“One of the Greatest Businesses We’ve Ever Found”, plus a look at Facebook for the Friday File

Solving a Dan Ferris teaser, and sharing some thoughts on advertising stocks

By Travis Johnson, Stock Gumshoe, November 11, 2014

We’re closing up shop early today for Veteran’s Day, and in the spirit of the holiday we’re running a membership special today. Stock Gumshoe will donate 50% of all membership revenue today and tomorrow to Homes for our Troops, an excellent charitable organization that builds specially adapted homes for severely disabled veterans — so for those who are thinking they might join as Irregulars (our paying members), I thought I’d give you a taste of the benefits that the Irregulars receive — aside, that is, from the warm feeling they get in their belly from supporting Stock Gumshoe and, this week, Homes for our Troops. (This is part of our “Gumshoe Gives Back” campaign that we do every year — this year we’re spreading it out a bit instead of doing it all in one concentrated week — we’ll have a couple more opportunities to join and have some of your membership contribution benefit a charity or nonprofit over the next few weeks).

So… what follows is the Friday File from about a month ago. It has not been edited, updated or revised — the teaser solution stock, PHX, is down about 20% from the day this article first came out, so in retrospect I’m glad that I said that I liked the business model but saw “little real rush” for this very volatile energy stock since we were then in the crush of falling oil prices… but maybe you’ll find it more appealing now. The Irregulars, in addition to the other benefits they receive for being the backbone that supports Stock Gumshoe (including guest articles and columns, the ability to start discussion topics, and the “Quick Take” box summarizing each article), receive special commentary each Friday from yours truly. Those commentaries often include updates on stocks I like and follow, new ideas I want to explore for you, or teaser solutions similar to what’s in the free articles, and they often read something like this:

—from 10/10/14—

There are two things I want to do for your Friday File today: chatter a bit about online advertising and Facebook, partly because I’ve been looking into the sector and partly because folks have been asking me about some of the stocks; and solve a Dan Ferris teaser pitch for y’all.

First, the teaser pitch. Dan Ferris edits Extreme Value for Stansberry & Associates, and this latest pitch of his is probably for a smaller company and wasn’t really widely teased — it has been pitched only in the S&A free newsletters, from what I can tell, like the S&A Digest, and some of those ads have been forwarded to me.

The emails quote Mike Barrett, who works on Extreme Value with Ferris:

“In the July issue of Extreme Value, we told readers about one of the greatest businesses we’ve ever found.

“Last month, the story behind our investment thesis got even better. Fortunately, most investors still haven’t figured this out. And the recent market weakness pushed this unknown small cap below our buy-up-to price.”

More clues:

“Most companies issue shares to raise money… This company hasn’t issued a single new share (other than share splits) since it went public 35 years ago. And it has paid a regular dividend for more than 50 years….

“What makes this company really special is its assets – the perpetual mineral rights to more than 250,000 acres across America where oil and natural gas are prolific… Places like the Fayetteville Shale in Arkansas, the Permian Basin in Texas, and the emerging South Central Oklahoma Oil Province (also referred to as SCOOP).

“Most energy companies must acquire leasehold interests from mineral owners, giving them the right to look for and extract any oil and gas they find. In return, energy companies are obligated to pay the mineral owner a percentage of the oil and gas proceeds (or a “royalty”). But the company we recommended is the mineral owner. That means it gets to collect (and keep) the royalties, not pay them. It also uses its oil and gas expertise to identify the highest-returning wells drilled on its acreage, then takes small working interests in these wells to generate additional revenue.”

So it’s not a lot, right? But don’t worry, you’ve got the Mighty, Mighty Thinkolator on your side — this is Pandhandle Oil & Gas (PHX).

They have indeed been paying a dividend for 50 years, and they did go public 35 years ago (1979), and it does own “more than 250,000 acres” of mineral rights (255,000, actually). This is all from their fact sheet, which you can see here with data from August — do note that the stock has not come down from $60+ to $26, they had a 2:1 stock split that happened this week. Though the stock is down about 20% from the recent highs. I didn’t know anything about this one before doing our teaser-solving work yesterday, but it had a phenomenal year in 2014 after three years of an essentially flat share price. So what’s going on?

Well, Panhandle is really not an oil company — they’re more like a royalty company, though unlike most oil & gas royalty companies they are a corporation, not a trust or a partnership. So it might be that they haven’t really had a natural “shareholder base” since they don’t pay much of a dividend (they do pay a dividend, but the yield is less than 1%), and dividends are usually what folks think of when they look for low-cost owners of mineral rights. The business is actually quite similar to that of Dorchester Minerals (DMLP), a mineral rights-owning MLP that I’ve owned for a long time — and on some metrics (EV/EBIT, for example), the valuations of the two are pretty similar (high teens, expensive as befits a low-cost non-operator).

