HNR Update

There may be some confusion on the value to be received by HNR once the conversion is completed. The $275 mn number is cited, but the net to HNR will be less.

Once the new agreement is finalized, HNR's subsidiary Petrodelta will receive reimbursement for oil and gas sales to PDVSA, to obtain the same economic result as if the conversion had been completed on April 1, 2006. Since April 1, 2006 through June 30, 2007, HNR delivered 8.0mn barrels of oil. The estimated price for reimbursement over this period is $47.53 per barrel. So, 8.0 x 47.53 = $380.2mn dollars. HNR also delivered 18.2bcf of gas, priced at $1.54 per mcf, for total sales of $27.7mn dollars. So total sales are $380.2mn+$27.7mn=$407.9mn. The 33% royalty must be deducted, so net sales are $273.3mn, which corresponds to Mr. Edmiston’s “approximately $275 million” comment.

During this period, costs have been about $58mn, most of which has already been reimbursed. Thus, during this period, the profit before tax for Petrodelta is $273mn-$58mn, or $215mn. Taxes are 50%, so net after tax profit is $108mn. HNR has an effective 32% interest, so its share of net income for this period will be about $34mn, or $0.97 per HNR share (after adjusting the share count to 35.4mn, reflecting the repurchase of 2.3mn shares in August).


I expect Petrodelta will dividend less than 100% of net income for this period. Petrodelta will need more cash on hand to fund (1) cost of new rigs (2) increased operating expenses as operations expand and (3) initial capitalization of Petrodelta.

PRXI Acquires Rights to Personal Property From Titanic

Premier Exhibitions announced today it has acquired Ownership Rights to the personal property on board the doomed ocean liner RMS Titanic from Liverpool and London Steamship Protection and Indemnity Association Limited (Liverpool and London).

The press release notes:

Liverpool and London was the insurer of the personal property on board the ship. By virtue of the settlements it reached with the Titanic passengers and their families soon after the tragedy, Liverpool and London acquired via subrogation ownership rights to the personal property, which remained on the vessel. With the acquisition of these rights, the Company now has the lawful claim to ownership.

By way of background, a subsidiary of PRXI has been recognized since 1994 as the salvor-in-possession. As such, PRXI has been able to display the artifacts, and display them for profit, but it has not been awarded title in the majority of the objects recovered. Through a series of court cases, PRXI has been recognized as owner of the approximately 1800 artifacts recovered in the initial 1987 expedition, but the remaining 3,700 recovered artifacts are subject to a claim for salvage. PRXI has previously submitted a claim for such salvage of $225 million.

By acquiring the insurers rights to subrogation, PRXI has strengthen its position in the residual value of the recovered artifacts, after satisfaction of the salvage claim. Further, it apparently will have claim over all remaining personal items to be recovered in future expeditions.

Continuing with the PRXI press release:

Admiralty and Maritime legal expert David Bederman, a professor at Emory University School of Law who also serves as maritime counsel to the Company, commented on the legal significance of this agreement: "the Company is now in a unique, although not unprecedented position with respect to a historic wreck. It now has duel roles -- that of Salvor-in-Possession of the wreck, and that as the de jure (by right) owner of the personal property from the wreck site. As it has for the past thirteen years, the Company continues to serve as the Salvor-in-possession, giving it exclusive rights to recover objects from the wreck. Now, as the owner of the subrogation rights to the personal property, the Company is well positioned in a legal sense to claim outright ownership to the personal property recovered from the wreck."

Arnie Geller, the Company's President and Chief Executive Officer, declared this acquisition to be "a dramatic moment in the history of the Company as it yields additional incentive to conduct further rescue archaeology of these important historic objects." He added, "since its first research and recovery expedition in 1987, the Company has proudly maintained it position as the Salvor and custodian of the priceless collection of objects recovered from the wreck of the Titanic. This new acquisition expands the Company's ability to increase its shareholder value."

We agree.

PRXI is undervalued at $17 per share

I wrote, but did not post, this before July 3 earnings announcement. The earnings announcement looks good.

* * * * *

Premier Exhibitions (PRXI) is an exhibition company featuring shows on (1) human anatomy (80% of revenues) and (2) salvaged items from the Titanic. The human anatomy shows, under the name Bodies, contain plasticized full body human specimens and selected body parts. The Bodies shows typically feature about 20 bodies and, in addition, displays of hundreds of organs. My favorite was the circulatory system – a very well lit and dramatic display.

PRXI currently trades around $17 per share and has a total market value of about $560 million. I estimate the intrinsic value to be greater than $30 per share. The current share price basically assumes no growth in shows beyond the 11 Bodies shows, no value from the Titanic assets, and no value for the opportunity to add other exhibitions. In fact, PRXI excellent opportunity to expand the number of Bodies shows, and the Titanic artifacts are likely worth much more than their current carrying value and earnings power.

* * * * *
I first ignored PRXI when I learned of it from this Value Investor Club posting in July 2006 (following the 45 day delay for non-members from a May 23, 2006 posting). More recently, I began to pay attention following a presentation on May 9, 2007 at the Value Investing Congress by Bill Vlahos, Managing Partner of Odyssey Value Advisors. [As an aside, at the Value Investing Congress, West Coast Asset Management presented two ideas, but not an idea it had originally planned to present, Contango Oil & GAS (MCF). In the conference planning, MCF was left to a presentation by Sellers. That only seemed fair, since Sellers holds a very concentrated portfolio, typically less than 10 names, with MCF representing 50% of the fund. Also, as it happens, as we learned in a June 1 article in the Financial Times, one of the few other names Sellers also owns is PRXI.]

The PRXI story offers the prospect of rapidly growing earnings based on an the popular Bodies exhibits increasingly concept, and downside protection because the current stock price appears to PRXI now has in place 11 separate Bodies shows by June 2007. As stated in the PRXI 10-K: These specimens are assembled into anatomy-based exhibitions featuring preserved human bodies, and offer the public an opportunity to view the intricacies and complexities of the human body. The exhibitions include displays of dissected human bodies kept from decaying through a process called polymer preservation, also known as plastination. In essence, the bodies are drained of all fat and fluids, which are replaced with polymers such as silicone rubber, epoxy and polyester. This keeps the flesh from decaying and maintains its natural look. Skin from the bodies is removed, or partially removed, to reveal musculoskeletal, nervous, circulatory, reproductive or digestive systems. The full body specimens are complimented by presentation cases of related individual organs and body parts, both healthy and diseased, that provide a detailed look into the elements that comprise each system. While controversy surrounds the provenance of the bodies, PRXI claims the bodies have been legally obtained from a hospital in China. The shows appear to be popular where exhibited, and the controversy does not appear to have harmed PRXI’s ability to exhibit.

Here’s the math for the current Bodies business:

Earnings Model and Value for 11 Bodies Shows

Tickets per show per six months: 300,000
Average ticket price: $22.00
Gross revenue per show per six months: $6,600,000
Gross margin: 50%
Gross profit per show per six months: $3,300,000
Times two six month periods per year: 2
Gross profit per show per year, before downtime: $6,600,000
Adjustment for required break-down/set-up time: 0.92
Gross profit, per year, per show: $6,050,000
Number of shows: 11
Gross profit from Bodies, annualized: $66,550,000
SG&A expense: $14,000,000
Pre-tax income: $52,550,000
Tax rate: 35%
Tax: $ 34,157,500
Shares outstanding, fully diluted: 33,000,000
Earnings per share: $1.04
P/E multiple: 15
Implied price: $ 15.53

Thus, based on the run rate for the 11 shows, earnings should be around $1.04 per share. A conservative 15 multiple would imply a value of $15.50 per share, just for the current Bodies business. The intrinsic value is likely greater, based on PRXI’s ability to exhibit more widely its Bodies shows, and monetize the value of its Titanic artifacts.

