China North East Petroleum: Investing Made Easy

We live in a period of low expected returns from investing across all asset classes. In this tough environment life is difficult for stock pickers. But life will surely not be tough for recent buyers of NEP.

China North East Petroleum (AMEX: NEP) is a low-cost, high-margin, cash-generative oil producer in northeast China. For more about the company, refer to earlier Seeking Alpha articles here and here.

There are 5 major catalysts in place to drive NEP’s stock price substantially higher:

The Bernanke Put: Ongoing economic lethargy will lead to more QE, with consequential devaluation of the Usd and large quantities of money moving into safer-haven commodities such as oil. Alternatively, if economic activity actually improves, we get higher oil prices via demand. Either way, a win-win for investors in the oil sector.

Acquisition: A significant cash acquisition of new oil properties by NEP is likely to be announced between now and summer 2011. This will be a game-changer for the company. NEP is building cash reserves and will have about $68 million cash at December 2010. The company has already announced its intention to acquire new oil leases and it owns drilling rigs which it can quickly deploy to profitably exploit new acreage. Everything is in place.

Recovery from quote suspension: NEP’s stock quote was suspended for over 3 months in 2010 whilst the company corrected accounting mistakes in 2008 and 2009 SEC filings. The stock had been trading in the $9-10 range in spring 2010 and, not surprisingly, fell hard in the run-up to suspension, finally closing at $5.50. Now, with all filings corrected and up-to-date, with the company’s finance functions and controls improved, and with the 2010 SEC filings confirming that the corrections do not have any material adverse effect on NEP’s expected profits going forward, NEP’s stock price is positioned to recover lost ground. This recovery is likely to be step-like in tandem with NEP proving to investors that good operational progress continues to be made. One such development has already occurred; NEP announced on September 28 that its drilling subsidiary had won a contract to drill 100 wells over a 2-year period with an independent oil producer. Without doubt other positive operational developments will be announced in the near future with corresponding positive effects on the stock price.

CFO position: As a consequence of the discovery of the accounting mistakes in the 2008 and 2009 SEC filings, NEP made changes to its finance function. The old CFO had some of his responsibilities modified, an interim CFO was appointed and, as yet, the company has not appointed a permanent replacement to the CFO position. In time this position will be filled.

Analyst coverage: During the period when the stock quote was suspended, NEP’s sole analyst predictably dropped his recommendation from buy to hold (investors could hardly buy the stock if it wasn’t quoted!). This hold rating remains in place as of today. Over time, when NEP continues to deliver strong operating profits and files pristine SEC reports, it is highly likely that NEP will regain its buy rating, unless the stock price balloons in the meantime of course. So long as NEP’s stock price remains deeply undervalued it is very likely to attract buy coverage.

What makes NEP a particularly attractive investment opportunity is that all 5 of the above major catalysts are likely to occur and that, ahead of these events, the stock price is deeply undervalued.

The following P&L and Balance Sheet summaries are built using conservative oil price assumptions; $70 for Q3 and Q4 2010, $75 for 2011 and $80 for 2012. Yes, these are low-ball estimates, especially considering that oil has recently been trading above $80, but it is always best to base investment decisions on conservative assumptions.

Summary P&Ls	2008	2009	2010	2011	2012
	Actual	Actual	Estimate	Estimate	Estimate
Ave Oil price	$94.29	$55.97	$72.73	$75.00	$80.00
	Usd ‘000	Usd ‘000	Usd ‘000	Usd ‘000	Usd ‘000
Sales – Oil	58,572	51,081	61,086	69,375	63,000
Sales – Drilling	0	13,577	48,099	60,000	60,000
Sales – Total	58,572	64,658	109,185	129,375	123,000
Prod'n & Drill costs	3,848	7,730	23,152	28,400	28,500
Dep'n & Amort	8,621	9,815	10,198	11,400	11,400
Gov't Surcharge	11,105	4,619	9,355	10,638	10,631
Total	23,574	22,164	42,705	50,438	50,531
Gross Profit	34,998	42,494	66,480	78,938	72,469
Gross Profit %	59.8%	65.7%	60.9%	61.0%	58.9%
SGA expenses	16,820	18,105	5,052	4,950	5,600
Operating Income	18,178	24,389	61,428	73,988	66,869
Other, Int, Fin.	5,261	1,920	43	500	500
(G)/L Warrants Reval	(4,464)	27,399	(25,439)	0	0
Debt extinguish loss	0	8,261	0	0	0
Income before Tax	17,381	(13,191)	86,824	73,488	66,369
Income Tax	5,277	6,900	21,706	18,372	16,592
Minority Interest	1,583	2,018	5,052	5,750	5,250
Net Inc Ord Shares	10,521	(22,109)	60,066	49,366	44,527
Reported EPS – basic	$0.53	$(0.99)	$2.04	$1.65	$1.48
Reported EPS – diluted	$0.53	$(0.99)	$1.93	$1.57	$1.41
Earnings excl Warrant Revaluation	7,412	19,622	40,987	49,366	44,527
Normalized EPS – basic	$0.37	$0.88	$1.39	$1.65	$1.48
Normalized EPS – diluted	$0.37	$0.88	$1.32	$1.57	$1.41
Normalized Net Income %	12.7%	30.3%	37.5%	38.2%	36.2%

This very high % of Net Income to Sales is a key factor behind NEP’s ability to be strongly cash generative.

Summary B. Sheets	2008	2009	2010	2011	2012
	Actual	Actual	Estimate	Estimate	Estimate
	Usd ‘000	Usd ‘000	Usd ‘000	Usd ‘000	Usd ‘000
Cash	13,239	28,693	68,000	122,000	160,000
Other Current Assets	5,323	16,909	23,348	27,486	24,762
Property & Equip, net	56,726	62,312	57,705	51,000	45,000
Other Assets	4,640	9,814	10,043	2,145	2,145
Total Assets	79,928	117,728	159,096	202,631	231,907
Current Liabilities	18,210	25,340	26,520	28,500	28,000
Longterm Liabilities	25,527	44,403	13,909	0	0
Minority Shareholders	3,378	7,665	13,679	19,429	4,679
Shareholders Equity	32,813	40,320	104,988	154,702	199,228
Total Liabs & Shareholders Funds	79,928	117,728	159,096	202,631	231,907

Note again the large cash balances. Without cash acquisitions - which of itself would be positive news - cash at y/end 2011 would be $122 million and at y/end 2012 $160 million. Set against NEP’s total market capitalization of $200 million these cash balances are eye popping.

Summary

NEP’s stock closed October 6, 2010 at $6.83. For that price an investor gets a 2011 p/e ratio of 4.35 plus $2 cash per share, this using a conservative oil price assumption of $75 per barrel. At $85 per barrel, NEP would generate fully diluted EPS in 2011 of $1.70, equating to a p/e of 4.0.

There are 5 catalysts that will lift the stock price in the near to medium term. Just 2-3 of these catalysts would normally provide a good boost, but, in this case, all 5 are set to occur.

Against this positive backdrop it would be surprising if the stock price doesn’t trade comfortably into double digits by early 2011, especially as various catalysts kick in. A 2011 p/e ratio of 8 would put the shares at $12 and still leave the $2 per share cash in for free. This is inexpensive, and particularly so in a world of currency devaluations and investors moving funds into safe havens such as oil and other commodities.

A 75% increase on yesterday’s closing price of $6.83 is certainly not too shabby in a world of anemic returns across all asset categories.

Disclosure: Author is long NEP