company, which can be distorted by outliers). The “median of ratios” is just the median of the calculated ratios. The downside of the average is that it gives greater weight to larger companies; the median is calculated and presented as an alternative.



Financial Condition Ratios 2006 through 2011 (6 year averages)

debt 4

The worst year for these companies was 2009, when they felt the impact of the rapid decline in oil and gas prices. In addition, the cost structure of several companies was higher as they pursued unconventional projects. The ratios for 2009 are below:



Financial Condition Ratios for the Year 2009

debt 5



Debt Servicing Ability by Cash and Liquid Assets

debt 6


E. Break-even Oil & Gas Prices and Break-even Costs

The gas predominant companies seem to have adequate debt servicing abilities when gas prices are in the $3.50 to $4.00 range, but at $3.00 or less they are tight. The oil predominant companies seem to experience pressure when oil prices fall to the $75 range. This gives evidence to the notion, I think, that if prices fall below these marks at the current cost structure, then the independent E&P companies will be incentivized to cut new exploration and development expenditures, thereby reducing supply.

The cost structure from 2008 to 2011 reflects industry adjustments to new operational requirements associated with unconventional production. Costs will probably decline in the future, and thus so will the breakeven price. The breakeven cost will also vary from basin to basin: the Marcellus Shale is known for having low costs – in part because of better economies of scale and a close proximity to its end-use markets – whereas oil sands production has relatively higher costs.


F. Relative Valuation

Valuation Multiples (5)

debt 7

debt 8

(5) Price data from Yahoo! Finance, using closing price data on July 13, 2012.

It seems that the market’s valuations of the Peer Group are based primarily on expectations of growth. Not much weight seems to be given to the risks undertaken to achieve that growth. In some cases growth is being achieved by utilizing a high percentage of debt financing. Normally, companies with a speculative capital structure are given a discount in the multiple as compared to equivalent companies that do not have a speculative capital structure. Among the 15 companies compared in this article, however, there seems not to be a noticeable association that can be attributed to the capitalization factor.

G. Concluding Thoughts

This article is not a complete analysis of the companies discussed. I cannot offer any definite conclusions as to which companies are speculatively capitalized, as simple statistical ratios cannot alone answer such questions. I think it is generally true, however, that companies with low liquid assets and a high level of debt are riskier. It is possible that some companies will be able to grow their way out of debt, but that level of analysis is beyond this article’s scope.

I am not an expert on each company mentioned in this article. If you have detailed knowledge of any of these companies, I would be grateful if you shared it in the comments section below for the benefit of everyone, or feel free to e-mail me. I have completed a 30 page analysis of Devon Energy Corporation that is available on my website.


Disclosure: Long position in Devon Energy (DVN)

H. Notes

Note 1:

The ratios are adjusted for impairments of proven oil and gas properties that are the result of “full cost ceiling” accounting, which practically means – although this is a gross oversimplification – that oil and gas companies must write off a portion of their assets when oil and gas prices fall by a large percentage.

Except for the affect on the cash flows of 2008-2010, companies were largely unaffected by the price volatility that caused the impairment. Although a significant portion of the impairment was warranted, especially for natural gas properties, the impairments have been added back to improve comparability among the companies.

In addition, the timing of the impairments among companies is different (most made the necessary impairments in 2008 and/or 2009, but some waited until 2010 or 2011, and some made several smaller write-offs over the whole period), so it is necessary to add the impairments back so the companies can be compared fairly.

Note 2:

The term “gross interest” is used to differentiate it from “net interest,” which subtracts interest income. Some oil and gas companies have little in cash and cash equivalents, and in those cases interest income is typically immaterial. In addition, the specific interest income is not even reported by some companies, which would reduce comparability if included.

Note 3:

The source of all data is the 10-k and 10-q statements of each company from the SEC database.

I. Raw Data Tables

debt 9 debt 10 debt 11 debt 12 debt 13 debt 14 debt 15 debt 16 debt 17 debt 18 debt 19 debt 20 debt 21

Copyright Jack Huddleston, 2012

You are allowed to copy all or part of this article as long as you credit:

James “Jack” Huddleston, www.jamesjackhuddleston.com

China Mobile Analysis (2011)


Note: The Devon Energy Analysis which was written in 2012 is a better example of my skills. Based on this analysis my client bought China Mobile stock.

Analysis of China Mobile (CHL)

By James “Jack” Huddleston, research in May 2011, posted on August 1, 2011

Note: If you have trouble reading the tables, contact me and I will email them to you.

Assumptions and Limitations:

This analysis is based on limited knowledge of China Mobile and the analysis was mostly undertaken in May 2011. The main purpose of the analysis was not to determine how China Mobile will perform relative to other telecommunications companies, but if China Mobile appeared to be a good long term investment. Based on the analysis we bought China Mobile on 5-31-11 for $45.60 per share and as of 7-29-11 the price was $49.83. Please note that the analysis was written in May 2011 and the language is as of that time frame. Much of the report is from my notes.

