Chesapeake and SandRidge Alum Tom Ward Just Admitted How Bad The Energy Exploration Business Model Really Is

Those of you who follow the energy exploration and production industry probably know Tom Ward very well. He co-founded Chesapeake Energy with the late Aubrey McClendon in 1989 and later left to start SandRidge Energy in 2006. With Chesapeake struggling mightily these days (there were whispers of a bankruptcy filing earlier this year and shares trade below $4, down from an all-time high of $74 back in 2008) and SandRidge having filed bankruptcy just this month (Ward was fired as CEO in 2013), Ward’s two companies are wonderful examples of how the need to grow via debt financing can cripple energy exploration firms. Undeterred, Ward founded Tapstone Energy in 2013 as act number three.  Tapstone’s web site reads “Tapstone Energy: A Tom Ward Company.” I’m sorry, but given Ward’s track record that’s quite humorous.

I just saw Tom on CNBC discussing the current state of the domestic energy market and one of his comments was very instructive for energy investors. He said the industry’s “dirty little secret is that you cannot spend within cash flow and grow production.”  This comment was following his assertion that lack of access to capital was the real hindrance to the industry right now because banks “want you to spend within cash flow.”

I guess banks only want to lend money to energy companies that can operate at free cash flow break-even at a minimum. This is very logical of course, as it means that the profits from the oil and gas sold can cover the interest payments due to the banks. I find it amusing that Ward is in a way criticizing the banks for being so strict so as to want to ensure they can be repaid.

But the “dirty little secret” comment is most important in my view. What Ward is saying is that energy exploration companies cannot grow their production without borrowing money to do so. Put another way, this means that drilling for oil and gas does not generate any free cash flow (after all, if it did there would be excess cash to drill more wells and thus grow production). In financial speak, maintenance capex (the amount of reinvestment requires to maintain a steady level of output) eats up every dollar of operating profit.

This is crucial for investors because stock values reflect the present value of future free cash flow. If free cash flow is never above zero, there is no profit left for equity holders after creditors are repaid. From a strictly textbook definition, that would mean that all of the common stocks are worth zero.

I wish I had heard this comment many years ago, as it might have allowed me to realize a lot sooner just how bad of a business model most independent energy producers are employing. What is amazing is how many people continue to want to invest aggressively in the sector.

Despite Strong Fundamentals, Restaurant Stocks Struggle To Deliver

There is a long list of things to like about the restaurant sector from an investment perspective. Secular trends such as dual-income households have led many families away from frequent home-cooked meals around the dinner table. The busier we are, the more likely we will rely on restaurants of all shapes and sizes. Add in low gas prices and one would think restaurant stocks would be among the stock market’s best performing groups. And yet it has been quite the opposite lately.

I have always liked to invest in the sector, not only for the reasons above but also because it is relatively easy to understand and analyze. Chains often try to differentiate themselves, but the general recipe is the same for most. Suffice it to say I am finding so many bargains in the sector lately it is difficult to choose which ones should make the cut in a portfolio. Valuations are about as low as I have seen them since I began investing more than 20 years ago.

So why are these stocks having so much trouble with both secular and cyclical tailwinds? I think a big issue has been a very strong market appetite for well-known restaurant IPOs. Consider that there are more than 50 publicly traded restaurant stocks in the United States, and more than 20 of them have IPO’d since 2010. Just as these companies are having to compete for customers, they are also competing for investors’ capital. Given that restaurants are a small subset of the consumer sector, there is a finite amount of investment dollars being allocated to the group. With more and more options boarding the public market train, many are simply being discarded.

And despite low gas prices and a propensity to eat out or carry out meals, there are operational challenges all of these chains are facing. The biggest in my view is simply the sheer number of new locations being opened by restaurant chains generally. The number of food options these days can often be overwhelming. At some point it is reasonable to assume the U.S. is going to be facing an overbuilt restaurant sector, at which point many will start to see material declines foot traffic, sales, and profits.

That said, I firmly believe that there are many attractive investment opportunities within the restaurant space. Within the small cap arena there are many companies that offer a compelling business model and meager valuation. A great example is Kona Grill (KONA), a sit-down concept that will deliver over 20% unit growth in 2016 and end the year with 45 locations across the country. The company averages $4.5 million in annual unit revenue and 17-18% unit level profit margins, with a build-out cost of $3 million per location.

