Adams Resources and Energy (AE, $18) is a collection of three well-managed businesses: energy marketing, oil and gas exploration and production, and tank truck transportation. You can buy its high return energy marketing business for half off and get its other two businesses for free. The stock is worth $37, up about 100% from here.

Like many small cap stocks, this one is down a lot and very cheap. Unlike many small caps, this one has strong management, a business with a high return on incremental capital and a consistent operating history AND its energy marketing business is likely to earn more in 2009 than in 2008 with investment bank competition exiting the market.

 

Adam’s energy marketing business generates $10m in EBITDA per year and has incremental returns on capital of around 25% excluding onetime gains. Management grew EBITDA before onetime gains by 14% annually in the last five year. The company has $5 per share of cash and no debt and an enterprise value of $53m, so you are paying 5x EV/EBITDA for a business that is worth at least 8x EBITDA and getting the other two businesses for free. Free cash flow for energy marketing is about $8m per year, so the company is trading at 6.6x free cash flow for this business alone. 

 

Energy marketing is composed of two parts, natural gas marketing and oil marketing. Overall the two businesses together have a 25% return on net assets. The natural gas marketing business needs very little capital and incremental returns are much higher than 25%. Earnings and margins in natural gas marketing are primarily driven by two factors: competition and the volatility of natural gas prices. Competition is decreasing. Investment banks are exiting the natural gas marketing business due to capital constraints and to refocus on core operations. There is no reason to expect natural gas price volatility to be reduced next year. Neither of these factors should be negatively impacted by the economy. The oil marketing business earnings are primarily a factor of volumes and competition. Volume in 2009 should grow and competition remains benign.

 

The stock trades at 2.6x EV / TTM EBITDA (excluding onetime gains) and 30% below tangible book value of about $22. Economic book value is likely substantially higher. Management has grown book value 15% annually since 1995. The stock is more appropriately valued at $37, based on a sum of the parts analysis. The balance sheet is strong, with $5/share of cash and no debt.

 

The opportunity exists because the stock is underfollowed and likely quantitative fund selling is punishing the stock. The company has no analyst coverage. K.S. Bud Adams, founder, owns about 49% of the stock. The other large holders are quant funds. When the quant funds finish selling, the stock should rise.

 

Note that because Adam’s carries oil inventory for its oil marketing business there will be a 3Q08 non-cash write down of about $9m at current oil prices. This could create a buying opportunity, but I suspect the market will ignore this non-economic accounting adjustment, as it has in the past.

 

 

 

1)     Discounted valuation

a)      Intrinsic value $37/share versus current price of $18

b)     2.6x TTM EBITDA excluding onetime gains

2)     Solid management

3)     Energy marketing earnings should increase next year.

4)     Opportunity to invest incremental capital at rates well over 25% in the marketing business

5)     Conservative accounting. Properties sold have generated book income every year in the last ten years, unlike the negative write downs often seen at peers. Over the years EBITDA has closely tracked EBITDA calculated from cash from operations (cash from operations plus interest and taxes).

6)     Transportation has historically earned more than its cost of capital and the E&P business has not destroyed value, probably earning its cost of capital.

 

 

1)     Marketing earnings are difficult to predict quarter to quarter; I evaluate the business on an annual basis, but many investors may not like the lumpiness.

2)     A recession will compress transportation earnings.

3)     Low liquidity.

 

 

 

 

 

 

 

 

Tangible book value is about $22 ($5 cash, no debt) and likely understated due to management’s use of depreciable lives that are often less than economic lives and property write downs. Since 1999 Adams has generated cash from property sales of $27m ($6.50 per share) whereas the book value associated with these transactions was only $6m.

 

 

 

Marketing model:

 

 

 

 

EBITDA of $8m is a normalized number calculated by taking the average return on assets over a cycle and applying it to assets employed today. For return on assets I used EBITDAR / (capitalized operating leases + book assets).  Simpler, but less robust, you get the same answer if you use average EBITDA margins (13%) and apply it to revenues of $62M. TTM EBITDA is coincidentally $8m.

