Agora Financial’s Rude Awakening

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Dubai, UAE

· Global markets swing wildly – can’t they just make up their minds?
· Mayer with details on one company set to make him money all over again,
· Bubble hopping from New York to New Delhi and much more…

Joel Bowman, reporting from Dubai in the Persian Gulf…

“Jubilation abounds! Financial crisis averted! We’re all saved!”

Well, so say the casual observers at your editor’s local coffee hangout and the credulous talking heads they read in the daily newspapers there. And maybe they’re right. We certainly wouldn’t say no to another eight or ten days “limit up,” as Japan’s Nikkei did on Tuesday…it’s just that we don’t think it’s very likely.

Worldwide markets pole-vaulted into relatively unfamiliar positive territory yesterday, “snapping” a losing streak that saw Japan’s Nikkei 225 drop to a fresh, 26-year low and Hong Kong’s Hang Seng suffer the worst intraday selloff since the Tiananmen Square catastrophe some two decades ago.

Before the Dow Jones Industrial Average clawed back a momentous 10.88% by the close of yesterday’s session, markets around the globe had already been hard at it, rebounding from Monday’s freefall. The Bombay Stock Exchange’s Sensitive Index, or Sensex, gained 5.9%…but only after shedding 20% over the previous four trading days. Japan’s measures piled on more than 6%. Even the Hang Seng, down by nearly two thirds for the year, clocked in a whopping 15% rally.

So, is that it for all those nasty selloffs and emergency summits? Are we done with the multi-hundred point index declines…and the multi-hundred billion-dollar rescue packages that tend to go along with them?

Dangerous environments breed nervous creatures, we observe, and the market climate of the past few months has been anything but a safe haven for investors. Forgive us then, Rude reader, if we are a tad reluctant to call in a bottom just yet. We prefer sailing in calm waters…and lulls between tidal waves do not count.

For instance, we notice that during sustained bull markets (however delusional they may or may not be), volatility tends to flatten out. The waters settle. For the better part of the last two years, investors built steady gains, then calmly took profits (some took more profits more calmly than others, granted). It was a kind of three steps forward, one step back routine. The average VIX index reading for 2007, even accounting for the unraveling toward the second half, measured only 17. That’s remarkably smoother sailing than anything we’re seeing today.

Last Friday, along with yet another one of those multi-hundred point swings, the VIX index reach an all time record high of 89.5. In fact, it hasn’t closed below 50 in the past three weeks. Uh, surf’s up…dudes.

We find that panicked volatility tends to occur when markets are heading lower, not higher. But that doesn’t mean every stock is set for lower lows, mind you. In fact, there is a great deal of bargains out there that will surely tempt even the cautious investor. The trick, of course, lies in separating the stocks that are unfairly sold off from those that are still in for a dangerous wipeout.

In yesterday’s edition of the Rude Awakening, our colleague, Chris Mayer, suggested that many stocks had become way too cheap. To illustrate the point, he tossed out a couple of names to buy: T-3 Energy Services (Nasdaq: TTES) and Contango Oil & Gas (NYSE: MCF). Chris didn’t provide any details in yesterday’s column, so in today’s edition he returns to put a little more meat on the bones of his T-3 recommendation. Details below…

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The last time I recommended T-3 Energy Services to the subscribers of my investment letter, Capital & Crisis, the stock tripled over the ensuing months. And even after I issued a “Sell” recommendation on the stock, it continued to move higher. But that was WAY back in July…and nothing is like it used to be.

From a high of $84 a share in July of this year, the stock has come all the way back down to $17. I issued a “Buy” on the stock in April of 2007, when it was selling for $21.60. We sold our final half at $63.60 — it’s now more than 70% below that price. And you know what? Not much has really changed…except the stock’s valuation. TTES is selling for about 6 times earnings now and about 5 times next year’s guess…and the company is enjoying huge macro-economic tailwinds.

T-3 makes something absolutely critical to drilling rigs. It’s called a blowout preventer (BOP). BOPs protect the crew — and preserve the rig — in the event of surges in the well. You absolutely have to them. Crews won’t work rigs without BOPs and anybody concerned about safety would never put a crew on a rig without them.

T-3 has about 15% of the market for new BOPs. If you count refurbishing older rigs, T-3 has about 30% of the market. It’s a small company, but a key player in this niche. BOPs make up about 70% of T-3’s business.

The remaining 30% includes a variety of other services for wellhead equipment and onshore pipelines. T-3’s customers are drilling contractors, exploration and production companies and pipeline companies.