Summary of Conclusions

China Mobile Limited (CHL), at a price of $45 per share, is selling at a price below what I believe it would sell for to a private buyer, which I believe would be between $65-100 per share. This means that the stock is undervalued by at least 44.44% and at most 122.22%. In other words, based on earnings of $4.55 for 2010, CHL should sell appropriately between a TTM P/E of about 14.29 and 21.98. This “private buyer” value is what I will refer to here as the “target price” or “intrinsic value.”

The low price, I believe, has three main causes: (1) a decline in earnings growth for 2009 and 2010, (2) a fear among investors of Chinese stocks which began late 2010, and (3) the perception of CHL as being too large to grow and operating in a “boring” industry. There are many other factors affecting the price – such as the trading price for its shares on the Hong Kong Stock Exchange (HKSE), the RMB (China’s currency) to USD exchange relationship, and so on – but these three are likely the most prominent.

Admittedly, CHL has not been given the same valuation as have reverse merger and small cap Chinese companies. What I have observed indicates that many people are altogether avoiding anything from China. I believe that the depressed price of CHL since the market crash of 2008 is heavily influenced by emotional factors.

It is well known that stock prices can move sometimes dramatically in response to recent earnings reports – it isn’t uncommon for a company to be revalued downward as much as 10% by the market because of a poor quarterly earnings report (often followed by a 10% upward valuation when the next quarterly report is favorable). This is may the case for CHL. The following table illustrates the story.

Table I: China Mobile Price Data1

This table requires some interpretation. In the past, the company has released its annual report between March and June. The exchange rate and share price data presented here are from July 15, or the closest day available, of each year. By July 15, the markets have had ample time to digest the annual report and adjust the stock price accordingly. “% change in market price” should be compared to the fundamental data for the previous year. Therefore, the change in market price by July 15, 2011 should be in response to a change in earnings per share – or any other fundamental measure – from 2010, which would have been reported just weeks before July 15, 2011.

The price of CHL has generally moved in motion with the market even in spite of strong fundamental changes. The share price declined about 25% in by the middle of 2009 from the same date the previous year despite of a recently reported increase in earnings of 44.28%. This was clearly the result of the stock market crash of late 2007 and 2008. Yet, while the general market has since increased to its previous level, CHL has frustratingly stagnated.

The reason is likely the result of very low earnings growth from 2008 to 2009 and from 2009 to 2010. Although China was relatively immune to the last recession, China Mobile’s earnings growth slowed for two main reasons: (1) slowing customer growth and (2) a decrease in revenue per customer. This slowdown and the reason as to why the past two years is likely temporary will be discussed in more detail below.

The other two causes of CHL’s undervaluation, although important, will not be given much consideration here as they are based on my limited observations and are not provable except in retrospect. The main refutation to both of these points is the valuations given to both of CHL’s main competitors, China Unicom (CHU) and China Telecom (CHA). Both of these companies, despite having no history of earnings growth, are being given extreme valuations by the market at the moment.

CHU, for example, is selling for 56 times the average of its EPS for the past 5 years and yet there has been no noticeable trend of growth in intrinsic value upwards or downwards since the year 2001. This is most likely the result of CHU’s exclusive rights to selling Apple (AAPL) products in China, but the current valuation is even more curious in that it is highly likely that this monopoly will be broken in the coming year.2 The future may show very high growth for CHU, but without a history of proof or any overwhelming reason to suppose it should happen, the current price is evidently speculative.

1 IFRS is the reporting method from 2010 to 2006 and U.S. GAAP is used from 2005 to 1999.

Competitive Position of CHL

CHL’s stock sells on both the NYSE and the HKSE. The actual shares are listed in Hong Kong and ADS’s (American Depository Shares) are listed on the NYSE. Each ADS represents 5 actual shares. CHL is one of the largest companies in the world, the largest telecommunications company in the world, and is listed in several indexes. The company is apart of the Hang Seng Index (HSI), one of the earliest indexes in Hong Kong.

CHL’s competitive strengths are threefold: (1) the oligopolistic nature of the telecommunications industry in China, (2) its pricing power as GDP-per-capita and inflation increases, (3) and the several million people right now in China who are without a mobile phone plan.

The telecommunications oligopoly in the PRC has been orchestrated by the government under the philosophy of “rational competition”. The Chinese government wants all the efficiencies that come about with economies of scale, yet want to avoid the creation of a complacent and sluggish monopoly. The current industry situation was created only a few years ago and there are no indications that the underlying philosophy will change in the near future. The PRC government has even gone in the past as far as to give assistance to CHL’s competitors by way of temporarily regulation that gives those competitors a shield from CHL, which was stealing market share from them.

