Why I got long Lululemon Athletica

The Great Retail Slaughter

One of the big investing themes of the last 6 months has been what I have dubbed “The Great Retail Slaughter.”  Consumer/Retail stocks – especially the legacy mall retailers – have been destroyed in the market.  A weak Holiday season was followed by an even weaker first quarter and a sense of impending doom has taken over the group.

Several companies have either gone out of business or are against the ropes – Coldwater Creek (BK), Wet Seal (on its way), Body Central (going going gone), American Apparel (there’s nothing left to save there, Dov), JC Penney (ew), etc.  Those retailers lucky enough to have survived the Holiday season are doing so by the skin of their teeth.  See this performance comparison in Finviz

I have spent many hours thinking about this phenomenon – the Great Retail Slaughter, that is.  The cause of the slowdown in retail performance remains a mystery.  There are many questions:

1) Is the economy bad and folks just can’t spend like they used to? Maybe.

2) Are new internet retailers like Gilte Group, Bonobos, Chubbies, etc. changing the retail paradigm? Probably, but how do we measure their impact on traditional retail?

3) Is the mall as a retail intermediating concept in decline or already dead? DeadMalls.com sure thinks so.  As a part of a larger theme, suburban America appears to be in decline (per this TIME article), which is no doubt correlated with the success/failure of traditional mall retailers.

4) Or was it just a really cold Winter season (Who wants to shop in -30 degree weather?) and the activity will pick up with warmer weather?  I know that I had no motivation to go shopping in the bitter cold this Winter.

Significant Doubt

The uncertainties facing the retail industry have caused investors to begin doubting the ability of many retailers to earn the way they have historically.  This doubt has manifested itself in indiscriminant multiple compression in the group (see the Finviz performance chart again).  Even the best retailers with the strongest brands have been thrown out with the bathwater.

Enter Lululemon Athletica (LULU)

LULU is one of the retailers that has been thrown out with the bathwater.


LULU is a retailer of “healthy lifestyle inspired athletic apparel.” LULU is best known for its yoga apparel, especially its yoga pants, which have become a fashion staple among female millennials. 


Since going public in 2007, LULU has had a meteoric rise in the United States and Canada growing from 52 stores in 2007 to over 260 as of the most recent quarter end. Revenues have ballooned from $41M in 2004 to $1.6B in 2013.  Cash on the balance sheet – once just $3.8M in the year 2006 – now stands at $752M.  Cash from operations – a paltry -$1.7M in 2004 – totaled $50M in what was considered a very weak first quarter 2014.

Given its blistering growth in North America, LULU has been afforded a very strong valuation in the public markets for most of its time as a publicly traded company.  It was not at all uncommon to see LULU trading for 25-50x trailing EBITDA.  With the company growing EBITDA 50% a year, these valuations are understandable.

With great growth and a lofty multiple comes a lot of expectation from the markets.  LULU at 25+x LTM EBITDA is priced for perfection.  That is to say, everything in the growth plan needs to go correctly for an investor to make money and to participate in the theoretical upside potential of the company.  Since 2006, everything has gone more or less right for LULU.  They’ve opened a couple hundred new stores; the yoga fad has really grown nicely in the United States; Same-store sales growth has been in the mid-teens to low 20s range for several years; and the brand image has grown immeasurably among young people.


As often happens with Icarus-type high flying fad retailers/companies, a chink appears in the corporate armor.  In this case, LULU was involved in a relatively minor controversy when it rolled out a series of yoga pants that became unintentionally see-through if worn too snugly (early 2013). 

LULU founder Chip Wilson was then involved in a related public relations snafu when on the talk show circuit attempting to dispel fears about see-through pants (ironically enough).  Mr. Wilson made a comment about some potential LULU customers that eventually became a PR nightmare.  He said:

“The thing is that women will wear seatbelts that don’t work [with the pants], or they’ll wear a purse that doesn’t work, or quite frankly some women’s bodies just actually don’t work for it.”

Although Mr. Wilson’s commentary is mostly innocuous, it is thought to be emblematic of LULU’s concurrent derailment from the path of perfection. 

See-through-pants-gate led to the dismissal of CEO Christine Day in June.  2013 went on to be a troublesome year for the retailer and midway through the 4th quarter (which ended up being the worst Holiday quarter in the company’s history), Mr. Wilson himself (I remind you, he is the founder of the brand) resigned from his position as Chairman of the Board. 

And the CFO just announced he is going to retire at the end of the year.  It was a full house cleaning.

Falling From Grace:

Before pants-gate, LULU traded at $80/share or roughly 25x LTM EV/EBITDA. Following the dismissal of Christine Day, Mr. Wilson’s commentary on yoga pants, his departure from the company, and a weak Holiday season, the shares found themselves under $40.

You can see investor expectations deflating in a stock price graph since June 2013.  LULU now trades in the 10-15x EBITDA context – a massive change of expectation with regard to future earnings power.  The last time one had an opportunity to buy LULU at 15x LTM EBITDA was in 2010 following the Great Recession.

Not only are the forces behind the Great Retail Slaughter driving pessimistic investor expectations, but competitive threats have emerged in an attempt to steal market share from LULU – the yoga market leader.  Gap has introduced its Athleta brand.  Moreover, Dicks Sporting Goods has a new yoga line in its stores and has introduced True Runner, a fitness/lifestyle brand that operates in a similar niche.

