The Rational Cloning: Weekly Ideas #68
Praetorian Capital, Cedar Creek Partners 2022 Results; Tweets That Make You Go… Hmm 🤔
Welcome to the 68th edition of the Rational Cloning Newsletter (Weekly Ideas Series).
Helping you discover the best ideas of others.
Happy cloning.
Weekly Investment Ideas
(1) Praetorian Capital: 2022 Q4 Letter
Position Review (top 5 position weightings at quarter end from largest to smallest)
(1) Uranium Basket (Entities holding physical uranium along with production companies)
It may take some time still, but I believe that society will eventually settle on nuclear power as a compromise solution for baseload power generation. This will come at a time when there is a deficit of uranium production, compared with growing demand. As aboveground stocks are consumed, uranium prices should appreciate towards the marginal cost of production. Additionally, there is currently an entity named Sprott Physical Uranium Trust (U-U – Canada) that is aggressively issuing shares through an At-The-Market offering, or ATM, in order to purchase uranium (we are long this entity). I believe that these uranium purchases will accelerate the price realization function by sequestering much of the available above-ground stockpile at a time when utilities have run down their inventories and need substantial purchases to re-stock. The combination of these factors ought to lead to a dramatic increase in the price of uranium as it will take multiple years for sufficient incremental supply to come online—even if the re-start decision were made today.
Ironically, I believe uranium will be a prime beneficiary of sanctions on Russia as Russia is one of the world’s largest enrichers of uranium. As the West is forced to enrich more of the uranium that ultimately goes into reactors, underfeeding of tails will flip to an overfeeding of tails. In my opinion, the net effect could be anywhere between 10% and 30% of the global supply of uranium disappearing—which may dramatically accelerate the timing of my thesis while increasing the ultimate magnitude of the upward swing in uranium prices.
(2) Oil Futures, Futures, and ETF Options and Call Spread
I believe that years of reduced capital expenditures, along with ESG restricting capital access, combined with Western governments that are openly hostile to fossil fuels, have created an environment for dramatically higher oil prices. While we could purchase oil producers, I feel it is far more conservative to simply own the physical commodity itself.
During the fourth quarter, I swapped out our December WTI 2025 futures for the Brent Oil ETF (BNO -USA) as I wanted to diversify our oil exposure from WTI and into a global commodity that is less likely to be manipulated by the US government. I also believe that over time, BNO should earn a roll yield, much like it did for most of 2022. Finally, I wanted more exposure to the front of the oil curve, as that is likely to be where the action will be. This position swap was done at a time when the spread between Brent Oil and our futures had compressed by a decent amount, allowing us to avoid paying up substantially for the above-mentioned benefits. We also purchased some shorter-dated futures at around the same time.
I believe that this leveraged play on oil gives us the most upside to oil and ultimately inflation, while exposing us to reduced risk when compared to producers.
(3) Energy Services Basket (Positions Not Currently Disclosed)
In 2020 when oil traded below zero, drilling activity ground to a halt and many energy service providers declared bankruptcy. Many of these businesses had teetered on the verge of bankruptcy for years due to reduced demand and over-leveraged balance sheets. The bankruptcies led to consolidation and reduced future industry capacity, removing future competition in the recovery.
With oil prices now recovering, I believe that demand for drilling and other services will increase from subdued levels. While producers have been slow to increase spending on exploration despite recoveries in energy prices, I believe that this only extends the timing on the thesis. In the end, the only way to reduce future energy prices is to see a dramatic increase in global oilfield services spending. Any postponement of this spending only leads to higher prices and more wealth transfer from the global economy to the oil producers, which will likely end up resulting in an increase in spending on exploration and production.
We purchased many of these positions at fractions of the equipment’s replacement cost, despite restored balance sheets and positive operating cash flow. As spending in the sector recovers, I believe that the potential for cash flow will become more apparent and this equipment will trade up to valuations closer to replacement cost.
(4) St. Joe (JOE – USA) JOE 0.00%↑
JOE owns approximately 175,000 acres in the Florida Panhandle. It has been widely known that JOE traded for a tiny fraction of its liquidation value for years, but without a catalyst, it was always perceived to be “dead money.” Over the past few years, the population of the Panhandle has hit a critical mass where the Panhandle now has a center of gravity that is attracting people who want to live in one of the prettiest places in the country, with zero state income taxes and few of the problems of large cities.
