1/05/2010

NEP is still undervalued

The title above may come as a surprise considering that this blog's last couple posts have been decidedly negative towards the prospect of further price appreciation from NEP. But its simply explained by the fact that my brother and I have a difference of opinions on NEPs future returns.

My brother is technically right when he says that "long-term (1-3years) share-price prospects for NEP are substantially lower at this price", but NEP will still have excellent returns going forward, especially on a longer term horizon (5-10 yrs). Will it return 5288% in the next 3.5yrs? NO. So in that sense my brother is right. Still, I think that it will still return at least 25%+ per year over the next few years.

My brother is a chartist and based on the chart I too agree that this move from $5 to $10 has happened very quickly and at some point I think we will see a substantial correction. But this correction might not happen until the shares reach $11, 12, or even $15. I did finally take some profits because NEP had become 75% of my portfolio, but I still hold most of my shares and plan to for a long time if the underlying business continues to improve like it has over the last several years.

I took a quick look at NEPs historical earnings on Morningstar. Their combined profit from 2004-2006 was about $.03/share, or 1 cent per year. This year we expect earnings to be $.73, and for them to jump to $1.20+ next year. So I would argue based on this that the price of the stock still has catching up to do, since its "only" up 5288%, while earnings are up 7200%.

I've spent some time the last several days creating a detailed long term valuation model for NEP. It's close to being finished, but I'm trying to figure out how to post the data succinctly in an easy to follow way. However I will post a couple main points now:

- Based on what I believe was a conservative scenario which assumed no further leases are signed and only slow growth in the drilling segment, NEP has a Present Value of $13/share if you apply a discount rate of 15%. This means that an investor wanting to receive a 15% annual return on his investment from now until 2022 would be will to pay $13/share assuming that NEP issued their free cash flows back to him each year.

- I will post details later this week, but its important to realize that this valuation assumes that management will fail to acquire more leases or other value-adding acquisitions. Management has proven to be quite good over the last few years, so I believe that there will be new acquisitions within the next year or so that will add more value.

- I assumed that oil prices would only increase by 7%/year over the next 13 yrs. I think they will in fact increase much more, which would also increase the PV.



The Bottom Line is that while I agree with my brother that the price of the stock is becoming extended on a technical basis and may retrace a portion of the incredible gains we have seen this last month, NEP is most certainly still UNDERVALUED. Thus if your horizon is longer then a few months, I feel confident that the stock is still a good purchase at $10/share. Just don't go all in.

1 comment:

Narayana said...

Good point, but you forgot to mention the valuation when you use a discount rate of 24%, calculated using Beta and risk-free rate, etc. Obviously when times are good, people don't worry about potential downside, but I believe that the long-term return for this stock is dwindling.