Pardee Resources – Is this company a Value Investor without knowing it?

When I got started in investing, I wasn't any different than the crowd. I felt extremely confident about whatever I did and I'm sure almost anybody would have agreed with me about my original investment thesis – luckily I didn't start in '99. Over time (actually just a few months), however, my approach changed from a Buffett-like "great company at a good price" to a Graham like "good company at a great price." Even though the Buffett style investing seems convenient for most people, a Graham style, deep value approach will lead to much higher returns with less risk - even for novice investors. What if I told you that there are, even at high market valuations like today, still some great companies at great prices waiting for you to be picked up. One of those is Pardee Resources (PDER, Financial). It's trading at a dirt cheap price, although management has proved its ability to do what it is best at over decades. Since 1995 management invested a total of $138 MM and achieved an estimated 19.3% pre-tax internal rate of return on invested capital. The stock is selling significantly below adjusted book value now. Isn't that great? But guess what? They don't buy and sell stocks as we do; they manage basic resources! In 1840 the company was founded to mine coal in Pennsylvania, but their approach has changed a little since then.

Coal still is the biggest of the company's four divisions, which are coal and minerals, oil and gas, timber and alternative energy. Their diversification takes out the risk of being exposed to a single commodity, which provides a more consistent earnings stream. So management can seize opportunities when the time is ripe to make big bets. Management also proved to be able to invest over various cycles. However, when they don't find good opportunities, they really are able to sit on their cash and wait – you know how hard that is, right? Actually, you can think of them like Value Investors. What I like best about Pardee is that it doesn't mine its own properties but leases its rights to others and receives a royalty instead. So the company owns the land on which its trees grow and when the time comes , somebody else comes in to harvest the forest.

When managing basic materials it's important to have a very long-term focus, stretching over many business cycles. Roughly half of the company's properties were acquired over 100 years ago, which is just one of the many indicators that management truly has a long term perspective.

I do have to admit, there is a reason why this company is so dirt cheap. The company is unlisted and it doesn't publish its financial reports on its website, which is a pain in the ass if you try to learn more about the company. Luckily somebody uploaded Pardee's reports for you here. Once you are a shareholder you will get its reports on a regular basis and management will treat you like a partner. Of course you think of yourself as an investor, not a speculator, so you have no problem with a dark company, right? You also have to consider the illiquidity, so please do your own research as well and use limit orders. The company buys back it's shares via a tender offer regularly and bought back over 7% of the outstanding shares recently. Most of the 31 employees have been with the company for a very long time, they even own over 30% of the business with a market cap of $ 177 MM!

So how does the risk/reward scenario look like? The current stock price provides an upside scenario of 2-3 x with limited downside. However, the big question is, how long it will take.

Undervalued assets

The company's book value is significantly understated, mainly because their assets were purchased decades ago and are still priced at cost. So I tried to evaluate their four divisions at both an optimistic and conservative price.

The adjusted book value is $390.8 MM on the lower end and $600.4 MM on the upper end. So the Price/adj. BV is 0,45 and 0,29 – oh, God, I am already getting greedy ...

1 Timber

In January 2014 the company (surprisingly) published a report on its website that announced a market value appraisal of their timberland assets; 136,200 acres of timberland were valued at $136 MM. However, the appraisal did not include the company's 7,780 acres of Virginia softwood timberlands that were acquired in 2010 for 13.9 MM, or the 8,920 acres of various hardwood tracts that are not considered core timberland holdings, which is worth about 3.7 MM ($413/acre). So these two are worth 17.6 MM. In 2013 the company sold ~ 40,000 acres of timberland for 16.5 MM, so I could come up with the value for the 8,920 acres.

upper end: $136 MM + $17.6 MM -> $153.6 MM

lower end: $136 MM

2 Coal

The coal reserves were difficult to evaluate so there is a huge difference between my lower and upper end valuation. I guess the fair value is somewhere in between. The company has total coal reserves of 313 MM tons, of which 7.8 MM were produced in 2013.

I'm totally agnostic about the coal price in the future, but even a sharp decline in coal prices won't be too dangerous for Pardee's coal business, because the majority of the currently operating coal lessees are low-cost producers. These low cost producers are a big advantage for Pardee, because in the Central Appalachian Basin many coal producers got out of mining, which might increase the market shares of the company's lessees. I used two methods to value the coal division.

Upper end: For the upper end valuation I used the information I got from that article: http://www.snl.com/MobileX/UI/Pages/News/Article.aspx?cdid=A-30509155-10554&FreeAccess=1

The article highlights recent sales of coal mining companies in Central Appalachia. The average price per ton paid by acquirers was about $1.03 per ton of reserves and $41.87 $ per ton of production. By multiplying these with the reserves/production of Pardee I concluded the following value:

- Reserves: 1.03*313=322.4 MM

- Production: 41.87*7.8=326.6 MM

Lower end: At the 2012 annual meeting management stated that 41% of Pardee's total coal reserves, or 131 MM tons, are metallurgical coal, which will earn over $500 million in future royalties at prices back then. So the royalty per ton was about $3.81, which is much higher than $3.47 in 2013. However, prices seem to stabilize and an average price of $ 3.80 seems reasonable over the next decades. At least I hope so... The company earned $21.35 MM in coal royalties, which can be used in a DCF analysis. By using zero growth and a 10% discount rate over 10 years that future earnings stream is worth about $ 130 MM today.

