Model Portfolio rmcduff:RMG1

Familiarity breeds Mediocrity

We've all heard the saying, "invest in what you know". This saying, coined by Peter Lynch, refers to the hope that good investments might be found at your very doorstep.

The mantra should be accompanied with a pharmaceutical "black box" warning, or at the very least a caveat. Investing in familiar names, by default, implies that we overweight in local or domestic companies. This creates the possibility of a "false confidence". In order to stay within our comfort zone, a very real risk exists that we wind up owning highly ordinary (or less than ordinary) companies. A confirmation bias is created for domestic firms at the expense of foreign firms. Such a view has been borne out by a host of academic research. One seminal paper "Familiarity breeds Investment," by Gur Huberman at Columbia University, is worth a read. (click here to download the article)

Perhaps it is time to put the notion of investing in what we know aside. False confidence is no substitute for fundamental investment research and thorough peer analysis.

Nowhere has this "invest in what you know" premise been more of a failure than in large cap US pharmaceuticals.

Long term investors piled in almost a generation ago. The lure was pie charts full of favourable demographic data on drug use. After all, companies produce a pill for every real (or imagined) need. And as we age, don't we all consume more drugs? The business model was touted as being recession proof.

This confirmation bias has produced a decade or more of disappointment. Investors bought into demographic trends while ignoring balance sheets, global competition and government regulation. Consider how investors would have done had they held the big three US drug companies based on enterprise value. These are Johnson and Johnson (JNJ-NYSE, $56.12), Pfizer (PFE-NYSE, $15.17) and Merck (MRK-NYSE, $26.21).

A dinner party to honour the outcome of these three purchases would be a "bleak tie affair" indeed. If JNJ was purchased back in September 24th, 2001, one has just broken even (before dividends). If Pfizer had been purchased way back on January 2nd, 1997, investors are now roughly even before dividends. Based on a purchase of Merck 14 years ago (July 1995), investors are STILL not even, before dividends.

Those who are bullish on US large pharma blithely explain away a decade of lost returns on the current recession and global market selloff.

However, they fail to explain why such so called "recession proof" US companies are acknowledging potential revenue and profit declines for the next several years. Bulls further fail to address how it can be that US large cap pharma firms are doing so poorly on a business basis, whereas European and Asian large pharma are quietly reporting record sales and earnings.

The latest tool in the corporate finance divisions of large pharma is to merge the weak.

Merck has agreed to buy Schering-Plough (SGP-NYSE, $23.76). SGP is forecasting flat to declining 2009 revenues and profit. Pfizer has agreed to merge with Wyeth (WYE-NYSE, $44.59). Once again, Wyeth is forecasting revenue and profit declines in 2009.

I personally fail to see how merging four firms into two solves the revenue decline issue. If Pfizer and Wyeth sales are dropping, combining these firms achieves nothing. If Merck sales are dropping and Schering sales are dropping, an acquisition of Schering with a healthy cash payout does not address the coming round of patent expirations.

It also remains to be seen how leveraging up the balance sheets of Merck and Pfizer does anything more than add capital risk for shareholders. I consider the recent wave of weakness mergers in the US to be acts of corporate finance desperation.

Sophisticated investors evidently don't buy the premise either. Bleak near term industry prospects for the US industry have compressed valuations. The median EV/EBITDA ratio for the top 7 drug companies globally has fallen to the lowest average level in more than a decade.

Investors should not assume that the global pharmaceutical industry is in the same leaky boat as US drug firms.

Three of the top seven global firms based upon enterprise value are based in Europe. Roche (ROG-Zurich, $131.5), Sanofi-Aventis (SNY-NYSE, $30.99) and Novartis (NVS-NYSE, $40.47) are forecasting revenue growth in 2009 and beyond. All three companies posted record 2008 fiscal results. All raised their 2009 dividend payouts. All suggest that new drug approvals and existing product growth may more than offset patent expiries through 2012.

The compression of large pharma valuation ratios has made these successful firms look incredibly cheap on a historic basis

The European giants are doing just fine. Clearly all are differentiated from US peers in a number of important areas. Capital ratios are much stronger, with lower levels of debt than US peers. In contrast to US counterparts, European firms already operate under widespread price controls for many drugs. Like US firms, the big three in Europe grow by acquisition. To the benefit of their existing shareholders, these firms generally pay with cash rather than dilutive stock. The companies are geographically closer to key emerging markets in Asia and Eastern Europe. And finally, European firms tend to be "asset heavy", with an emphasis upon building new pharmaceutical plants. They have made substantial inroads into China and emerging markets with major capital investments.

My personal choice as a GARP investor, among the three European names mentioned above, is Sanofi-Aventis.

With 2.62 billion ADRs outstanding, SNY is the world's 3rd largest pharmaceutical company on a global basis by revenues. Sales were $36 billion for 2008, and should surpass $40 billion US in 2009, primarily from pharmaceutical products. EBITDA could exceed $16.1 billion in 2009. The company generates more than 69% of its revenues outside of the US. In the current quarter, the US dollar has fallen rather sharply against the global currency basket. At Sanofi, this should be of benefit. Recent currency moves should also assist Roche and Novartis in 2009.

SNY is the world's leading producer of vaccines. The Sanofi-Pasteur division holds 21% of the global market, and is increasing share. Management has determined this division to be a major driver of revenue and earnings growth. Accordingly, significant capital is being invested to double global vaccine output in the next five years. Of major significance is the potential commercialization of a Dengue fever vaccine. SNY hopes to bring this product to market in 2014. A $475 million plant in France is now being built to produce the vaccine. Second only to malaria in terms of commercial potential, this vaccine could post sales in excess of $1 billion US.

Sanofi also has core strengths in the diabetes market. On a global basis, SNY is #2 behind Novo Nordisk (NVO-NYSE, $52.28). Both firms have been capturing market share from Eli Lilly (LLY-NYSE, $34.77). SNY forecasts its forecast 2009 diabetes revenues ($4.5 billion) to virtually double by 2013. The global diabetes market has the potential to become a de facto duopoly.

Sanofi makes acquisitions. Existing shareholders are well served, since SNY pays cash (not stock) for small bolt on purchases. Thus far in 2009, three emerging markets generic drug makers have been acquired just off the market lows. Over one full fiscal year of operations, these acquisitions will add $1.2 billion of revenues.

On the basis of all key metrics, Sanofi-Aventis appear to be a bargain vs. peers.

At forecast EBITDA and revenues, Sanofi would appear to deserve a top three enterprise value on a global basis. The company is only valued as the 7th best in the peer group. Sanofi sells for a 2009 EV/EBITDA ratio that I forecast to be 6.8X, well below the industry average of 8.9X.

SNY's sheet is the strongest among the top #7 global peers, and by far. Only Novo Nordisk (another current holding of RMG#1) boasts a better balance sheet.

Profit and dividends are likely to grow in the near term.

In 2009, management of Sanofi anticipates revenue growth rate of about 7%, tops among large companies.

The current dividend payment provides for a gross yield of 4.9% and is just 34% of forecast 2009 profit. On an absolute basis, the dividend payment has grown by 83% since 2004

The dividend growth rate contrasts to large cap US peers, most of which have produced limited dividend growth since 2004. PFE has recently slashed its dividend in half. Merck's dividend payout is touching 50% of forecast earnings, and is unlikely to increase in the near future. JNJ's payout ratio appears to be almost 45% of forecast 2009 earnings, and is unlikely to be increased substantially in the near term.

A lack of research coverage may account for the limited number of Sanofi shareholders in the US.

Only 4 US firms provide coverage. 1 firm rates SNY as a buy, 1 as a hold, and 2 as a "sell". I find this inexplicable.

In contrast, 15 US analysts provide coverage on Merck. 13 report on Pfizer. 17 cover JNJ. Despite the fact that the three US peers are faced with the prospect of declining revenues and earnings in 2009, not a single US analyst in the bunch will dare to publish a sell.

It seems clear that a North America confirmation bias exists. US large cap pharmaceuticals are praised, irregardless of investment merit. Taking into account the lack of coverage on Roche (1 analyst), Sanofi (4 analysts) and Novartis (4 analysts), it also seems clear that a negative confirmation bias exists for international large pharma.

An analyst buy rating seems unnecessary to confirm my investment case here.

Sanofi's industry leading growth rate, world class business model, best in class balance sheet and high, sustainable and potentially growing dividend are all the validation I require.

The shares appear undervalued by 20%-32% to the peer group in the near term. My view is that this gap will close in the years ahead. If success in the vaccine and diabetes franchise continues, SNY may ultimately deserve a premium valuation. I consider Sanofi-Aventis to be a core holding in a globally themed large cap portfolio and own shares personally.

RMG #1 has recently initiated a position in Sanofi. This holding will be gradually increased to a core weight as funds permit.

The corporate website may be found here: http://en.sanofi-aventis.com/

Posted by Randolph McDuff at 12:44 PM | Permalink

Traffic Patterns Normalized

Guangshen Railroad: (GSH-NYSE: $17.29)

All amounts, unless stated otherwise, are expressed in US dollars. Amounts are converted from Chinese Yuan at the rate of $.1463. Estimates are my own, and may differ materially from analyst reports.

ADR Shares Outstanding: 141.67 million.
Total liabilities cash (09/30/08): $724 million.

Estimated EBITDA for 2008: $434 million.
Estimated EBITDA for 2009: $503 million

Estimated 2008 year end EV/EBITDA ratio: 7.4X
Estimated 2009 year end EV/EBITDA ratio: 6.3X

Guangshen Railway's 9 month revenue reports provided the first indications in 2008, of normalized traffic flows

Primarily a passenger railroad, GSH revenues are heavily front loaded to the 1st quarter of the fiscal year. This coincides with the January spring festival holiday travel period. Accordingly, as much as 30% of the total years' revenues, and up to 35% of annualized EBITDA are earned in the first quarter of each fiscal year.

In 2008, massive snowfalls in the transport basin resulted in a complete shutdown of rail transport for much of the spring festival. Travellers did not choose alternative transport, as all roads were closed. The Chinese government simply advised migrant workers to stay put during the holiday period.

The cessation of holiday travel produced a reduction in 1st quarter revenue growth, as well a drop in 1st quarter EBITDA. 2nd quarter revenues and EBITDA demonstrated improvement, but were not sufficient to overcome the 1st quarter drop.

The 3rd quarter has proved to be more indicative of GSH potential. My estimated 9 month EBITDA has now surpassed that earned in the first nine months of 2007.

While modest, it now appears that GSH has the potential to increase 2008 total EBITDA by up to 6% above 2007 numbers. Revenues could be roughly 17% above 2007 year end figures.

GSH has now completed its major purchases of rolling stock in the near term

The firm completed the most significant expansion of its history. Between 2004-2007, Guangshen purchased a major trunk line and completed a $450 million high speed rail line expansion.

Rolling stock purchases were the focus of capital spending in 2008. Most of the equipment purchases have now been delivered, and are producing planned revenue growth. Net liabilities have increased by more than $258 million in 2008. Only two more train sets are scheduled for 2009 delivery. I anticipate a steady reduction in total indebtedness from here.

Guangshen appears to be setting up for a robust 2009

Based on my current EV/EBITDA ratio, the investing public seems to have lost complete faith in the Chinese secular growth play. Analysts too, appear to be extrapolating the current lack of economic growth, well beyond any reasonable time frame for historic global slowdowns. In short, I consider the consensus view to be too sceptical, by far.

