Wednesday, February 18, 2009

UTS Energy, Part II

A few days ago, we looked at a lesson value investors can learn from a company that is dealing with a hostile bidder. Today we look at a second lesson that may be learned from the attempted takeover of UTS Energy (UTS): the valuation uncertainties that result when commodity products are involved.

UTS owns oil assets that were not scheduled to come online (and therefore generate revenue) until 2011 at the earliest. It is difficult enough to figure out what the oil price will be in the next few months, let alone years into the future. UTS stock price behaviour reflects this pricing volatility: less than a year ago, UTS traded at $6/share; following the collapse in the oil price, it traded at just 80 cents/share a month ago.

Now, even with a bid on the table at $1.30/share, there are huge variations in estimates for what this company is worth. The market price of the shares is $1.80, which is almost 40% above the bid price. The company itself issued a statement that its shares are worth $3.57 each, 175% above the bid. BMO analyst Randy Ollenberger puts the fair value of this company at $2.23/share.

Why are these numbers so far off from each other? The assumptions that went into each valuation only have to be off by a little bit to change the expected profits that are the basis of these valuations. And all of these estimates are including best guesses of what the oil price will be during the years the company is extracting, which is hardly an exact science. Rest assured, when valuing Coca-Cola (KO), the numbers would not be so far off. What's most amazing is that the company and the analyst cited above actually give their estimates to the penny, as if they can rely on any sort of precision when the valuation really comes down to an unpredictable, volatile oil price!

Value investors prefer investing in companies where the pricing and volume outlooks for the firms' products are not so uncertain. When revenues can be reliably predicted, investors have more confidence in future profit expectations. When future profits can be determined with reliability, this in turn makes it easier to determine if a company is trading at a discount to its intrinsic value. UTS is at the opposite end of this spectrum: it's anybody's guess what these assets are worth, but it won't stop people from trying.

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