CHL has a 70% market share at the moment and it is likely that this will decrease over time, as the company does not indicate to me that it has the managerial ability and industry economics to protect its moat perfectly from the two other firms in the industry and changing government policy. The degree that its moat or market share will decrease, if at all, is unknown, but the companies, like countries, need not last forever and it can be reasonably expected that its position will weaken over time.

The company’s current competitive position is advantageous in that it provides a great deal of stability and predictability of future earnings than in allowing for high growth rates. The infancy of the telecommunications industry, however, has allowed and will allow for strong growth into the future for some time. The mobile penetration rate in China was 64.40% in 2010. There is much more room for growth as a result of customer additions. Further, the average time spent talking on the phone per CHL customer per month was 8.70 hours. If China ever reaches the amount of wealth of the most advanced countries in the world, that amount of time should increase several-fold. Average revenue per user (ARPU), as well, will likely increase as Chinese GDP-per-capita increases.

2 See “Catalysts for a Valuation Reserval” below for further discussion.

Telecommunications Industry in China

China Unicom (CHU) and China Telecom (CHA), the two competitors of CHL, are valued at 50x and 20x historically demonstrated earnings power, respectively. Both companies have a history of increasing assets and sales several folds yet being unable to increase net income and earnings per share over the same time period. Being that one can increase earnings at the same rate as principal simply by depositing more money into a savings account, that is not entirely impressive.

Currently I am not very familiar with both companies in qualitative terms, but it appears that CHU’s valuation is based on it having exclusive rights to sell AAPL products in China. CHA’s high valuation is unclear, but it is presumably also related to 3G smart phones. It could also be because both companies are smaller and perceived as having greater growth opportunities (similar to the high valuations given to independent oil drillers, currently valued at about a 20 P/E, versus the major integrated oil companies, with P/E’s of about 10 on average). Where CHU and CHA have been awarded rights by the government to use internationally accepted standards of 3G technology, China Mobile has been required to use a homebrewed version of 3G referred to as “TD-SCDMA,” which is generally considered inferior and prevents the company from selling iPhones, as AAPL believes that standard may affect the quality of the phone and thus its reputation.

An expert of the industry may know better, but CHU and CHA, are without a doubt speculative. Without a proof of income growth in the entire history of the two companies, the analysis of future growth must qualitatively stated. The current prices could only be justified by an extraordinary earnings growth that can only be sustained by stealing customers from CHL. Presumably it is assumed these people will eventually flock to those companies to have access to western smart phones. This logic seems to ignore that the vast majority of Chinese customers are buying cell phones for practical purposes, rather than discretionary purposes (see section below “Calculation of Intrinsic Value”). This will change sometime in the future, but by then it would seem too late as CHL has long been in talks with AAPL to release AAPL devices utilizing either the TD-SCDMA or TD-LTE (4G) standard. AAPL obviously wants access to the rest of the Chinese population, of which CHL stands as a toll bridge (see “Catalysts for a Valuation Reversal” for further discussion).

Operational Statistics

The table below shows all the relevant operational statics relating to CHL.3

Table II: China Mobile Operating Statistics4


CHL’s return on equity (ROE) is very high in comparison to its industry and all businesses in general. A look at return on invested capital (ROIC) shows an even more favorable picture – CHL achieves its returns using little debt. The ROE is driven primarily by a high profit margin. This high profit margin, in turn, is mainly the result of a very strong industry position – the major firm in a triumvirate of general telecom providers – in a very strong economy. This profit margin has been maintained in spite of government-mandated decreases in the prices charged to customers.5

Operating ratios:

Interconnection appears to be an unprofitable business whereas SIM cards and handsets is enormously profitable. These statistics are of limited value, however, because it is unclear how the costs are distributed. For example, the costs relating to “interconnection” (see Appendix I for CHL’s income statement) could include overhead or other costs that benefit another part of the company. Similarly, the costs relating to “SIM cards and handsets” may not be including some expenses.

Efficiency ratios:

Asset turnover and other “asset efficiency” measures are not as important for CHL as it has little in inventory and receivables. In any case, the company beats its industry in the two figures shown.

Liquidity ratios:

The company has a sufficient amount of working capital to prevent any serious loss of business in the event of a liquidity crunch arising from a recession in China or such. CHL exceeds its industry average in both measures of liquidity shown here. Liquidity is not an issue overall and thus only two ratios are presented.

Credit ratios:

CHL’s capitalization is about 90% equity and is not at all pressured by debt or interest. The 20-F notes that the company’s credit rating by Standard and Poor’s is “AA-/Outlook Stable,” the same rating as the PRC’s sovereign debt.