$65-70 oil will revitalize the global economy much faster than policy initiatives ever will. I consider the current economic slowdown to be a major buying opportunity for the next economic cycle.

The 3rd quarter report for GSH confirms that EBITDA growth has turned for the better. To the chagrin of current holders, recent market volatility has temporarily trumped positive fundamental news.

As to mid term outlook for Guangshen Railroad, it appears bright. With additional rolling stock, the new high speed rail line will be more fully utilized. This should prove highly beneficial to both the top and bottom lines.

Based on my forecast, Guangzhou Railroad now appears to be selling for the lowest EV/EBITDA ratio in almost 10 years. With a major capital expenditure program now completed, the focus for 2009 will turn to revenue growth and margin expansion.

GSH traditionally sells for a premium to North American rails, due to better secular growth trends and less emphasis on commodity hauling. This is one of the few instances that I have seen, where this Chinese passenger line sells for discount to North American commodity hauling peers. I believe that the shares are too cheap by far.

Posted by Randolph McDuff at 02:59 PM | Permalink

A Category Killer Next Generation Insulin

Novo-Nordisk (NVO-NYSE: $53.51)

Shares outstanding (fully diluted as of 09/30/08: 618.6 million.
Total liabilities- short term cash as of 09/30/08: $1.68 billion.
Enterprise Value: $34.78 billion.

Revenue forecast for 2008: $9.1 billion.
Revenue forecast for 2009 $10.1 billion.

EBITDA margin forecast for 2008: 30%
EBITDA margin forecast for 2009: 32%

EBITDA estimate for 2008: $2.7 billion.
EBITDA estimate for 2009: $3.2 billion.

In an investment world plagued with companies reporting earnings disappointments, reduced guidance or balance sheet blowups due to credit markets, it is refreshing to find world class companies that have INCREASED their guidance. Novo Nordisk is one of just a handful of firms on a global basis to have done so.

http://biz.yahoo.com/ap/081030/earns_novo_nordisk.html?.v=2

Novo Nordisk is the world leader in diabetes pharmaceuticals

NVO has a 52% market share of the worldwide insulin market. This market share has been growing consistently over time. The firm has worked diligently to produce better and safer insulins over the past 20 years, which have been well received by patients. The company has demonstrated considerable success in the modern insulin market as of late, capturing a 44% global market share of this fast growing market. The diabetes division accounted for 73.5% of total revenues in the first 9 months of 2008

Major global competitors include Eli Lilly and Sanofi Aventis.

The firm also has considerable strengths in hormone therapies and haemophilia pharmaceuticals

Novo produces human growth hormones and coagulation products. Revenues continue to grow at double digit rates.

Novo has a superb balance sheet

Using the conventional model that is employed by analysts at most firms, NVO would be considered completely debt free and carry a liquid balance of 1.7 billion US.

http://www.novonordisk.com/images/investors/reports/interim_reports/2008/PR081030_9M_UK.pdf

Analysts generally lump all short term assets into models employed at major brokerage firms, when producing their Enterprise Value (EV) estimates. My valuation models are more stringent. I consider inventory to be a permanent part of the capital structure. Without inventory, a company cannot produce any product. A failure to include inventory in investment analysis represents an admission that a business is not a "going concern".

My EV calculations only include true "cash and short term assets" and exclude inventory, accounts receivable and marketable securities. As we are all now intimately aware, marketable securities sometime become "unmarketable".

Using my model, NVO reported net liabilities of $1.68 billion on 09/30/08. This works out to be less than 9 months of 2008 operating cash flow.

The firm has a near term diabetes product in the pipeline, with blockbuster potential

Liraglutide may be approved by the FDA as early as 2009. This drug is designed to compete with an Eli-Lilly/Amylin Pharmaceuticals product known as Byetta. According to comprehensive phase 3 testing, Liraglutide has the potential to become the industry standard in this newer class of diabetes compounds. Adverse side effects are much less pronounced in Liraglutide than Byetta, and patient tolerance is considerably higher. Novo does not factor in any revenues from this drug in 2009 revenue estimates.

Of greater interest is a "Category Killer" insulin now heading for phase III trials

NN5401 and NN1250 have the indications to completely redefine the conventional treatment of diabetes. Novo had kept this development under wraps until quite recently. Now, it appears that management is highly confident of their potential to better the lives of diabetics globally. These two innovative, next generation insulins will commence phase 3 testing in the latter half of 2009. Both are long lasting insulins (more than 24 hours), and appear to be both safe and very well tolerated. Instead of daily injections, patients would only require 3 injections per week.

Novo is the only company worldwide, with a new generation of insulin in full clinical development. Now that details are more fully disclosed, it appears that NVO might have caught Eli Lilly and Sanofi Aventis napping. Either of these products may serve to completely change the dynamics of the marketplace. If approved, NN5401 and NN1250 could steal enormous market share from competing products.

The global market for conventional insulins (modern and human) is estimated to be larger than $11.2 billion, and is growing at almost double digit annual rates. While NN5401 and NN1250 would cannibalize Novo's own sales, commercialization of either of these insulins could potentially add incremental sales by at least 10% per annum, commencing in 2012.

In terms of market potential, a 3 injection per week insulin, considered much safer than conventional products, with weight loss potential, would reshape the playing field. Novo appears to have as much as a 5 year window over potential competition. If successful, these insulin's could hit the market as early as 2012. While this sounds ridiculous, the potential exists for Novo to capture 100% of the remaining market share

A game changing drug could also be a game changer for Novo investors

At a 7% annual growth rate for conventional diabetes products, the market share that Novo does not have, may grow to $7.4 billion in five years. The operating margins on insulin sales approach 76%. EBITDA margins for this division approach 40%.

Total market share could add an incremental $3 billion of EBITDA for Novo shareholders by 2016. Novo's current product portfolio seems to offer the potential for 15% annual EBITDA growth, for some years to come. Commercialization of NN5401 or NN1250 would make NVO the fastest growing large cap pharmaceutical firm on the planet.

In ten years, if either insulin is approved, NVO appears to offer "five bagger" potential from here.

Unlike many peers, Novo carries little pharmaceutical liability

If a drug does not have the potential to be an industry standard, NOVO management won't run it through the clinical trial basis. The firm also has no reservation about scrapping drugs in the early testing phase. This has been proven again. In the most recent quarter, a promising compound was dropped.

When a drug company cancels a research project in the testing phase, this results in an immediate expense against the current years earnings. This is generally punished by analysts. Perversely, legal settlements are often considered to be "one time" items, and are therefore ignored by analysts.

NVO has demonstrated that it is willing to take the ethical high road. Accordingly, the company's litigation docket is the lightest of any major pharmaceutical firm that I follow.

On a historic basis, the shares are inexpensive

Novo is a quiet global success story. According to Yahoo, only 2 Wall street firms now report on NVO. Yet, in the past five years, investors have almost tripled their investment value, when dividends are added to the total return. That said, the shares are presently selling at the same EV/EBITDA ratio as in 2003. This is because the company's sales and EBITDA have grown proportionately.

Eli Lilly and/or Sanofi-Aventis may ultimately be forced to launch a takeover bid

I don't normally comment on the potential for takeover with any stock, as they seldom come to fruition.

In the short term, potential commercialization of Liraglutide appears to place Lilly at a clear disadvantage. In the mid term, NN5401 and NN1250, if successful, could totally destroy the high profit insulin franchises of Novo's competitors. Lilly, in particular, has lost considerable market share in the past decade. Without a competitive product, the only defense against a category killer, is a high cost friendly takeover.

Posted by Randolph McDuff at 08:37 PM | Permalink

It's all relative . . .

The quarter ending September 30th, 2008 was certainly a tumultuous time. Irregardless of whether a "long only" manager maintained a value philosophy, a growth philosophy or growth at a reasonable price methodology, the outcome was the same; a down quarter.

It also made very little difference as to whether one was in large cap or small cap. The only differentiation between portfolios was based upon the percentage loss incurred in the quarter. Global investors, both personal and professional, went into net redemption mode.

RMG#1 has a global focus. The portfolio posted a loss of 14.3% for the quarter ending 09/30/08, and was down by 19.36% YTD.

I appraise the relative success, or lack thereof, against similarly configured publicly available mutual funds with a global theme, in similar cap weights. These peers include:

Trailing Returns as of 10/1/08

Returns assume reinvestment of dividends and distributions. Performance data quoted represents past performance. Past performance is not a guarantee of future results. Investment returns and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted.

1. All returns as of October 1, 2008
2. Mutual fund returns from Morningstar
3. RMG1 returns are from a model portfolio managed at www.marketocracy.com using virtual money. Returns include virtual transaction fees of 5 cents per share and virtual annual operating expenses of 1.95%

Among global portfolios with a larger cap focus, Morningstar reports that the representative fund in their coverage universe lost 27.72% YTD, as of September 30th, 2008. The Morgan Stanley Capital International Index, known as MSCI EAFE (developed) was down 29.26% YTD on that date.

The larger cap portfolio RMG#1 has maintained its #1 status among peers YTD. I am quite certain that none of the managers, me included, are impressed with the absolute negative returns posted year to date. Most of the managers in this class have exhibited minimal turnover of their holdings, since the end of the last quarter. This seems to imply that they are very much standing pat with their investment selections, as am I.

During periods of market volatility, investors can sometimes second guess themselves, and fall prey to panic, or media hype. The media has a 100% track record in reacting to events. However, the media's interpretation of such events, and predictive ability for the future, is not nearly so clear.

I believe that economic recessions have one great virtue. During periods such as now, truly world class companies become abundantly obvious to all. Poorly run firms, ordinary firms and many fine firms don't meet EBITDA and revenue expectations during downturns. Sometimes, earnings are met, but only with an * being attached to their financial statements, which is every bit as bad as a miss. However, there are companies in each and every economic cycle, which beat targets, and sometimes raise them.

At times such as now, I look to identify these corporations, potentially for inclusion in a portfolio. Businesses capable of beating expectations during tough times often become multi-baggers when economies revert to growth.

Here is a summary of the top three investment position in RMG#1 with my long term outlook. In addition, I am including a quick layout of what I feel are the key criticisms that generally represent the bearish thesis on each company.

Mastercard Inc (nyse: MA)

A. Mastercard (MA-NYSE $171.34). I consider Mastercard to be a global company, as more than 50% of its revenue is derived outside of North America. The company earns fees for processing transactions on its system, and has no direct exposure to bad debts or credit collections.

There are roughly 131 million shares outstanding, and the company had net liabilities on June 30th, 2008 of $3.04 billion. This produces an EV of $25.5 billion.

Mastercard, in my view, is a cash generating machine unlike few in the world today. The company has sustaining capital expenditures which appear to be less than $100 million per year. EBITDA for 2008 could exceed $1.7 billion, which prices the stock at 15X the current years EV/EBITDA ratio. Provided that the secular trend continues, MA could generate as much as $2.1 billion of EBITDA in 2009, for a ratio of 12X my 2008 estimate.

The shares were initially floated to the public at a ridiculously low valuation. MA rose quickly as investors became aware of the growth potential based upon the secular trend towards debit/credit usage vs. cash.