The oddity of the current disdain for so-called “value investments” is that many of them are growing quite fast. I believe that JOE will grow revenue at 30% to 50% each year for the foreseeable future, with earnings growing at a much faster clip. Meanwhile, I believe the shares trade at a single-digit multiple on Adjusted Funds from Operations (AFFO) looking out to 2024, while substantial asset value is tossed in for free.
Besides the valuation, growth, and high Return on Invested Capital (ROIC) of the business, why else do I like JOE? For starters, land tends to appreciate rapidly during periods of high inflation— particularly an inflationary period where interest rates are likely to remain suppressed by the Federal Reserve. More importantly, I believe we are about to witness a massive population migration as people with means choose to flee big cities for somewhere peaceful.
I suspect that every convulsion of urban chaos and/or tax-the-rich scheming will launch JOE shares higher, and it will ultimately be seen as the way to “play” the stream of very wealthy refugees fleeing for somewhere better
(5) Legacy to Digital Transformation Securities Basket (Various Positions)
Most global print newspapers have seen their readership decline for decades as subscribers seek out alternative digital sources of information. In response to this, newspapers have tried to build up their digital presence. Historically, this digital revenue stream was always rather negligible as it was coming from a small base, especially when compared to steep declines from the print side.
Over the past few years, digital revenue growth has accelerated to the point where I expect that the newspaper companies in our basket are within a few years of their digital revenue overtaking their print revenue—assuming recent trends hold. Digital revenue represents a higher margin and higher return on capital business when compared to the capital and manpower intensity of printing and distributing physical newspapers. My belief is that, as these digital businesses come to dominate the revenue stream, newspaper company valuations will re-rate—particularly as many of them trade as if they are dying businesses, when in reality, the digital side of their businesses is growing quite rapidly.
While many well-known global newspapers have successfully made this digital transition and seen earnings growth for a number of years, many smaller papers have continued to see earnings decline. I believe that these smaller papers are now on the cusp of an inflection to earnings growth as digital growth overtakes print declines. Should this happen, I anticipate it will dramatically change the narratives for these companies, along with their valuations, much like what occurred at more wellknown papers. The fund owns a global basket of these smaller newspaper companies.
(2) Cedar Creek Partners 2022 Results
Below is an update on the larger holdings of the fund:
M&F Bancorp (MFBP)
is a North Carolina based bank with two million shares outstanding. In the summer it received $80 million of low-cost capital through the US Treasury’s Emergency Capital Investment Program. The stock is currently at $26 per share. Our cost basis is under $12. In the third quarter M&F earned $0.51 per share. Most of the ECIP funds appear to have still been in cash, likely earning 2% max. Annualizing third quarter earnings gives a $2.05 per share earnings run rate. We expect earnings to have continued to grow in the fourth quarter on the assumption that some of the cash would have been moved to higher yielding short-term treasuries and some of their loan portfolio re-pricing (i.e., existing loan rates increasing due to the prime rate being higher) faster than their cost of deposits has increased. A buyer today is paying 11-12 times earnings for a bank with the potential to see earnings double or potentially triple from an acquisition using the ECIP funds or steadily grow by attracting deposits and making loans. (See our 2022 third quarter letter for a more detailed discussion of ECIP recipient banks.)
Solitron Devices (SODI) -
the bid price for shares decreased by 21% in 2022 from $11.00 per share to $8.70 at year end. As a reminder, I am CEO and CFO of Solitron due to a proxy fight in 2015 and management change in 2016. Solitron’s annual meeting was held in January 2023 and I discussed the press release issued by the company related to the U.S stockpile program, which noted.
In December 2022 the President signed the $1.7 trillion omnibus spending bill. Included in the bill (was) appropriations to replenish supplies used in Ukraine and to increase stockpiles. A number of programs are included in the spending, including two that represent Solitron‘s two largest revenue sources. The increased stockpiles program is a multi-year program that we currently expect to add approximately $20 million in total revenues starting in late (calendar) 2024 and running through 2028, or approximately $4 million annually. Actual contract awards are expected to occur by the fall of 2024.