At the current $11 share price, which is down a stunning 50% from its 52-week high, the stock trades at a total market value ($127 million) below its $135 million replacement cost (note: replacement cost is how much money it would take to replicate the company’s assets if you started from scratch today). Throw in a long runway of future expansion potential and you have a very attractive long-term investment that Wall Street is completely ignoring. And there are many other bargains out there to be found if you look closely.

Kona Grill (KONA) – 2-Year Chart

kona

Full Disclosure: Long shares of Kona Grill at the time of writing, but positions may change at any time

Is Facebook Stock Approaching Bubble Territory?

Here is a list of the U.S. companies that are worth at least $300 billion today based on stock market value:

  1. Apple $522B
  2. Microsoft $392B
  3. Exxon Mobil $365B
  4. Berkshire Hathaway $357B
  5. Facebook $336B
  6. Amazon.com $318B
  7. Johnson & Johnson $311B

If you are surprised to see Facebook (FB) registering as the 5th most valuable U.S. company you are not alone. Given the company’s high growth rate, many investors do not mind the stock’s valuation. At $117 per share, the stock trades at 33 times this year’s consensus forecast of $3.54 per share of earnings. Given that Wall Street is currently estimating more than 30% earnings growth in 2017, this P/E ratio seems high, but warranted, if you are a true believer in the company’s future.

I am not going to delve into the company’s future growth prospects in this post, as I have been wrong about them so far. My thesis was that Facebook usage would decline over time as early adopters such as myself tired of the service and the network became overloaded with parents, grandparents, aunts, uncles, etc. That has proven to be wrong. Perhaps Facebook has evolved from a cool place to connect with friends to a crucial hub to connect with family. At any rate, the stock’s valuation is what has peaked my interest lately.

Facebook is one of a growing number of growth companies in the technology space that is overstating its profitability by paying its employees with stock and not treating it as an expense when speaking to Wall Street analysts. The official GAAP financial statements do disclose how much stock they dole out to employees (for instance, in 2015 the figure was a stunning $3 billion), but when investors quickly look at earnings estimates, they see the $3.54 figure for 2016 which does not include stock-based compensation.

So what happens to the stock’s valuation if we treat stock compensation as if it were cash? After all, if Facebook decided to stop paying its employees with stock, we can assume they would have to replace it with cash. Below I have compiled the company’s free cash flow generation since 2012 and subtracted the dollar amount of stock they have paid their employees. This simply tells us how much actual free cash flow Facebook would have generated if they compensated solely with good ol’ U.S. dollars and cents.

FB-FCF

As you can see, adjusted for stock-based compensation Facebook had free cash flow of $1.09 per share in 2015, which is about 50% less than their actual reported free cash flow ($2.13). Put another way, Facebook’s employees (not their shareholders) are being paid out half of the company’s profits.

From this perspective, Facebook stock looks a lot more overvalued. If you annualize the company’s first quarter 2016 free cash flow adjusted for stock compensation ($0.38 per share), the company trades at a P/E of 77 ($1.53 of free cash flow). There is certainly an argument to be made that such a price resembles bubble territory. That potential problem could be rectified if the company continues to grow 30% annually for the next five years, resulting in $4.05 of “adjusted” free cash flow in 2020. But buyers of Facebook stock today at paying about 30 times that 2020 estimate right now, which is still a very high price.

Below is a summary of Facebook’s stock market value relative to reported and adjusted free cash flow since 2012, as the stock has nearly quintupled in price:

FB-Pr-FCF

How do situations like these typically play out? One of two ways. The less likely scenario is probably one where Facebook’s growth hits a wall and investors quickly slash the P/E ratio they are willing to pay by 2-3 times. That would be ugly, but does not appear to be the most likely outcome given their momentum right now. The more likely scenario is the one that we usually see with very good companies that have staying power but simply have seen their stock prices get ahead of the fundamentals. In that case, the cash flow multiple comes down slowly over a period of several years, resulting in the stock price lagging the company’s underlying profits.

If I had to guess, I would say the latter seems like a real possibility going forward from here. Regardless, investors should check to see how much of a hit a high-flying tech company’s cash flow would take if stock compensation was factored into the equation. As Warren Buffett likes to say, “if stock-based compensation is not a real expense, I don’t know what it is.”

Full Disclosure: No position in Facebook at the time of writing, but positions may change at any time