Mastercard shares have come down rather hard in the last quarter. The bearish case centers on the credit crisis, and valuation. In terms of the crisis, discussion centers on the possible slowdown in the growth of credit and debit card transactions by consumers. European, Asian and South American use expanded at anywhere from 15%-20% in the first half of 2008. In the US, volume growth was much lower. Should volume growth slow, EBITDA growth will also slow. This might result in further compression of the share price (valuation).

While I understand the bear case, even detractors can't see volumes NOT growing. Bears and bulls simply disagree as to the rate of future volume growth.

My ONE key concern is the possibility of some short term collateral damage, should Visa come up short on their forecast. Visa generates a far greater percentage of revenues from the US than does Mastercard. Visa also generates a very high percentage of volumes from California, which might be harder hit than other markets from the credit crisis.

Myself, I estimate that by 2018, at a 10%-12% rate of annual volume growth, MA could generate as much as $7 billion of EBITDA in that year. If the market continues to value the stock at 12X- 15X EBITDA, MasterCard could have an enterprise value of $84 billion-$105 billion at that time. I forecast up to $39 billion of EBITDA may be earned in that entire period, which greatly exceeds the market cap. In short, I believe that MA has the potential to be a multi-bagger for patient investors.

Novo-Nordisk A/S (nyse: NVO)

Novo-Nordisk (NVO-NYSE $52.91) is the world's leading pharmaceutical firm specializing in the treatment of diabetes. Headquartered in Denmark, NVO has a 53% (and growing) market share of the worldwide insulin market. In the US, Novo's market share is 42%. Diabetes care products accounted for roughly 73% of 2007 sales. The firm also has core strengths in hormone replacement therapy, haemostasis and growth hormones. Revenue could touch $9 billion in 2008 and $10 billion in 2009.

There are 623.5 million shares outstanding, for a market cap of $33 billion. NVO has net liabilities of just $1.25 billion, which produces an EV of $34.25 billion. I forecast that NVO may generate more than 2.8 billion of EBITDA in 2008. This may rise to $3.2 billion in 2009. This prices the shares at 10.7X my 2009 EV/EBITDA ratio, a four year low.

US sales of insulin products were up by an impressive 21% in the first half of 2008, a rising US dollar could materially bump revenues and earnings for the better. Novo generates roughly 53% of total revenues from North America. In local currencies, revenues were up by more than 13% in the first half of 2008. This reduced revenue growth somewhat for the first half of the year. However, for the quarter ending September 30th, 2008, the US dollar appreciated vs. the Danish krone. In early August, NVO raised earnings guidance by almost 10%, over their prior forecast. Since that time, the dollar has strengthened further.

EBITDA margins now exceed 30%, and have been rising year over year for quite some time. Novo has a potential diabetes blockbuster drug, Liraglutide, awaiting FDA approval, which may materially add to revenue and profit.

Bears, of which there appear to be few, tend to focus somewhat upon valuation. NVO has a flawless balance sheet, with little of the litigation that dogs most large pharmaceutical firms. Accordingly, the shares have tended to trade for a modest premium to peers in the marketplace. Detractors also appear concerned about difficulties experienced by a competitor, with an existing drug in the same class as Liraglutide.

I consider the modest premium valuation to be well deserved. Corporate governance is world class. NVO historically has quickly scrapped products that don't appear to be safe and effective, in the testing phase. This is why litigation is so light. I see few reasons to doubt management' current assertion; that Liraglutide is safer and more effective than the current standard. NVO seems to have gone above and beyond in its testing process. When/if the FDA clears Liraglutide for US sale, 2009 and 2010 earnings will need to be bumped up rapidly. If I am wrong, a company growing revenues by 10% + per annum, featuring 30%+ EBITDA margins still seems an impressive value at the current price.

Guangshen Railway (nyse: GSH)

Guangshen Railway (GSH-NYSE $26.03), is my top pick on the infrastructure and transport growth story in China. Guangshen operates high speed and normal freight rail lines in a heavily industrialized region of China. In mid 2007, GSH completed a major expansion of their high speed rail lines. In January 2007, management also purchased a sizeable trunk line from the Chinese government. The effective price was less than 8X EV/EBITDA. This purchase added a significant freight hauling business as well as long distance passenger revenue. Shares were sold to Chinese investors on the Shanghai stock exchange in December 2006, to raise the cash for the railway acquisition.

By my calculations, GSH had invested more than $450 million in the past 4 years to build its new high speed rail lines. This was paid for with internally generated cash flow. With the lines completed in 2007, management needed to purchase rolling stock to utilize the additional capacity. GSH added $375 million of debt in the last year, for the purchase of new train sets. Most of these were placed into service in early 2008.

There are 141.7 million shares outstanding, which creates a market cap of $3.7 billion. On June 30th, 2008, GSH had total net liabilities of $446.5 million. This produces an EV of $4.1465 billion. I estimate that GSH may generate $477-$500 million of EBITDA in 2008, and $515-$540 million of EBITDA in 2009. This effectively values the company at 8.7X the 2008 ratio, and less than 7.4X-7.8X my 2009 ratio.

The bearish sentiment on GSH comes from a sector dislike of China, coupled with the potential for additional competition from rails and bus in China.

I would note that as the Chinese stock market is off a whopping 65% from the 52 week high, there can't be many foreigners left in this sector. With GSH down by roughly 24% on the year, the shares have held up relatively well.

As to competition, with Chinese growth in both traffic and freight seeming to be a clear secular trend, there appears to be plenty of market share for all. In the next year, as the train set purchases are paid down, Guangshen should find itself with a very healthy cash flow to pay for more rail line assets, should they become available.

This is the only publicly traded railway in China with shares listed overseas. As I intend to benefit from the long term secular trend, Guangshen is the obvious choice.

At the current price, American investors are effectively paying less for GSH, than $27.45 US price paid per share by Chinese nationals in the secondary issue of almost 2 years ago. The shares now sell for a discount to North American peers, on a forward EV/EBITDA basis.

In closing, the media would have us in the throes of a pending great depression. This is exactly the same talk that I heard in the last several recessions. Recessions, while unwelcome, represent an inevitable part of the investment cycle. At their worst, recessions typically DELAY, but do not cancel, the progression of clearly defined secular trends.

In the weeks to come, I intend to provide my thesis on other holdings within the account, so as to bring investors up to speed with my approach and methodology. I look forward to sharing these views with you.

Regards,

Randolph

Posted by Randolph McDuff at 07:46 AM | Permalink

This is a commentary from Marketocracy on Randolph McDuff's RMG1 model portfolio

When selecting a manager, we always look at their largest positions, particularly when they represent a large portion of their portfolio. We like to know what their track record is with those stocks: how they've traded them, whether it is in their "performance zone" or not and what they see in the stock.

mFOLIO Master, Randolph McDuff's two largest positions are Mastercard Inc (nyse: MA) and Novo-Nordisk A/S (nyse: NVO) currently representing about 30% of the portfolio. Randolph writes about these two stocks, along with his third largest position, Guangshen Railway (nyse: GSH) in his Q3 Review above.

Below is a chart which details McDuff's trading of Mastercard since he started buying it just after its IPO in May 2006. You'll see that to keep MA from becoming too large a position as it skyrocketed to a six bagger, McDuff has made astute sells on jumps in the price including right near the all-time high. But as MA has dropped in price with the credit crisis - losing more than half of its value, McDuff has held on. This is very much in keeping with his investment style and you'll see from his interview in MarkeTalk and in his Q3 Review why he continues to like Mastercard and expects to keep it as a long-term position in his portfolio.

In the chart above, the stock price of Mastercard is shown as a BLUE line with the prices shown on the far right vertical axis. The number of Mastercard shares owned by McDuff in RMG1 is shown as a RED line with the values shown on the far left vertical axis. The GREEN Shaded vertical bars represent the dates when McDuff was BUYING more shares of Mastercard and the RED Shaded vertical bars represent the dates when McDuff was SELLING shares of Mastercard.

Posted by Randolph McDuff at 07:52 PM | Permalink

Ecopetrol ADR (EC-NYSE $23.65) 3.1X forecast 2009 EV/EBITDA

All amounts are quoted in US. The conversion rate from Columbian Pesos to US dollars on September 29th, 2008 was $.0004784. 1 US dollar =2090.5 COL pesos

Shares outstanding: 1.55 billion
Total liabilities short term cash on 12/30/2007: .71 billion.
Enterprise Value: 09/29/2008: $37.35 billion.

EBITDA generated in 2007: 9.6 billion.
Trailing 2007 EV/EBITDA ratio: 3.9X

Forecast 2008 EBITDA: $13 billion
Est. 2008 EV/EBITDA ratio: 2.8X

Forecast 2009 EBITDA: $11 billion.
Est. 2009 EV/EBITDA ratio: 3.X

American Depository Receipts of Ecopetrol (EC) have recently been listed on the NYSE. Each ADR represents 20 underlying shares of Ecopetrol common shares, which trade on the Columbian stock exchange. The shares were issued to Columbian citizens pre-market at $13.40 US. Since listing, the underlying EcoPetrol shares have traded in a 52 week range of $20.20-$33.00 US. The ADR of Ecopetrol started trading in North America on September 18th, 2008

Previously a government enterprise, Ecopetrol shares were floated to the public on November 28th, 2007 on the Columbian stock exchange. Each Columbian was limited to about $700 of initial investment at the time. The Columbian government still holds more than 89.9% of the total capitalization.

Ecopetrol was listed on the NYSE to provide a more liquid market than the Columbian stock exchange could offer. The company intends to create an international profile in line with companies such as Petrobras. Ecopetrol reports 1.45 billion barrels of 1P oil equivalent reserves (1.8 billion barrels including 2P). Other assets include 2 refineries with the capability of processing 270,000 bpd, 8400 km of pipelines and petrochemical facilities. Oil and natural gas production averaged 399,000 boepd in 2007.

http://www.ecopetrol.com.co/documentos/41350_Presentacion_19_Congreso_Petrolero_Mundial__julio_02-2.pdf

Ecopetrol is virtually debt free, reporting just $708 million of net liabilities on 12/31/07. Among oil companies its size, ECO has arguably the strongest balance sheet in its class.

Management intends to boost oil production from 399,000 boepd in 2007, to 1 million boepd by 2015.

All oil companies tend to talk up strong production growth potential, which is seldom realized. For a major to forecast an 18% plus annual production growth rate in the next 8 years seems almost absurd.

Ecopetrol however, has a unique operating advantage over many oil companies in South America. The firm can back into almost any new discovery made in Columbia, to a potential 30% holding. This trigger can occur when EC pays all costs incurred to the point where a discovery is declared commercial. Columbia boasts a low royalty regime (5%-25% of production). Corporate taxes are currently 33%, and have declined sharply in Columbia for the past 5years. This attractive fiscal regime has sparked renewed interest in this oil prone country. Too, Columbia has large heavy oil deposits which are likely to be exploited in the years ahead. The geography is quite similar to Venezuela, which has substantial heavy oil deposits.

The attractive fiscal regime, heavy oil potential and development initiatives underway in key oil basins, give me confidence that EC is likely to grow production materially in the years to come. A 150% increase does seem to be a stretch, but review of the field potential does suggest a potential doubling of production over the forecast period.

