Bargain shares updates

Heritage pumping up

First-half results from oil and gas independent upstream exploration and production company Heritage Oil (HOIL: 183.5p) are supporting a much overdue re-rating in the shares.

Following a series of complex transactions to fund the $850m (£531m) acquisition of OML 30, one of the largest of Shell's onshore Nigerian assets sold in the past couple of years, Heritage Oil ended up with a 30.7 per cent working interest in the investment vehicle controlling OML 30. The balance is held by its Nigerian energy partner, Shoreline Energy. The good news is that after a blip in the second quarter, when production missed targets due to a manifold in a gas lift compression system failing and a strike by local workers in Nigeria, output is now above 35,000 barrels of oil per day (bopd).

In fact, OML achieved record gross production of 44,000 bopd last month, almost treble the average output in the first half. As a result, production is expected to average 45,000 bopd in the second half, which will raise full-year output to an average of 30,000 bopd. The increase in production from OML 30 for the remainder of this year will be achieved by the installation of new equipment, working over existing wells and commencing production from the Uzere West field, which has been shut-in for nearly two years

Guidance is for a ramp up to between 60,000 and 65,000 bopd in 2014, which looks feasible as OML has over 200 wells, but only half are in production, mainly because many were vandalised in the period from 2006 to 2009. However, pipeline repairs should restore production from a large number of these wells and the plan is to drill over 200 new wells and restore approximately 60 wells to production with a focus on horizontal drilling. Drilling will commence in the middle of next year with one rig, and one new rig will be added every six months.

Valuable resource

The lease on OML runs to 2019, but it is anticipated by Heritage, in accordance with the licence terms, that an extension of 30 years will be granted. To put the size of the resource into some perspective, OML is one of the largest onshore licences in the country, with eight producing fields and associated infrastructure; gross proved and probable reserves of 1,114bn barrels of oil. Geographically, it is located onshore in the Delta, less than 50 kilometres east of Warri in Southern Nigeria.

Analysts estimate that OML has an economic valuation of proved plus probable reserves estimated at between $3.1bn and $3.8bn (£2bn to £2.4bn), which doesn't seem unreasonable for a 1.1bn barrel resource. And to exploit the full potential of OML, the long-term plan is to ramp up output to around 300,000 bopd by 2020, according to the management team at Heritage. The nearer-term aim is to increase production to almost 100,000 bopd in 2015 and close to 150,000 bopd the following year.

In turn, this sharp increase in output will generate the bumper cash flow needed to pay down the $500m (£322m) of net borrowings Heritage took on to fund the purchase of the interest in OML. And it was the cash-flow generation that first attracted me to Heritage when I included the shares in my 2013 Bargain Share Portfolio. In fact, in the first half of this year, and despite the second-quarter blip, Heritage generated cash flow from operations of $113m and made a net profit of $57m in the period after paying tax of $28m and finance charges of $36.5m. As a result, net borrowings were cut by $80m in the six-month period and ended the half year at $394m.

It's worth noting that Heritage is not a one-trick pony, either, and has exploration assets in Malta, Tanzania, Pakistan, Libya and the Democratic Republic of Congo, which could provide decent newsflow. Ultimately, though, investors are focused on the interest in Nigeria and realising the value in the OML interests. And on that basis, the investment case looks well supported.

Low valuation

Analysts at Northland Capital currently expect Heritage to report full-year revenues of $372m, adjusted pre-tax profits of $198m and EPS of 35.2¢. For 2014, the respective figures are revenues of $512m, profits of $302m and EPS of 67.5¢. On that basis, the shares, at 185p, are trading on eight times current year earnings estimates, falling to a miserly 4.2 times 2014 forecasts.

The valuation is also attractive on a sum-of-the-parts basis. Analysts at Canaccord Genuity calculate that Heritage has an unrisked net present value of $1.63bn on its assets, including $1.3bn on the OML assets, assuming a 12.5 per cent discount rate. That assumes a 2015 Brent Oil price of $102 a barrel and 2 per cent growth in the oil price thereafter, which does not seem unreasonable.

Moreover, assuming a conservative risk factor of 80 per cent of success on the production ramp up, the risked net present value of the company is $1.3bn. Based on 277m shares in issue (fully diluted), this implies a risked valuation of 469¢ a share, or 303p a share using an exchange rate of £1=$1.55. In other words, with Heritage Oil's shares trading at 185p, the current valuation is a hefty 40 per cent below conservative risked valuations of the company and these discount cash flows back at a rate of 10 per cent. On a slightly more aggressive discount rate, the net present value is 366p a share and the share price discount widens to 50 per cent. And even if you are uber conservative and wish to use a huge 15 per cent discount rate to Heritage's future cash flows, the net asset value still comes out at 263p a share.

So, not only are Heritage's shares lowly rated on an earnings basis, they are also trading on a huge discount to sum-of-the-parts valuations using very conservative valuation metrics.

Share price recovery

As I noted earlier, shares in Heritage have rallied strongly in the past three months and have recovered much of the lost ground from earlier this year. The price also looks poised to take out the August high of 191p, which would open up a run up to the February high of 225p. The technical set-up is certainly positive for further share price upside as the 14-day relative strength index (RSI) is around 60, and is therefore not in overbought territory; the MACD is positive and above its signal line; the price is not ever extended above its 20-day moving average (currently around 171p); and, importantly, the price has now moved above the 200-day moving average (currently around 173p). For good measure, if the rally continues then expect a bullish golden cross in the coming weeks as the 50-day moving average plays catch up (currently around 161p).

So with Heritage's operating cash flow forecast to ramp up, and the earnings multiple set to drop rapidly, an investment in Heritage's shares has potential to hit pay dirt this year. Buy.