 

 

 

 

 

 

Management is strong:

 

 

Officers and directors own 50.3% of the stock, with founder K.S. “Bud” Adams holding 49% as of the April, 2008 proxy. Mr. Adams is 85. There is no plan for Mr. Adams shares of AE that I could ascertain. Mr. Adams’ AE shares are a small part of his overall net worth.

 

The top three non-management holders are all quantitative driven. A Fidelity quant fund owns 9.8% of the shares and has owned it since 1999. Dimensional owns 5% and has owned the stock in varying amounts since 2000 as far as I can tell. Renaissance owns about 5%.

Improved marketing earnings since competitors are exiting the market.

 

 

 

Adams has three main operating divisions: energy marketing, tank truck transportation and oil and gas production and exploration.

 

Comments

a)      Regional marketer of oil, natural gas and refined products, primarily in Texas and Louisiana.

b)     Competitive advantages

i)       Management team: strong execution, risk management and focus on return on capital

ii)     Low personnel turnover: every trader in the natural gas marketing business has been there since Adam’s acquired it in 1999

iii)   In house software

iv)    Low-cost operations

v)     Customer relationships

c)      Return on net assets of about 25%

1)     Oil marketing (about half of normalized energy marketing profits)

a)      Adams transports oil from wells of independent producers to where it can be sold.

b)     Management in 2007 hired a new sales person in oil marketing and believes it can stabilize or grow oil marketing volumes again. I do not give the valuation any credit for growth in the marketing business, but it seems likely. Oil marketing volumes have grown four quarters in a row after declining for years.

c)      Competitors are small, regional focused players

d)     Oil marketing profitability tends to be higher in less volatile, trending oil markets.

e)      From the 10-K:  “The Company’s subsidiary, Gulfmark Energy, Inc. (“Gulfmark”), purchases crude oil and arranges sales and deliveries to refiners and other customers. Activity is concentrated primarily onshore in Texas and Louisiana with additional operations in Michigan. During 2006, Gulfmark purchased approximately 61,800 barrels per day of crude oil at the wellhead or lease level. Gulfmark also operates 70 tractor-trailer rigs and maintains over 50 pipeline inventory locations or injection stations. Gulfmark has the ability to barge oil from nine oil storage facilities along the intercoastal waterway of Texas and Louisiana and maintains 120,000 barrels of storage capacity at certain of the dock facilities in order to access waterborne markets for its products. Gulfmark arranges transportation for sales to customers or enters into exchange transactions with third parties when the cost of the exchange is less than the alternate cost incurred in transporting or storing the crude oil.”

 

a)      From the 10-K: The Company’s subsidiary, Adams Resources Marketing, Ltd. (“ARM”), operates as a wholesale purchaser, distributor and marketer of natural gas. ARM’s focus is on the purchase of natural gas at the producer level. During 2006, ARM purchased approximately 354,000 mmbtu’s of natural gas per day at the wellhead and pipeline pooling points. Business is concentrated among approximately 60 independent producers with the primary production areas being the Louisiana and Texas Gulf Coast and the offshore Gulf of Mexico region. ARM provides value added services to its customers by providing access to common carrier pipelines and handling daily volume balancing requirements as well as risk management services.

b)     Adams’ natural gas marketing competitors are often divisions of utilities or gas producers. Competitors (per Mastio survey) include:

i)       In the last few years competitors have included investment banks such as Macquarie, which is now exiting the business.

ii)     National examples: BP, Chevron, Cinergy, ConocoPhillips, Constellation Energy, etc.

iii)   Regional examples: Amerada Hess, Anadarko, Atmos, Cargill, CenterPoint Energy, Crosstex, etc. (Atmos filings have good descriptions of the business; in the last two years the ROE for Atmos’ marketing business was 52% and 20%).

c)      Natural gas marketing profitability tends to be higher with greater natural gas volatility. Thus profitability of this subsidiary is generally higher in the winter months, or around storms / hurricanes.

 

i)       The Company’s subsidiary, Ada Resources, Inc. (“Ada”), markets branded and unbranded refined petroleum products, such as motor fuels and lubricants. The primary product distribution and warehousing facility is located on 5.5 Company-owned acres in Houston, Texas. The property includes a 60,000 square foot warehouse, 11,000 square feet of office space and bulk storage for 320,000 gallons of lubricating oil.

