Hibiscus Petroleum Berhad (5199.KL) - Part 2
What if you could turn an O&G company... into a bank?
Before I start, I’d just like to qualify that my sub-title is slightly clickbait in nature. Rest assured that it gets the point across; but for the uninitiated, please understand that I don’t mean that Hibiscus intends to turn itself into a bank. You’ll understand what I mean by the end of this article.
In April 2020, when the world was falling apart and oil prices entered negative territory for the first time in history, I made a case for buying a small-cap upstream O&G stock called Hibiscus Petroleum Berhad (‘Hibiscus’). You can read the case study in its entirety here.
Since then, Hibiscus has had one major development. On 12 Oct 2020, the company announced that it would seek authorization to issue Convertible Redeemable Preference Shares (‘CRPS’) - likely riding the wave of the general mispricing of convertible issuances in capital markets. However, what was surprising wasn’t the news of the issuance itself, but rather the staggering magnitude of the CRPS issuance involved.
At the time, Hibiscus was trading at a market capitalization of roughly RM (‘ringgit malaysia’) 1 billion , give-or-take some apples-to-apples adjustments. However, the CRPS announcement involved an authorization of up to RM 2 billion of CRPS issuance, which could be converted to ordinary shares at any time. That means that shareholders should conservatively assume that they were going to be diluted by 3x.
Now, Hibiscus’ management has a good track record of cost discipline. One of the MD’s wittier highlights during their analyst discussions is how the company technically broke even on their North Sabah oil field on Day 1 - due to the way the legal transfer of ownership played out. Regardless, the North Sabah oil field has delivered stellar operating performance since its acquisition, with variable OPEX/bbl in the sub-USD 20/bbl range and my own estimates of all-in OPEX/bbl hovering around USD 40/bbl. Keep in mind that for a small-cap upstream O&G company with a market cap of roughly USD 300M and basically no economies of scale to speak of, this could only be achieved with an ultra-low cost base and an intensive focus on cost discipline. By any standard, it’s pretty impressive.
For more colour on the economics of their legacy business, I’d highly recommend reviewing my April case study on them. However, we’re not here to talk about their past. We’re here to discuss their future.
Convertible Redeemable Preference Shares (‘CRPS’)
For those not familiar with CRPS, it’s basically sort of like a convertible bond. The 30,000 feet view is that it pays out a 4% dividend, and can be converted to ordinary shares on a roughly 1:2 basis. However this conversion ratio isn’t exactly relevant for valuation purposes, as at the end of the day the maximum dilution impact is still going to be around RM 2 billion. The exact details of the issuance escapes me at the moment, but you can find them in the CRPS’s Circular to Shareholders (‘Circular’) if you’d like.
On page 3 of the Circular, you’ll find the parameters for the utilization of the CRPS proceeds. It basically says that the payback period on the assets acquired with the proceeds would be <5 years, and that the assets acquired would have a minimum IRR of 12%. It further goes on to say that the IRR rate would be determined via consideration of their ‘2P case production and cost profiles’, and that this would in turn be ‘determined by the Independent Expert prior to entering into the relevant Definitive Agreement for such Acquisitions’. As a friend who is an O&G industry veteran put it, this is as close to completely objective as you’re going to get.
Assuming they fully issue the authorized amount of RM 2 billion for acquisition purposes, this would imply that they would have an additional RM 2 billion of equity capital for investment purposes. Based on their FY2Q21 quarterly report, they have an equity base of roughly RM 1.25 billion - which is pretty much unchanged from when I last analyzed them in April 2020.
Hence, the logical assumption is that with an additional investment base of RM 2 billion, they can more or less 3x their existing production rate (i.e. bbl/day). If you’ve read my previous assessment, you’ll see that they’ve historically been in a net cash position and that the large current liabilities are quite irrelevant for liquidity purposes (as they pertain to accelerated tax depreciation).
Management has previously stated their intention to utilize financial leverage in the upcoming acquisitions, which is itself a story for another time. But since financial leverage can only be beneficial for returns, we can conservatively assume the worst-case scenario of the company remaining in a net cash position for the purpose of this valuation exercise.
At this point and for simplicity’s sake, we are going to make a few assumptions:
Management will utilize the full RM 2 billion that has been authorized to acquire new O&G assets.
Management will not use any debt.
Management will maintain the same level of cost discipline as they previously had, going by their ROI track record.
As a result, Hibiscus will maintain its net profit margin going forward
If these assumptions hold true, then from a financial analysis perspective, it would be reasonable to assume that Hibiscus would be able to extract 3x the current volume of oil from the ground. Multiply that by the same net margin, and you’ll get 3x the existing net profit.
However, remember that the CRPS issued could potentially be converted in its entirety into ordinary shares, which would lead to 3x shareholder dilution. In other words, the 3x net profit would be diluted by 3x, leading to the same amount of post-acquisition EPS as before.
So… what gives? Why go through the trouble of issuing the CRPS and acquiring the O&G assets, if it’s just going to lead to approximately the same unit amount of EPS for the individual shareholder?
Turning into… a Bank?
Here’s where the magic happens. Recall that the upstream O&G industry tends to be extremely capital intensive. That’s why the sector as a whole tends to be levered up to the gills - because the ROE would be otherwise unattractive. (Hibiscus is a bit of an anomaly in its sector, in that it occupies a net cash position. Not only that, it is also highly FCF-accretive, given its brownfield asset profile.)
However, the industry doesn’t just benefit from financial leverage - it also benefits from operating leverage, due to its capital intensive nature. In layman’s terms, that simply means that they incur a lot of fixed costs upfront, which reduces their variable unit costs later over time.
How does this play out in the upstream O&G sector? Well, just think of the business economics of an oil rig. A brand new offshore oil rig can cost upwards of USD 500 million, while the FPSO (Floating Production Storage and Offloading) vessel that Hibiscus uses in its Anasuria oil field costs about USD 800 million new. Now that’s an unavoidable hefty upfront expense if you want to be a player in this sector (presumably a brownfield acquisition will come with the extraction asset, but just stay with me).
However, while the upfront costs can be punitive, the economics of a capital-intensive oil rig dictates that the incremental marginal cost to extract the next barrel of oil is essentially zero. To illustrate, assume that the maximum production rate of an oil rig is 1,000 bbl/day. Whether you decide to extract one barrel of oil or 1,000 barrels of oil on any particular day, the accrued fixed costs (i.e. depreciation) remains the same. At the same time, the variable costs involved are pretty much negligible (to a certain extent).
If you flip it around however, what the above means is that for a given unit of cost, operating leverage should result in a supernormal unit of yield. Hence - and to oversimplify - investing the RM 2 billion of CRPS proceeds into new O&G assets should (in theory) be able to yield in excess of 2x the volume of Hibiscus’ existing oil production rate (e.g. 2.5x).
It is this operating leverage which allows Hibiscus to extract a higher unit volume of oil per unit cost involved, resulting in value accretion. For illustration’s sake, imagine that they acquire 2x the existing equity base worth of assets, but can extract 2.5x the existing volume of oil from the ground. That 0.5x difference is akin to free unit revenue, which would drop straight to the bottom line in the form of an increase in net margin, leading to an incremental unit profit.
It is this characteristic of operating leverage which I believe will result in an increase in EPS attributable to shareholders despite the dilution. Now that 0.5x might not sound like a lot, but when you’re increasing volumes by 3x, it could very well lead to a doubling of EPS in a steady-state oil price environment. And if oil prices ever return to 2013 levels? Who knows.
What about the bank part? What Hibiscus is doing as described above, is issuing equity at a particular cost of equity (COE) in order to invest the proceeds for a certain return on equity (ROE). My own estimate of their COE is 10%, while their promised minimum IRR from the upcoming acquisitions would be 12% - which means that they would essentially breakeven on a spread basis. However if we assume that they remain fully funded by equity, the financial risk from leverage is essentially zero - which means that they could theoretically scale this strategy up ad infinitum. This infinitely scalable “NIM” spread model is what I’m referring to when I say that they are basically adopting a banking business model (as long as net-positive acquisition opportunities exist). It is financial engineering at its finest.
For the most part, most of the other financial characteristics of the business haven’t changed much since my last analysis of Hibiscus in April 2020. I’ll just give a quick run-down of them again, as well as some additional thoughts I’ve had about the company since then:
The company is a small-cap brownfield upstream O&G operator, which is basically an anomaly in the space - as you would naturally look for economies of scale in a brownfield operation.
They have also historically been net cash, which again is an anomaly in the space. Whether this is an active choice or a function of being unable to secure bank loans, it has kept their financial risk low. However, discussions with management suggest that they plan to utilize some debt going forward.
However, this lack of financial leverage seemingly hasn’t impacted their ROI profile at all. Hibiscus’ pre-pandemic ROE has hovered between 15%-20% - which is pretty incredible when you consider that not only are they not using debt, they also basically have no economies of scale. The high ROI is completely a function of acquiring O&G assets very cheaply - which is something I expect them to be able to replicate with their upcoming acquisitions. (by the way, if you ever interview management, don’t forget to ask them about how they managed to achieve North Sabah’s barrel-scraping OPEX of USD 18/bbl)
Due to their brownfield nature, FCF has been pretty decent as well. FY20/LTM OCF was positive, while FY20/LTM FCF was only slightly negative (FCF = OCF - depreciation). In addition, FY20/LTM net profit was in the black after adding back one-time impairments. For a small-cap upstream O&G business reporting in the year where oil prices actually went negative, this just blew my expectations away.
In any commoditized industry, the business consideration ultimately boils down to optimizing: i) Cost and ii) Risk. Clearly, management has an iron fist on both.
My discussions with management indicate that they have a moral compass. E.g. they will not compromise on employee safety. Also their upper management team is 30% women. ESG fans, riot.
They recently announced their maiden dividend. It’s not much - just a dividend yield of about 1.5% - but I thought it was worth mentioning. Also, the MD owns 10% of outstanding shares, and the MD&A section of their annual report is fire.
Going by their track record, they appear to have a contrarian management style. They made the decision to issue tons of equity in the depths of an oil price recession (while their share price was depressed), in order to expand their asset base by 2x - without going full reta*d on debt (both US & Malaysian companies come to mind).
Quite clearly, they are opportunists just waiting for the right time to swing their bat (i.e. acquiring bankrupt O&G assets today), while managing risk with the elegance of a Japanese samurai sheathing his katana. Warren Buffett, if you’re thinking about adding this company to Berkshire Hathaway’s stable of contrarians, I hope you’ll consider my finder’s fee.
Hibiscus financial information: https://www.malaysiastock.biz/Corporate-Infomation.aspx?securityCode=5199
Hibiscus Investor Relation website: https://www.hibiscuspetroleum.com/investor-relations/
CRPS Circular to Shareholders: https://disclosure.bursamalaysia.com/FileAccess/apbursaweb/download?id=203730&name=EA_DS_ATTACHMENTS
Update: Announcement of acquisition terms (9 June 2021): https://disclosure.bursamalaysia.com/FileAccess/apbursaweb/download?id=115517&name=EA_GA_ATTACHMENTS