How Simon Thompson's 2013 Bargain Shares Portfolio has performed

Polo shares a trading buy

Aim-traded resource investment company Polo Resources (POL: 21.25p) has proved an incredibly frustrating holding and perhaps the most frustrating one I have held in the past few years. In fact, the shares are still below my recommended buy-in price of 24.5p even though the investment case is even stronger now than seven months ago.

If you missed my last update three weeks ago, I have revisited the investment case again for the simple reason we can realistically expect some important newsflow by the end of this month. This looks an opportune time to take advantage of the current valuation anomaly.

Unloved and undervalued

To put the extent of Polo's undervaluation into some perspective, at the end of June the company was sitting on short-term investments, cash and receivables of 6.4p a share, or 30 per cent of its current share price of 21.25p. Strip those liquid resources out from the company's book value of 36p a share, and assets worth 29.6p a share are in effect being valued at only 14.85p, or only half their carrying value in Polo's latest accounts. That is an extreme valuation considering that only four months ago a new investor, Michael Tang, acquired 11.77 per cent of Polo's share capital at 40p a share - almost double the current share price and 11 per cent above book value of 36p a share - through his vehicle, Mettiz Capital, an investment company with corporate and financial experience in natural resources, power generation, manufacturing and real estate. He is now the company's largest single shareholder with a 14.55 per cent stake, so he clearly sees the potential in Polo's investment portfolio.

This is not only a very rare situation where we can buy into this undervalued company on far better terms than a large fund can, but Polo's shares would have to double for Mr Tang's investment to turn a profit. Moreover, that is no forlorn hope as there is a realistic chance of some very positive newsflow in the coming weeks to kick-start a well overdue, and much deserved re-rating.

Value out of Africa

That's because five weeks ago Polo's board announced that it's "making good progress with a number of potential bidders" for farming out or even disposing of a major interest in one of its major holdings, Signet Petroleum, an African oil and gas explorer that has four prospective assets in Benin, Burundi, Namibia and Tanzania. Signet's main investment is an 80 per cent interest in Hydrotanz, a company that has a production-sharing agreement with the United Republic of Tanzania and the Tanzania Petroleum Development Corporation on the offshore North Mnazi Bay Block. This prospect is adjacent to BG and Ophir Energy's offshore Chaza 1 gas discovery well, which is targeting an eye-catching 12 trillion cubic feet of gas.

It's therefore worth noting that Polo has a 48 per cent stake in Signet worth £28.1m, or the equivalent of 10.4p a share, and First Energy Capital Corporation has been appointed by Signet to assess strategic alternatives for Mnazi Bay, including potential farm-out opportunities. It's also worth noting the progress being made here as Mr Tang sees "substantial upside for Polo as a major Signet shareholder". Expect a deal to be announced by the end of this month and one that can only highlight the hidden value in Polo's stake in Signet, not to mention a potentially large uplift on the carrying value of the investment.

In my opinion, Mr Tang's confidence is not misplaced as Polo is not a one trick pony, either. There is decent upside potential in the company's largest investments, the Nimini Komahun Gold Project in Sierra Leone, in which Polo holds a 90 per cent stake worth £33.4m. A new Mineral Resource Estimate was published in late June, which confirmed a significant increase in both the indicated and inferred mineral resource.

The last resource estimate showed an indicated gold resource at the site of 550,000 ounces and another 330,000 inferred ounces of gold, bringing the total potential resource to 880,000 ounces. On that basis, the £33.4m carrying value on Polo's investment values the project at only $51.8m, or the equivalent of $59 an ounce. That's a 30 per cent discount to the valuations attributed to sector peers, so the resource is hardly being overvalued. Furthermore, the gold price has been recovering some of the hefty falls earlier this year and, at $1,400 an ounce, is at a level that would make Nimini commercially viable - especially when the gold is in the books at less than $60 an ounce.

True, we have to now await the release of the Preliminary Economic Assessment (PEA), the technical inputs for which were completed last month. The date of publication of the PEA is dependent on the outcome of discussions with the government of Sierra Leone regarding the terms applicable to the project, the first large-scale underground gold mine in Sierra Leone. I expect a positive outcome.

Polo Resource's investment portfolio at 30 June 2013

Sum-of-the-parts valuation

No matter which way I look at Polo the shares are significantly undervalued. Combined, the holdings in Signet and Nimini are in the books for £61.5m, or 63 per cent of Polo's net asset value of £97m, and are worth more than its market value of £57.4m. That leaves cash and marketable investments worth £17.2m, or 6.4p a share, in the price for free as well as interests in four other companies worth a further £18.5m, or 6.9p a share.

It is only reasonable to assume that any positive news from Polo's interests in either Nimini and Signet, or further stake-building for that matter, would be the catalyst to spark a well overdue re-rating. It is also one that looks primed from a charting perspective as the share price appears to have found a bottom around the 19p level in July. In fact, there was positive divergence on the charts as the price tested the 19p lows from April, but the 14-day RSI didn't. This can be a good sign that a decent rally is at hand. The price action since is only supportive of this view with the price rallying above both the 20-day and 50-day moving averages. At a reading of 60, the 14-day RSI is not overbought so there is scope for a continuation of the upwards price trend.

So, with the technical set-up positive, and a potentially lucrative deal on Signet in the offing later this month, I have no hesitation in recommending using the unwarranted low valuation of the company as a buying opportunity. My fair value estimate remains 35p, which if achieved would provide us with 55 per cent potential upside. On a bid-offer spread of 20.25p to 21.25p, Polo's shares rate a buy.

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