The above attempts to show the earnings power of the 11 bodies shows, and does not attempt to show a earnings projection for specific period. For example, it is not an EPS estimate for the fiscal year ending February 2008.

Titanic Value
PRXI is recognized as the exclusive salvor-in-possession of the Titanic site. As such, it is entitled to a lien against the property recovered to compensate it for its salvage service. PRXI has submitted a claim for for its salvage of $225 million. The determination of the value of the salvage claim is subject to court proceedings.

Vlahos estimates that the Titanic exhibits contribute an additional gross profit of $5 million. If Titanic artifacts contribute $5 million of gross profit, they add about $0.09 per share of EPS, or $1.35 of value at a 15 P/E multiple. Further, Vlahos estimates that the artifacts are worth $200 million, or about $6 per share. Mark Sellers in his FT article provided an estimate for the Titanic artifacts of $125-$225 million, or $3.78 to $6.80 per share.

Bottom Line
Assuming PRXI can take bodies to 20 shows, I’d estimate earnings, excluding the Titanic shows, to be about $1.90 per share. At a 15 p/e multiple, that’s worth around $28-$29 per share. Though if PRXI executes on that plan, it will likely command much more than a 15 multiple. As of February 28, 2007 PRXI had no debt and cash of about $16.8 million, or $0.51 per share.

Key areas for follow up:
In the May conference call, management indicated that they think about Bodies business as 550,000 average annual attendees, $20 average ticket price, and 50% gross margins. Do these figures include the revenues and contributions to gross margin from other merchandise sales?

How quickly can Bodies be ramped from 11 shows?

How will SG&A expense grow in relation to future growth in exhibits and gross profit?

What are the value maximizing opportunities for Titanic assets?

Current and Planned Bodies Shows

From their 10-Q, filed July 3, 2007, and re-categorized by me:

The following is a list of our “Bodies...The Exhibition” and “Bodies Revealed” exhibition locations during the three months ended May 31, 2007:

• “Bodies...The Exhibition,” South Street Seaport, New York, New York (November 19, 2005 to an undetermined date);

• “Bodies...The Exhibition,” The Tropicana Resort and Casino, Las Vegas, Nevada (June 23, 2006 to an undetermined date);

• “Bodies Revealed,” OCA Ibirapuera Park, Sao Paulo, Brazil (February 28, 2007 to July 29, 2007);

• “Bodies...The Exhibition,” The Streets at Southpoint, Durham, North Carolina (April 5, 2007 to an undetermined date);

• “Bodies...The Exhibition,” 1101 Wilson Boulevard (the former Newseum site), Arlington, Virginia (Washington, D.C. Metro Area) (April 14, 2007 to an undetermined date);

• “Bodies...The Exhibition,” Westfield UTC, San Diego, California (May 12, 2007 to an undetermined date);

• “Bodies...The Exhibition,” Palacio dos Condes do Restelo, Lisbon, Portugal (May 5, 2007 to an undetermined date); and

• “Bodies...The Exhibition,” Lucerna, Prague, Czech Republic (May 5, 2007 to an undetermined date).

Ran exhibited and ended during three months ended May 31, 2007, but now closed:

• “Bodies...The Exhibition,” The Shops at Sunset Place, Miami, Florida (September 22, 2006 to March 25, 2007);

• “Bodies...The Exhibition,” 800 Pike Street (across from the Washington State Convention Center), Seattle, Washington (September 30, 2006 to April 29, 2007);

• “Bodies...The Exhibition,” Beurs van Berlage Concert and Conference Hall, Amsterdam, The Netherlands (November 25, 2006 to April 14, 2007);


Opened subsequent to the three months ended May 31, 2007:

• “Bodies...The Exhibition,” 9 Treasure Lake Drive, adjacent to the IMAX Entertainment Complex, Branson, Missouri (June 30, 2007 to an undetermined date); and

• “Bodies...The Exhibition,” Easton Market, Columbus, Ohio (June 30, 2007 to an undetermined date).

