Monthly Archives: May 2013

Conduril: balancing concentration and diversification

One of the toughest things as an investor is the balancing act between managing risk by building a diversified portfolio and maximizing returns by putting money at work in your best ideas. Warren Buffett is known for his dislike of diversification, and this quote from the 1993 letter to Berkshire Hathaway shareholders nicely illustrates his thinking:

If you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk.

Key in this statement is of course that he’s talking about companies with a long-term competitive advantage. This is worlds apart from a Graham net-net approach where you almost always buy below average companies, but you simply buy them at a very cheap price. Some will fail, some will just limp along and others might turn around spectacularly. Buying a portfolio with 10 net-nets is, in my opinion, foolish from a risk management perspective, and buying 20 is still borderline irresponsible. Buy a basket of 30-50 stocks and you should be doing alright. How concentrated you should be not only depends on the returns you expect, but also the range and amount of possible negative outcomes. And this is easier said than done: translating the theory in a portfolio percentage isn’t trivial.

While Berkshire Hathaway is reasonable diversified these days Buffett made very concentrated bets in the past. In his early investing career he had for example invested more than 65% of his net worth in GEICO. Interesting enough that investment resulted in what was probably his biggest investing mistake since he sold after a year for a 50% gain while it would have delivered a 100x return the next two decades. From Buffett’s 1995 letter:

You may think this odd, but I have kept copies of every tax return I filed, starting with the return for 1944. Checking back, I find that I purchased GEICO shares on four occasions during 1951, the last purchase being made on September 26. This pattern of persistence suggests to me that my tendency toward self-intoxication was developed early. I probably came back on that September day from unsuccessfully trying to sell some prospect and decided despite my already having more than 50% of my net worth in GEICO to load up further. In any event, I accumulated 350 shares of GEICO during the year, at a cost of $10,282. At yearend, this holding was worth $13,125, more than 65% of my net worth.

You can see why GEICO was my first business love. Furthermore, just to complete this stroll down memory lane, I should add that I earned most of the funds I used to buy GEICO shares by delivering The Washington Post, the chief product of a company that much later made it possible for Berkshire to turn $10 million into $500 million.

Alas, I sold my entire GEICO position in 1952 for $15,259, primarily to switch into Western Insurance Securities. This act of infidelity can partially be excused by the fact that Western was selling for slightly more than one times its current earnings, a p/e ratio that for some reason caught my eye. But in the next 20 years, the GEICO stock I sold grew in value to about $1.3 million, which taught me a lesson about the inadvisability of selling a stake in an identifiably-wonderful company.

This excerpt also shows something that was recently mentioned by Nate at Oddball Stocks: Buffett seems to have made a lot of money by buying extraordinarily cheap companies. Reading his old letters you get the feeling that back in Buffett’s early days everybody with a few working brain cells could have made money simply by buying companies at a 1x or 2x PE-ratio. Today there are probably less companies that are that cheap, but Conduril is one of them. The following three ratios should say it all:

  • P/E: 2.3x
  • P/B: 0.33x
  • EV/EBITDA: 0.61x

And that’s for a company that compounded book value at a 33% annualized rate the past six years straight through a recession, while paying dividends and without posting negative results in a single year. Just for fun I tried running a screen with the above three ratios as screening criteria. The only thing it returned from the US market were a handful of Chinese frauds, but most frauds even failed to meet the above criteria: Conduril is that cheap!

While I think that Conduril is really cheap it’s also not without risks, although it’s getting increasingly less risky. Their asset/equity ratio has been decreasing every year since 2006 and is now standing at 2.36x versus 2.93x last year (and 4.21x in 2006). They also turned around a net debt position of €6.4 million in 2011 to a €15.3 million net cash position at the end of 2012.

With the kind of valuation ratios that Conduril has it shouldn’t come as a surprise that it also looks very cheap compared with other public construction firms in Portugal. Two of the firms listed below are on the brink of bankruptcy with an insane amount of leverage. The best comparable is probably Mota-Engil that, just like Conduril, does a lot of business in Africa.

