Exploration Risk Hits Home

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This story features MACQUARIE GROUP LIMITED, and other companies.
For more info SHARE ANALYSIS: MQG
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

By Greg Peel

It would have been easy to believe that this stock market caper was money for old rope if you’d jumped into the Australian market in 2003 and held on into 2007. The truth is, however, that the period in question offered stand-out returns on a historical basis. And now that some form of correction has been in progress since about July (or November if you count the misconceived share market rally), the risks inherent in stock market investment are only too clear.

In major corrections it is often the small caps which suffer badly, given small caps tend to offer higher risk/return scenarios than large caps. Investors look to ditch anything on the fringes and circle the wagons around only the trusted names. This is a bit tough if you’re a small cap, given often your upside potential may have little to do with what’s happening in the wider market. This does mean, of course, that some bargains could well present themselves if you are happy to take a plunge.

Cabcharge ((CAB)) is one company that may fit that bill, given its shares have followed the broad market down and turned $14.25 into less than $10.00. One could perhaps put forward an argument that Cabcharge is not defensive, because in times of financial difficulty one can always catch a bus. But the reality is we’d have to be in the deepest of recessions before you could find a cab within minutes in Sydney on a Friday night and besides, Cabcharge also runs a fleet of buses.

The other reality is that Cabcharge operates a unique cashless charge service used by cabs, not the cabs themselves, and that service is currently being ramped up in Britain. Cabcharge’s system is used in 96% of Australian cabs, and now that Macquarie ((MQG)) has withdrawn from rival Lime, the monopoly is once again cemented. Credit Suisse analysts note Cabcharge’s EBIT growth has averaged 26% in the past three years, it is implementing cost reductions when all about are suffering cost blow-outs, and it has all sorts of potential deals in the offing. CS has just added Cabcharge to its Top 20 preferred small cap picks, hot on the heels of similar positive comments about Cabcharge elsewhere.

So what’s this got to do with AED Oil ((AED))?

It came to FNArena’s attention that still sitting on the CS Top 20 list was one AED Oil, a stock that has fallen from $11.40 to $1.30 since October. It would be easy to jump in here and say the moral is never listen to Credit Suisse, but the truth is the whole world has been caught out by AED, and not for any sinister reason. UBS, for example, upgraded AED to Buy in October with a target of $11.48. Only on Monday morning did the analysts reverse their recommendation, turning the Buy into a Sell and offering a new target of a mere $1.16.

It is not the analysts’ fault. It’s not never the analysts’ fault, as sometimes they come out with some screamers, but in AED’s case the early enthusiasm had much justification. AED is an owner of the Puffin wells off the coast of far north Western Australia, an area already proven to be teeming with black gold. Surely one had only to send down a drill bit and another gusher would appear? And so it was, as the oil price climbed rapidly to US$100/bbl, that analysts placed great faith in AED’s exploration potential. Such a play had come off for so many small cap resources companies since 2003. Just think of Paladin ((PDN)) in uranium or Fortescue ((FMG)) in iron ore, for example. And analysts are always careful to apply risk ratios to their valuations anyway.

There’s little point in buying an oil exploration company after the gusher has appeared, if you’re looking for extraordinary returns. It’s like going to the bookie’s window and trying to back a horse after it’s already won. And so it is that Australia is a hotbed of “speccy” mining and drilling companies, with share prices having risen to the moon during the commodities boom despite not having reached production. Fortescue has still not sold one rock, but at least the company is safe in the knowledge it does have a lot of iron ore.

Conversely, AED found dust.

Or, more specifically, water. The Puffin wells are not totally devoid of oil, but Jed Clampett might have elected to go after the food instead. AED is keeping a brave face, and is sure there are commercial amounts to be found and exploited. In the meantime, what oil there is at Puffin can still be brought to the surface, but for one small problem – AED has run out of money.

It is never surprising if a small cap explorer joins up with an equity partner to take its reserves to a production level. