Public markets are a wonderful tool for the patient business-minded investor. Everyday Mr. Market quotes you a new price on every equity in the universe. Somedays Mr. Market is optimistic.

“Amazon at $3,000 per share to anyone who wants to drop an order. Google at $2,700 for anyone with the excess cash. Tesla at $1,200.”

Then other days Mr. Market is pessimist.

“Amazon at $1,500 and dropping sharply. Google at $2,000 with no strong bids. Tesla at $650.”

The business-minded investor who focuses on purchasing companies and not stocks, who relies on numbers and not emotions, gets to take advantage of the mood swings of Mr. Market every day.

If you don’t like the price quoted at you one day, just ignore Mr. Market and hold onto your cash. If Mr. Market gets extremely optimistic on a stock you hold, sell it back to him. If Mr. Market pukes on a company you have been patiently waiting to buy, run out into the rainstorm with buckets and try to collect as much water as you can.

The great thing about public markets is that you don’t have to swing at every pitch Mr. Market throws you.  This is a game where patience and long-term thinking pays off. Wait, wait, and wait for Mr. Market to throw the right pitch, then swing as hard as you can when that fastball comes your way. Swing for the fences.

My goal in the public markets is to wait for Mr. Market to throw me a pitch where I can buy a company trading meaningfully below its replacement value. I love buying companies where their public market valuations trade below their private market replacement value.

An example of a company that tends to trade under the replacement value of their assets is Macy’s (M). Macy’s is a volatile retail department store company. Sometimes Mr. Market is optimistic on Macy’s and values their assets at or above fair value. Other times, Mr. Market thinks retail department stores have a negative value and prices Macy’s for a considerably cheap valuation.

The thing with Macy’s is that they own some of the highest quality real estate in the world. This real estate is in top demographics including Manhattan, San Francisco, Chicago, etc. Private market valuations imply that this private market real estate has a replacement value of $15-20 billion.

I have a detailed model of Macy’s, including tracking all their owned real estate locations. I have taken advantage of the mood swings Mr. Market has with Macy’s in the past and should Mr. Market value Macy’s significantly under the replacement value of their real estate in the future, I plan on swinging yet again.

But Macy’s isn’t the only company that Mr. Market values under replacement value. Almost every company I invest in typically trades to a meaningful discount to what I think the replacement value is. One company I have previously written up for Alpha Letter Pro Subscribers continues to trade manically with Mr. Markets mood swings. At the current valuation, I think it is trading near the replacement value.

I’ve been an owner of this company for a few months now. The stock price has been extremely volatile. I’m up 50% one week and down towards my initial purchase price the next week. I’ve traded in and out of the stock successfully when Mr. Market is optimistic and bought back in when Mr. Market freaks out about the future.

The volatility in the stock makes sense. The company operates in the highly competitive and commodity dependent oil and gas market. When oil explodes higher the valuation increases. When oil falls, the valuation crumbles.

Despite the highly volatile nature of the oil and gas industry, the setup on this company is almost as beautiful as you can get from the eyeglasses of a trained security analyst.

• The company has a large net cash balance that is quite understated as one-time items in Q1 restricted the company from collecting a rather larger pile of cash, which was subsequently collected in Q2.

• The low-cost production profile of the company ensures that free cash flow will be generated in an energy bear market. Breakeven production costs at the well are $30 per bbl and trending under $25 per bbl over the next few quarters. Breakeven free cash flow production costs including corporate G&A, should be right around $40 per bbl.

• Management is unlocking shareholder value by investing in new offshore wells with low production costs and low long-term decline rates which should meaningfully increase production, putting the company on the screen of larger investors (and frankly larger companies who are acquisitive), driving shareholder value.

• Proved reserves at the strip, adding cash and current assets (highly liquid receivables that are not impaired) and subtracting all liabilities implies at the current valuation, investors are purchasing the equity near or under replacement value.

• With Brent Crude Oil at $100-110, this company will generate significant free cash flows for investors.

• I think this company is worth $8.50-13.00 per share and it is currently trading for $5.82 per share.

I’ve taken a meaningful stake in this company and plan to continue to add on weakness. The stock tends to trade wildly with energy markets and allows business-minded investors to take advantage of Mr. Market’s mood swings.

I hope you enjoy my research. Feel free to reach out if you have any questions.

VAALCO Energy (EGY) is an oil and gas company listed in the United States which offshore properties on in the oceans outside of Gabon. The company has a market cap of $344 million and an enterprise value of $325 million. In 2021 VAALCO produced 7,120 barrels of oil per day with an average price of $70 per bbl and a production cost of $30 per bbl.

Since 2021, the energy markets have meaningfully improved. VAALCO sells their oil into the Brent spot market and has historically gotten a premium to Brent. For an example in Q1 2022, Brent averaged $100 per barrel, yet VAALCO realized production per barrel of $109.

In addition, the management team has embarked on an aggressive 2021/2022 expansion plan. This expansion plan calls for the drilling of four new offshore wells in the ocean of Gabon. Two of these wells have been completed successfully.

The first well had a strong initial flow through of 5,000 gross barrels per day with 2,560 bbl net revenue interest to VAALCO. The well is now around 4,000 gross barrels per day or around 2,000 bbl net revenue interest to VAALCO.