Conduril comparables

I don’t think the mean and median values are very useful in establishing an implied value for Conduril since there are a lot of outliers / distressed companies in the list above. But it says something when even the most crappy competitors are trading at higher valuations. Based on the comparables I’d say that Conduril should trade at least at book value and potentially higher. That doesn’t seem like a stretch given their historical profitability and their current backlog. To get an idea of how Conduril compares to Mota-Engil a quick overview of some financial stats and ratios:

Conduril versus Mota-Engil

I’m not quite ready to follow Buffett’s footsteps and put the majority of my net worth in a single stock, nor do I think it’s a great idea in this specific case since an emerging market construction company is not a sure thing. But Conduril is remarkable cheap, especially considering the profitability of the business and the low amount of leverage compared to its peers. Not allocating a significant portion of my portfolio to an idea this attractive seems like a major mistake. So even though the stock is up ~36% since I initiated my position last year I added ~70% more shares. This increased my allocation to the stock from ~7% at the beginning of the year to 12.5% now, making Conduril my biggest position.

The million dollar question is of course: is this the appropriate balance between risk and reward? Personally I think I might have erred on the side of caution, but since overbetting on a position is a bigger mistake than underbetting I’m comfortable with that. What do you think? How would you size this?

P.S. If someone thinks he owns something that’s cheaper than Conduril I’m all ears!

P.P.S. If you have a good argument on why this will end in tears I’m even more interested!


Long Conduril

Bought Awilco Drilling

After thinking some more about the risks and rewards inherent in an investment in Awilco Drilling I have decided to buy a relative small position in the stock. There are a lot of risks, but at the same time I do think it’s an asymmetric bet. It’s highly likely that a very large part of my original investment will be returned in the next three years, and while the future is uncertain there is a wide range of possible favorable outcomes. Dayrates going down to $250K/day is probably still fine, dayrates staying at the current level is great and dayrates going up is even better.

Awilco Drilling also reported the results for the first quarter of 2013 yesterday and it’s good news all around. EBITDA was up compared to the last quarter of 2012, revenue efficiency was at 91.2% (pretty good for the winter season I’d guess) and most importantly the board approved a $1.0/share dividend. At current prices that represents a 25% annualized yield, and that’s more than what I would have expected given the tendency of companies to find reasons to spend and keep cash. Also positive is that Premier Oil exercised its option to extend the term of its drilling contract with AWDR, so rates have been locked in for a longer period in 2014.


Long Awilco Drilling

Awilco Drilling (AWDR.OL): cheap with a catalyst redux?

Awilco Drilling PLC is a recently formed company that owns two semi submersible drilling rigs. The rigs were bought from Transocean in the beginning of 2010 that, following a merger, was under obligation to reduce its exposure to UK waters. The two rigs, the WilPhoenix and the WilHunter, have been upgraded in 2011, and after a bit of a slow start in 2012 the company is now set to generate a significant amount of free cash flow that it intends to pay out to shareholders. The author of this write-up at the OTC Adventures blog sees a possible yield of more than 20%, and that sounded cheap enough that it got my attention. As usual some quick stats before diving deeper:

Last price (May 10, 2013): 82.75 NOK
Shares outstanding: 30,031,500
Market Cap: NOK 2.49B ($428.7M)
Free float: 51.27% ($219.8M)
P/B (mrq): 2.4x
P/E (ttm): 11.0x
EV/EBITDA (ttm): 7.35x


Based on these metrics the company doesn’t look very cheap, but we can make a decent estimate of the future profitability based on the current contract backlog. The WilHunter is on contract until 15 November 2015 while the WilPhoenix is on contract until early May 2014. The day rates that Awilco Drilling will receive are therefore already locked in. From the latest company presentation:

Awilco Drilling backlog April 2013These rates are quite high thanks to tight supply in the UK drilling market, and if everything goes smoothly Awilco Drilling should generate a lot of cash. I have created an estimate for 2013 based on the above backlog assuming that other items such as operating expenses and depreciation stay at levels consistent with previous year. Note that the interest expense is slowly going down because the company is paying down approximately $16.5 million in debt this year.