Fiscal 2022 revenues were $12.3 million versus the prior years $10.5 million, which shows the significance of a $4 million annual increase. The press release also noted Solitron’s cost savings program is achieving or exceeding its targets. In addition, at the end of the fiscal second quarter and first part of the fiscal third quarter Solitron purchased 1.1% and 1.5%, respectively, of the outstanding shares of two small community banks that were recipients of the Emergency Capital Investment Program (ECIP).
Citizens Bancshares (CZBS)
is an Atlanta, Georgia based bank with similar characteristics as M&F. Citizens has roughly 2 million shares outstanding. Shares traded last at $31 per share. The fund started buying in June at $12 per share, which was less half of common book value, and six times 2021 earnings. Our basis is under $18. Citizens received $95.7 million of additional capital (ECIP) at the end of June 2022. Citizens does not report quarterly earnings, but the bank does file quarterly Call Reports which are available on otcmarkets.com. Earnings for the third quarter of 2022 were about $1.27 per share, giving an annualized rate of over $5 per share. Earnings increased due to a chunk of the ECIP funds being invested in US Treasuries during the quarter.
Citizens still had a high amount of cash on its balance sheet as of September 30 and likely increased its securities portfolio in the fourth quarter, further boosting earnings. Assuming a $5 to $6 annual run rate in earnings, Citizens is trading at a multiple around 5-6 times. Over time the capital should move from being in 4% treasuries to being leveraged via growing deposits and loans or securities, which will boost earnings further, or Citizens can use the funds to buy another bank and increase earnings that way. Without an acquisition we think the bank can earn $7 per share in 2024 and in excess of $8 per share in 2025. An acquisition would likely speed that timetable up.
During the fourth quarter Citizens announced receipt of a $5 million preferred investment by TD Bank. Details on the rate were not announced, but we would assume it was favorable as Citizens didn’t really need the capital. Our guess is the rate is around 2% and may have a share of future dividend increases.
PD-Rx Pharmaceuticals (PDRX)
is an expert market stock that has historically released financials yearly on its website. The company manufactures both brand and generic pharmaceuticals from its Oklahoma City facility. The company had been profitable until fiscal 2019 and 2020, when it incurred small losses. They adopted a cost cutting program. In fiscal 2021 they returned to profitability earning roughly $0.40 per share excluding PPP loan forgiveness. Net cash was $1.69 per share. Through November 2022 we steadily increased our ownership as shares were available at prices between $3.05 and $3.60 per share (we assumed we were paying 3-4 times earnings net of cash). In late December 2022 they reported fiscal 2022 results. After results, the stock jumped to $6.00 per share and we continued to purchase. We marked the position at $6.00 per share, which was the last market transaction. For the year ended June 30, 2022, PD-Rx had earnings of $1.83 per share. Book value increased to $6.90 per share. They have no debt, and net cash of $3.33 per share. In addition to the cash, their $4.46 million of receivables is more than double total liabilities.
At $6.00 per share we are paying 3.5 times trailing earnings and only 1.5 times trailing earnings net of cash. There was nothing in their annual results or management letter that would lead us to believe that earnings will change in the current year versus the prior year. We think PD-Rx can earn $2.00 per share in fiscal 2023 by just investing a portion of their cash in treasuries. While we would love to own the whole business at $6 per share, we are happy to own a part at that price. If earnings in fiscal 2023 are similar to fiscal 2022 results, then book value as of December 2022 is already at $8 per share. We estimate value based on earnings (free cash flow), not book value, and think the company could easily fetch $20 per share in a sale, and likely above $25. We had seen a few years ago that someone who spoke with management had commented that management said they would sell for 1.5x sales which would be over $26 per share. That seemed high at the time, but not at current earnings levels. All but one person in senior management is above 70 years of age, so a sale may well happen over the next few years
Pacific Coast Oil Trust (ROYTL)
During the fourth quarter we joined with Shipyard Capital in filing a joint 13D on Pacific Coast Oil Trust. We subsequently added a private investor and Evergreen Capital, who owns 8.5% of the units, to the group bringing it to over 21% of outstanding units. We have called for a Special Meeting to remove the Trustee. We think that the operator, PCEC, is improperly trying to assess Asset Retirement Obligations (ARO) to the trust. ARO’s are the cost to return a well back to normal state (i.e., plugging well and removal of equipment, etc.). PCEC contends the Conveyance Agreement allows for it (pages 7 (n), 22 (l)). We contend that the Conveyance Agreement forbids any assessment of costs incurred or accrued prior to April 1, 2012 (pages 5, 20 that govern what pages 7 and 22 refer to) and secondarily that the proforma financials in the offering documents clearly show the liability remaining with PCEC (see the Offering documents page PCEC F-30 asset retirement obligation line). Meaning it did not transfer to the Trust.