Thus far, as a public company, Ecopetrol has made good on their goals. In the first half of 2008, output rose to 438,000 boepd. This compares to the 399,000 boepd produced in 2007, a gain of 9.8%.

http://www.ecopetrol.com.co/english/documentos/41492_Ecopetrol_en_cifras_Junio_08-ingles.pdf

Management intends to boost recovery factors from existing fields using improved technologies. Too, Ecopetrol intends to take a more active interest in exploration and development, in and around, key underexploited fields. It does not seem unreasonable to suggest that 2P reserves might grow to almost 3 billion barrels by the end of 2015.

Refinery capacity and petrochemical output is forecast to grow dramatically in the next 7 years.

Management intends to double refined output by 2015. Petrochemical production growth of almost 475% is planned in this period.

Provided that oil remains in the $90-$100 bpd range for the next 7 years, internally generated cash flow should pay for this expansion.

A better known peer, Petrobras, intend to increase output by about 1/3 in the next 7 years, but might need about $250 billion of external capital to meet this goal. Ecopetrol intends to spend about $60 billion in the next 7 years, with a view towards more than doubling in size. This will be less than forecast EBITDA, which suggests minimal need for external capital funding.

The shares seem very inexpensive on an EBITDA basis.

Ecopetrol generated $8.99 billion of EBITDA in the first half of 2008, up from $5.1 billion in the same period of 2007. Oil prices have moderated since Q2, but are still higher than in 2007. Should oil prices remain in the $90-$100 per barrel range for the balance of 2008, EC may generate as much as $13 billion of EBITDA in 2008.

The balance sheet appears to be improving. Capital expenditures are forecast to range from $4.1-$4.6 billion for 2008. As this is less than half of forecast EBITDA, EC may report a positive net cash balance at the end of 2008.

It clearly appears that the windfall profits from high commodity pricing are over for the industry.

Most global oil companies grew EBITDA rapidly in the last 24 months based on extraordinary pricing of oil. Production growth in large caps was largely stagnant. Now that oil pricing has moderated, the majority of large cap exploration and production companies will begin to post declining quarter over quarter comparisons. In short, the market will now start to become highly selective.

Companies that look capable of outperforming their peers will need to be low cost producers, in lightly taxed jurisdictions, with clearly defined growth prospects. Ecopetrol seems to fit my criteria nicely. Columbia, while virtually unknown to investors, boasts a declining corporate tax rate (33% for 2008) and royalty rates of 5%-25%. I believe that the Columbian economy has excellent macro potential overall.

While EC will not match 2008 EBITDA forecasts in 2009, the shares seem awfully inexpensive on all valuations. Oil prices are such that conventional producers will make strong profits. Shale oil and shale gas producers, with their extremely high capital costs and low productivity, will not be so lucky.

Spotting a potential multi-bagger early always invites the wrath of sceptics.

The company looks like an early version of Petrobras (PBR), which I purchased way back in the 1990's. Then, I took plenty of flack from the professional investment community, for purchasing shares of a third world oil company operating in a leftist country. Considering my country of origin, this seems deeply ironic.

Now, PBR is an integral part of most international oil portfolios and Brazil has a larger economy than Canada. Many of these experts who refused to acknowledge the thesis early on, now feel quite comfortable calling PBR a buy, at prices more than 15X above my initial purchase price.

Ecopetrol is NOT a suitable investment on a stand alone basis.

The shares are completely unknown to the public, and are not liquid at present. 89.9% of the stock is tied up in government hands. At best, a further 9.9% of the shares might come to market someday. Further, the stock started trading at a precipitous period in the markets. Improved institutional attention will NOT be forthcoming in the near term. As the firm should require minimal capital from external sources, brokerage firms will not pay any attention to the ADR.

Ecopetrol should only be considered as an extremely long term investment and should be no more than a modest portion of a well diversified global account. That said, I predict Ecopetrol will one day be a widely held investment in oil accounts, much like Petrobras. I will be happy for broadly based markets to inevitably arrive at my conclusions, and will be soon adding shares for the Marketocracy large cap account.

My 7 year forecast hold period might be made more comfortable with a decent dividend. Based upon 2007 results, EC paid out a basic dividend of $.80 US per share, a 3.3% dividend rate. Provisions exist for a bonus payout annually, which added a further $.60 US per share, or 2.5%, to the 2007 amount.

Plenty of oil companies pay dividends far above this rate. However, the cushion of safety at most is inadequate, when oil is $90 per barrel and gas is $7 per mcf. With a highly conservative balance sheet, Ecopetrol's basic rate could grow steadily over time.

The corporate website, in English, may be found by linking here:

http://www.ecopetrol.com.co/english/

Posted by Randolph McDuff at 07:41 PM | Permalink

Editors Note: This analysis was presented by mFOLIO Master, Randolph McDuff at a gathering of the m100 on October 6, 2007 when MA was trading at $153. In Q2, 2008 MA reported a loss due to a settlement with American Express. Excluding this charge, revenue grew 25% and earnings 9%. The stock is now trading at $230 and is still RMG1's largest holding.

MasterCard (nyse: MA)

MasterCard manages and licenses out the MasterCard, Maestro and Cirrus payment systems to third party users. Revenue is a combination of transaction processing income through the MasterCard interchange systems, assessments on gross dollar value (GDV) run through their systems, gateway fees and licensing fees. Revenue is earned globally, with roughly 52% of total income earned from the United States.

MasterCard is my preferred play for growth in global commerce

As one of the two major global credit card processors, MasterCard is uniquely positioned to earn revenues which should at least match worldwide growth. MasterCard reports 750 million active accounts globally.

MasterCard also should participate from a global shift towards "non-cash" payments.

Growth rates for MasterCard are impressive

Statutory filings report growth rates 2x - 3x higher than each regions' GDP, for all markets that MasterCard competes in.

3 month growth (in local currencies) for the six major markets that MasterCard operates in, for Q2 ending June 30, 2007 were as follows:

In addition to growth in transactions, cash volumes also grew sharply in each region. The exception was in the United States, where cash transactions were essentially flat in the second quarter of 2007.

MasterCard should generate more than 1/2 of total revenues from outside the U.S. as soon as Q1, 2008

MasterCard is now accepted in more European locations than the U.S. Asia should also have a higher acceptance rate than the U.S. By the end of 2007. At that time, MA may be considered a truly global company.

There is NO representative peer group

The only company that appeared close to being a peer, First Data, was recently taken private by KKR. EBITDA margins of 22% for FD greatly lagged that of MA. The takeover was priced at an effective rate of 16.8x EV/EBITDA.

First Data differed somewhat from MA, inasmuch as FD paid for access to the MasterCard and Visa interchange networks. In short, First Data was as much a "client" of MasterCard as any other credit card firm.

Investors occasionally place MA into a group with American Express and Discover

This is wholly incorrect. While AXP and DFS participate in interchange networks, MA DOES NOT issue credit cards, extend credit, determine interest rates & other fees, or establish merchant discounts. AXP and DFS also lack the international penetration of MA.

DFS ($21.77): 87.7% U.S. Revenue. 98% of operating income is tied to the U.S. Economy. Loan losses were 17.1% of total revenues in the 2nd quarter of 2007. Discover loses money from international operations and lacks a comprehensive international interchange network. Consequently, DFS pays MA and VISA for international access, just like any other client.

According to most recent GAAP balance sheet, it appears that DFS is selling for 13.2x my 2007 estimated EV/EBITDA. I would note that the balance sheet is virtually impossible to work through on a representative basis. The firm does not segment securitization revenues, but I estimate that they are at least 2x higher than AMEX.

Discover produces 2 balance sheets in each quarter; one assumes the sold portfolio is retained (which appears better than GAAP results). One complies with the basics of GAAP, but is very light on detail. DFS emphasizes the results of the retained portfolio, which is not GAAP compliant.

My impression: a bad read. In my experience, opaque balance sheets are generally hiding something from the public. I believe that Morgan Stanley spun off DFS at the high, with a clear understanding that business was turning for the worse.

AXP ($60.63): Sells for roughly 11.4x my estimated 2007 EV/EBITDA. 72% of revenues are U.S. 54.7% of operating income derived from the U.S. Securitization income accounts for 9.8% of total revenues. Loan losses were 15.4% of total revenue (1st half of 2007). Interestingly international loan losses were just 10.2% of foreign revenues. EBITDA margins were 17.8% of revenues in the first half of 2007. AXP also produces 2 balance sheets, but places more emphasis on GAAP results.

The firm still does not fully segment travel related operations and private banking from credit card operations. These are a larger component of AMEX than one would think, and may obscure loan losses as a percentage of total revenues.

My impression: I have followed AXP on and off for the better part of 20 years. Financial reporting has vastly improved over that time. A better read than in years past.

MA ($153): sells for roughly 14.5x my estimated 2007 EV/EBITDA. EBITDA margins were 36.8% of first half 2007 revenues. I removed a sizeable non-recurring payment in the second quarter to arrive at my EBITDA margin. 73% of revenues were based upon transaction processing, and 27% of revenues were earned from various assessments based upon the GDV (gross dollar value) of charges run through the interchange networks as well as licensing and "gateway" fees.

U.S. Dollar revenues were 51.8% of total revenues in the last quarter. Revenues were roughly .0024% of purchase volumes. 42.5% of MasterCard accounts are U.S.

My impression: The balance sheet is a top notch read.

The lack of peers means that MasterCard coverage is problematic for a largely "reactive" Wall Street

17 analysts (according to Yahoo) remain nicely scattered with recommendations. There is an 11% difference in the analyst mean recommendation for 2007. The mean difference grows to almost 15% for 2008, suggesting some analysts are actually doing homework, and some aren't. Price targets range from a low of $88 to a high of $190.

Competing technologies will have a difficult time eroding the MasterCard's franchise

Recently, some discussion has revolved around the potential for displacement of traditional credit card processors (such as MasterCard and Visa); by "alternative" suppliers, such as Paypal, Amazon, and "Revolution Money." In point of fact, some of these "competing" technologies represent new clients for the MasterCard system.

My review of the industry suggests that structural barriers should limit alternative supplier penetration in the general market. The alternative suppliers go after the merchant to generate revenues, but make limited efforts to attract banking systems that represent "gatekeepers" of the interchange.

Without full partnership of banks (i.e. Revenue splits at least as lucrative as the banks presently have with credit card processors), the business model will have a hard time scaling to the mass consumer, mass business level. Alternative payment system operators are not new, and have come and gone in the past.

Due to economies of scale enjoyed by the Visa-MasterCard duopoly, it is virtually impossible for new competitors to compete on price

While small merchants often complain about charges, the formula to determine fees is complex. Most of the "charge fees" are earned by merchant banks and suppliers. MasterCard earns a modest tolling fee of just .0024% of purchase volumes. New firms such as Revolution Money intend to charge gross fees of 0.5% to merchants. However, the lack control over "push fees" (among other charges) which move money to bank accounts from business.

Paypal fees (across the board) are equivalent or higher than MasterCard and Visa. Small merchants (less than $3,000 per month) pay 2.9% + $0.30 per transaction. The lowest fee ($1,000,000 per month of sales) is 1.9% + $0.30 per transaction. According to data supplied by Ebay, overall Paypal net transaction charges as a percentage of total payment volume was 3.7% in the first half of 2007. As this fee is virtually unchanged from 2006, one can assume that 3.7% represents the aggregate cost of using Paypal.