In this context it makes sense that investors have begun to doubt the previously impervious yoga retailer.

The Night is Darkest Just Before the Dawn

LULU is coming off of two of its worst quarters as a public company.  4th Quarter 2013 saw LULU’s first ever same-store sales deceleration.  LULU missed revenue and SSS guidance pretty badly.

Sales, operating income, and EBITDA per store were the lowest that they have been in the last 3 years. 

To top it off, management guided revenue expectations to the lower half of its previous guidance.

When it rains it pours.

What do I think?  I think this is the new management team coming in and using the poor retail backdrop to reset expectations.  Instead of guiding for SSS growth in the mid-teens to low 20s per year, a new regime of single digit SSS is being instituted.  Margin expectations have been reduced by several hundred basis points.  Everything you don’t want to hear a retailer say and do is being said and done under the new management team led by CEO Laurent Potdevin. 

I think it is simply a reset of expectations.  I’m calling peak negativity at LULU. 

Laurent Potdevin is setting the bar low by bringing in expectations.  It is much easier for him to please his Board of Directors (the same BOD that sent Christine Day, Chip Wilson, and CFO John Currie packing in the last year) if expectations aren’t too high.

I think Laurent is setting himself up to be a “beat and raise” type manager in 2014 and beyond.

Management and the sellside have begun to classify 2014 as a “transition” year for LULU – one in which margins and earning power are reduced in lieu of growth initiatives and investments.

However, I think Street expectations are way too low.  For instance, the CS analyst has LULU doing $409M EBITDA in 2014 despite having done $440M in 2013 and having 45 new stores on deck for 2014.  I find it hard to imagine the company will see negative EBITDA growth absent alarming SSS declines.  The sellside has bought management’s manufactured reset of expectations hook, line, and sinker.  I think the CS analyst will be surprised when Laurent beats expectations later in the year.

Assuming the stores perform just as poorly in terms of margin in 2014 as they did in 2013, I have LULU doing just over $500M EBITDA.  If you assume the margins improve to the management target of mid 50s gross margins, LULU could do $525-$540M EBITDA this year.

The Growth Path

Going out to 2017, LULU management has suggested a desire to grow to 350 stores in North America and 20 stores in both Europe and Asia.  Again, LULU will add another 45 stores in North America in 2014, which should get them to 299 stores by the end of the year.

(Aside: On the last call, management said that their first store in London is doing $7M of sales at an annual run rate, which is higher than the average North American store.  So we can assume there is similar demand for yoga apparel in those markets as there is in North America.)

The average store in 2011 did $2M EBITDA; in 2012 $2.1M EBITDA; and in 2013 $1.8M EBITDA (big fall off).

If we assume the forward EBITDA run-rate per store is $1.8M, these stores would theoretically do over $700M EBITDA.  That’s a realistic goal within 3 year’s time in my mind.

What’s LULU Worth?

I assume LULU will do $500M in 2014 EBITDA based on “normalized” (same margins by quarter as 2013) margins and 45 new stores coming online.  The company has no debt and $750M cash in its balance sheet.  I assume the core business is worth 15x EBITDA in a base case given its market leading position and defined international growth plan for the next several years.

($500M * 15x EV/EBITDA + 750M Cash)/145M Shares Outstanding = $57/share

If the company is able to execute a successful international expansion, the shares have considerable upside in a 2-3 year timeframe.

($700M * 15x EV/EBITDA + 750M Cash)/145M Shares Outstanding = $77/share.

This valuation obviously assumes no further cash accumulation and no share repurchases, which together are unlikely as there is a $450M share repurchase program underway.


Enter Chip Wilson

Chip Wilson, unceremoniously dumped from the company he founded in December, is back.  He allegedly wants to take the company private once more

Chip owns something like 30M of the 145M shares outstanding and has allegedly had talks with private equity firms to take the company private – much in the same way Mickey Drexler teamed with TPG and Leonard Green in 2010 to take J.Crew private.

I have a feeling there is a good chance Chip tenders for the company before the end of the year.  If I were in his position, I know what I would do.



o   LULU is a best of breed retailer that has been beaten down in The Great Retail Slaughter

o   Expectations have come in considerably over the last half year

o   Despite the negative expectations, the company is still wildly profitable with a clear growth trajectory

o   Valuation is attractive given historical valuation

o   Outside chance the estranged founder reenters the scene with a takeover bid

HOLDINGS UPDATE – March 2, 2014

HOLDINGS (In no particular order)

Jones Energy (JONE):

JONE released a reserve report and guidance on Feb 24 that was disappointing.  It was disappointing in the sense that the new completion design might not be worth it.  I wouldn’t necessarily call the PR ugly, but the market reaction sure was given the illiquidity in the shares.

The disappointment stemmed from a production rate for FY 2013 that was a little light of the guided midpoint (17k boe/d vs range of 16.6k-17.9k boe/d) and from what appears to be the company “abandoning” the new completion design.

The following section is the most important part of the PR in my opinion:

Update on Completion Techniques in the Cleveland

Jones Energy has completed 20 test wells in the Cleveland using a new completion technique, which has an average of 20 stages (3 clusters/stage resulting in approximately 70 foot spacing between clusters) compared to the prior design of 20 stages (210 foot spacing).  The new technique uses a cased-hole design as compared to an open-hole completion in the prior design.  The average cost per well of the new design is approximately $4.0 million, compared to $3.1 million using the historical design.  All of the 20 wells in the first phase of the test program have been completed and are currently producing hydrocarbons.