The second well recently came on at an initial flow through rate of 3,100 gross barrels per day or 1,586 net revenue interest to VAALCO.

Two more wells are scheduled to be drilled in 2022 which have the potential to add another net barrels per day of 3,000 or so, depending on where the flow through rates come in at.

Offshore drilling is an extremely expensive endeavor. The net capex costs to drill these wells for VAALCO are estimated at $54 to $74 million. Despite the high costs to drill, offshore wells have low decline rates (6-7% per year) and a long life, unlike horizonal wells with decline rates in the 20% range and shorter lifetime values. If you drill right, you can have a cash flowing asset for years.

The important question is what the economics of an offshore oil company generating 10,000 to 12,000 barrels of oil per day. I attached a few hypothetical situations.

In this situation I am assuming VAALCO generates 10,000-12,000 barrels of oil per day with the price of oil at $100-105 per barrel. Production costs per barrel are estimated at $30/bbl and corporate expenses at $15 million per year. This leads to pre-tax, pre-capex and pre-hedging free cash flows of $240 million to $313 million.

In the second scenario I am assuming all the former inputs besides a decrease in the price of oil to $70 per barrel. In this scenario pre-tax, pre-hedging and pre-capex cash flows are $131 million to $162 million.

In this next scenario I am assuming the energy market goes through a bear market and VAALCO is only able to realize $40 per barrel in realizations. This puts pre-tax, pre-hedging, and pre-capex cash flows at $21 million to $28 million. Even in a drastically bad situation, VAALCO can generate cash flows, showing the value of owning and controlling a low-cost reduction base of assets.

Finally in this last situation I am assuming the other two wells VAALCO is drilling comes on successfully, in addition to the price of oil coming in at $110 per barrel, with the cost of production dropping to $25 per barrel (which are estimated to happen given the large investment in the FSPO this fall). In this bullish scenario, VAALCO will generate pre-tax, pre-hedging, and pre-capex cash flows of $357 million to $419 million.

With a market cap of only $344 million and an enterprise value of $325 million, these four scenarios point to a clear undervaluation of the assets that VAALCO owns and controls. What makes the valuation even more compelling, VAALCO collected an additional $48 million in cash after Q1 end from an additional lifting they were not able to do in Q1 due to weather related issues, putting the implied enterprise value at only $277 million.

In terms of true free cash flows, VAALCO has entered a significant capex expansion program. 2022 capex is estimated to be $100-115 million which includes $54-74 million in drilling committed capex, another $26-30 million in capex to convert their FSO into an FSPO (payback estimated in less than a year as production expense drops from $30 to bbl to under $25 per bbl), and an additional $5-10 million for additional margin of safety.

VAALCO also has entered into hedges to lock in their capex for the 2021/2022 drilling season. These hedges are tough to model out as they depend on the price of realized oil. In Q1 2022, there was a negative $31 million of derivative losses that impacted operating income. These are non-cash now but will be settled up when the hedges end. Actual settled derivate losses in Q1 2022 were $12.5 million.

My sense is that VAALCO should generate anywhere between $75 million and $100 million in true free cash flow for 2022. With an implied enterprise value of only $277 million, you are buying a cash flow producing commodity asset for only 2.7-3.7x. What makes this more compelling is that management will likely continue to aggressively invest in additional drilling programs (I’m estimating $75-100 million per year) and take daily production up to 20,000 to 30,000 barrels of oil per day. And given managements prior background (CEO sold his last onshore African oil company), they will probably flip VAALCO to a larger energy company at that point and walk away into the sun.

The big question is what VAALCO is truly worth. In my opinion, I think paying $275 million for an asset that will generate $75-100 million in free cash flow in a year is simply a steal. For valuation purposes, I think VAALCO should be worth $500-750 million, which is a share price in the $8.50-13.00 per share range.

In terms of risks, VAALCO is an African offshore oil and gas company which comes with its whole set of problems. I typically only invest in U.S. based jurisdictions as owning assets in the U.S. allows me to sleep well at night. On a historical front, VAALCO has operated in the offshore oceans of Gabon for many years and has generated free cash flows to investors during these times.

Another risk is commodity price risk. The price of oil could plummet from here. But as show in my scenarios above, VAALCO generates cash flow even at $40 bucks per barrel and with a clean balance sheet, equity owners can sleep well at night knowing the cash flows are coming to them and not debt holders.

A final risk to think about is the risk of operating offshore wells. Offshore drilling is a tough and dangerous business. Things can go wrong here and probably will go wrong. Oil wells can blow up. Drilling rigs can sink. Drilling programs could be duds with wasted capital sunk into the ocean. It is good to be aware of this risk and the host of problems investing in this industry.

Despite the risks with investing in VAALCO, I think the downside is limited. Using the implied enterprise value of only $277 million, proved reserves alone are worth $300 million plus at the strip and then you have probable reserves which should have a positive value in an environment with oil prices above $100. For a company that generates 10,000 to 12,000 barrels of oil per day, I would own this entire company at $277 million if I had enough capital to buy the entire asset out.

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