Finally, since many consumer Paypal accounts are funded with credit cards, companies such as Visa and MasterCard remain fully in the loop, earning their interchange fees.

VISA's public aspirations for 2008 should be good for comparative analysis

Intuitively, I think that VISA will increase investor interest for MasterCard. Evaluations to an incorrect peer group should finally be put to rest.

MasterCard has been considered a "first mover" in many fronts, primarily in Europe and Asia. Comparisons with Visa will likely be favorable.
As a private company, VISA does not break down financial figures. However, industry sources suggest that MA has been gaining market share on a global basis, and has absolute dominance in European debit cards.

MasterCard has a strategic investment

MA owns 4% of the stock of Redecard SA. Redecard is a publicly traded MasterCard equipment provider and service provider to financial institutions in Brazil. This holding has a market value of $450 million U.S. And is recorded on MA's books at the historic cost of $12.9 million.

Harmonization of the European debit card systems should be a major plus by 2011

French residents cannot pay for a purchase in Belgium with a debit card. This is because uniform standards for payment processing at the bank level do not exist. The European Union has mandated that a national system be implemented by 2010. The "Single Euro Payments Area" or SEPA will adopt one system for clearing both debit and credit charges and payments in a uniform and timely fashion.

The Maestro systems now in place at MasterCard have been designed expressly for this purpose. Visa does not have a competing system capable of meeting SEPA standards in place, and appears several years away from doing so.

The credit crunch may have produced unintended benefits for MasterCard; that being a reduction of potential competition

A small group of individual banks had discussed setting up their SEPA standardized debit system in Europe, so as to try and compete with Maestro. However, recent credit turmoil and apparent mutual distrust on counterparty obligations have left banks wary of one another. The capital cost to develop a competing system could be significant. Such a system may never to market. As a result, I suspect that upfront costs for a competing debit card system won't get past capital allocation departments at major banks.

Conclusion

Investors interested in MasterCard should be willing to accept that misperceptions will persist until/if Visa goes public. As part of a global duopoly, a public peer for comparison will then truly exist.

I own MasterCard, for duopoly profit margins and an outstanding business model. High EBITDA margins earned at MasterCard do not come at the expense of merchants or consumers. They are earned via an efficient business with global economies of scale.

Member banks earn the overwhelming majority of profit from MasterCard relationships, but also take on most of the business risk. This provides both MasterCard and merchant banks with mutual incentives to vigorously expand the franchise. As a result, I do not consider competing technologies to be a credible threat for the business model.

MA appears to be at the forefront of a European SEPA payment program. If SEPA is enacted using the Maestro system, future growth would accelerate.

MasterCard represents the largest investment position of RMG1. I endeavor to purchase world-class companies for less than 10x forward EV/EBITDA. This suggests that a new entry point for MA would be $127 U.S. Or better. Macro developments in Europe and Asia suggest that EBITDA may surprise on the upside, and I prefer to overweight Europe.

Posted by Randolph McDuff at 11:00 PM | Permalink

Rapid Growth potential with a Kazakhstan E&P

BMB MUNAI (AMEX-KAZ, $6.95)

Investors seeking an international junior oil producer with rapid growth potential should consider an investment in BMB Munai. This company has a 100% interest in a 460 square kilometres concession in western Kazakhstan, known as the ADE block. This block is located within 28 km of oil pipelines and is fully covered with modern seismic undertaken in 2003. Infrastructure, rail and roads allow the firm to quickly bring oil production to markets. In addition, BMB has the right to explore an adjacent area known as the "extended territory".

The ADE block consists of carbonate Triassic formations, typically found at 3100-3800 metres (10,161-12,500 feet) below surface. Exploration drilling at the ADE block to date has proved up two oil fields, known as Aksaz and Dolinnoe fields. To date, a total of 8 wells have been drilled at these fields. Production from 4 Aksaz wells to date average 216 bpd. The 4 Dolinnoe wells have produced an average of 99 bpd.

Investors have found some Kazakhstan oil plays to be a frustrating experience

Kazakhstan exploration and production companies have sought to develop both sandstone reservoirs and carbonate reservoirs. There has been a clear correlation between the success of a junior in Kazakhstan and the type of oil reservoir targeted for development. Historically, companies in Kazakhstan that developed sandstone reservoirs generally grew production steadily, were highly profitable and eventually were bought out.

Kazakhstan companies that develop oil production from carbonate reservoirs have, on the other hand, often experienced difficulties in trying to coax oil flows from the "tight" shale like deposits. Wells plug up frequently and are tricky or expensive to stimulate. Production can be highly erratic. Some juniors find carbonate reservoirs to be problematic, and financial results have been disastrous in certain cases. Accordingly, sophisticated investors prefer sandstone reservoir producers.

BMB's newish discovery has the potential to be, by junior standards, a "company maker"

Until 2006, BMB was considered one of the "carbonate" companies, and traded at a steep discount to global peers based upon reserves. The discovery of a sandstone reservoir in the Kariman prospect may have changed fortunes for the better. A total of 6 wells have been drilled over the past 2 years in a relatively uncomplicated sandstone formation. Average production has been surprisingly good, at 528 bpd per well. BMB intends to drill at least 4-6 more wells into this structure within the next 12 months. I am confident that equally high levels of productivity might extend to future wells in the Kariman field.

Proven reserves are likely to grow rapidly in 2008

BMB reported 14.95 million barrels of proven reserves in 2007, which included 2.7 million barrels attributed to one successful Kariman well.

Since that report, a total of 5 more Kariman wells have been drilled. All were successful.
Probable and possible reserves attributed to Kariman were 20.1 million barrels in 2007. A shift of some of these reserves to the proven category should have occurred in 2008, based on this success.

Production looks to be on a steep growth curve, albeit from a modest base

In 2006, production averaged 624 bpd. Average production for 2007 was 882 bpd. For the fiscal year ending March 31st, 2008, it appears that production averaged 2400 bpd.
This year, production might average 3700-3800 bpd. Next year, I forecast 5600-5800 bpd of average production. In 2010, production could surpass 10,000 bpd.

EBITDA looks to be increasing at an equally fast pace

I report a fully outstanding share count of 55.6 million shares. I include a variety of "in the money" options, warrants, share grants and a $60 million convertible debenture that verges on being "in the money". BMB has net liabilities of 10.4 million, after assuming conversion of the debentures. This results in a current enterprise value of $391.2 million.

For fiscal 2007, EBITDA was $2.5 million. In 2008, EBITDA was approximately $38.7 million. For 2009, EBITDA could surpass $61 million. At this level of EBITDA, capital expenditures and SG&A look to be about fully met. In 2010, EBITDA could surpass $90 million.

Based upon my forecast, BMB is selling for roughly 6.4X my 2008 EV/EBITDA ratio and 4.3X next years' forecast EV/EBITDA ratio. This represents a discount to valuations for 11 other international junior E&P firms in my sample.

Management's interests seem to be fully aligned with common shareholders, a rarity in Kazakhstan

BMB is considered to be the first public oil and gas company listed in the US that is operated and controlled by Kazakhstan citizens. Management and insiders control roughly 34% of the outstanding common shares. BMB's CEO is Boris Cherdabayev, a well known member of the Kazakhstan oil community. The Cherdabayev family has ties with many of the leading public and private companies now operating in Kazakhstan.

As a largely Kazakhstan company, BMB may be better prepared to operate in the Kazakhstan oil business than foreign run firms. Unlike many junior oil and gas firms that I have followed in Kazakhstan, I am impressed with management's attention to detail during the exploration and development stages of the field concession. Often, juniors take shortcuts in their efforts to quickly get production flowing. In Kazakhstan, shortcuts generally cost a firm its concession. A rigid oil ministry often pulls licenses for failing to comply with exploration contracts to the letter. When this happens, local Kazakhstan firms readily swoop in and claim potentially valuable assets for themselves.

BMB, thus far, has taken great pains to exceed all terms and conditions of its concessions, at the expense of short term production growth. Many of the ADE and extended territory wells can produce from multiple horizons. Management carefully tests all productive zones and shuts in wells periodically to satisfy conditions spelled out by the government. Current rates are being reported from just one zone in each well. It seems clear to me that rates from all fields will jump during the production phase.

One caveat to this story is that tax rates for BMB will jump dramatically in the latter half of 2009

Investors should note that oil producers in Kazakhstan are required to sell 20% of all oil production to local markets, at local prices. This is priced at 25%-27% of quoted Brent. Remaining output may be exported at world prices.

All export production in Kazakhstan is now subject to a recently imposed export tariff of $14.95 per barrel. BMB export sales also have freight and shipping charges of $14.15 deducted from quoted Brent prices.

BMB presently pays a modest royalty (2%-6%) on production, as the firm is in the exploration phase on its oil fields. Production licenses are to be sought on July 9th, 2009. Upon conversion of the concessions to a production license, the fiscal terms change considerably. In addition to increased royalties, an export rent tax, based upon a sliding scale will apply during the license phase. At current prices, this tax is 33%.

To put this into simple terms; while in the exploration phase, BMB should receive roughly 63% of Brent benchmark prices for its output.

For all of 2009, taking into account that BMB will have lower taxes until July 9th and higher taxes thereafter, the firm should receive an average of 54% of Brent benchmark in that year.

In 2010, after the license agreement is fully in force, BMB should receive roughly 46% of world prices after all government taxes, levies and shipping charges apply.

In order for BMB to simply remain as profitable in the license phase as they are at present output will need to increase by 36%, or 1332 bpd. For many junior companies in Kazakhstan this would represent a real challenge. As I estimate that BMB's oil output may grow by a further 6300 bpd over the next 24 months, the new taxes should not be problematic.

It is possible that BMB will shortly become a self funded producer

In the next 24 months, accelerated development at Kariman might push total oil production from all fields to above 10,000 bpd. It is possible to envision 2010 EBITDA of $120 million. At that rate, BMB could dramatically step up development of all fields, without having to issue more shares or add debt.

BMB is my top Kazakhstan oil pick for US investors

Unlike a number of US junior firms which have "tried and failed" in Kazakhstan, local management at BMB is intimately familiar with the workings of the oil ministry. BMB has at least one uncomplicated field with some real upside (Kariman), which is all a junior generally needs to become self funding. Management also seems keen on the outlook for the Aksaz and Dolinnoe fields. I consider any potential success from these fields to be an added bonus. If production growth meets my forecast, BMB could be fairly valued at $15 per share, or 6.5X my 2010 estimated EV/EBITDA ratio.

I have recently purchased BMB for RMG#2 as an overweight position. To see my RMG#2 portfolio and performance, click here

Posted by Mark Taguchi at 03:39 PM | Permalink

A Global Food Giant that trades on the Pink Sheets

All financial figures are quoted in US dollars,. The conversion rate from Swiss Francs to US dollars at the rate of $.9921 was booked as of 03/25/08. All forecasts are solely that of the author, and may differ from published analyst estimates. The author owns shares of Nestle at the time of publication.

Blue chip investors seeking to capitalize on global growth trends should consider Nestle as a core holding within a diversified account. Over the next two years I forecast a rising stock price, driven by positive earnings surprises. A spin-off of a very valuable subsidiary is possible.