Awilco Drilling estimated 2013 results

Awilco Drilling pays almost no taxes because the rigs are owned by subsidiaries located in sunny Malta. The effective tax rate might even go down in the future because the UK corporate tax rate is being lowered the next few years from 28% to 20%, and the taxes that they do pay are mostly UK taxes. Last year the company paid just 6.4%.

The possible income of roughly $116 million in 2013 would translate to a significant amount of free cash flow. Last year capex spending was $5 million while depreciation was $17.5 million. This means that free cash flow could approximately be $129 million while free cash flow to equity (after paying down $16.5 million in debt) could be ~$112.5 million. This represents a yield of roughly 25%!

Do I expect that they company will achieve this? No, because this is more-or-less a best case scenario. On average we should expect some bad stuff and operating expenses are probably going up compared to 2012. But with a possible 25% yield you have room for some unfavorable events and still arrive at a >20% FCFE yield. But a significantly worse results is certainly also possible. The company owns just two rigs, and serious problems at one of them could have a very big impact. There is a lot of idiosyncratic risk.

Dividend prospects

The second big positive is that Awilco Drilling is planning to return basically all free cash flow to investors, after maintaining a $35 million cash buffer. This intention is communicated crystal clear in  the financial reports and the various presentations. See for example the latest presentation:

Awilco Drilling divided prospectsGiven how much cash flow the company could generate the next few years it isn’t hard to see how the initiation of a big dividend could be a catalyst for the shares to reprice higher. Since the company already had $17 million on the balance sheet at the end of 2012 it should be right on track to start quarterly dividend payments in the second quarter of 2013.


So we will get probably get a high yield with limited risk the next couple of years because high rates have been locked in, but is this enough reason to pay more than two times book value for a company that is active in a commodity industry? The question is of course how well book value reflects the economic value of the two rigs build in ’82 and ’83. The rigs were sold by Transocean for $195 million in January 2010 in what was arguably not the best economic climate. Transocean booked a loss of $15 million on the transaction while it already had recognized a $279 million impairment loss on the two rigs in 2009 when oil went below $40/barrel. In other words: a couple of years ago the book value of the two vessels – before being upgraded in 2011 for almost $100 million – was around $500 million. Add that Transocean was forced to sell because of antitrust concerns and it seems plausible that Awilco Drilling got a good deal.

This doesn’t bring us really closer to a valuation, and fact is that a narrow value estimate is going to be a though task because it depends on volatile day rates multiple years in the future. The UK market is almost sold out until 2015, but what will happen with the rates after that? It’s highly uncertain, but even if rates would plummet you would have some downside protection since you will get a large part of your investment back the next couple of years while the company is simultaneously deleveraging. If rates stay around the current level, or go up, an investment in Awilco Drilling should work out very well as long there is no negative tail event (think Deepwater Horizon, Piper Alpha etc).

While you would get a good return in that scenario I think investors should also demand a high expected return. You get the idiosyncratic tailrisk that everybody thinks about when see a burning oil platform on the news with Awilco Drilling, and you can diversify that away, but there is also a lot of market risk, and I think that’s a lot bigger and more important. The profitability of oil drilling is strongly correlated with oil prices and thus the strength of the economy, and there is a lot of operating leverage involved in owning a drilling rig. Throw a bit of financial leverage in the mix and it should be clear that equity investors should demand a healthy return! The average value investor isn’t a big fan of CAPM, and for a good reasons, but seeing that Transocean trades with a beta slightly above 2 should say something about the market risk.