Announced subsequent to May 31, 2007:

• “Bodies...The Exhibition,” Carnegie Science Center, Pittsburgh, Pennsylvania (October 1, 2007 to an undetermined date);

Start With the A's

How would Warren Buffett do it if we were starting all over again?

In October 1993, Adam Smith aired an interview with Buffett and it went like this:

Adam Smith: If a younger Warren Buffett were coming into the investment field today, what areas would you tell him to point himself in?

Warren Buffett: Well, if he were doing – if he were coming in and working with small sums of capital I’d tell him to do exactly what I did 40-odd years ago, which is to learn about every company in the United States that has publicly traded securities and that bank of knowledge will do him or her terrific good over time.

Smith: But there’s 27,000 public companies.

Buffett: Well, start with the A’s.

Warren Buffett -- 50% Returns

Much attention has surrounded reports that Warren Buffett said he could generate 50% returms on small sums of money. Typically, three immediate questions arise:

Did he really say that? Did he really mean it? And, how would he (or me or my favorite money manager) do it?

Looking at the record of his comments, it's pretty clear that he said it (and repeated it) and he really means it.

Buffett seems to have got the set this ball rolling in 1999. At that year's BRK shareholder meeting, he was aked:

Shareholder: Recently, at Wharton, Mr. Buffett, you talked about the problems of compounding large sums of money. You were quoted in the local paper as saying that you're confident that if you were working with a small sum closer to $1 million, you could compounded at a 50% rate. For those of us not saddled with a $100 million problem, could you talk about what types of investments you'd be looking at and where in today's market, you think significant inefficiencies exist?

Buffett: I may have been very slightly misquoted, but I certainly said something to that effect. I talked about how I polled this group of 60 or so people I get together with every couple of years as to what rate they think they can compound money at if they were investing small sums: $100,000, $1million, $100 million, $1 billion, etc. And I pointed out how the return expectations of the members of this group go very rapidly down the slope.

But it's true. I could name half a dozen people that I think can compound $1 million at 50% per year -- at least they'd have that return expectation -- if they needed it. They'd have to give that $1 million their full attention. But they couldn't compound $100 million or $1 billion at anything remotely like that rate.

There are little tiny areas, as I said, in that Adam Smith interview a few years ago, where if you start with A and you go through and look at everything -- and look for small securities in your area of competence where you can understand the business and occasionally find little arbitrage situations or little wrinkles here and there in the market -- I think working with a very small sum, there is an opportunity to earn very high returns.

But that advantage disappears very rapidly as the money compounds. As the money goes from $1 million to $10 million, I'd say it would fall off dramatically in terms of the expected return -- because you find very, very small things you're almost certain to make high returns on. But you don't find very big things in that category today.

Later, similar comments by Buffett were reported in the June 25, 1999 Business Week:

"If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that."

He has repeated similar statements in recent meetings with college students, and at the 2007 annual meeting, he hit the topic again:

If I were working with a very small sum – you should hope this doesn't happen – I'd be doing almost entirely different things than I do. Your universe expands – there are thousands of times as many options if you're investing $10,000 rather than $100 billion, other than buying entire businesses. You can earn very high returns with very small amounts of money. Everyone can't do it, but if you know what you're doing, you can do it. We cannot earn phenomenal returns putting $3, $4 or $ 5 billion in a stock. It won't work – it's not even close. If Charlie and I had $500,000 or $2 million to invest, we'd find little things we could do, not all of it in stocks.

This most interesting part of the statement is the emphasis on how different his activies and opportunities would be with smaller sums of capital and therefore more opportunities: "I'd be doing almost entirely different things than I do." Not sitting on Coke, the Washington Post, AXP. Not committing new money in the past few years to BUD, WMT and JNJ.

What then would he do? Well, he's hit this theme a few times also. At the 1998 shareholder meeting he said:

There are little tiny areas, as I said, in that Adam Smith interview a few years ago, where if you start with A and you go through and look at everything -- and look for small securities in your area of competence where you can understand the business and occasionally find little arbitrage situations or little wrinkles here and there in the market -- I think working with a very small sum, there is an opportunity to earn very high returns.