Both of those stocks collect royalties on wells that operate on their mineral rights acreage, and they also both boost returns by participating in some of the wells by paying a share of operating costs (DMLP calls it a “Net Profit Interest”, PHX a “Working Interest” — PHX says it takes a working interest in about 70% of the wells proposed on its acreage, I’m pretty sure DMLP is far lower than that but it has been increasing its NPI investments).

Both have low costs, as befits non-operators — Dorchester Minerals has about 20 employees, Panhandle about 40 (in terms of market cap, DMLP is about twice as big as PHX). I prefer the stability of DMLP, since they effectively just generate $50 million or so in free cash flow every year, don’t borrow money, and pay that cash flow out as distributions to unitholders (yield is about 7% now), but Panhandle is definitely getting more levered to oil after their large acquisition of some rights from a private producer in the Eagle Ford this Summer (right now their proven developed producing reserves are 86% natural gas, but the last quarter had 35% of revenue from oil and 10% from natural gas liquids, like everyone else they’ve been emphasizing oil over gas wherever they can).

It will probably be another month or so before Panhandle reports their next quarterly results, which will include more of this Eagle Ford oil, but if you want an overview of their operations and an explanation of why they believe their low-cost, mineral rights-owning model works well, check out their recent investor presentation here. If you’re curious about Dorchester Minerals, you can see their latest annual presentation here (I’m not suggesting you buy DMLP, and it is different and is not likely to grow as much as PHX might, it just happens to be one of the only companies that comes to mind which has a fairly similar business model).

PHX carries risk if oil and gas prices collapse, both because all energy companies do and because they’ve been fairly aggressively increasing their spending using debt to boost their earnings capacity, but they don’t have that much debt so it’s not terrifying — and it reflects a good long-term shareholder-friendly philosophy, that you should borrow cheap rather than dilute shareholders, and retain earnings to reinvest them in growth potential. Oil and gas is still a depleting asset, but they do have something like 3/4 of their mineral rights acreage that’s not generating any royalties right now (much of it never will, of course), and they are expecting growth both from new Oklahoma shale drilling and from the Eagle Ford, both of which are oil plays.

Panhandle Oil & Gas has been trading broadly in line with the broader sector (oil and gas exploration and production companies, as measured by the XOP ETF) for most of the last eight years, but it broke out in 2014 and did dramatically better. I like PHX more than I like typical oil and gas companies, I like the capital discipline and the growth in earnings over time, and it has had tremendous long-term price appreciation, but the volatility is very high and the shares do react sharply to oil and gas prices. If the stock just recently came under the Extreme Value “buy up to” price then that price must be somewhere in the $28-30 neighborhood (post split, so that would have been $56-60 a week ago). So, color me interested — I like the royalty business model, I like the lack of analyst coverage, but I’m not all that excited about adding more oil exposure right now to my portfolio. The dip in price is looking fairly appealing, but that dip is being caused entirely by falling oil prices — which will, of course, impact Panhandle’s revenues directly (though they do say that they hedge about half of their production) … PHX has had impressive enough performance to warrant consideration for patient investors who would plan to hold through oil price volatility for a number of years, but the price doesn’t jump out as being spectacular at my first read-through.

And I wanted to chatter a little bit about advertising, so let’s go way over to the other side of the market, to the land where the growth stocks dwell and where Dan Ferris would presumably never wander.

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Facebook (FB) is in the news this week because of their move to further open up their mobile ad network — letting advertisers use the unique targeting capabilities of facebook (and their wealth of information about 1.5 billion people) on a bit more inventory, part of their continuing effort to monetize the value of their incredible store of knowledge about all these people in addition to the willingness of those people to spend hours browsing their news feed.

That’s not going to make a huge difference for Facebook overnight, but it is, frankly, ridiculous how fast Facebook is growing right now. Apple (AAPL) of a few years ago is really the only comparison when it comes to large cap growth stocks, but Apple is a hardware company — it was and is a lot cheaper than Facebook, but the cap on their potential growth was and is also much clearer. They can only sell so many physical phones, and the margins on those phones cannot keep rising forever (though AAPL is clearly far better at getting premium pricing and squeezing suppliers than anyone else, and they do a good job of making a physical object almost like a recurring service through the constant push for every-two-years upgrades).