As explained later in this report, CHL’s future growth rate will most likely fall below the historic growth rate as the company faces diminishing returns. There are multiple reasons as to why the historical growth rate may continue for some period, but a core tenet of “value investing” is that the merit of an investment should not be based on the expectations of good future results. In value investing, the chief purpose is to guard against the future rather than bet on it.

It is noteworthy that the “total voice usage” growth rate is almost double that of net income. The reason for this is explained in more detail later and relates primarily to a regulatory-mandated decrease in prices charged by telecommunication operators in the PRC.

Payout ratios:

The company’s expected payout ratio for 2010 was 43%. The 20-F notes that the expected payout ratio for 2011 is also 43%.

Market-price ratios:

Table II shows that the company is being given a lower valuation by the market overall to its peers. It is hard to comment as to why this might be the case, as I have not investigated the prospects and competitive position of each and company in the industry. It seems to me that CHL would have better opportunities than most other companies, however, given its special position in China’s flourishing economy, which CHL will partake in at least as much as the average company. As stated above, I believe this relative undervaluation is attributed to recent slow growth, temporary distrust of Chinese companies, and it being just a large and boring sort of company.

The large price to sales and price to book ratios are the result of the company’s high profit margin and return on equity. Market capitalization to net income and net income to sales multiplied by one another results in the price to sales ratio. It follows that a higher profit margin will necessarily result in a high price to sales ratio. Similarly, price to book a function of price to earnings and return on equity. A higher ROE always results in a higher P/B because of the mathematical relationship.

Other ratios:

Net income has stayed slightly above free cash flow as a large portion of the company’s capital expenditures were for expansionary purposes and therefore were higher that year’s depreciation charge. This is not unusual for expanding companies.

3 See “Appendix I” for a balance sheet, income statement, and cash flow statement for CHL from 2010 to 2006; all the aforementioned statements stated as the percentage growth from the previous year; and all the aforementioned statements stated as a percentage of assets (balance sheet), revenues (income statement), and pre-tax cash flows from operations (cash flow statement).


4 Calculated from data stated in RMB terms, which accounts for the differences in earnings growth shown in Table I. With the exception of “Dividend yield” and “Operating margin,” industry average information is from MSN Finance and is current as of July 11, 2011. Industry average data is shown only where available and 5-year average industry data is used where available or can be by calculated using other available data (such as with the tax rate). See “Appendix II” for the exact formulas used in these calculations.


5 See “Estimation of Earnings for 2011” for further discussion.

Method of Calculating the Target Price Explained

The intrinsic value of an asset, in general, is the present value of its future cash flows. The intrinsic value of an asset, then, can be found by (1) taking the average of historical earnings, (2) projecting these earnings into the future at a conservative growth rate, and (3) discounting these earnings on the basis of the risk of those earnings not being realized. It is assumed in this calculation that the company will be a going concern at least 100 years from now, as earnings from that time forward have no worth in present value terms. History has shown that very few companies are capable of lasting that long as most either go bankrupt, get acquired, merge, and so on.

It is very easy to plug in numbers into such a model and deceive oneself into believing a stock is undervalued based on the output (“garbage-in, garbage-out”). For that reason, a high level of conservatism is used in this calculation and the final calculation of intrinsic value is discounted further about 25% to reflect the model’s weaknesses. Some may say that this level of “conservatism” is going overboard, but I believe it is necessary to achieve good results. If the company is selling at a strong discount to this number, in spite of my all efforts to make the company look bad, then it has a strong chance of being undervalued with an adequate “margin of safety.”

Some may also argue that this kind of calculation isn’t necessary and that CHL can be proven as an investment operation on the basis of its operations, its strong position in its industry and economy, and so on. I have, however, two reasons for making this calculation: (1) I have limited knowledge of the telecom industry and the Chinese economy and (2) there is no way to judge those factors relative to the price of the stock short of having the an intuitive feel gained from long experience and knowledge of studying companies in the industry. Qualititative aspects of CHL are more like the icing and cherry on top, rather than the substance of the reason for its stock purchase. Benjamin Graham, the father of “value investing,” once said that while it is a requirement that a security be justified on quantitative grounds, it is by no means sufficient – it must be justified on both quantitative and qualitative grounds.

I do believe, however, that the purchase of CHL is justified by the merit of its competitive position, which I summarized above. 7 out of every 10 people with a mobile phone in China use CHL as its service and this ratio has not changed significantly over the past decade.6 In addition, the mobile penetration rate was about 64% in 2010 whereas it was 7.79% in 2001.7 This means that CHL, up until today over several years, has attracted and retained about 7 out of 10 people in the past decade who were looking for a mobile phone service. The company must be doing something right, they will probably continue to do that, and there are still hundreds of millions of people in China without a mobile phone plan. CHL’s ability to attract as many customers as it has is probably related to its low price, which is one reason the company’s ARPU has declined as much as it has over the decade. In other words, most of its new customers are relatively poor.

