February 2007 Archives

Yesterday I had a discussion with a friend concerning his holding in Canadian Oil Sands Trust (Toronto: ACOS.UN). He was and still remains upset about the Halloween surprise when the Canadian government provided its pronouncement on trust units. But now, he is concerned about more political risks—namely, potential changes because of Kyoto or similar protocols, a change in taxation, a change in royalties. Let us examine each one.

Environmental Regulation Changes and Costs

A minority party is leading the Canadian government. Most public opinion polls that ask Canadians for their largest concern indicate that the environment is number one. Thus, the Conservative government is likely going to act in some capacity. While no one knows what the outcome will be, you can be sure that it will be an additional cost to greenhouse gas emitters.

CCA 41

Oil sands companies (and mining companies) benefit greatly from a special capital cost allowance (CCA) classification 41. If an oil sands company's capital falls into one of the three buckets:

• Starting a brand new mine;
• Increasing production by 25% or more; or
• Spending capital in excess of 5% of gross revenue;

then that capital qualifies for 100% write-off, with some exceptions. While 25% of the capital write can flow back from the project to the parent corporation, 75% is ringfenced to the project. And, there is an available for use rule that delays the write off for two years or until the equipment is available for use, whichever is less. I am not completely certain on the exact mechanics of the last statement. (You can also read an alternate description at the Natural Resources Canada website.) When I last investigated the impact of the immediate capital write-off, it was a huge driver. It supercharges the returns to the developer (oil sands company or mining company). The reason why it is in place is because oil sands and mining developments require vast sums of capital and take many years of construction before the project begins to earn income. If the project is economic, then the developer; province through royalties and provincial tax; and federal government through federal taxes all earn their proportionate share. However, for oil sands developers, a strong case can be made that, with the current high prices, the developers no longer require this supercharged write-off. I believe the Liberal party has hinted strongly at removing some tax incentives for the oil industry if it were in power. Class 41 is a prime target.

For oil sands companies that are already in operation and are not planning major expansions, this CCA 41 is no longer of concern. But most, if not all, companies are planning on further expansions. Shareholders need to pay attention to this potential change.

Royalty Changes

The last threat is a change to the royalty regime. It might take one of several different forms. One potential change might be to assess royalties on synthetic crude oil rather than bitumen. Bitumen is a very heavy oil from the oil sands and by itself is not very useful. Bitumen needs to be upgraded so that it can be refined. If you like, you can think of a value chain with four steps:

1. An undeveloped oil sands lease;
2. A mined lease where the oil sands has been extracted to a bitumen state;
3. Upgraded synthetic oil after upgrading; and
4. Refined products after refining.

The value of bitumen compared to synthetic crude oil (SCO) varies over time. It depends largely on whether there is a shortage or surplus of upgrading capacity. At present, there is a glut of oil sands production with a scarcity of upgrading capacity. Thus, bitumen has a lower value, or equivalently, the light heavy spread is very large at present. In its desire to capture more value from the oil sands activity, the provincial government could levy its royalty against synthetic crude oil instead of bitumen. In fact, for many, many years the owners of Syncrude Canada Ltd. paid royalty on SCO, not bitumen.

Under normal circumstances, upgraders are simply a necessary evil. They are expensive and do not return much, if any, profits. Under this scenario, the price of bitumen is high, and the light heavy differential is narrow. But today, because of the explosion of the oil sands development, the opposite is true.

If you are running an oil sands company under normal circumstances, you would actually prefer to have the royalty levied against SCO. That is because when the differential is wide, the upgrader is making a lot of money, the company can afford to pay royalties, and the upgrader costs are part of the cost base for assessing royalties. And when the margins are small and upgrader is loosing money, the upgrader actually lowers the royalty payment because the upgrader costs are still part of the cost base. In effect, by placing the upgrader inside the royalty ringfence, the company has created its own hedge.

In today's environment, however, the differentials are wide and will remain so for the next few years at least. Thus, companies want the royalty levied against the bitumen. If the Alberta government were to change its royalty from bitumen to SCO based, that would negatively affect today's oil sands companies. With this current scenario, companies are not interested in the hedge. They are instead interested in maximizing their profits. If you assume a weighted average cost of capital of about 10%, then you know that the first 10 years are the important years. And thus, today's oil sands companies want the royalty assessed against bitumen, not SCO.

My friend wants to sell Canadian Oil Sands before any of these potential adverse political developments transpire. However, he is concerned about being hit with a large tax bill. One potential solution might be for him to short another oil sands company and effectively lock in the price for his Canadian Oil Sands trust units. Therefore, he is investigating that as an alternative to liquidating his position. If he were to short another oil sands company, he must compare the developments for both Syncrude and other company to see if they are and will remain good proxies for one another. He must also concern himself with Canadian Oil Sands distributions and changes to the trust as it approaches the end of its trust structure. He also has to investigate margin requirements. And while having a pair trade should work in theory, there is always some risk. He must weigh those risks against a potential tax savings today.

None of what I have written should be considered investment or tax advice. I am merely providing some commentary for those who might be in a similar situation.