Of the 14 wells with 30 or more days of production, 12 have produced at or above historical type curveOver the next two quarters, the Company will monitor production data on the test wells and undertake additional optimization techniques, prior to making a decision on whether the level of production is significant enough to justify the incremental capital investment per well, and which design to utilize going forward.  In the interim, Jones Energy will be employing its traditional open-hole completion technique in the Cleveland, which is the basis for its guidance for the balance of 2014.  Going forward, the Company expects its average Cleveland AFE to remain at a best-in-class $3.1 million, which we expect will allow us to continue to generate compelling rates of return in our core play.

The new completion design is showing production above the historical type curve, but obviously not at rates that would imply a superior rate of return and the company has decided to wait to see if results improve.  In the meantime, they will go back to their play-leading open hole completion design.  Perhaps the results over 2 quarters will show increase EURs or lower decline rates from the wells => That would be a positive.  Perhaps the company will find that the completion design at almost $1M incremental cost is just too restrictive => That would be a negative.

Frankly I am not concerned about the report or the new completion methodology.  As I have said before, the worst case scenario is the company reverts back to its industry leading open-hole design that costs $3.1M and produces IRRs in some cases over 100%.

I think the market reaction was overdone and that the impact of the new completion design experiment was limited.  Let’s think about it this way: The company drilled 20 wells with the new design. Presumably the company spent $20M more than it otherwise would have to case and frack the wells according to the design ($1M incremental cost per well).  Let’s assume the new design is just an abject failure (which is unclear at this point, maybe it is ultimately a success), then the company essentially torched $20M.  What’s that per share? With 49M shares outstanding, it’s only about 40 cents per share.  On the day of the announcement, the shares were down almost $3/share!

The company risked $20M for a chance to increase its already large lead as an operator in the Cleveland.  And it’s not like the $20M is gone! This capital will still produce a return, just not as large a return as it otherwise would have.

There’s always the chance that costs come down and/or EURs (and therefore IRRs) go up in the future. You never know.  It’ll become a problem if the company stubbornly tries and tries again to make a new design work.

In light of the disappointing results, the company is doing the right thing – it is going to utilize the old completion method going forward.  That is, unless the new design is perfected and shown to produce superior returns.

Backing up to the 10,000 ft view: Using the old design through the first half of 2013, JONE was to my knowledge the only small or mid cap E&P company that was growing at 25% top line and spending within its cash flow.  I don’t see any reason why that cannot continue being the case (unless of course mgmt acts stubbornly and throws good money after bad).

Magnum Hunter (MHR):  MHR had year end results last week.  The company missed horribly on its 2013 exit rate guidance of 23-25k boepd.  The actual exit rate came in at 11,298 boepd – or 15,386 boepd adjusted for divestitures and shut-ins.  Given the horrible weather up here in SW PA, I understand the difficulties facing the company.  There were days I had trouble starting my car this winter.  I can only imagine what it is like trying to orchestrate a drilling effort in sub-zero temperatures.

According to Jim Denny (EVP of the Appalchia Ops), the company would have been right at 22k boepd if it weren’t for the weather delays.  Here are his exact words:

“We’ve had extreme temperatures as all of you might realize living — most of you living in the Northeast, it’s been very difficult to operate in these conditions when we get down below 10 degrees on a wind chill or at absolute temperature. The diesel in our engines and vehicles begins to gel and will not flow without heat [Dedwards – Yeah, I experienced this in my driveway several times]. But — and a further complicating it is the hydraulic oil, which we — hard for me to get my arms — head around — actually becomes a sludge. So we’ve had a very, very difficult time continuing drilling and completion operations when we can’t test our BOP’s properly. … So I would say that we are a good 50 days behind where we anticipated being even in the third quarter, or early fourth quarter of last year. So if we — just to summarize, with what we have tested and are shut-in and what we are now completing, all of which what I anticipated being in 2013, we would have been right at 22,000 Boe a day.”

=> According to the call, MHR will be drilling 5 Utica wells in 2014.  Assuming these are 30 million cubic feet a day monsters, the company shouldn’t have a problem getting to its 35k exit rate.  Add in shut-in production and wells waiting to be completed in the Marcellus, the production story here could change rapidly.  (Fingers crossed that it finally does!)

Fortunately for MHR, Eureka Hunter appears to be doing well.  The company just barely missed its YE throughput target of 200 MMbtu/d, but demand for the pipe looks strong as new wells from 3rd parties come online.  This demand should only get stronger as the company builds out its Ormet lateral in Monroe County OH (a hot spot).

We’re also try to increase marketing exposure for Triad and other producers, getting 2 additional pipelines, new interconnections with companies such as REX, TETCO, Dominion and TICO. As Gary mentioned in the opening statements, we — Eureka touched just under 200 million — of 200,000 MMBtus a day, the other day. That was a record for us. Our volumes swing widely with freeze-offs and producers doing various operations at various wells. Our volumes do continue to ramp very nicely though on average through the fourth quarter and into the first quarter of ’14. Over the next 90 days, we’re expecting additional volumes from new production from naturally Triad, but also Eclipse, JB, Stone, and into the summertime, Noble and CONSOL.”