In addition, the quantitative data presented in Table II, Appendix I, and Appendix III says a lot about the qualitative aspects of the company (its competitive strengths, managerial ability, and so on). That these ratios and figures have remained substantially unchanged over time speaks volumes.

6 Market share, according to the CHL’s 20-F statements:

2010: 69.30%

2005: 65.60%

2001: 69.60%


7 The mobile penetration figure is implied by other data available. Dividing the number of customers in 2001 by CHL’s published market share and then dividing that figure by China’s population in 2001 yields 7.79%. 2010’s figure is the official data of the Ministry of Industry and Information Technology (MIIT).

Estimation of the Growth Rate for 2011

As discussed above, a rate of earnings growth must be determine for the calculation of the target price. The primary determinant of long-term intrinsic value growth is return on equity (ROE) multiplied by the percentage of earnings that are to be reinvested into the company. Historic ROE provides a starting point, but it is marginal ROE that will ultimately determine future growth rates. It should not be expected that the fantastic growth rates so far experienced by CHL should continue indefinitely into the future as it (1) faces increased competition and (2) experiences diminishing returns.

The calculation of marginal ROE is somewhat complex, so the explanation will be as brief as possible. Below is the historical exhibit of ROE and marginal ROE in comparison to EPS (note that the earnings shown in Table I are the ADS figures stated in USD’s, while this table shows the earnings per Honk Kong share stated in yuan):

Table III: China Mobile Returns8

Marginal ROE for 2011 is expected, by my calculations, to be 15.45%. This adds to the evidence that CHL faces diminishing future returns and that the growth showing during 2009 and 2008 is probably temporary. This means that the overall ROE for 2011 is likely to decline slightly, probably somewhere from 19.00% to 20.50%. Discounting that ROE by the percentage of earnings that is expected to be reinvested (43% is expected to be paid in dividends), the expected growth rate for earnings – before accounting for changes in currency translation – for 2011 is between 10.83% and 11.69%.

8 Marginal ROE is calculated as follows:


Marginal ROE = (NIt – NIt-1) / (BVt-1 – BVt-2)


NI = Net Income

BV = Shareholders’ Equity



This formula takes into account that a reinvestment generally takes a year before the full effect is shown on the income statement.

Estimation of Earnings for 2011

The calculation of marginal ROE for 2011 requires estimating 2011’s earnings. The first step in this process is estimating revenues, which are a function – in CHL’s case – of the number of subscribers and the overall ARPU per month. This section will show the process taken in calculating earnings for 2011.

As of May 31, 2011, CHL has 611.17MM customers according to its investor relations website. Assuming that CHL’s customer base increases at about the same at as it has so far for 2011, it should add up to 650MM customers by the end of that year, which is about the same number added during 2009 and 2010. This method of estimation cannot be used forever, as the company will eventually reach a wall as there are a limited number of people in China, but it doesn’t seem unlikely that it will be reached in a big way within the next 7 months to December 31. The table below shows ARPU for the past decade:

Table IV: CHL ARPU 2010-20009

The downward trend of ARPU is obviously unsustainable, but it has some worried that it will lower future revenue growth. It has not thus far because the company’s increase in the number of subscribers has outpaced the decreases in ARPU. The decrease in ARPU is mainly the result of regulatory mandates implemented so that a greater percentage of the population may afford mobile service. The specific cause of the decrease for 2010 is attributed by the company to regulated price ceilings set by the PRC’s Ministry of Industry and Information Technology (MIIT) and increased competition. It is anyone’s guess as to where ARPU will be in the next year or two, but it probably will increase over the long-term as GDP per capita in China grows and “data” services (mobile internet, etc) – not facing as many government pricing regulations – becomes more popular.

The “prepaid” subscribers are apparently mostly rural citizens and that appears to be the cause of the decrease of ARPU. The company’s 20-F for 2010 states that it expects ARPU to decline further as its customer base expands. In addition, it notes that about half of new customers for 2010 were from such rural areas. It seems proper to assume 2011’s ARPU will be 73 yuan.

Thus far it is calculated that that total customers by the end of 2011 is expected to be 650MM and the ARPU on average for the year will be RMB 73. Using this data, total revenue for 2011 is expected to be RMB 540.49B.10 Multiplying this revenue number by the average of the profit margin over the past 5 years, 24.36%, results in expected net income of RMB 131.66B, or RMB 6.48 per share assuming no change in shares outstanding.