Because of my interest in photography, I enjoyed reading The Wall Street Journal Page One feature article concerning fashion modeling Strike a Pose, Count Your Pennies (subscription required). While the work might seem glamorous, I get the sense that for most models, it is a challenging career choice.

Bianca Gomez, an 18-year-old model from Los Angeles, is rail-thin at 5'11" with almond shaped green eyes, honey-colored hair and translucent skin. She attracted interest from famous New York design houses well before she'd arrived in town to audition for their runway shows.

But in the brutal new calculus of high-fashion modeling, the odds of becoming a big-time mannequin have grown even slimmer. Competing with a deluge of fresh faces from Russia, Eastern Europe and Brazil, Ms. Gomez has faced many rejections. Expenses -- such as foreign travel costs -- have siphoned thousands of dollars from her fees. In December, she even considered calling it quits.

The global economy is transforming the modeling world. Supply has soared, as aspirants from developing countries stampede into the field. At last season's New York's fashion week, the quintessentially American design house of Calvin Klein didn't send a single American down its catwalk. Twelve of the 22 chosen were from Russia and Eastern Europe.

...

Part of Ms. Gomez's problem was that at 5'11" and 120 pounds, she wasn't quite thin enough for some designers. On the runway, "the ideal body type for models today has been smaller shoulders, small waist, small rib cage, small hips," says Nian Fish, creative director of KCD Worldwide, which produces fashion shows for Calvin Klein and Marc Jacobs. Eastern European girls, with their distinctive bone structure and narrow bodies, often fit the bill.

The WSJ also provided a video that accompanies this article. Note, those viewing this article through a newsreader might not see that there is an embedded video below. If you are unable to see the embedded video, then if you want to see the video, you will need to view my weblog article.

The video certainly give the reader a different sense of the career of a fashion model.

Blue Nile, Inc. (NILE) is an interesting stock to follow in part because of its heavy short interest. There are at least two good sources for looking up the number of shares that are short or the short ratio. One is Yahoo's site (Yahoo: NILE) and the other is Short Squeeze (Short Squeeze: NILE). Yahoo indicates a short ratio of 15.4 and Short Squeeze indicates a short ratio of 24.2. The short ratio is the number of days of average trading that would be required to cover all short sales. Thus, according to Yahoo, 15.2 days of average day trading would be required to cover all short sales. Short Squeeze indicates 24.2. I treat five days as a yellow caution, and ten days as a red light signaling not to short.

Compare Blue Nile with Amazon.com (AMZN), another internet retailer. According to Yahoo, Blue Nile has the following characteristics:

• Forward P/E (fye 01-Jan-08) 1: 41.35;
• PEG Ratio (5 yr expected): 2.54;
• Price/Sales (ttm): 2.56;
• Price/Book (mrq): 14.77;
• Enterprise Value/Revenue (ttm): 2.30; and
• Enterprise Value/EBITDA (ttm): 25.857.

Similarly, Amazon has the following characteristics:

• Forward P/E (fye 31-Dec-07) 1: 54.78;
• PEG Ratio (5 yr expected): 3.98;
• Price/Sales (ttm): 1.64;
• Price/Book (mrq): 81.13;
• Enterprise Value/Revenue (ttm): 1.61; and
• Enterprise Value/EBITDA (ttm): 23.85.

Looking at these two set of metrics, we note that NILE has a significantly lower forward P/E and lower PEG ratio, both of which are good. NILE also has a higher Price/Book ratio, but that makes sense given that is also a lower PEG ratio. In other words, investors are willing to pay a higher price for relatively faster growing companies. The same applies to the two Enterprise metrics as well.

If we use Amazon as a relative proxy, then so long as Blue Nile does not stink up the joint when it releases its financials on Monday, 12 February 2007, investors might enjoy a nice pop in the stock. The key is that Blue Nile is massively shorted. If Blue Nile continues to do well, then there is no reason for the stock price to plummet. While it might be overvalued on a fundamental basis—a forward PE of 41 is rich—the stock might continue to stay at its current price level or go higher. The shorts need to cover sometime. And if all the shorts head for the exit at the same time, that action could propel the stock higher. Remember, there are between 15 and 24 days worth of short covering. That is a lot.

Another more traditional retailer operating in the same space is Zale Corporation (ZLC). It operates traditional brick and mortar jewelry retail outlets. While it metrics are much more modest, you need to think of what happened to all those small bookstores when Amazon.com first appeared.

As a matter of disclosure, I am long Blue Nile and short Zale.

I have written in the past about Dell Inc. (DELL), and I have been critical of Kevin Rollins's comments. But I am also critical of Michael Dell, because the two leaders practically shared an umbilical cord with the company. I strongly suspect that all major strategic and tactical decisions were discussed between the two of them. Thus, how can one be faulted and not the other? That said, change in itself is often a good thing.

I like using Dell computers and think the company will find its mojo again. That said, I am not anxious to invest in Dell or any other PC manufacturer. I would rather be a consumer than an investor.