What was the Adam Smith interview? It aired in October 1993, and it went like this:

Adam Smith: If a younger Warren Buffett were coming into the investment field today, what areas would you tell him to point himself in?

Warren Buffett: Well, if he were doing – if he were coming in and working with small sums of capital I’d tell him to do exactly what I did 40-odd years ago, which is to learn about every company in the United States that has publicly traded securities and that bank of knowledge will do him or her terrific good over time.

Smith: But there’s 27,000 public companies.

Buffett: Well, start with the A’s.

As he explained at the 2001 shareholder meeting:

When I started, I went through the manuals page by page. I went through 20,000 pages in the Moody’s industrial, transportation, banks and finance manuals -- twice. I actually looked at every business -- although I didn’t look very hard at some.

He told Columbia business students in 2006:

Reading has made him rich over time. He told the story of going through Moody’s annuals in 1951. “It was absolutely a question of turning pages”. On page 1433, he found Western Insurance Securities. Its earnings per share were as follows: 1949 -$21.66, 1950 - $29.09. In 1951, the low-high share price was $3 - $13. He went to a broker and read the Best’s Insurance manuals, and talked to agents – it was a perfectly fine company with nothing wrong. Ten pages later, on page 1443, he found National American Fire Insurance (“This book really got hot towards the end!”) NAFI was controlled by an Omaha guy, one of the richest men in the country, who owned many of the best run insurance companies in the country. He stashed the crown jewels of his insurance holdings in NAFI. In 1950, it earned $29.02. The share price was $27. Book value was $135. Buffett found it fascinating that this company was located several blocks from the broker where he worked. His fellow brokers were bright, rational people whose job it was to buy cheap securities, and they refused to buy NAFI, instead investing in “blue chips”.

He then took out a copy of the 2005 Korean Stock Market guide. It was more of an almanac than a brokerage report. It was sent to him for free by a broker. “If it had been $10, I wouldn’t have paid for it.” Based on the recommendation of a friend who thought South Korean stocks were cheap, Buffett spent 5-6 hours leafing through the pages and put together a $100m portfolio of 20 or so companies. Daehan Flour sold 25% of the flour in South Korea, which had a large and stable economy. It’s earnings over the last few years: 12,870 won, 18,000 won, 22,830 won. It had over 100,000 won in securities. The stock price was 38,000 won. “You have to make money buying stocks like this at 2x earnings. Brokers aren’t going to tell you about Daehan Flour.”

All this corresponds nicely with Charlie Munger's recent comments to the graduating class of USC law school:

Another thing you have to do, of course, is to have a lot of assiduity. I like that word because it means: sit down on your ass until you do it.

Harvest Natural Resources (HNR)

HNR is an oil & gas company. Its primary asset is the right to drill and sell oil and gas from fields in Venezuela.

The big picture: HNR appears to trade at a substantial discount to its intrinsic value. Current share price compares to estimated intrinsic value of $20-$25 per share. The big risk is political risk, the risk that HNR is subject to continuing expropriation through renegotiated or broken contracts with Venezuela. Given that the original contract been broken by VZ in 2006, and renegotiated in late 2006, has enough risk been removed to justify investment?

Total reserves 3P (proved, probable and possible) are worth about $23 per share. Cash on hand, net of debt, is about $3.00 per share. Thus for $7.00 per share (excluding net cash) you get reserves worth $23 per share, if HNR starts operating again.

A great Warren Buffet quote comes to mind:

I prefer businesses domiciled in the U.S. Susie and I each have one share of a stock I bought in 1955. It looked very safe at the time. It was a marvelous stock. There’s just one problem. Its property is located in Havana and Castro seized it. We can’t get title to it. It just sits there. We’ve got huge claims against the government. And it’s never going to be worth anything. I keep it round to remind me of what can happen. The rules in other countries can change overnight.