This estimation of earnings is a 10.05% change over 2010’s EPS of RMB 5.89. This is about in line with the expected earnings growth rate calculated above. The actual rate may vary considerably from this depending on changes in the exchange rate between the RMB and USD. If ARPU declines again for 2011 (meaning it will increase further in the future), growth for the next year will around 4-5%. This report, however, makes no attempt to predict near term prices, earnings, and so on. Any decrease in a year’s earnings because of a regulated price ceiling could just as easily result in a great increase in earnings as the ceiling in lifted and ARPU rises or as more customers begin buying data services.

The strengthening of the RMB in the past few years has allowed U.S. stockholders to receive more in value than created by the company intrinsically. I will not, however, make any attempt to predict exchange rates. If the U.S. government decides to clear away some of its debt by inflating the dollar, it does seem possible that U.S. inflation will outpace Chinese inflation, which is high because of demand, and thus result in the yuan strengthening further, resulting in an increase the growth rate of earnings beyond that aforementioned.

Additional data of a miscellaneous character regarding CHL customers, along with a brief commentary, is in Appendix III.

9 The company stopped including ARPU data for contract and prepaid customers as of 2007.

10 (584MM + 650MM) / 2 = 617; 617 x RMB 73 x 12 = 540,492. This method of calculation – taking the average of customers at the beginning of the year and the end of the year and multiplying by ARPU for the year – has proved a fairly accurate predictor of revenue for 2010 and 2009.

Calculation of the Target Price:

The growth of earnings is projected in the following way:

  • 10% for 3 years
  • 6% for 27 years
  • 2% to infinity

The previous two sections dealt with the calculation of 10% growth. The 2% to infinity after 30 years is meant to reflect basic increases in inflation whereas earnings generally stagnate. The medium term growth rate, 6%, is simply a rough estimate of earnings growth that can be expected over the long-term based on:

  • Mobile penetration rate increasing from 60% to about 90%.
  • Higher ARPU as GDP per capita in China increases (presumes that there will be less “prepaid” users and more contract users paying more for data services such as mobile internet and so on).
  • Inflation over the long-term of about 2%. Note that this is number is based on the average Chinese CPI from 2009 to 1996. 1994 had an usual spike of inflation and including 1994 into the calculation would have brought the average rate to about 4%.
  • Moderate Chinese population growth of about 0.50%.
  • CHL’s market share declining over time.

Long-term earnings projections defy calculation, but I think it can be reasonably assumed that the company’s volume of business and the ARPU of its customers will generally increase at a slow rate over time and thus that period deserves a higher rate than inflation. The following table shows the discounted cash flow table:

Table V: Calculation of Intrinsic Value11

The cash flows are distributed between retained earnings (which are expected to result in capital gains) and dividends. The dividends are assumed to be taxed at 35% (the qualified dividend rate will probably decrease in the future as the Bush-era tax cuts expire). This is not everyone’s tax rate, but it is probably a median figure.

The discount rate used in this calculation differs from some analysts in that I do not calculate them using the cost of equity capital or a function based on stock price volatility. The inherent stability of CHL’s mobile subscription revenues in the PRC and the company’s dominant position in its industry means there is less risk as the company is not as vulnerable to the vicissitudes of the economy. The discount rates used are instead calculated based on the 10-year T-bond plus a spread subjectively determined to reflect the risk of those cash flows not arriving by at least that amount.

It is important to remember that many of CHL’s subscription revenue are not a part of their customer’s discretionary spending – the business is not seasonal. Many Chinese today have mobile phone subscription plans because it is logically perceived as either a necessity or such a great convenience as to be too good to live without. This is evidenced by the fact that the ARPU annually for mobile services as a percentage of GDP per capita is 3% in China whereas it is 1.5% in the U.S.12 In addition, the average amount of time spent talking on the phone per CHL customer per month in 2010 was about 8.70 hours – or 17 minutes and 24 seconds a day on average. The average Chinese customer clearly isn’t subscribing to CHL for frivolous matters.

The intrinsic value using the discounted cash flow method – and hopefully conservative estimated inputs – is about $82. At a price of $45, this means that CHL is potentially undervalued by about 80%. Interestingly, the price of CHL’s common reached above this calculated value before the market crash in 2008. The importance of this calculation of intrinsic value is that it assumes no special performance by the company in the future. The company can perform quite poorly, even, and still be yield a good result. There is obviously quite a bit of speculative value well above this calculated figure if the company has exceptional performance.

This model can, at best, just give a ballpark estimate. The calculation here is quite sensitive to changes in the inputs. A difference of 1% in the discount rate for “Years 11-Infinity” can result in a change in the calculation of as much as $15. Moreover, the estimates in the model, while at a very low figure, are still quite speculative and it is almost certain that the actual figures in the future will differ. For those reasons, it is difficult to rely on the model blindly and instead set a range around which intrinsic value should lie reasonably. Therefore, as stated at the beginning of this report, the intrinsic value “range” is between about $65 and $100.

