Saturday, 29 December 2012

Poseidon Concepts - Value or Value Trap?

The average company trades for about 15 times earnings.  What if I told you about a company that was trading not for 10 times earnings, not for 7 times earnings, but for 4 times earnings?  Oh, and that's 4 times quarterly earnings - just over 1 times dividends.  Sound too good to be true?  It's kind of true - but, alas, it's also sort of too good to be true.  The dividend in question was recently suspended, and the quarterly earnings, unfortunately were not from the most recent quarter, or, perhaps, for any quarter in the foreseeable future.  Let me explain.
The company in question is Poseidon Concepts.  Spun out of Open Range Energy last year, Poseidon experienced astronomical growth by offering oil and gas companies a simple, but very efficient, alternative to storing water used for drilling.  Employing a device not unlike an above ground pool, Poseidon’s novel concept was not only cheaper, it was quicker and less environmentally risky than the standard methods then being used.  In an impossibly short period of time, Poseidon had a foothold in most major North American plays.
The high point came in this year's first and second quarters - the same quarters mentioned above - when earnings per share were $0.38 in each period, and funds from operations were $0.49 and $0.48, respectively.  Until only this past week, the company paid a dividend of $0.09 per month, or $1.08 per year, within reach of the current share price, which has fallen by a gut-wrenching 90%-plus from its high.  What a difference a quarter makes.  By the third quarter, Poseidon's net income had fallen to just $0.10, in part due to a $9 million charge for bad debts that the company is unlikely to collect on.
What happened?  It appears the company was hit on two fronts.  Not only has demand been weak industry-wide, increased competition pushed down margins, too.  Indeed, some firms in the industry have been forced to offer discounts of up to 75%, a sure sign of a commodity-type offering.  Though the company holds a patent on its main product - which is responsible for the bulk of its business - it doesn't appear that it will prevent competitors from offering similar items.  And there was never any doubt that the high margins and returns on capital that Poseidon has enjoyed would invite salivating rivals.  To be sure, the company is rightly trying to use their installed base of storage tanks as a foundation from which to sell added products and services, but it remains to be seen if they will be successful in a fast-changing market.
Clearly, there have also been some troubles specific to Poseidon, as well.  For one, it appears that the recent wild growth was faster than management could handle.  Indeed, at the end of the third quarter, receivables were $126 million, compared to revenue in the first nine months of the year of $148 million.  On such a large base of uncollected cash, further write-downs could be immense.  At the end of the third quarter, $36 million of Poseidon's receivables were past due, a worrisome figure, particularly after having written off $9 million altogether.  Though receivables in the oil and gas services industry are regarded as difficult to collect on, competitors have not suffered nearly to the extent that Poseidon has.  Painful as it must have been, however, the newly arranged board has made the right decision to suspend the dividend, which will give them much more liquidity, buying precious time to - hopefully - right the ship.  In addition, at the end of the third quarter, $44 million remained undrawn on the company's credit facility, which doesn't come due until June of 2014.
The changes at the top are unusual.  Scott Dawson, former CEO of Open Range Energy and current Chairman of Poseidon will step into the CEO role immediately.  Lyle Michaluk will move from the CEO role into the CFO role, which is unusual in such cases - after all, most ousted CEOs are not offered another senior executive position, nor would they ordinarily be interested in accepting one.  Similarly, Cliff Weibe will assume the role of Chief Technology Officer, having until recently served as the Chief Operating Officer.  Both men, as well as one other director, have resigned from the board.  On a positive note, if there was reason to suspect any major ethical breaches or wrongdoing, it's virtually impossible that any of the above officers would have been offered alternative positions.  Based on the facts available, it seems reasonable to conclude that the company simply grew too fast for the management team, and the company's processes and system of controls, to handle.  In the third quarter report, the company, to its credit, admitted to weaknesses in internal controls, specifically a lack of accounting expertise, and pledged to remedy to problem as soon as possible.
Is the stock a buy at today's dramatically reduced price?  It's impossible to know - which means, "No."  Wise investors only commit hard-earned capital if the odds of permanent impairment are low - for now, the picture is simply too fuzzy to rule out that possibility.  As Warren Buffett has often said, the first rule of investing is "Don't lose money," and the second rule is "Don't forget the first rule."  Many bottom-feeding investors may be tempted to scavenge on Poseidon's shares, knowing that if the story works out they could enjoy a radically high return.  But if they look down first they will likely find that they're not protected by a margin of safety, and ignoring the risk while dreaming about the upside is foolish.  If things turn for the better in the months to come, there will likely be an opportunity to buy shares at a higher, but still bargain price, with the confidence that any mortal danger the company may now be facing has passed.
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