Having been warned by the master, how do we estimate intrinsic value? Two methods to start: (1) enterprise value per barrel of oil and (2) enterprise value compared to discounted value of income from reserves (ev/PV10).

Enterprise Value Per Barrel of Oil
Currently, at a $10 share price, that's equity market value of 376mn (37.55mn shares @ 10 per share) plus 98mn of debt less 213mn of cash. 376+98-213=261mn.

Reserves net to Harvest after Petrodelta agreement takes effect are:

Proved: 45mn
Probable:31mn
Possible: 74mn

Thus, you pay $5.80 per proved barrel, or $1.74 for 3P (proved, probable and possible).Leading oil & gas companies without political risk trade around $18 per proved barrel.

Since per barrel comparisons can be tricky, because different companies have different prices for oil sales price, lifting costs, etc., we should also look at ...

Discounted Value of Reserves
HNR provides an estimate of after-royalty, but before VZ tax, income, discounted at 10%. Proved $616mn Probable 317 Possible 792

Total $1,725 Subtracting a VZ tax of 50% would leave discounted net income for reserves of:

Proved $308mn, or $8.20 per share
Probable $159mn, or $4.22 per share
Possible $792mn, or $10.55 per share
For a total of $863mn, or $22.96 per share.

Out enterprise value is $261mn, or about $7.00 per share. Thus at $7 per share, HNR trades at a 70% discount to total reserves value.

Reimbursement -- Source of Additional Value?
Once the new agreement is finalized, HNR's subsidiary Petrodelta will receive reimbursement for oil and gas sales to PDVSA, to obtain the same economic result as if the conversion had been completed on April 1, 2006. Since April 1, 2006 through March 31, 2007, HNR delivered 6.7mn barrels of oil. The estimated price for reimbursement over this period is $47 per barrel.So, 6.7 x 47 = $315mn dollars.HNR also delivered 14.8bcf of gas, priced at $1.54 per mcf, for total sales of 22.79mn dollars.

So total sales are 315+23=$338mn.The 33% royalty must be deducted, so net sales are $226mn. During this period, costs have been about $46mn, most of which has already been reimbursed. Thus, during this period, the profit before tax for Petrodelta is $226mn-$46mn, or $180mn. Taxes are 50%, so net after tax profit is $90mn. HNR has an effective 32% interest, so its share of net income for this period will be about $29mn, or $0.77 per HNR share.

In theory, the value of this income should already be included in the discounted value of the reserves, which is as of April 1, 2006. Thus, to add the value of the interim net income would I think be double-counting, relative to the discounted value of the reserves. The dividend payment will no doubt be welcome, and might be a catalyst to recognizing overall value, but this should be a secondary factor to the value of obtaining final approval of the National Assembly and Chavez.

I expect Petrodelta will dividend less than 100% of net income for this period. Petrodelta will need more cash on hand to fund (1) cost of new rigs (2) increased operating expenses as operations expand and (3) initial capitalization of Petrodelta.

Proving Additional Reserves?
The estimates of recoverable reserves could increase after HNR resumes active drilling and development of the new fields obtained in the renegotiation. HNR has had a good record in the Monagas fields. In 1992 when HNR entered Monagas, proved reserves were 18mn barrels and HNR produced 124mn barrels in the following years.

No value has been included for the China WAB-21 parcel, but that's alright because it is the subject of a terratorial dispute between China and Vietnam. Thus no value will be realized until that dispute is first finished.

Bottom Line
HNR looks like a bargain. The political risk has been reduced, but not eliminated, with the renegotiation. Petrodelta has begun to secure rigs to drill, and PDVSA has appparently agreed to reimburse Petrodelta a portion of the costs if the agreement is not approved by the National Assembly. That appears to be a meaningful signal that approval is expected. A reasonable upside case is $25. A bad downside scenario would be probably produce the cash value of $3 per share. Weighing the odds, HNR seems like a good investment, the words of the master notwithstanding.