PCEC had already accrued an ARO obligation when it purchased additional properties in 2008, 3 evaluated it annually, and made adjustments accordingly, prior to the trust being created in 2012. At that time, April 2012, the ARO was approximately $22.3 million4 and should have accreted (compounded) at approximately a 7 to 9% rate annually. After ten years of accretion, it would be nearly double the original $22.3 million, which is nearly the amount the operator says the assessed ARO obligation was. Further, in all the Offering document proformas no assessment was made to the trust for asset retirement obligations, nor was the Trust assessed any ARO obligation from 2012 through 2019 when, interestingly enough, PCEC was purchased by new owners.
Our argument is that the ARO should not have been assessed to the Trust (unitholders) at all. Thus, all the funds that have been withheld need to be repaid with interest. If true, the operator owes the trust roughly $25 to $30 million, or $0.65 to $0.80 per unit, versus its current $17 million market cap and $0.44 per unit price, and distributions would resume at approximately $.023 per unit per month, or $0.28 annually. We think fair value of the units would be in excess of $2.00 per unit under this scenario, or five times the current price.
What if courts disagreed that the ARO was assessable? Would it be fully assessable or partially? We contend that it is clear in the conveyance agreement that the Trust can only be assessed costs related to production during its existence, not production that pre-dates the creation of the trust or future production. That would mean the ARO cost has to be allocated to production units since PCEC, the operator, purchased the fields, and only the portion related to the time the Trust has been a recipient of cash flows is assessable to the Trust. This would still mean excess funds have been withheld and would be returned and distributions would resume. Under this scenario, we think fair value would be above $1.25 per unit, or nearly three times the current price.
We also believe that the funds should be escrowed since if any of the properties/fields were sold, the ARO transfers to the buyer, thus releasing the obligation. Further we contend that the funds withheld should be credited the discount rate, currently 9%, used in the ARO calculation to avoid double assessment. In other words, the amount that has been paid is the present value of future costs discounted back to the present. It would be double assessment to then assess the increase in the present value due to time to the Trust. Since the amount is pre-paid the obligation to earn the discount rate should be borne by the operator.
Obviously, there is some chance that the courts deem the ARO fully assessable, ignore our calling of a Special Meeting, and allow the Trustee to proceed to an auction since the Trust did not receive the minimum required distributions from PCEC in 2020 and 2021. A strong case can be made that an auction of the properties is clearly a sale and that the ARO obligation transfers to the buyer and the withheld ARO must be paid back to the Trust with interest along with any proceeds from the auction. Even if that argument was rejected, then the near full payment of the ARO obligation means that cash flows would resume in six months from today and in even less time by the time any auction closed. While the buyer has to assess the attractiveness of working with PCEC, we still think fair value is above the current price and likely above $1.00 per unit since the ARO obligation would have been paid and monthly distributions resume.
Mortgage Oil Company (MGAG)
is also presently trading on the expert market. We covered it in more detail in our Q2 2021 letter. It once went nine years without a published trade. It has only 40,915 shares outstanding. Last trade was at $355.00 per share. They do not invest in oil or mortgages, rather real estate, primarily multi-family and some commercial. We bought almost 2% of the company in an hour in May 2021. Current yield is 4.2% based on yearly $15 dividend. The properties have been on the books long enough their tax basis is negative. That likely means there is potential for gains on sale or distributions via refinancing should rates come back down. Recent distributions from real estate holdings to the company have been roughly $20 per share annually. In addition, cash and securities were $118 per share as of June 2021. We haven’t seen financials since that time. For some reason there is no balance sheet liability accrual for taxes on unrealized gains on marketable securities. We expect the stock to be a long-term holding that can give us real estate exposure and generate double digit returns.
Tweets That Make You Go… Hmm 🤔