On 03/25/2008, Nestle had a market cap of $189.7 billion, and a trailing enterprise value of $243.1 billion.

Nestle is the world's largest food and beverage company

Key divisions include freeze dried coffee company, ice tea and bottled water. Nestle also produces infant formula, baby foods, dairy products, confectionary products, ice cream and pet foods (Purina). 70% of total revenue is derived from "billion dollar" brands.

2007 revenue was $106.7 billion. 2007 EBITDA was $18.1 billion, for a margin of 17%. Net profits for 2007 were $10.56 billion.

Business is truly global

Nestle has divisions in 103 countries. Europe generated more than 38% of total sales, and produced almost double digit revenue growth in 2007. The US and Canada (30% of total sales) showed revenue gains of 6.7% in 2007.

Russia, Australia and Brazil each produced 20%+ revenue growth in 2007, and accounted for more than 9% of total sales.

Top and bottom lines have grown organically and via acquisition. In July 2007, the Novartis medical nutrition business was purchased for $2.5 billion. In late 2007, Nestle added Gerber, the maker of baby foods, for $5.5 billion.

In 2007, Nestle demonstrated why its business is the envy of the industry.

Nestle noted that raw materials, packaging and energy costs rose by more than 23% during 2007. Many consumer products companies, particularly in the US, were unable to fully pass on costs to customers.

Management at Nestle was prescient. They correctly forecast commodity inflation for a few years out, raised prices quickly and hedged many inputs. The strength of the Euro has also offset a great deal of cost inflation.

2008 looks to be equally good

Nestle intends to increase sales by at least roughly 7% for 2008 and improve margins further.

Several European countries have reduced corporate taxes for 2008, some by whopping amounts. This should aid Nestl's net result.

All else being equal, earnings have the potential to increase by up to 17% for 2008.

In comparison to global peers, Nestle seems inexpensive

Pepsi sells for about 13.9X my 2008 estimated year end EV/EBITDA. DANONE sells for about 15.4X my estimated 2008 year end EV/EBITDA and has a revenue mix geographically similar to Nestle. Nestle shares sell just 11.9X my estimated 2008 year end EV/EBITDA.

Nestle has a strategic holding which may be spun off in the future

The firm owns 230.25 million shares of Alcon (ACL) with a current market value of $33.2 billion. Alcon is accounted for as a subsidiary, and represented 4.5% of 2007 revenues and 8% of EBITDA. Despite the modest contribution to Nestl's overall results, ACL represents about 17.5% of Nestl's current share price. It is logical to suggest that Nestle may divest Alcon at some point.

Nestle also owns 176.4 million shares of L'Oreal, worth $22.7 billion. L'Oreal sits on the balance sheet at a $7.9 billion value. The two firms have joint ventures that produce corticosteroids and cosmetic nutritional supplement.

What could fair value for Nestle be in 24 months?

My assumption is that EBITDA could touch $21.4 billion in 2009. Total liabilities-short term cash may fall to -$39 billion.

At 13X EV/EBITDA, a share price of $155 for Nestle is realistic. Add in the $3.03 per annum of current dividends, and an annual return of 15.6% through 2009 is possible.

Taking into account Nestl's growth prospects, I feel the firm deserves a valuation at least in line with Pepsi. Should my thesis prove out, a 24 month forecast share price of $170 is possible. With dividends, a total return of 21.6% per annum through 2009 is achievable.

A spin-off of Alcon by year end 2009, could add a further $18.5 per share to my forecast.

Nestle is underfollowed by Wall Street, underowned by global institutions & underheld by US retail investors

Oddly enough, for such a major company, Yahoo reports just 3 US brokerage firms which issue coverage. Therefore, it is certainly not widely held by individual investors in the US. S&P doesn't follow it either.

Institutional ownership accounts for less than 27% of the outstanding issue. 44% of these institutions are deemed to be "low turnover" funds.

The largest mutual fund position is held by Oakmark Equity and Income fund (OAKBX). This is a 5 star rated fund in the moderate allocation category. The fund has actually pulled a net positive return out of the market YTD and is gathering assets thus far in 2008.

The Vanguard Wellington fund (VWELX) is the second largest mutual fund holder of NSRGY in the US. They are also rated 5 stars in the US in the moderate allocation category. Once again, this fund looks to be gathering net new assets so far in 2008.

Nestle is my #1 pick in large cap food and beverage companies for 2008

Food and input inflation proved to be a shock for several consumer products companies in 2007. More than a few peers may continue to suffer negative consequences in 2008.

Furthermore, many non diversified North America peers struggle to avoid becoming little more than "off balance sheet" subsidiaries of Wal-Mart; whereby Wal-Mart demands and obtains lower prices from manufacturers, at the expense of operating margins.

Nestle, with a focus upon Europe and emerging markets, seems little impacted by the margin pressures imposed by Wal-Mart. As a shareholder, I'm pleased for that.

A 24 month return forecast of 15.6%-21.6% per annum, might seem unappealing to those yearning for headier times. However, Nestle looks to be one of the few firms capable of beating forecasts, in a tough operating environment. Should Alcon be spun off, total returns of 23.1%-29.1% per annum through 2009, are possible.

Posted by Randolph McDuff at 05:21 AM | Permalink

Canon Inc. (CAJ-NYSE $46.50): 6.5X estimated 2008 EV/EBITDA

Shares outstanding (fully diluted) 1.33 billion
Total liabilities cash & equivalents (est. on December 31, 2007): -$5.4 billion
Estimated 2007 Revenue: $39.9 billion US

Estimated 2007 exit EV: $67.2 billion.
Estimated 2007 EBITDA: $9.4 billion

Estimated 2008 exit EV: $64.8 billion.
Estimated 2008 EBITDA: $10.1 billion.

Estimated 2009 exit EV: $61.5 billion.
Estimated 2009 EBITDA: $10.7 billion.

Canon is a nimble giant in several important industries

Canon is one of the world's leading manufacturers of plain paper copying machines, digital multifunction devices, laser printers, bubble jet printers & cameras. The company also makes semiconductor equipment. Canon is THE world leader in the production of high definition television broadcast lenses. A medical products division manufactures
X-ray cameras, retinal cameras, autofractmeters and image-processing equipment for diagnostic systems. Canon pioneered digital radiography.

The stated corporate objective is for Canon to achieve #1 status in each of its core businesses.

Canon has a technological edge over many competitors in core industries

Canon has been consistently ranked as the 2nd or 3rd leading company in North America for patenting its technology. Accordingly, many competitors license out Canon patents. This produces a long lived royalty stream, which largely funds research and development expenses. Licensees include:

As well, Canon also has significant cross licensing agreements with the following companies:

Management feels that new products protected by seminal patents will not easily allow competitors to catch up with it. This should provide Canon with lasting advantages in establishing standards for these markets.

An impressive balance sheet contains many "little recognized" strengths

My financial analysis excludes more than $6 billion of marketable securities held by Canon. The firm also has a portfolio of long term investments in public and privately traded Japanese securities. These are held for strategic purposes. As such they are not marked to market.

Canon produces its products at 40 plants globally. The company owns all of the land and buildings where production is located. In Japan alone, Canon holds over 37 million square feet of commercial property. Outside of Japan, Canon also owns 10.6 million square feet of commercial property. Many of these properties have been depreciated to nominal values. In addition, Canon has recently opted to increase its depreciation charges, for the purpose of reducing taxable earnings.

Revenues are growing at a pace much faster than global GDP

In 2006, revenues exceeded $36.36 billion, and are forecast to exceed $39.9 billion for 2007. For 2008, revenues could exceed $43 billion. A modest growth assumption in 2009 produces a revenue estimate of $46 billion.

EBITDA growth has historically outstripped revenue growth. Accordingly, Canon has the potential to generate EBITDA of $10.1 billion in 2008, and as much as $10.7 billion in 2009.

Free cash flow appears to be substantial

Annual capital expenditures for 2008 are estimated to be $5 billion. Recently, Canon has applied surplus cash towards repurchasing more than 5% of the outstanding shares. This appears to be a highly productive use of funds at the current share price.

The capital generating capabilities of Canon are such, that the firm could increase its annual dividends by more than 10% per annum for the next 2 years, increase capital spending by more than 10% annually, and still produce more than $6.3 billion of surplus cash through fiscal 2009. Funds could be used towards additional share repurchases or debt retirement. Either use could accelerate EPS growth over the next 24 months.

Canon shares appear to be very inexpensive; both on a relative as well as an absolute basis

At the current price of $46.97, Canon shares are selling for roughly the price that investors paid back in April 2006. Since that time, the company has raised its dividend and retired $3.9 billion of stock. The firm has grown revenues, EBITDA and earnings since that time, by rates well above global GDP.

In light of Canon's global diversification, the discount may be unjustified

Perhaps investors are concerned about a US economic slowdown. If that is true, they could be selling shares in anticipation of a negative earnings impact for Canon. Tempering this view is the fact that Canon generates less than 30% of revenues from North America and South America. The percentage of revenue generated from the United States has been falling for several years now, while growth in other regions has accelerated. European revenues now make up more than 1/3 of the total, and have increased by almost 14% in 2007.

Consequently, as Canada, South American and European economies appear to be quite strong, a US led slowdown might have surprising little impact upon Canon's top and bottom lines.

Alternatively, investors in 2006 may have simply overpaid for their holdings, are unhappy with negative returns and are selling for tax losses. Should that be the case, their untimely loss could be driving Canon down to bargain prices. This should delight new investors.

I am now adding shares of Canon to my Marketocracy RMG1 mFOLIO as a core position

Irregardless of the reason(s) for the decline; Canon is selling for less than 6.5x my estimated 2008 year end EV/EBITDA. This seems an unduly large discount for a world class firm.

Management's conservative approach to financial accounting provides me with great comfort, with respect to the quality of Canon as a business. Based upon my forecast, I estimate that fair value could be $71 per share by the end of 2009. This would price the company at just 9X my estimated 2009 EV/EBITDA.

Should the dividend rise to my expectations, the total potential return could exceed 55% over the forecast period. If Canon can recapture the imagination of growth oriented investors, my total return forecast may prove to be conservative.

Posted by Randolph McDuff at 12:19 PM | Permalink

The Federal National Mortgage shareholder presentation which accompanied the recent 10-Q is chock full of telling information.

http://www.sec.gov/Archives/edgar/data/310522/000095013307004554/w42414exv99w1.htm

I consider two points to be of utmost importance in this overview.

1. If temporary impairments are ultimately considered to be long term, and adjusted accordingly in the future by auditors, FNM's shareholder equity will decline to as little as $34.9 billion. This is just adequate to maintain the existing mortgage portfolio, at status quo.

2. Absent any other positive changes to the current business model, a 10 basis point loss on mortgages in 2008 will make FNM unprofitable in that fiscal year.

My investment mandate is to own companies with strengthening balance sheets and growing EBITDA. FNM management is apparently confirming that neither event is likely to occur in the next 12 months. Therefore, I will elect to remove my entire position of FNM from RMG#1 in the near term.

When evidence of a sustained turnaround in FNM's business model presents itself, I will certainly consider reinvesting in the company.

Disclosure: On November 12th, the entire FNM position was closed out at a net price of $47.20 per share.

Posted by Randolph McDuff at 04:00 PM | Permalink

Microsoft: A "shareholder friendly" monopolistic competitor

All numbers are reported in US dollars. Fiscal year ends June 30th.