After the report came out, MHR shares slid pretty hard because of the production miss and also because the company’s precarious financial situation became clearer.  As of January 31, the company had $55M of liquidity ($48M cash, $7M on the revolver), versus a capital budget of $400M.  The budget implies a cash burn of $33M per month.  This means the MHR had roughly a 7 week runway as of January 31 before it would encounter a liquidity crisis.  Fortunately, MHR has a solid asset base and appears to be involved in negotiations to raise cash.  It will be interesting to see how this plays out, but the company has a lot of options including:

  • JV unproven Washington County acreage
  • Sell Tableland Field/Saskatchewan acreage
  • Sell dry gas Huron/Weir Shale acreage in Kentucky
  • Sell the pipeline (they won’t do this yet unless the price is ridiculous)

Whatever management decides to do, it will have to be done soon as the cash is probably running thin at The Hunter.

Gastar (GST):  Gastar came out with 2014 guidance in February that the market thought was no Bueno.  The company exited 2013 with 9.2 Mboe/d production and guided for only 9.7-11.0 Mboe/d production over 2014, while spending $192M in the capital budget.

The company plans to drill 17.1 net wells in Oklahoma (9.7 net non-op and 7.4 net operated with 2 in WEHLU).  Assuming each of these Oklahoma wells IPs with 400 bbl/d, you’re looking at almost 7,000 boepd of initial production right there.  Obviously these rates will decline and not all the wells will come online at the same time, but it looks pretty clear the company will beat its 10.3 Mboe/d midpoint 2014 guidance (or at least the exit rate will be impressive).

The company’s finances are strained, but not horrible.  They have a $192M budget for 2014 – $32M cash as of year-end + $100M available on a revolver. The balance – $60M – should easily be made up through operating activities (street has them doing $75M EBITDA in 2014).

The next batch of catalysts are Hunton well results that should be out soon.  What we have found with the Hunton wells is that it takes 60-90 days for the wells to de-water before hydrocarbons start to flow.  We are waiting on the Burton 1H and the Townsend 1H, which must be flowing back at this point.

Antares Energy (AZZ.AU/AZZEF): Antares was a nightmare, sale cancelled and company will attempt to drill its own horizontal program in the Permian.  Management continues to play games with the shares.  I feel stupid for being involved here.  I will be exiting on any and all pops.

Emerald Oil (EOX):  EOX has a new investor presentation here.  The company has shown a strong ability to execute on its operated drilling program.  You can see on slide 6 that the company’s results in the Low Rider area have been quite strong.  90 day rates are over 600 bbl/d on average and the company is outperforming its 550 Mboe type curve.

The company maintains solid liquidity – $145M ($105M cash, remainder available on revolver) vs a capital budget of $307M for the year ($182M for drilling, $125M for leasing activities).  I can see the company covering drilling capex via current liquidity and cash from operations, but see them struggling to meet the $307M bogey when leasing activities are thrown in. The company will undergo a borrowing base redetermination in April, which given the strong drilling results should mean an increase in the revolver.  I am still unsure the borrowing base bump the company expects will get them to this $307M mark.  I assume they will be selling more non-operated acreage in the near term.

The third rig is due to come online in Q2.

Alaska Communications (ALSK): We will get FY results from them on March 6.

Black Diamond (BDE): This is my newest position and surprisingly is not an E&P company (not that I am exclusively an E&P investor… I have just been content riding that wave for some time now).  Black Diamond is a brand manager that has a portfolio of interesting outdoor brands.  You can see the latest investor presentation here.

BDE’s products – from the website:

From carabiners, skis, headlamps and harnesses, to freeride ski boots and trekking poles, we design and manufacture an exceptionally wide range of superior products for climbing, skiing and hiking. This diverse collection of products is united by excellence in quality, true innovation, and inspired details and features. This is partly the result of desire and diligence by an extraordinary team of people, as well as the fact that we are climbers and skiers ourselves.”

I first came across this company when someone on Twitter mentioned it (in freefall from 52-week highs following a holiday-time slaughter in retail names).  Then, I happened to be watching a really cool snowboard documentary on Netflix called The Art of Flight, which was sponsored in part by BDE.  I mention this in order to bring up an important aspect of investing in retail names or brand managers – trends and popularity.

One trend I have taken note of is the recent and growing prominence of outdoor sports and outdoor apparel.  REI appears to be a successful outdoor retailer that appears to have a new store everywhere I go these days.  L.L. Bean is cut out of the same mold (or I should say cut the mold that REI is now exploring in retail brick & mortar).  Judging by Cabela’s stock price and financial performance, outdoor sales are doing pretty well.

Long story short, outdoor retail is hot right now.  BDE is a good way to play that trend in my opinion.  As the company makes a push into apparel from accessories, I think there are significant growth prospects – apparel market is much bigger than outdoor accessories.  BDE has hired impressive talent away from competitors Patagonia and The North Face (slide 13 of presentation) and has seen recent success in apparel.  BDE targets getting to $250M of apparel sales by 2020.  That would more than double company revenue in  6 years.

The company has a history of successful acquisitions and $212M of NOLs available.  I expect it to make accretive acquisitions and to fully utilize these NOLs.

Value: Not a value stock, instead a trend stock.  $380M EV ($345M mkt cap + $35M net debt) vs. 2012 EBITDA @ $14M.