That doesn’t appear to be a problem with Facebook — they will max out on the number of users eventually, though they’re fighting that with efforts to break through the Great Firewall of China (not likely) and to expand internet access in India, but the advertising spend per user on Facebook is still very low relative to the amount of time people spend using Facebook. Google and Facebook are now the big entities pushing for more and faster internet access all around the world, including wacky ideas like Google’s blimps and Facebook’s solar-powered drone “hotspots”. Adding more users to the internet is very, very good for Google and Facebook (though of course, new users who come online for the first time in subsaharan Africa are not going to be as immediately valuable as users in developed countries — Facebook got almost $6 in revenue per U.S. user last quarter, $2.50 in Europe, and $1 or so in many smaller economies… though that number is growing everywhere).

But even without accelerating user growth, Facebook’s revenue is climbing dramatically — and earnings are coming along with it. Facebook is not nearly as great a company as Google is, not yet, because Google has a more diversified business and a phenomenally huge inventory of ad clicks to sell and the computing power to make sure those ads are relevant — Google follows you around once they learn your interests, and they can be tracked and proven for advertisers. A $5 click by a customer is a lot more valuable than a $1 click by a looky-lou who doesn’t buy anything. Know who else is starting to do that? Facebook.

I was thinking about this because I’ve been reading up more on Criteo (CRTO), the French online ad tech company I bought recently that specializes in retargeting — and I still very much like CRTO, primarily because it’s so directed at retargeting and so small that the possibilities are more open-ended (like for an acquisition) — but everything keeps coming back to Facebook. Facebook is phenomenal in its ability to target based on your social activity, and Mark Zuckerberg’s folks have proven that they can and will keep fans and advertisers happy… and we are just getting started. Facebook is getting better and better at appealing to the big advertisers, like the large consumer brands, and it is providing them with ever more data to justify their large investments in Facebook advertising — they’ve gotten this first spurt of growth on the back of sponsored posts and online viral video ads, but the next wave will likely come from larger advertisers and from using Facebook’s targeting data outside of Facebook.

The average user spends 40 minutes a day on Facebook now, including much of it on mobile where Facebook’s advertising growth rate is incredible. Mobile advertising has improved substantially over the last year and a half, since the days when it was feared that Facebook was going public “at the top” because it was going to lose out as people drifted away from using Facebook on desktops and no one was making money yet on mobile advertising… but no one has improved their mobile ad offering as much as Facebook has, and that’s why, despite crazy things like spending billions to buy WhatsApp or Oculus, Facebook bounced back so dramatically from it’s post-IPO slump in the Summer of 2013 (incidentally, no one says Instagram was a crazy $1 billion buy anymore, not now that teens are reportedly “fleeing” Facebook for… Instagram. Much like no one says YouTube was a crazy Google buy anymore).

Missing that slump price, when FB dipped below $20, is a big regret — I said at the time of the IPO that I thought getting in at the IPO price was a no-brainer (and I did have indirect ownership of FB at the time, through Mail.ru shares that I have since sold), but I didn’t actually act on that assertion with my money.

And I even got another chance — I should have known that the 50% haircut the stock got in the subsequent months would be temporary — a billion consumers who are primed to pay attention to advertising is obviously a hugely valuable asset, even if you haven’t proven to everyone that you’re going to effectively “monetize” it yet, but I didn’t buy.

Still, Facebook is a substantial “closet” holding of mine. After Facebook’s first good quarter, when they reported great mobile ad earnings late that Summer and the stock got back above $40, I did jump in with a large LEAP options buy that is now in the money and that I might actually exercise in January (I’ve sold about half of the position along the way). So why would I buy it now instead of just taking more profits form that options speculation?

Facebook is an expensive stock, but they are growing fast and show no signs of saturating their market (so they should be expensive). I think they’re likely to beat earnings estimates handily again in the key fourth quarter thanks to their expanding ad offerings in that most critical advertising period, and their best business has only been growing for a year.

It is ridiculous to think that a $200 billion company can double in value again, if you look at it from that direction, but I think that’s the wrong way to think about Facebook. Facebook’s return on equity and profit margins are still rising, which provides tremendous leverage when revenue is also rising by better than 50% in a sector that’s seeing revenue rising dramatically. Everything is working in their favor, and these are strong and established business and social trends — this isn’t a one-time boost. Just because $200 billion companies have a harder time doubling than smaller companies doesn’t mean they can’t. Google has. Apple has. I think Facebook has a similar opportunity, still, and even at these high prices, mostly because they have such an incredibly scaleable business that is, compared to the global advertising market, still fairly small.