 

 

 

From the 10K: The Company’s subsidiary, Adams Resources Exploration Corporation, is actively engaged in the exploration and development of domestic oil and gas properties primarily along the Louisiana and Texas Gulf Coast.

 

In the last fifteen years Adams production has averaged about 80% gas and 20% oil. The company reports only proved producing reserves, which were about level at 1.8 million boe in the past ten years until management sold production in 2007. Reserves at the end of 2007 stood at 1.5 million boe.

 

In May 2007 the company sold its interest in undisclosed production for $15.3m, which resulted in a pretax book gain of $12.2m.

 

I don’t subscribe any value to Adams UK North Sea activities, but the company does hold a promote license in the United Kingdom North Sea Blocks 21-1b, 21-2b and 21-3d.  The Company holds a 30 percent equity interest in these blocks located in the Central Sector of the North Sea.  The Company has two years to confirm an exploration prospect and identify a partner to finance, on a promoted basis, the drilling of the first well on the Block.  The terms of the license do not include a well commitment.  The Company also acquired an approximate nine percent equity interest in a promote licensing right to Block 42-27b, located in the Southern Sector of the U.K. North Sea.

 

The business appears to have earned its cost of capital over the past decade.

 

 

 

Description. From the 10K: Service Transport Company (“STC”), a subsidiary of ARE, transports liquid chemicals on a "for hire" basis throughout the continental United States and Canada. Transportation service is provided to over 400 customers under multiple load contracts in addition to loads covered under STC’s standard price list.  Presently, STC operates 322 truck tractors of which 40 are independent owner-operator units.  STC also maintains 428 tank trailers.  In addition, STC maintains truck terminals in Houston, Corpus Christi, and Nederland, Texas as well as Baton Rouge (St. Gabriel), Louisiana and Mobile (Saraland), Alabama. Transportation operations are headquartered in Houston at a terminal facility situated on 22 Company-owned acres.  The property includes maintenance facilities, an office building, tank wash rack facilities and a water treatment system.  The St. Gabriel, Louisiana terminal is situated on 11.5 Company-owned acres and includes an office building, maintenance bays and tank cleaning facilities.

 

Solid return on capital. Adams has deftly managed this business, generating returns solidly above its cost of capital, despite a tough industry. Adams ten-plus years of no operating losses is rare compared to peers, an indication of management’s strong operating skills and the company’s low cost operating model.

 

To gauge the return of the business, I used segment EBITDA minus a G&A allocation minus capex as a proxy for cash flow, and assumed a purchase price for the business in 1999 and a sale price in 2007 based on an EV/EBITDA multiple of 6.0x each respective year’s EBITDA. The pretax IRR is 19% under these assumptions

 

Changing the multiple doesn’t change the conclusion materially. I used a time period of 1999 since it captures a full cycle for the business, about mid point to mid point. Using a starting point of 1996 yields an IRR of 19% and in 2001, 42%. I’m comfortable using EBITDA as a proxy for cash flow for the company since for the company overall a reconciliation of EBITDA from cash flow from operations closely tracks reported EBITDA. The company does not report cash flow by segment.

 

The tank truck industry in the U.S. is fragmented. Bulk Transporter’s Tank Truck Carrier 2007 Gross Revenue Report provides a list of tank truck carriers in rank order of revenues (http://bulktransporter.com/grossrevenue/BT508_07GrossRev.pdf). Of the 80 companies listed, only two appear to be stand alone public companies: QLTY and TMA.UN.

 

From Dow Chemical (http://www.dow.com/tss/bg/)

 

 

 

2001 was Adam’s only year of losses in the last ten plus years so I provide some detail here. The company lost $2/share or $9m, from continuing operations.

 

1)     $7.2m in losses tied to holding 1M barrels of oil for its oil marketing business while the oil price declined from $26 to 19. Adams now holds about 150k barrels of oil.

 

2)     $1.9m bad debt provision for Enron receivables.

 

3)     Enron’s bankruptcy caused turmoil in the natural gas marketing industry and hampered Adams business as counterparties restricted the amount of trade credit available to Adams. With $22m in cash, Adams is experiencing no problems obtaining letters of credit.

 

I suspect that the Enron turmoil benefited Adams over the long run as the industry shakeout led to higher return investment opportunities for the company.