2013 FY numbers are out as of tonight. BDE missed its revenue guidance of $205-210M, with FY 2013 revenue at $203M.

HOLDINGS UPDATE – January 25, 2013

Market Update:

Natural Gas: When I started this blog a year ago, one of the theses I used to direct my investing was that commodities were undervalued in a world dominated by easier and easier monetary policy.  I decided to focus on oil & gas companies as market dynamics appeared much more stable and predictable than other commodities (steel for instance => No idea how to predict global steel demand).  While monetary policy has had little to do with my performance and oil & NG aren’t really viewed in the same way as precious metals, I am glad I was involved in the domestic energy story.  As recently as a year ago natural gas appeared unable to break $4, which was considered the breakeven for Marcellus producers; folks were aggressively and openly short the commodity and its producers; “incidental production” was something every fund manager used to rebut the NG recovery story; and storage of the commodity was at historic highs.

This section will be my victory lap: The march of time sure is a bitch.  In the interim, producers have lowered their costs in many cases below $4 (drilling efficiencies, increased EURs etc) and demand for natural gas has been very strong.  The macro picture of natural gas has been excellent.  Net imports have fallen off a cliff (down from 10 Bcf/d in 2007 to under 4 Bcf/d now), domestic production leveled off year over year (just shy of 70 Bcf/d), and surprisingly industrial demand has been very strong (20 Bcf/d what!?).  Aggregate demand for gas pretty much has been in line with production for the last couple of years.  We produce or import let’s call it 74 Bcf/d and use anywhere between 55 and 90 Bcf/d depending on the time of year.

Obviously, the big X-factor for gas is residential and commercial demand, which can vary significantly.  In the winter people need gas to heat their homes.  It just so happens that this winter has been horribly cold – after all, we are living in a polar vortex!  As a personal anecdote, I have lived in Pittsburgh my whole life and never witnessed the three rivers ice over – like they did twice in the last month!!

Just two weeks ago, the USA set a record weekly net natural gas draw from storage.   The week ended January 10 saw 287 Bcf drawn from storage over the preceding 7 day period.  Just to ballpark it, over those 7 days, the country produced or imported ~518 Bcf (7 days x 74 Bcf/d).  We used those 518 Bcf plus another 287 Bcf (805 Bcf).  That’s 115 Bcf/d of demand! Woah.

Natural gas storage levels are about 20% below where they were this time last year and about 13% below 5-year averages.

Folks who are short natural gas must have got the memo last week because they bid up the commodity 10% on Friday alone – to close at ~$5.20.  Friday must have been the day when risk managers at funds and banks all around the country tapped their traders on the shoulders and whispered the words: “We’re gonna have to close out this short…”

I am listening really hard for the faint voices that were so strong a year ago claiming “incidental production” would keep gas lower for longer.  All I have to say is suck it shorty. 

Outlook:  Gas has come too far.  Sure we’ve had a cold winter and storage is down, but this will quickly reverse in the Spring season when stocks start to build again.  Given that demand and production are more or less in line, I think natural gas should trade range-bound from $4 to $5.  The exuberance over gas is great and exactly what I wanted to see and the ride up has been fun, but we will see the other side of the coin soon.  How high will momo traders and the short squeeze take us? I have no idea, but I am glad a lot of my companies will have a chance to hedge production (despite how backwardated the curve is) over $4 in 2014 and 2015..  This will give them much needed income and capex clarity.

HOLDINGS (In no particular order)

Jones Energy (JONE):

I did a writeup on JONE mid-January here.  I have added to JONE at $14.25, $14.50, $14.75, $14.90, $15, $15.45, and $15.50.  It is now my second largest position.  Given the value proposition, the strong management team, the company’s leading position in the Cleveland play, I wouldn’t bat an eye making this a 40-50% position.  The company’s lockup expiration date came and went without fanfare and the shares are meandering up and to the right.  2014 guidance and the results of the company’s new well design will be out by the end of Q1.  I expect good results and strong year over year growth reflected in company guidance.

Magnum Hunter (MHR):  I have been actively reaching out to fund managers hoping I might get interest from an activist manager who would be willing to hear the pitch.  Feel free to shoot me an email (you can find it on the contact page) if you have serious interest or know someone who would realistically be able to assist the activist effort.

The shares have run quite a bit over the last month or so.  They are sniffing the $8.50 level here, which is important because it is the level at which Gary can force conversion of the warrant dividend he did earlier this year (so smart).  This would give the company some much-needed financial breathing room (17 million shares at 8.50, $140M).  Even though the shares have run a lot, I still think the assets are worth as much as $25 dollars if the right actions are taken.  I do not trust Gary to do what is necessary at the company and think a shareholder advocate is required to effect the right changes.

Gastar (GST):  We are waiting on some operated and non-operated Hunton wells in this name.  They should be out in February.  The company is trading rich to next year’s consensus EBITDA, so I think that any disappointment in the wells could disproportionately impact the shares.  Could they trade back to $5 or below on bad news? Sure they could.  If the wells are good, we could see the shares break the $7 technical barrier.

Given all the newsflow and excitement out of the Southern Utica and the liquids-rich Marcellus, I’m beginning to think GST is still undervalued.  GST is right across the river from some MHR acreage and could have stacked pay potential in the liquids rich Utica in Tyler County WV (we already know they have dry gas).  If it does, that would be a game changer for the stock.  We have no indication this is the case yet, but if it turns out to be true, we could be holding a $15 stock (as opposed to $10).

Antares Energy (AZZ.AU/AZZEF): Still a waiting game. January 22, 2014 shareholders meeting and close by end of February.