Mobile ads, and particularly the far more engaging “in stream” and mobile video ads on Facebook’s mobile app and across their ad partners, are taking increasing share from other advertising formats even though advertisers don’t really trust them yet — mobile advertising overall is expected to triple to almost $60 billion in 2018 just in the United States. This is a cyclical business to a substantial degree, as you can see from looking at Google’s earnings during 2009 when a falling economy cut into advertising spending, but Facebook has an irreplaceable global reach and they are delivering the engagement and the eyeball time that advertisers want.

Advertising preferences change slowly, print newspapers still get 10% of U.S. ad spending (about what mobile is expected to get in 2014)… but they are changing, and Facebook and Google are leading the way in proving the effectiveness of their ads and have created the only two really unassailable “network effect” advertising programs — if an advertisers uses both of those they don’t really need to use any other digital advertising network, any consumer they want is accessible by Facebook and/or Google.

If you think advertisers will continue to shift more money to digital ads, and that we’re going to continue to spend more time staring at our phones (and most new internet users around the world are coming in on smartphones), then it seems foolish not to accept the fact that Facebook and Google are the best, highest-margin businesses profiting from that. Their ability to generate high returns on equity and leverage their revenue into increasing profits is probably still underappreciated by most investors, particularly those who are afraid of having “missed” the big run in these stocks or who fear a high valuation relative to the market.

I wouldn’t rush out and make Facebook my largest position immediately, but I would be happy to own decent-sized stakes of Facebook or Google at these prices and not look at them for five years (I’ve done that with Google already, and expect to continue to hold) — no, they’re not cheap, they’re not undervalued, they’re not bargains that no one knows about, so you don’t get to feel smarter than your neighbors for buying FB and GOOG… and there is an (overstated, I think) risk of obsolescence with any technology company (less so because these are media and advertising companies, they own relationships), but I think these are among the best, most scaleable and least capital-intensive large global businesses in the world and I think they’re going to have long-term earnings growth that’s better than most people expect. Facebook, even at a $200 billion market cap, has only 7,000 employees and that employee count only went up by about 10% as they doubled revenues. Google, with twice the market capitalization, has 50,000 employees. Apple, with a $600 billion market cap, has 80,000 and that doesn’t even include the subcontrctors who assemble their products. (FB’s annual profits per employee are at $330,000 as of June 30, up 20% in six months and just passing GOOGL on that metric).

Of course, the market is still pretty expensive and jittery, and there will be a time when the market falls by 10 or 20% — if that happens, or worse, it’s certainly possible that FB falls by 30% (whether it goes up by another 50% before that happens, I don’t know). And Facebook reports earnings in a couple weeks (Oct. 28), so that will give us another data point for the growth chart that might impact valuation (depending on whether growth is slowing or accelerating), which means there’s likely no need to rush into it. I was talking about stocks I’d be delighted to buy on a pullback recently, and Facebook is one of those — I might effectively do that by exercising my options, which could make FB one of my larger positions (and perhaps let me put off some of the taxable gain from those options), but I’ll let you know what I decide.

Other small advertisers like Criteo or the other ad-tech companies may well grow substantially faster than Google (it would be hard for them to grow a lot faster than Facebook has recently, even with FB at a $200 billion market cap), and they have the potential for an overnight 50-100% gain on a buyout, but they are not stocks you could “put away” and ignore for a couple years like I think I could do with GOOG or FB.

And yes, Facebook might lose favor — that’s not a risk that worries me, though it does create headline risk. Every now and then it reportedly loses favor with teenagers who are afraid that their parents are on Facebook or that the cool kids are somewhere else, and there’s the widely discussed Ello social network that is a stripped-down “invitation only” Facebook without ads or privacy issues, but in the end, more people use Facebook than anything else and that network effect is now completely unassailable. More than 800 million people look at facebook EVERY DAY (close to 1.5 billion use it at least once a month), and only about 20% of their most active users are in the US and Canada. Are you going to switch to Ello? Maybe you’ll try it out, if you’re a musician who’s sick of the fact that you have to pay to make sure your posts get promoted to all your followers, or if you’re a privacy enthusiast… but if you want to keep that loose connection to the 200 or 2,000 people you know and kind of like, most of you have to stick with Facebook. Friends go where their friends and possible future friends (and photos of grandchildren) are, and even Google’s multibillion-dollar investment in Google+ has gone essentially nowhere. Tastemakers in their teens and folks in their 60s are not Facebook lovers or ardent users all the time, perhaps, but almost everyone else is.

Some investors are looking to Twitter (TWTR) as a possible Facebook replacement, too, but TWTR does not interest me nearly as much — they simply don’t have the user data that Facebook does, nor do they have the singleminded leadership (and push to use that data) that’s driving Facebook to take over the world and dominate connectivity (and mobile advertising).

Twitter is slightly earlier in the “monetization” process than Faceboo