Share Price: $28.65
Shares Outstanding (fully diluted): 9.38 billion.
Current assets-total liabilities (est. on Sep. 30th, 2007): $13.1 billion.

Estimated 2008 EBITDA: $24.4 billion.
Estimated 2008 year end EV/EBITDA: 10.4X

Microsoft is not resting upon its laurels as the world's largest software company. The firm now appears poised to emerge as a digital gaming leader. I feel that the recent release of "Halo 3" will prove to be a great success and will accelerate Xbox 360 sales throughout 2008.

I further envision accelerating sales of Vista operating systems, a strong rollout of new Microsoft Office products and increased penetration of Windows Live over the next 24 months. This growth, coupled with my expectation for surprising gaming revenues, leads me to believe that EBITDA surprises are possible in fiscal 2008 & 2009.

Microsoft's new product cycle is off to a fast start.

Windows Vista and the new Microsoft Office line should result in 2008 revenue growth of at least 15% when compared to 2007. These products carry operating margins of 78% and 65% respectively. I expect Microsoft to generate EBITDA margins of 40% for 2008. Revenue could touch $58.5 billion.

The declining US dollar will add a kick to top and bottom line results for 2008.

International sales were 39.5% of total revenues for 2007, and have continued to grow as a percentage of total revenues over time. For 2008, I anticipate that international revenues will exceed 41% of total sales. MSFT does hedge currency exposure somewhat. Nevertheless, currency changes may add up to $.05 per share of incremental EBITDA for 2008. Greater contributions from foreign markets appear likely in 2009, provided US dollar weakness persists.

Microsoft continues to aggressively lower its fully diluted outstanding share count.

In the past three fiscal years, Microsoft has repurchased 2.037 billion shares, or more than 20% of the fully diluted outstanding share count.

Management' interest at Microsoft appears to be wholly aligned with existing common shareholders.

Share option awards at Microsoft averaged 1.8% of the diluted share count (per year) since 2004. Many public companies routinely award 3X that percentage to employees and insiders.

The 35 Wall Street analysts who produce research on Microsoft are strangely uniform in their outlook.

According to data supplied by Yahoo Finance, the 2008 EPS estimates lie within just 2.5% of the median. In other words, there appears to be no meaningful variation in any single analyst report throughout Wall Street.

Unless Microsoft actually tells analysts exactly how much revenue, EBITDA, closing year end share counts, currency exchange values and net taxation to expect for 2008, no rational reason exists for 35 separate estimates to be so tightly grouped.

I find this analyst convergence to be both disturbing (is plagiarism rampant on Wall Street?) and intriguing (what will happen to the share price should all analysts increase estimates simultaneously).

Conclusion

I anticipate that EBITDA will increase by almost 20% above the 2007 figure. Microsoft may be selling for roughly 10.4X my 2008 year end EV/EBITDA. At the present price, growth investors and value investors alike, could find Microsoft to be attractive.

Provided that MSFT's revenue and EBITDA for 2008 meet my targets, the entire herd of analysts may be forced to revise estimates. Should all analysts change price targets simultaneously, it might be prudent to own shares of Microsoft beforehand.

I am purchasing shares for both RMG#1 and for my personal accounts.

Posted by Randolph McDuff at 01:04 AM | Permalink

Federal National Mortgage (nyse: FNM) Right-Sized for Growth

Shares Outstanding: 973 million.
Shareholders Equity (12/31/06): $41.5 billion.
Share Price/2006 Shareholders Equity: 1.58x

Federal National Mortgage is the largest single family & multi-family mortgage buyer in America.

The firm buys secondary mortgage loans, primarily of a long term fixed nature and packages them into mortgage backed securities. The pools are then resold to the capital markets, producing stable fee revenue.

Fannie Mae also holds a portfolio of mortgages for its own account. Income is generated based upon the spread between its own costs of capital vs. the income received from the mortgages. Revenue from this division in Fannie Mae's financial statements, as well as related activity income, are grouped under the heading "capital markets".

According to recent Fannie Mae filings, mortgage problems in the market started to show up around mid 2006.

Based upon present trends, US home sales may now tracking at an annualized pace similar to 2001.

Management of FNM anticipates a further decline in net interest income, a potential doubling + of guaranty contract losses as well as an increase in the overall credit loss ratio. This should imply a reduction in projected 2007 earnings vs. 2006. Earnings may fall by a further 20% this year, possibly to below levels last seen in 1999.

The well documented problems in the mortgage markets may NOT have as pronounced an impact upon Fannie Mae, as at many firms.

I believe that the sub prime mortgage debacle will widen and spill into more traditional mortgages. The current confidence crisis in the capital markets has exacerbated the issues in the short term. I do not consider "Fed" moves to inject liquidity as being a sign of an economic turn for the better. Rather, liquidity injections are generally short term, and allow a more measured approach for the repositioning of investment portfolios. This probably spells bad news for the majority of financial service businesses with assets in North America, and could potentially result in a mild recession.

Conventional long term fixed mortgages will likely experience higher defaults than in the last several years, This should not prove any more problematic for FNM than in previous interest rate cycles. Fannie Mae has demonstrated an ability to grow throughout prior downturns through capturing new market share. While some firms may not survive a protracted downturn in the housing market, Federal National Mortgage considers the current environment to be very much "business as usual".

There are a host of reasons to explain why Fannie Mae stock is pushing toward 52 week highs, in a worsening housing market.

1. Fannie Mae is prepared to expand its retained portfolio, as the firm is overcapitalized.

A 36 month period of downsizing, which shrunk the mortgage portfolio by 26%, has ended. A total financial statement recalculation was begun in 2004, after it was disclosed that FNM was improperly accounting for derivative gains/losses from its capital markets division. In the aftermath of this disclosure, it became evident that FNM had used derivatives to leverage its balance sheet beyond prudent levels, relative to its capitalization.

It was also determined that the capital markets subsidiaries had strayed far from their original corporate objectives. Fannie Mae had become a securities trading firm disguised as a government sponsored agency. A major restructuring of these business lines has largely been completed.

In hindsight, it seems evident that FNM was able to sell down its mortgage portfolio at relatively high prices. Now, unlike many firms in the mortgage related business, Fannie Mae now finds itself with a balance sheet capable of growing in the months to come. Bargains may be plentiful which would allow Federal National Mortgage to be one of the few firms able to "buy low".

In addition to growing the mortgage portfolio, I also sense that FNM management might see financial benefits from purchasing a large bankrupt (or near bankrupt) national mortgage originator. There may be some surprisingly good candidates available soon, for a mere assumption of liabilities.

2. Fannie Mae could be benefiting from a "flight to quality".

Portfolio managers permitted to own FNM stock, and those with a mandate requiring ownership of mortgage related stocks, may be selling riskier (more leveraged) investments, and replacing them with shares of Fannie Mae. This "sell the weak, buy the strong" approach may continue through 2008.

3. Some are buying Federal National Mortgage in anticipation of the firm becoming a timely SEC filer.

While the accounting scandal unfolded, many securities houses had to remove or restrict coverage on Fannie Mae. This greatly limited the number of investors capable of holding FNM shares.

Individual investors at major wirehouses are often discouraged from owning securities where official investment coverage is restricted. Numerous institutions are also prevented from owning shares in companies which do not have current financial filings.

On June 30th, 2007, there were just 19,000 registered shareholders of Fannie Mae. By contrast, American Express (with a similar market cap) reports over 51,000 shareholders of record. In the near future, I expect that a wide range of investors will be able to add FNM to portfolios

4. Interest spreads should rise over the next 12 months.

In 2003, Fannie Mae earned an interest spread of 2.12% on its retained mortgage portfolio. In each subsequent year, interest spreads have narrowed. They averaged just .85% for 2006. As the housing slowdown impacts other sectors of the economy, interest rates should decline. I believe that expanding spreads for FNM will result, which could produce dramatic profit growth.

5. Interest sensitive stocks are often counter intuitive.

In a traditional housing market cycle, defaults peak while the market is already turning for the better. Should this be the case, then by late 2008, Fannie Mae's business may show an accelerating rate of growth. Recovery in share prices often tends to anticipate these trends.

Fannie Mae looks to be a value from both a historic point of view as well & a balance sheet perspective.

Core single housing and HCD business have shown total revenue increases of almost 16% since 2004. FNM has greatly reduced its reliance upon the capital markets trading desk activities as a profit center. The balance sheet is stronger than at any time during the past decade, and management now seems opportunistic. Expectations from shareholders are remarkably low. Upside earning surprises are possible going into 2008.

Presently, FNM presently trades at 1.58X the 2006 reported shareholders equity. This compares very favorably to the 3 year "pre-scandal" share price which averaged 2.7X shareholders equity.

I expect Fannie Mae to be a winner as both housing market and capital market conditions normalize.

In the long run, business conditions in ANY industry are seldom as strong as market bulls play them up to be during good timesnor as bad as pessimists pan them out to be in bad times. While Fannie Mae is predicting further contraction in the housing markets, it holds a dominant position in the safest sector of the mortgage markets. This, and a uniquely overcapitalized balance sheet, should position the firm extremely well for the inevitable recovery. If/when interest rates decline in the US; widening credit spreads could lead to exponential profit growth.

Importantly, FNM should NOT require dilutive capital infusions to weather the current storm. While many financial institutions will sharply curtail mortgage activities in the coming months, FNM may be in a position to act as a predator.

Conclusion

Resumption of full SEC reporting status, coupled with my belief that balance sheet growth of up to 10% is possible within the next 12 months, could make for a compelling investment case. Should my thesis prove out, a year end 2008 fair market value of 2.5X estimated 2007 shareholders equity, or $110 per share, is certainly possible. The recently increased dividend looks safe, and may add to the overall return.

Posted by Randolph McDuff at 02:00 PM | Permalink

While some might question the short term price of Mastercard Incorporated (nyse: MA), I consider the investment thesis to be better than buying eBAY some years ago.

MA was incorrectly priced from the outset, as investors and analysts evaluated the stock as though it was a credit card company. Originally, the few analysts that covered the stock simply lumped MA into a peer group with American Express and a number of other publicly traded credit card firms.

All credit card companies have to deal with bad debts, but MA doesn't. It is not even a credit card company, but is a brand name that franchises out its brand and technologies to all the banks which use the MA trademark.

In point of fact, MA is a processor of payments and an oligopoly, with technology and placement that will enable the company to remain at the forefront of both debit and credit card processing. It is a dominant force in Europe, and its Maestro payment processing systems are poised to become the European standard in the near future. Europe is harmonizing its debit systems, and will require banks to clear through just one system by 2010. Visa apparently does not even have the technology or systems in place to provide a competent bid, which makes MA a virtual shoo in for this business.

If one thinks of MA vs eBAY, one could easily make a case for suggesting that MA is still very undervalued.

1. MA has no delinquencies, no missed payments and no product returns. Those issues are the responsibility of the franchisees (the various banks and firms like MBNA which assume the credit risk). eBAY generates a lot of revenue, but has to to factor in bad debts every quarter. MA has higher gross and net margins than eBAY, and faster growth. Far more people worldwide will use the services offered by MA than eBAY
2. Both MA and eBAY have limited competition, and global reach. Both are debt free and generate more cash than they require.
3. eBAY has a current enterprise value of almost $44 billion, whereas MA's present EV is just $21.3 billion.