Update: The shareholders almost unanimously approved the sale of Permian assets at the Jan 22 meeting.  We should hear about a deal close any day now.  I have a limit order to sell most of my position close to $1/share.

Emerald Oil (EOX):  EOX announced 4Q production and new operated well results.  It was a magnificent report.  They are beating their own guidance with two rigs and expect a third rig in service in April.  Rather than comment on the report, I’ll let it do the talking for itself.

Alaska Communications (ALSK):  Rather than bullshit you guys, I’ll admit I haven’t kept up with the story over the last couple of weeks.  The shares have languished.  I don’t think there as been much news.

I still think the idea of owning a monopoly telecom asset in the state of Alaska is really cool and valuable.  They should have 2014 guidance or quarterly results to report sometime soon.

Strayer Education (STRA): I am all out of Strayer now.  I used the proceeds to get bigger in JONE, which I think is a better story.  JONE is growing quickly unlike STRA, is similarly cheap and has fewer industry headwinds.

Jones Energy

Executive Summary

Jones Energy (JONE) is an exploration and production company operating in the mid-continent, primarily focusing on the Cleveland play in the Anadarko Basin (Texas panhandle) with a south-central Oklahoma Woodford shale kicker. JONE has become an orphaned equity following a weaker than expected IPO in July 2013.

Since its IPO, JONE has completed an accretive acquisition in the Texas panhandle. Despite its orphaned status, JONE appears to have an exciting near term event path including the lockup expiration, well results utilizing a new completion design, and 2014 guidance.


Jones Energy has operated as a family owned business in the mid-continent since the late 1980s and has drilled several hundred wells in at least 5 different mid-con plays. In recent years the company has grown via acquisition and has focused on expanding its leading position in the Cleveland play.

In December 2009, JONE made its first significant acquisition by partnering with Metalmark Capital, a private equity fund, as the winning bidder in the bankruptcy auction of Crusader Energy Group, Inc. The acquisition included approximately 13.7 MMBoe of proved reserves and an extensive drilling runway. The acquisition price was $241 million.

In April 2011, JONE acquired estimated proved developed reserves in the Arkoma Woodford shale formation of approximately 31.1 MMBoe as of December 31, 2012, which is referred to as the Southridge acquisition. This marked JONE’s entry into an area Newfield Exploration (NFX) refers to as the SCOOP (South Central Oklahoma Oil Province). This transaction was $165 million.

In December 2012, JONE acquired approximately 22,000 net acres in the Anadarko basin, including 36 gross productive wells, in the Cleveland and Tonkawa formations, from a group of sellers including Chalker Energy Partners III, LLC, a private exploration and production company. The acquisition price was $250 million.

Finally, in November 2013 (IPO proceeds financed the majority of this transaction) JONE announced the acquisition of Sabine Oil & Gas for $195 million. The transaction included 26,000 net acres in the Cleveland, Tonkawa, and Marmaton plays in the Texas panhandle and western Oklahoma, 225 drilling locations (~180 in the Cleveland), 3,400 boe/d of existing production, and 92 producing wells (54% liquids).


JONE decided to conduct its IPO in order to take advantage of an M&A frenzy that has overtaken the Texas Panhandle (mentioned on the Q3 conference call; CEO: “at least 4 data rooms open that I can think of…”).

The IPO was slated to sell 14 million shares in the $17-19 range, but the offering was downsized to 12.5M shares at $15. Interestingly, the Jones family purchased 1.3 million shares of the offering in the IPO and the CFO acquired 30k shares. I have never before seen insiders acquire shares in an IPO. The IPO proceeds of $177 million were used to pay down the revolver (which was then utilized to fund the Sabine transaction).

Metalmark did not sell a share in the IPO. Therefore JONE’s float is only about 11M (12.5M offered less 1.36M taken down by insiders) shares, or 28% of the capitalization. The stock is currently not investable for funds looking to amass large positions given the low float. Part of my thesis is that Metalmark will conduct a secondary offering shortly after the lockup expiration, which should allow larger hands to come into the stock and assist the shares higher.

Cleveland Play

The Cleveland play is an exciting unconventional resource play. JONE is active in the liquids-rich window of the play. While the wells are not necessarily explosive (<650 boepd in 30 day rates), the economics can be very intriguing so long as costs are contained.

JONE’s type curve with 440 MBoe Gross EURs and $3 million well costs suggests that the single well-IRRs in the Cleveland could be in excess of 100% under various pricing scenarios.

Competing operators with less effective drilling techniques and higher single well D&C costs likely do not see as attractive of returns. Therefore, JONE (now with access to fresh capital in the public markets) is the likely natural acquirer in the play. We should expect JONE to remain active in the M&A space as deals can be immediately accretive given the company’s superior operating record.




New Completion Design

JONE’s shares zoomed to $18 by October, but were sent back to the $13-15 range after the company’s Q3 update, which included a poorly communicated operational adjustment. The company has committed to a new Cleveland well completion design and thus projected a sizable uptick in capital expenditure for 2014 with no production increase. This uncertainty scared the shares down below the IPO price.

The capex uptick – almost $1M per well – had to do with the company’s new well design, which includes tighter stage spacing and more perforating. The new completion design will include 5 times the proppant as the prior design, 3 times the amount of water, and 3 times the perforating.