Demand for T-3’s services follows drilling activity. Over the years, we’ve had to drill more and more gas wells, just to maintain current levels of production. That’s because the newer wells tend to deplete much more quickly that the old wells used to.

That trend has only continued. According to Baker Hughes, the number of working rigs rose to 1,782 at the end of 2007 to 1,906 today. As we exploit the more unconventional shale basins, which are more drilling intensive, the number of working rigs ought to keep rising.

The shale plays I’ve written about before – the Barnett, Fayetteville and in the Appalachian regions – all take a lot of drilling. Since 2001, for example, drilling in the Barnett is up nine-fold by rig count. These prolific plays now make up 12% of the total rig count according to Raymond James.

Drilling activity is what really drives T-3’s business. And energy prices dictate drilling activity. So, as the price of oil and gas has come down a bunch, the market has crushed T-3’s stock price. I think, though, that it’s been overdone. Drilling activity may slow, but we’re not rolling back to 2002 levels, which is how the market is pricing T-3.

I also especially like the rig equipment and infrastructure market. Since 2004, this market has grown 27% annually, which tops the broader oilfield services group. (The latter grew about 17% annually.) T-3 serves a good niche in this sub-market.

The company is also expanding overseas. Already 60% of the company’s sales come from overseas markets. New orders from West Africa and Russia, new subsea orders and new orders from its joint venture in the Middle East could all be catalysts for the stock price beyond just solid execution of its existing business. Earlier this year, T-3 won a contract for work in West Africa, which was the biggest single award in the company’s history. As of the last conference call, T-3 said it had $320 million in outstanding bids and 60% of that was for international markets.

Last quarter, the company reported a backlog of $81 million, a 36% increase from the prior quarter and a 31% increase from a year ago. T-3 should grow earnings at a 25% clip, yet it’s trading for 7 times earnings. You got a lot of room for error when you buy something for 7 times earnings that’s growing 25% per year.

T-3 will probably earn $40 million in free cash flow this year. Next year, the company should generate $50 million in free cash flow and earn close to $4 per share. At current prices, therefore, you’re paying less than 5 times next year’s guess for a 21% free cash flow yield. Those are bargain numbers for a healthy, growing business with little debt.

Another way to look at the stock’s value is to look at past acquisitions. Last year, acquirers paid 11 times EBITDA (earnings before interest, taxes, depreciation and amortization) for companies in this sector. Even this year, if you could pull off an acquisition at 8 times EBITDA in this sector, you were a hero. Analysts would praise you for making a good deal. Now the sector is in the toilet. T-3 trades for a bit more than 4 times EBITDA. So again, there seems to be plenty of room on the value spectrum here. The world did not change so much in the last 90 days as stock market prices seem to indicate.

Right now, multiples across the resource sector have just collapsed. If T-3 were to regain a reasonable multiple of only 10 times earnings — well below what it commanded even months ago — T-3 could be a $40 stock by next year. That’s more than double.

If we get some more juice from oil and gas prices, we could go much higher. Some of the research I’ve read on the company puts the value much higher, in the range of $72 to $90 per share. Remember, the stock hit $84 this year. So, I think my numbers are quite reasonable. We’ve got a good shot to do a lot better than $48 per share, perhaps getting back to around $60 and tripling our money again.

I’d buy the stock up to $25 a share.

[Joel's Note: As bargains begin to surface from the wreckage, many an astute investor will have the opportunity to pick up some great companies at heavy discounts. In this area, Chris has the distinct advantage of being a career value investor. He actually makes his living from sniffing out stocks that go for artificially depressed prices. And he’s very good at what he does.

As more and more of these bargains float ashore, you can be certain Chris will be there with the net, scooping them into his Mayer’s Special Situations portfolio. If you’d like to grab a spot on his mailing list and land a few bargains for yourself, here’s a free report to get you started.

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[Rude Endnote: “You’re just a bubble-hopper,” a friend joked to your admittedly itinerant editor over Instant Messenger on Monday.

“First you were in New York and Sothern California, then the U.K. Now you’re in Dubai…” he observed, followed by a smiley emoticon.

“Yeah, and now the bubble has overtaken us,” we replied, while watching markets further to the east of us explode all over our computer screen. “We’re off to *gulp* Asia at the end of the year.”

“Hmm…,” came the considered response …Dan is typing… “If you wait long enough, maybe you’ll get a good rate on your rent? … OR”… Dan is typing … “You could just move straight to South America now!”

The problem seems not to be how to escape the bubbles, Rude reader, but rather how to time it just right so you can rent (or buy) AFTER the bust.

More on that later in the week.

Until next time…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com