Model Portfolio rmcduff:RMG1

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