For a description of the new completion design, see slide 15 here: http://investors.jonesenergy.com/files/doc_presentations/Jones%20Energy_CapOne%20Energy%20Conference%20December%202013%20vFinal.pdf

Results of this new well design have not been shared with the public, but preliminary results should be imminent (possibly a batch of 30-day IP rates). I anticipate the company will also provide 2014 guidance after having disclosed the results of its latest batch of wells.

Valuation – Enterprise Value

Cash – $23.1M
Senior Credit Facility – $473M
Second Lien – $160M
Stockholder’s Equity – $750M ($15.19 per share, 49M shares out as of 1/10/14)
Total Enterprise Value – $1,406M

Liquidity – $125M
Debt/LTM EBTIDA – 2.5x

Valuation – EBITDA Multiples

Street 2014 EBITDA = $300M (assuming 23,000 boepd for 2014)
@ $1,406M EV = 4.68x EBITDA
Pro-forma for Sabine acquisition: Assuming they do $33 EBITDA/boe (like JONE) (3,400 boepd*365 days = 1,241,100 boe * $33 EBITDA/boe (based off Q3 results) = $41M)
Pro-forma 2014 EBITDA = $340M
@ $1,406M EV = 4.13x EBITDA

Valuation – Target Valuation/Share Price Targets

Valuing JONE is a tricky proposition given that there are no other publicly traded Cleveland-focused E&P companies. And so, a price target has to encompass something other than quantified relative value. In this case I think it is important to outline the qualitative characteristics of the company that make it a compelling investment and argue how those should promote multiple expansion.

First and foremost, the company is very well run. The Jones family has been involved for almost 30 years and are leading Cleveland operators. Their focus on cost control has been instrumental in JONE becoming the best in class operator in the Cleveland. See slides 17 and 22: http://investors.jonesenergy.com/files/doc_presentations/Barclays%20CEO%20Energy-Power%20Conference.pdf. Moreover, JONE is an acreage leader in the play and has been at the forefront of technological innovation in the play for the last decade.

I might add that through Q2 JONE sported a free cash flow surplus while also growing its production by over 25% YoY, which is exceedingly rare among small-mid cap E&P companies. Although the company reported a slight free cash flow deficit in Q3, relative to its peers JONE remains on very solid financial footing with minimal cash burn.

Argument Summary
1. Excellent seasoned management team with large ownership stake
2. Acreage leader in the play with 30 years operating experience
3. Free cash flow positive while investing in expansion acreages
4. Technological innovator in the play
5. Optional free cash flow upside from further technological innovation

Price Target
Where do I think JONE should be trading? Established E&P companies that have proven themselves as operators and have significant multi-year drilling inventories like JONE can often trade in excess of 10x EBITDA.

In the spirit of conservatism, my upside EV/EBITDA target multiple is 8x.
@ 8x 2014E pro-forma EBITDA of $341M
Target EV = $2,728M
Less Net Debt: $633 Debt – $23M cash ($610 net debt)
Target Equity = $2,118M
@ 49M shares outstanding
Target Price Per Share: $43

What will lead the shares higher? There are several near term events that should be instrumental in removing some of the uncertainty that hangs over the company at the moment.
1. Lockup expiration (1/20/14) followed by a Metalmark secondary allowing larger hands to support shares higher
Result: Remove JONE’s orphaned status
2. New completion design well results successfully increase EURs and well-level economics in the Cleveland play
Result: Remove uncertainty about the capex increase
3. Guidance raised above acquisition-adjusted street EBITDA of $340 million on the new well design
Result: Show effects of technological innovation in terms of earnings power
4. JONE begins operating consistently with a free cash flow surplus – will require several quarters of results
Result: Build a track record of profitability and ability to cash flow

HOLDINGS UPDATE – January 5, 2014

Market Update:

It has been about a month since I posted on the blog.  I have made a number of changes since the last update that reflect my New Year’s resolution to do less heroic bullshit.  I made a resolution to myself to keep things simple in the New Year.  Heroics are just too hard in life and to be honest I am not equipped for any Herculean efforts at the moment.  As such, I have simplified my stock holdings to focus on my single largest conviction idea – the domestic energy revolution.  There are a lot of things happening in energy that are potentially very positive for not only the industry, but the country as well.  The domestic energy production scene has been so active that there is semi-serious talk that the US might lift the domestic oil export ban, which has been in place since the 70s.  This would be a huge win for oil producers looking to sell into the Brent premium and would be an excellent means of narrowing the USA’s impressive trade deficits.  While I doubt we get very far through the political gridlock and the ban ever gets lifted, the sentiment couldn’t be more positive for domestic energy.

Furthermore, large parts of the country have been under an Artic deep freeze for the better part of the last month.  It appears natural gas storage volumes are set to plunge as the country will likely report back to back (to back to back) 200+ Bcf storage draws in January/February.  I am one of the optimists who thinks that we could see sustained $4.50-$5 gas prices heading into the Spring shoulder season.  In any case, $4 is way better for producers than $3 gas.  As such, we should see companies with large gas reserves start getting credit for those reserves in the market.  That is something I have essentially betted on.  My fingers are crossed of course.

One word of warning with regard to the Artic deep freeze that has come home to roost, there will undoubtedly be production delays at many E&P companies who are having difficulty operating in the cold.  Apparently the temperatures in Williston, North Dakota are approaching -50 degrees Fahrenheit, which I read online is about as cold as the face of the planet Mars.  If there aren’t at least midstream disruptions or worse I’ll be surprised.

