Petrobakken – Watch for a dividend cut

I wrote earlier about how Petrobakken (TSX: PBN) was a value trap. After PBN reported their first quarter results, my assessment has not changed that much.

Serious investors will just look at their financials, but you can also look at their press release.

The most salient point (and note that this analysis is not exhaustive by any stretch of the imagination – I will leave it to the reader to punch holes in this summary assessment) is that the company has maintained their production at around 41,500 barrels of oil equivalent per day. However, in order to maintain this production they needed to spend about $300 million in the quarter in capital expenditures. Operationally, the company did roughly $140 million in cash, so when you subtract another $45 million out in dividends, you are left with a negative $200 million cash flow quarter.

The company is expecting to spend another $600 million in capital expenditures this year. Doing some paper napkin calculations, if you assume for the rest of the year the company will be able to maintain a rough $150M/quarter operating cash flow, a $45M/quarter dividend rate, and $200M/quarter capital expenditure rate, you are still net negative $315M cash. Their bank facility has about $240M room left. The difference in cash is a $75M gap.

If they get lucky, they can bridge this gap with increases in revenues from increased crude and gas prices or an increase in production (via drilling new wells), but their margin of error is tight. The only other realistic option that management has (since I do not foresee them doing another debt financing) is cutting their dividend.

Anybody investing in PBN for yield is going to receive a nasty shock if this occurs. Petrobakken shares do have value, but I believe they are still trading above their fair value.

Skype – Another kick at the can

The news is making the rounds that Microsoft is paying a large amount of money for Skype, approximately $8.5 billion in cash.

It is virtually guaranteed the acquisition will lose money. EBay tried their hand with Skype back in late 2005 and they only had to pay $2.6 billion for the privilege before they threw up their hands in late 2007 when they dumped the company for a loss.

Now Skype has found a bigger sucker to sell itself to, which in this case is Microsoft.

All of these value investors that have their money in Microsoft have to be wondering what Steve Ballmer is thinking, and how much more money Microsoft will run themselves through before realizing that it has gotten to the size where it is unable to compete effectively outside of its Windows/Office monopoly.

Why consistent high returns are impossible without leverage

On the right-hand side of my bookmarks, I posted a 5-year performance of about 22% compounded annually. This is a high number, and as the years tack on, this will likely become lower. 2011 is going to likely be a low single digit percentage year.

The mean value theorem in mathematics can explain why such a level of return is not likely to continue. Let’s pretend that every company I put my money in will have a 15% earnings yield (either retained or given out in dividends; it does not matter). In the long run, my portfolio will be able to increase 15% a year. However, in order to achieve a 22% return, I must invest in something that has a greater than 22% return.

If I cannot find those investment candidates, then in order to achieve 22% on a 15% investment base, I need to borrow money at a rate less than 15% and put it into that 15% investment.

The risk of this is that my capital might “blow up” and I will be forced to liquidate my assets at precisely the wrong moment. Another way of thinking about this is that I want to be investing at precisely the moment that everybody else is forced to liquidate, rather than an arbitrary point in time such as now.

Unfortunately at present I am having grave difficulty identifying candidates that will give these types of returns. I also do not feel comfortable with employing leverage, so I will continue to twiddle my thumbs and wait for a better opportunity. I also do not think ploughing into commodities is any sort of “fix” to this problem – there are much better lower-variation equities out there that will give you a more stable return on investment and also be able to provide inflation-adjusted returns over the long run. Even though it is abundantly clear that commodities such as inexpensive-to-mine oil is rapidly depleting, it is still no reason why the price of such commodities at some point will not go to marginal cost of extraction, or even lower (e.g. natural gas). Commodity markets are cyclical and investors should never assume that the trend will be continuously straight-line up. There will be brutal price corrections in the interim – they are just very difficult to predict.

The beginning of the end of the commodity rush?

I’ve been slowly trying to get back into the rhythm of the marketplace and then hopefully I will be able to continue researching some opportunities. Nothing looks promising so far, and this quarter has been turning out to be a very low transaction period.

It seems like when Osama Bin Laden got shot, that it also took out the wind of the commodity market. High-risers, especially silver, got pummeled this week:

Who wants to be the person admitting that they bought Silver at $50 an ounce?

Anecdotally, I was walking down the street a week ago and remember these two people walking out of a currency exchange store, and they were clearly holding silver coins as they exited the place. Maybe I should have taken this as some sort of contrarian signal and short the commodity, but I was too busy with other matters to do so.

Also, it is my opinion that the indexes appear like they will be treading water and not exhibiting the run-up that they were doing between September 2010 and February 2011.

Best ways of playing the Federal Election

I am neck deep in the federal election, hence my very infrequent writing in April.

With the surge of the NDP in Canada, there is a distinct possibility that the NDP will be a very significant partner in any coalition government against the Conservatives. Economically, one of the promises all the other parties have had is an increase in the corporate tax rate. In particular, banks and oil companies have been singled out by the NDP. Whether they would take action upon them in government or not is another matter, but the corporate tax rate increase is something they would likely implement.

In terms of making a trade based on the projection of the election, I would suspect that selling/shorting profitable large-cap companies on the TSX would be the best way of betting against a Conservative majority government. You would close the position on May 3rd.

In the event that the Conservatives are quite short of a majority government (e.g. a status quo situation), there is likely going to be a few months of major uncertainty before the House of Commons sits for its throne speech. Although the writs are going to be returned sometime in the later part of May, the Prime Minister has the option of not convening Parliament until after the summer break, in September. This is probable if there is another minority government.

This uncertainty only leads in one direction – equity price decreases in Canada.