11 CHL, in its own DCF model for the purpose of calculating asset impairment, uses a perpetual growth rate of 0.50% and 10.00% as the discount rate.

12 U.S. ARPU calculated as the average of AT&T, Sprint, and Verizon.

Final Analysis:

The lower limit of $65 has been chosen kind of arbitrarily. The type of discounted cash flow analysis as described above can be misleading. I do not think it is prudent to make actual decisions rigidly based on such a quantitative model, despite the variables being so conservatively calculated, because of the number of estimates involved. Furthermore, many people may never attribute any value to earnings “to infinity” or even a hundred years from now.

Ultimately, a person can only sell an asset for what the other person is willing to pay. No matter how logical and conservative my calculations may be, the other person may never come to agree with them because of either differing opinions or some ideology. It is logical to not rely very heavily on the pure math of the matter.

Therefore, I believe this amount should be discounted to $65 for the following reasons:

  1. A discounted cash flow calculation is very easy to make mistakes in on account of how difficult it is to predict the future. It is easy to deceive oneself as to the surety of the calculated value because it very mathematical. The company’s lifespan may not last for 100 years, for example, or the telecommunications industry in China may be dramatically different from today’s.
  2. Even if the data rigidly states the intrinsic value is $82, the market may never agree with this calculation. CHL may perpetually stay below what a conservative discounted cash flow analysis say it should be.
  3. My own limited experience and knowledge in regard to CHL creates the need to discount for any chance my analysis is mistaken.

Therefore, a lower limit intrinsic value of $65 has been chosen as the absolute minimum value that should be attributed to the value of China Mobile as of today. This is about 25% less than the “true” intrinsic value calculated above. The reason for choosing $65 is a little simplistic.

Figure 1: CHL Price History13

It is a general axiom in value investing that the price of a stock is not always equal to its intrinsic value and that the price generally fluctuates above and below that intrinsic value. Table 1 near the beginning of this report shows that the P/E of China Mobile has been as high as about 30 and as low as about 10.30 – its current P/E. The period during 2007 where the price rose briefly to about $100 in response to a year of high reported earnings growth was probably an overvaluation. The stock price later tumbled in response to the recession (although China was not affected by the recession, its shares are listed on the NYSE) and has stagnated in response to very low growth rates for the years 2009 and 2010. The overvaluation retreated to an undervaluation.

The price of $65, based on this logic of the price fluctuating around a central value, is taken as just the average of the historic prices. The price during late 2007 and early 2008 was about $80 and that price represented probably an overvaluation. The price during 2009 to now has been about $50 and represents a period of undervaluation. The price has recently retreated to as far as $44 in response, probably, to the general dislike and perception of riskiness of Chinese stocks in general. The central value, therefore, is calculated as $65 as the proper lower limit intrinsic value. Keep in mind that this is not a “target price” for next year or any time in the future. I do not know what the price will be in the future. Value investing supposes that over the long-term, stock prices will eventually reach their calculated value and it is hoped for, though not guaranteed, that CHL and any other stock will eventually reach that value.

In any case, it seems odd that a company with stability and future prospects like China Mobile would sell for a P/E of less than the average stock, as shown by the S&P 500 index’s P/E of 14, and even less than the average major Chinese corporation, as shown by the “iShares FTSE China 25 Index Fund” with a P/E of 11, of which China Mobile is a constituent. I believe this degree of discounting is unwarranted.

13 From Yahoo! Finance.

Catalysts for a Valuation Reversal

As stated above, a fundamental principle of value investing is that there is an element of emotion or irrationality in decision making by investors. The necessary corollary is that stock prices deviate from their intrinsic value. There are also many whose investing decisions are logical, but are independent of stock values – technical traders, selling to pay for retirement, and so on. It is known that stocks generally fluctuate above and below a stock’s intrinsic value. These undervaluations and overvaluations may last as long as a few days to a few years. The point is that one major assumption of a “value investor” is that at some point his or her diversified portfolio of undervalued securities will reverse at some point in the future, although the exact time frame for this revaluation is uncertain.

There are many investors and portfolio managers, though, who are not satisfied with this “wait and pray” approach. Many demand a “catalyst” – a reason for a security to be revalued by the market within a specific time frame. As for CHL, there are three catalysts I know of that could cause a reversal of the current valuation. These are: (1) a great bull market, (2) a strong reported growth in earnings or some other fundamental measure, and (3) CHL being given rights to sell AAPL products in China. I won’t discuss the first catalyst, but the latter two have a strong probability of occurring.