HOLDINGS (In no particular order)

Jones Energy (JONE): I recently took a position in JONE that is in excess of 10% of my capital.

JONE is a closely held E&P business that operates in the Texas panhandle and in the SCOOP (South Central Oklahoma).  JONE came on my radar after it completed a neat accretive acquisition in the Texas panhandle.  The company appears to be conservatively run with more than manageable debt levels and choice high-IRR acreage.

What’s the rub? The company has a really low float and is closely held by the Jones family of Austin Texas and a private equity firm called Metalmark.  Metalmark and the Joneses got together in 2009 to buy a company called Crusader Energy Group out of bankruptcy, which solidified JONE’s leading position in the Cleveland play in the Texas panhandle.

The company is very cheap (probably less than 4x next years EBITDA if you assume the 2013 acq is accretive) and the lock-up expiration will happen on the 20thI view JONE as an orphaned post-IPO equity that will stand to benefit from increased float.  I am hoping Metalmark will sell a sufficient number of shares into the market such that bigger institutional investors can come into the name and support the shares higher.  => The clock starts ticking on January 20.

Lest I forget to mention it, the Jones family BOUGHT shares in the IPO of the company about 6 months ago.  I cannot say I have ever seen insiders purchase shares in an IPO before… And so, it is pretty clear what the Joneses think about the stock!

Magnum Hunter (MHR):  MHR is still my largest holding.  I have been transitioning out of the stock and into the January 2015 $7.50 calls of late in order to free up some cash for investment in other ideas.

Updates: MHR came out with its 2014 guidance in mid-December and an operational update in mid-to-late December.  The operational update was great.  The Ormet pad came in at about what the company guided they would in their corporate presentation and the Collins pad had two monster wells that blew away projections.  I am hoping for more Collins-type wells going forward.  It is becoming clear that the core of the Marcellus/Utica is likely to the south (right where MHR sits).  Of course more data is necessary to make this call, but I am excited.

As for the 2014 guidance, the company is spending the majority of its capex budget in the Marcellus and Utica (as it should) and nearly 25% of the capex spend will be on the Eureka Hunter pipeline.

I have a couple of bones to pick with the company about their guidance.  First of all, it is clear the company is going to be producing a lot of gas.  Therefore, they should report their guidance in Mcfe and not Boe – it’s just better form.  Second, MHR should sell the pipeline to the highest bidder as soon as they have the core of the Utica delineated and tied into the pipe.  The pipeline is nothing but headaches and operational mishaps.  Not to mention MLP ponzi schemes like Kinder Morgan are about gobbling them all up at 25x made-up EBITDA numbers.  Instead of planning to sell the pipe, management suggested they would borrow against it.  This would be the equivalent to borrowing against a house in Las Vegas in 2005 => doomed to fail.  The clear optimal decision would be to sell the pipeline now at some inflated valuation to the unknowing LPs of ponzi partnerships like Kinder Morgan and reinvest all the profits in the dirt in the Utica.

I had a call with MHR management and explained my thinking with regard to the pipeline.  I’m not sure my ideas were well received, but at least I voiced my opinion and they are ostensibly aware of the risks of keeping precious capital invested in a vastly overvalued pipeline asset.

Gastar (GST):  Gastar had a mid December operational update that was very good.  They announced their 7H Hunton well had a 24 hour IP in excess of 900 boe!  Hopefully the next set of wells are this good, but I have a healthy amount of skepticism that the whole Hunton play won’t be as prolific as the area around the 7H, but you never know.

The shares have rallied pretty strongly on good operational updates and the introduction of an activist investor into the name.  I’m going to be honest.  Kleinheinz is late to the game, but if he is here and willing to support the stock above $6, then I won’t sell too many of my shares.

I remind anyone who is still reading that Russ Porter has said multiple times before that he thinks the Marcellus acreage alone is worth $7/share.  That has been my target for a couple of months.  Since we got pretty close to the $7 bogey last week and the company is trading at around 10x next year’s EBITDA, I sold some of my position – about 30% of my original capital.  I could end up regretting this decision, but I feel it was worth it to put the cash into JONE instead, which is much much cheaper and easier to own.

Antares Energy (AZZ.AU/AZZEF): Still a waiting game. January 22, 2014 shareholders meeting and close by end of February.

Emerald Oil (EOX): We have 2014 guidance here.  Waiting on well results/operational update.  To be honest I expect the updates to be bad given the cold up in North Dakota (and so does the market given the sell-off in the shares).  This name may require some patience, but I think in a year it is a $14 stock at least.

Alaska Communications (ALSK): I still think ALSK is worth in excess of $8.  There hasn’t been any news since they reported Q3 results.

Strayer Education (STRA): I sold half of this bad boy as part of my New Year’s resolution to do less heroic bullshit.  I’ve already lost about 15% on STRA because I failed to properly recognize the hatred that exists for this industry and the massive regulatory risks that hang over all of the for-profit stocks.  I read that the CFPB is investigating competitor ITT Educational Services, which obviously poses a threat to the whole industry.  I decided to cut my risk in half immediately.

My thought process: Is STRA cleaner than ESI in terms of off BS liabilities? Yes.  Does STRA still make a lot of money and have a FCF yield in excess of 15%? Yes.  Will the market care about those things when a negative CFPB ruling is made on ESI? No.  Why be a hero with STRA when I can wait until Obama is out of office and the CFPB relaxes on the for-profits? => Great point, I should sell half my risk in this today.