So, while I don't diagree that the share price of MA is high, and is certainly approaching what I would consider fair value, the next couple of years could take this stock to a market cap that I feel will surpass eBAY.

Posted by Randolph McDuff at 11:44 AM | Permalink

by Randolph McDuff, m10 & mFOLIO Master

Grupo Aeroportuario Del Sureste (nyse: ASR) is the fastest growing airport manager in Mexico, operating 9 airports, including Cancun International. The majority of revenues are earned from serving the Atlantic/Caribbean coast of Mexico, focusing on the highly profitable international passenger market.
Until late 2005, ASR sold for a premiere valuation well-deserved, based on the company's revenues and EBITDA when compared with its publicly-traded Mexican peers, Pacific Airport (NYSE: PAC) and North Central Airport Group (NASDAQ: OMAB). ASR was in the right place at the right time as the growth of tourism to the Caribbean has traditionally outpaced the Pacific coast, which was largely served by PAC and OMAB.

Hurricanes aren't all Bad!

But then Hurricane Wilma dulled the luster for ASR's near-term prospects. Many hotels in the Cancun, Cozumel and Mayan Riviera corridor were damaged or destroyed, severely reducing airport revenues for both fiscal 2005 and 2006.

Consequently, ASR's shares fell to valuation levels equal to/below that of PAC and OMAB, where they have remained for more than a year.
However, a silver lining has emerged from that black cloud. Many outdated pre-Wilma resorts put their insurance proceeds to good use, rebuilding their hotels to more expansive properties with higher standards, resulting in a 20% increase in available accommodations for the tourist trade. And I'm happy to report firsthand that Cancun looks better than ever.

Fortunately, I'm not the only pleased traveler. By the first quarter of 2007, ASR reported that traffic growth at its airports has once again surpassed that of PAC and OMAB. In the first 4 months of 2007, passenger counts throughout the ASR system increased by 1.1365 million persons overall, or up almost 20% year over year.

But that's not the only catalyst to ASR's earnings. . .

The Opening of Cancun International's Terminal 3 Promises BIG Growth for ASR

In 2006, the Cancun International airport processed 9.728 million passengers 7.3 million international and 2.4 domestic passengers. The advent of Terminal 3 which opened last month will boost international capacity by a whopping 7.5 million passengers more than double the airport's previous capacity!

What that means for ASR is more money, via a three-pronged strategy:

1. 150,000 square feet in new retail, advertising and boarding zones will increase commercial revenues, which will filter into ASR's coffers through a fixed rent as well as a percentage of retail sales.
2. Capacity bottlenecks, which prevented time for passenger shopping and dining and which I believe to be the primary culprit behind the 10% decline in ASR's commercial revenues from 2005-2007 will be alleviated.
3. New gates will allow Cancun International Airport to handle almost 50% more daily arrivals/departures, improving traffic flows and reducing passenger transfer costs (as a result of transporting them via the prior archaic tarmac-to-buses-to terminal operation.

For 2006, ASR's average net revenue and EBITDA per person were $16.12 and $10.69 per person, respectively, compared to the $12.45 and $4.46, respectively, earned at ASR's other 8 airports. The reason for this dichotomy: 71% of revenues generated at the Cancun airport came from international passengers, while the passenger mix at the other 8 airports was 18% international and 82% domestic. With ASR's international passengers set to double at Cancun International, that spells a tremendous opportunity for top- and bottom-line expansion perhaps as much as $120 million and $70 million in annual revenues and incremental EBITDA, respectively.

A Possible Blockbuster Airport Concession in Playa Del Carmen

Chances are that ASR along with OMAB and PAC would be an invited bidder for the building and operation of the Mexican government's proposed new 15-20 million passenger international airport in the growing Playa Del Carmen tourist area.

But ASR's prospects improve considerably due to another new proposed airport in Mexico City, which would more than likely be awarded to either OMAB or PAC, since that is their regional area of operation. Because the Mexican government probably would not want to hand two new airports to one operator, the winning bidder for Mexico City would effectively be eliminated as one of ASR's competitors from the Playa Del Carmen bidding wars.

ASR's CEO New Tender Offer is Intriguing

Mr. Chico has publicly declared his desire to increase his holdings of ASR to as much as 52% (an increase of 42%) of the outstanding shares. What is intriguing is that he has provided an offering document that clearly states that in his capacity as chairman, he has routinely been given access to "non-public" management budgets with respect to the possible future performance of ASR, and as a result of my information, I'm offering to buy more shares and take a controlling stake in the company."

Additionally, the document announces a new $275 million corporate credit facility. With its winding down of a major capital spending program, nearly $50 million of current assets total liabilities, the potential to generate more than $330 million of EBITDA over the next 24 months, and only $100 million of new capital spending during that time, a large cash balance should build up by 2009. Unless ASR plans to build a brand new airport, there seems to be no use for this credit facility.

Each of these developments bode well for ASR's future growth. All else being equal, I feel that ASR has the potential to deliver superior performance among the three publicly-traded Mexican airport managers and presently deserves a premium valuation vs. its peers. My 2007-2009 forecast suggests that EBITDA may rise by up to 65%, on a revenue growth forecast of up to 50%. And at 12X my 2008 estimate EV/EBITDA, a fair value would suggest a price of up to $76 US per share.

These shares may have a place within a diversified account which seeks to capitalize on global growth trends.

Disclosure: I personally own shares in ASR (ASR) as well as PAC, but do not own OMAB. RMG#1 owns shares of ASR.

Posted by Randolph McDuff at 09:00 PM | Permalink

Several weeks ago, I was provided with an opportunity to outline my views on TMY, via the Marketscope newsletter.

At that time, my views were bullish. TMY had recently announced the successful completion of a 1400 bpd producer and had intimated that a second well was testing in the range of 400 bpd. The first formal brokerage recommendation of the stock in the United States had just been issued by a mid market firm called Jefferies Group. Management was guiding investors and analysts to anticipate exit 2006 production of up to 10,000 bpd.

Unfortunately, subsequent developments have now called into question the validity of my bullish call on Transmeridian.

My original thesis for owning TMY for during past 5 years has been centered around the development of a large reserve base. While production from the South Alibek field had been erratic, the possibility of owning up to a 200 million barrel 2P reserve was sufficiently enticing to keep me focused upon the prize. With the hiring of staff from a competitor who has specialized in a technically challenging field adjacent to TMY's South Alibek, it appeared that production obstacles had been overcome.

Sadly, it appears that Transmeridian has far more work ahead in the next 6 months to prove that they can successfully operate the South Alibek field.

In the quarterly conference call completed today, TMY has confirmed that 100 million barrels of their 2P reserves are contained within a zone called KT1. At this time, the firm has not yet drilled a successful well targeting only this zone. This makes an assertion of 100 million barrels of 2P reserves, shall I say, optimistic.

TMY also confirmed that the 1400 bpd well has shown a production decline of approximately 450 bpd within the first 8 weeks of production. A second well has been brought on stream with a production rate of merely 150 bpd. Dusters do occur in the oilpatch, and are to be taken as part and parcel of the business. However, the wells that Transmeridian drills are quite deep, technically complex, and are very expensive to drill. While some firms would be quite happy to find an oil well that produces 150 bpd, when well costs routinely exceed $7 million to complete, a 150 bpd producer is a money loser.

Furthermore, the reserve reports at the end of 2005 indicated that new wells would produce an average of at least 400 barrels per day, and show annual declines of approximately 30%. Since the 7 wells presently on production are producing less than 328 bpd (including the 2 wells just brought on stream), it is becoming more and more possible, to envision an oil reserve writedown by year end.

What has become apparent to me, is that TMY has an extremely challenging field to develop. While major firms have the capital and internal expertise to develop larger fields that carry challenges, junior firms from time to time, do get in over their heads. I now suggest that this is may be one such case.

Thus, while Transmeridien Exploration may hold great promise in the long term, I cannot make an investment case for it in my Marketocracy portfolio any longer.

Consequently, this morning, I sold off my entire position in Transmeridien Exploration for my RMG#1 account. In real life, I also disposed of my entire personal holdings.

I do regret having to make a bullish call and reverse that outlook so quickly. However, it is very important to me, that investors be made aware of my changed view, and that I no longer hold TMY.

Posted by Randolph McDuff at 08:12 PM | Permalink

by Randolph McDuff, m100 member

Marketocarcy: "Kazakhstan oil has been a good place to invest for us. Petrokazakhstan was a double in just a few months and Chaparral Resources (OTC: CHAR) was an interesting play until it abruptly agreed to merge with Lukoil this March.

An even better play is Transmeridian Exploration, Inc. (amex: TMY), an early stage oil company without the partnership issues. TMY has been a 23 bagger for m100 member, Randy McDuff since he first bought TMY in his Marketocracy model portfolio 3 years ago. He has proven himself to be one of the best traders of TMY so I asked him why he thinks TMY could still double over the next two years. Heres what he has to say:"

Transmeridian is a junior driller in the difficult to value transition stage from discovery to oil production. Revenues arent there yet so TMY does not show up on many radar screens. Production ramp is taking longer than normal so it looks to most investors that their fields wont be successful. But, Kazakhstan complexities have elongated the process. Even though TMYs market cap has risen spectacularly to $500M, obscurity during this transition gives us the opportunity to buy while there is still a double or more.

Three attributes set TMY apart: 1) large resource base not fully delineated so depletion rates will be low; 2) 100% effective interest so TMY can focus on production growth for the benefit of shareholders; 3) reserve base is highly concentrated, so economies of scale will kick in as production grows.

Doing business in Kazakhstan can be tricky and both Petrokazakhstan and Chaparral had difficult partners that eventually caused a less than expected value sale. In late 2005, TMY bought out its Kazakhstan partners so now they have complete control to optimize operations for long-term value.

TMY has been in the early stages of figuring out production methods and proving its reserves in a brand new Kazakhstan field called South Alibek. From 2003-05 TMY has tried a variety of completion techniques, fracture methods and stimulation techniques with mixed results. Production was just 1100 bpd in Dec. 05. Recently, TMY stimulated a new well with production in the range of 1400 bpd. Armed with this information, TMY has budgeted $200 million of capex through 2007 and contracted a 5-rig fleet and 1 completion rig. Exit 2006 production rates may surpass 10,000 bpd.

South Alibek is open on 3 sides and reserves have been extrapolated from 8500 acres of the 14,000-acre concession. Peak production is expected to be 40-50,000 bpd. At year-end 2005, South Alibek had an estimated 202 million barrels of 2P (proven and probable) reserves. At a rough price of between $5-10/barrel for 2P reserves, TMY could have a projected value in the range of $1-2 Billion.

2007 should be TMYs breakout year. Assuming another 24 wells are drilled with an 85% success rate, average production rates may exceed 15,000 bpd. If TMY receives $50 per barrel, 2007 EBITDA may exceed $178 million, supporting at least a double in the stock price.

With 100% ownership of a large, highly concentrated, and slowly depleting oil field, TMY will make an attractive acquisition target. And as production increases and reserves get proved it will be more difficult for potential acquirers not to pull the trigger and buy - something we can do today.

Posted by Randolph McDuff at 07:36 PM | Permalink