I’ve played around with a few valuation approaches and what makes most sense to me is to assume that earnings will be high the next three years, and that the risk in achieving these earnings is moderate so that the expected cash flows for the next three years can be discounted at a reasonable average rate such as 10%. Current day rates are probably the best starting point for a prediction of future day rates, but since this is a lot riskier a significantly higher discount rate is appropriate. If I would use a 10% discount rate for the first three years and a 20% discount rate for the years after that I get an approximate value of ~$600 million dollar and more than half of that NPV comes from the first three years. Lower discount rates can obviously increase the value a lot, but I doubt how appropriate that is given the amount of risk involved after the first few years.


Awilco Drilling PLC is owned for 48.73% by Awilhelmsen AS, a privately owned investment company. Sigurd E. Thorvildsen is the Group CEO and also Chairman of Awilco Drilling PLC. The COO of Awilhelmsen AS is also a non-executive director. So while the CEO of Awilco Drilling PLC doesn’t have a stake in the company (besides a few options) shareholders are well represented on the board. I prefer to see a CEO that owns a significant stake in the company, but this is also a decent structure.


The near term cash flows of Alwilco Drilling and the intention of the company to return that money to shareholders through dividends sound very attractive, and especially in today’s yield starved world I can imagine that the initiation of a healthy dividend can act as a catalyst to propel the stock higher. But I’m not willing to buying stocks hoping on a greater fool to sell them to in the future, I have to be comfortable with the underlying intrinsic value. And while I do think that Awilco Drilling is cheap, I’m not that sure that it is a huge bargain. It’s a very risky asset and it should deliver a relative high yield as a compensation for those risks. I haven’t yet completely made up my mind, but at the moment I’m inclined to pass on this stock. What do you think? How much is it worth?


No position in Awilco Drilling, but thinking about it…

Exited Aker Philadelphia Shipyard

I made an U-turn today and sold Aker Philadelphia Shipyard after initiating the position exactly a month ago. In this period the price of the stock has gone up more than 35% while I realized that I significantly overestimated the value of the company.

The biggest source of error is the accounting of the variable revenue from the profit sharing agreement. When you see $3.3 million in revenue in Q1 2013 from the profit sharing agreement it makes sense, at first sight, to assume that this is their part of the income generated with the ships in that quarter. Rule #1 in accrual accounting is that revenue should be recognized in the period it was generated. But from the perspective of Aker Philadelphia Shipyard this wasn’t revenue that they earned during the quarter, this was revenue that they earned while building and selling the ships. So what they recognize is the net present value all future revenue that can be reliable estimated. Note 11 in the Q3 2012 report confirms this clearly:

AKPS Q3 2012 report, note 11 quoteThe company has recognized $3.3 million in variable revenue for each vessel, and expects more than $35 million in revenue over the life of each vessel (estimated to be more than 25 years). If you assume $1.35 million in revenue per year and a 10% discount rate the NPV of a 3 year charter agreement would be $3.3 million and the total revenue over a 25 year period would be $34 million. The length of the charter agreement could of course be slightly different, or they could have used a different discount rate, but this seems close enough.

If the first 3 years of revenue from the profit sharing agreement is already recognized the NPV of the remaining amount is far less than I originally estimated. If you assume $1.35 million in revenue per year per ship from year 4 till year 25 the NPV of this cash flow is just $10 million (assuming a 10% discount rate and a 35% tax rate).

I think my estimate of the value of the operating business was also a bit on the high side (see the discussion here in the comments), so an updated rough approximation of the value of the sum-of-the-parts would be:

  • $46 million (cash + current project)
  • $26 million ($3.7 million in income from operating business with a 7x multiple)
  • $13 million ($10 million NPV of future profit sharing + $3 million from last quarter)

This would give us a value of $86 million versus a market cap of roughly $62 million. This is still a ~27% discount to intrinsic value, but this would not pass my hurdle for new investments so I’ve sold. In addition I already have exposure to the shipbuilding industry through Conrad, and I also have various other names in the industry on my watchlist that are probably cheaper.


No position in Aker Philadelphia Shipyard anymore