Any growth in earnings beyond that shown in 2009 and 2010 can possibly lead to a higher valuation by the market. As discussed above, I believe the growth in 2009 and 2010 is temporary. The second catalyst is AAPL selling products through CHL, which it currently does not because CHL uses the incompatible TD-SCDMA as its 3G technology. This situation, however, may change in the future.

According to the news site M2M, China Mobile is rumored to have reached an agreement with AAPL over iPhone 5, which is supposed to be released sometime in the second half of 2011. This rumor’s basis is founded in Tim Cook, COO of AAPL, having visited the company on June 23rd of 2011. In addition, the site reports that an agreement has been reached on TD-LTE (4G) iPhones. TD-LTE is one of two 4G standards in the world and is gaining some international acceptance.

Further, a state-run paper, People’s Daily, reports that China Mobile had 5.6MM iPhone users with access to its wireless network by the end of May 2011. In addition, 700,000 iPhone 4 users were added to CHL’s network in May. This fact along with competitive pressure from CHA means that CHU’s toll-bridge status for owning an iPhone in China will not last forever. As a result, as People’s Daily reports, CHU has recently been promoting multiple smart phones, rather than promoting primarily the iPhone as before. This could mean that the valuation attributed to CHU is no longer warranted, if it ever was.14 More importantly, some of the enthusiasm for Google, Apple, and others could rub off on CHL.

14 People’s Daily. July 8, 2011. “China Mobile puts more pressure on Unicom.” Accessed July 14, 2011. http://english.people.com.cn/90001/90778/90860/7434076.html

Appendix I: China Mobile Financial Statements

Presentation of financial statement data:

The statements presented are adjusted where possible to represent a truer picture of the company. For example, “deposits with banks” have been consolidated with “cash and equivalents.” The “other current assets” account actually includes amounts that are due after 1 year, but the company does not give enough information to make an adjustment to non-current assets. Certain other immaterial items have just been consolidated under the most relevant account.

The company also uses strange terminology for some accounts that I’ve adjusted to something more typical (e.g. “current taxation” to “taxes payable”). The account “reserves” has been broken down into its component parts. Various esoteric reserves – the reserve required by PRC law, a reserve for unused stock options are consolidated under “other reserves.” A minute accounting standard was adopted during 2009 by the company that changed certain balance sheet accounts. There is inadequate data to adjust 2006 in a similar fashion and that is the reason why there is a sudden increase in certain accounts. Deferred tax assets, deferred revenue, and accrued expenses and other payables were affected by the changed. Operating leases have also been added to both assets and liabilities.

The income statement has been similarly adjusted to be more descriptive and to represent the true situation better. One annoying factor, from an analysis point of view, of IFRS is that it desires financial statements to have “minimum information.” For example, about 50% of all operating expenses were placed in an ambiguous account called “other operating expenses”. The average analyst obviously would want to know what such a significant account includes, so the statements have been readjusted to show the major components.


China Mobile Balance Sheet (December 31)


China Mobile Income Statement (December 31)

China Mobile Statement of Cash Flows (December 31)


China Mobile Balance Sheet (December 31) – Annual Percentage Change

China Mobile Income (December 31) – Annual Percentage Change

China Mobile Statement of Cash Flows (December 31) – Annual Percentage Change

China Mobile Balance Sheet (December 31) – Percentage of Assets

China Mobile Income Statement (December 31) – Percentage of Total Revenues

China Mobile Statement of Cash Flows (December 31) – Percentage of Operating Cash Flows


Appendix II: Table II Formulae


Appendix III: Additional CHL Customer Data

CHL Historic Number of Customers

CHL Historic Customer Usage

Based on information in CHL’s 20-F, prepaid customers seem to be mostly from rural areas. In part for making profits and in part for adhering to PRC philosophy, one of CHL’s and the PRC’s objectives is to minimize the growing “digital divide” between the country’s urban and rural dwellers. Thus, CHL has made great efforts to make mobile phone services available to rural communities. The 20-F for 2010 notes that about half of new customers in 2010 were from rural areas.

It is questionable to me, given my limited data, how profitable these rural customers are at the moment. My knowledge of Chinese civilization is limited to articles and figures showing that men have moved off to cities “in droves,” leaving the women and old men working in the countryside in very poor conditions. At the very least, they may be a decent investment as they will hopefully be wealthier one day and be capable of paying more to CHL for additional and better services.

It is also interesting to note the explosion of billions of minutes usage during the recession years while at the same time the company had less earnings growth. The company’s 20-F for 2010 complains of strain on the network from an increase in communications as an explanation for additional capital expenditures upgrading and expanding the physical network. Increases in ARPU as the country becomes wealthier will almost certainly provide growth for years to come.

Copyright Jack Huddleston, 2011

You are allowed to copy all or part of this article as long as you credit:

James “Jack” Huddleston, www.jamesjackhuddleston.com