Mark Sellers: Optionalities add up to buying opportunity

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I’ve written previously that my firm focuses its research on two types of stocks: companies with wide economic moats and companies whose tangible asset values equal or exceed their current market values (asset plays).

The latter type is often shunned or ignored by the investment community at the time I’m buying. Often, what makes them compelling investments is not the liquidation value of the assets – essentially a safety net – but the “optionality” attached to the stock price. Frequently, the market ignores the value of this optionality because there is uncertainty involved. This uncertainty can create a buying opportunity.

This concept is important for value investors to understand because it’s a source of market inefficiency. Optionality has nothing to do with employee stock options (those are generally bad, not good). The type of options I’m talking about can’t be traded, yet have value.

When I use the term “optionality”, I’m referring to a situation where binary outcomes are possible and it’s difficult to determine the likelihood of either scenario occurring. When it’s difficult to determine something, the market will sometimes take the lazy route and just ignore it. That’s where the inefficiency comes in. Bill Miller has said the market won’t pay for optionality. In my experience, this is often true.

One such situation is occurring now with Carrizo Oil & Gas, in which my fund invests. Based in Houston, Carrizo is an exploration and production (E&P) company with natural gas reserves in the Barnett shale in Texas and onshore Gulf of Mexico coastline, coal bed methane deposits in the western US and a recent oil discovery in the North Sea.

The company’s current enterprise value is approximately $1.4bn. To get a fair value for Carrizo’s shares at, or below, the market price of $43 a share, you have to ignore a lot of optionality. I come to this opinion based on the following sum-of-the-parts valuation.

Carrizo has 87,000 acres in the Barnett shale in north Texas, which has become the largest source of onshore natural gas in the US in the past few years. The liquidation value of Carrizo’s acreage is between $1bn and $1.5bn based on potential reserves in place, recent drilling results and comparable transactions in the Barnett in the past couple of years.

In addition, the value of a recent oil discovery in the North Sea is $150m-$250m, depending on the ultimate size of the discovery and the assumptions you make for the price of oil.

Adding the liquidation value of the Barnett and North Sea assets gives a liquidation value of about $1.15bn to $1.75bn. As I mentioned, Carrizo’s current enterprise value is just $1.4bn so these two assets are pretty much worth the entire enterprise value of the company. That means anything else that adds to the liquidation value is a free option. And Carrizo has a lot of these options floating around.

First, the value of the Barnett acreage should rise as future wells are spaced ever more closely owing to technology improvements. The “downspacing” will increase the ultimate amount of natural gas that is recoverable but the market doesn’t seem to care; it values the optionality at $0.

And the company also has eight to 10 more prospects in the same area of the North Sea where oil was recently discovered. There has to be some value to this although it’s difficult to determine what that value is. The market takes the easy route; it values the optionality at $0.

Third, the company has drilled and is currently testing a 22,000ft deep well called MegaMata on the Gulf coast of Texas. The well could be worth nothing (no results have been announced yet) but Carrizo has spent a lot of money testing and completing the well and it’s unlikely it would still be spending money on it at this point if insiders thought it was going to be a dry hole. There is most likely something down there; we just don’t know how much. But the market is ambivalent; it values this option at $0.

Carrizo also has 137,000 net acres in an emerging shale play, the Floyd shale in Mississippi. The company is currently drilling its first couple of test wells. The value of this acreage, if things work out, could some day be huge, of the order of $1bn or more. For now, let’s assume there is a 25 per cent chance that this play works and, if so, the value will be $7,000 an acre two years from now (on a par with the current market value of acreage in the core area of the Fayetteville shale). This adds another $200m to the company’s value (adjusted for the 25 per cent probability), yet the market doesn’t care: it values the option at $0.

Finally, Carrizo has about 100,000 acres in other onshore shale plays including the Fayetteville shale, the New Albany shale and the Woodford shale in west Texas. The market doesn’t care about these either and values this acreage at $0.

If a couple of things go right, this could easily be an $80 stock two years from now. If none of the options works out, we get our money back. Seems like a pretty good risk/reward trade-off.

The writer is a former equities strategist at Morningstar who manages a hedge fund, Sellers Capital, in Chicago. msellers@sellerscapital.com

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