So the final valuation for the coal division is

$ 322 MM on the upper end and

$ 130 MM on the lower end.

Oil and Gas

In December 2013 the company closed the largest acquisition in the company's history. The $60.1 MM investment added 435,572 acres of Central Appalachian oil and gas royalty interests to Pardee's holdings. Using the purchase price as a metric for the total value of the company's oil and gas assets, the division should be worth about $88.8 MM.

Solar

The company's solar division certainly is a masterpiece. Basically they have locked in the revenues, which come from Power Purchase Agreements for ~ 20 years. The company also sells Solar Renewable Energy Credits (SRECs) to utility companies. Utility companies have to either generate renewable energy or purchase SRECs on the market to avoid a penalty. Even though these SRECs don't have a big impact on earnings, I'm happy to pick up every penny from the street :) Besides the solar revenues, the company also generated tax savings of $2.9 MM. So how much is the solar division worth? I don't know. If you figure out a way to calculate the true value of the solar business, please let me know. Simply valuing the solar business at cost will result in a valuation of $36 MM.

Cheap on earnings

Besides being absolutely cheap on the asset side, the earnings stream is a little bit undervalued as well.

I used Vitaliy Katsenelson's Absolute PE Model to estimate a fair value of the earnings stream.

The model derives the intrinsic value based on five conditions:

1. Earnings Growth Rate

2. Dividend Yield

3. Business Risk

4. Financial Risk

5. Earnings Visibility

Fair Value P/E = Basic P/E × [1 + (1 − Business Risk)]×[1+(1−Financial Risk)]×[1+(1−Earnings Visibility)]

This model interprets growth, dividends and qualitative factors, which will be discussed later.

So how do you calculate the Basic P/E?

First you have to assign a P/E ratio, which you are comfortable with to invest in a no growth company. Ben Graham suggested a P/E of 8.5, however, I will stick to 8. For every percentage of earnings growth you can add 0.65.

So the P/E to start with is:

8+(growth*0,65)

For Pardee I used two ways to value the expected growth:

1. From 2004 to 2013 earnings grew about 12% per year -> P/E ratio of 15.8. I guess management is able to reach a growth rate of 12% in the future.

2. Because of the recent stagnation of earnings, I also assign a more conservative growth rate of just 5%. So my lower valuation is a PE of 11.25.

Most people forget how important dividends are. They contributed enormously to the returns of most investors in the past. The absolute P/E model also includes the dividend yield, which is about 2.8% for 2014 at current market prices.

So the Basic P/E = 8+(growth*0.65)+2.8 which results in 14.05 on the lower end and 18.6 on the upper end.

For the qualitative aspects of the valuation the model uses business risk, financial risk and earnings predictability.

To estimate business risk I looked at ROE, ROA and ROIC. The company did very well on all three of those in the last 10+ years. However, due to the sharp decline in recent years I assigned a premium of just 6%.

ROE 2005-2013:

The financial risk metric is much easier to measure, especially for a company like Pardee. I looked at the CR and Total liabilities/Total assets. All of those metrics are terrific, mainly because Pardee is unlevered – what a great score! I assigned a premium of 10% (my maximum), otherwise the PE ratio could become inflated...

For earnings predictability I analyzed the gross margin, net margin, earnings stability and operating cashflow (OCF). Due to the business model, the company has terrific margins, which also result in very high OCF. However, the earnings stream is a little volatile, mainly because coal still is the biggest part of the company's divisions. The volatility of Pardee's earnings stream is why I gave the company a premium of just 1%.

That leads to a fair value PE of:

16.55 - (8+(5*0,65)+2,8)*(1+(1-0,94))*(1+(1-0,9))*(1+1-0,99) and

21.90 - (8+(12*0,65)+2,8)*(1+(1-0,94))*(1+(1-0,9))*(1+1-0,99)

The conservative estimation is on the very low end and I do expect the company to perform better over the next 5 - 10 years.

Conclusion

Pardee could benefit from increasing commodity prices tremendously. The slow recovery of the housing market certainly will increase the profits from timber back to where it was before the crisis. I'm confident about the future of the solar division, mainly because management has reached, or even exceeded, their return targets and I do expect them to do so in the future. I guess the best catalyst for Pardee is time, which will close the gap between price and value someday. In the meantime I am happy to own a good operating business with very talented management, which increases in value over time. The steadily growing dividend makes the wait a lot more comfortable. The low capital requirements to keep the business going shouldn't be neglected and milking a cash cow doesn't seem bad to me as well. However, I like to see management to invest capital elsewhere and create wealth for shareholders.

Disclosure: No position. The author intends to buy shares mentioned in this article.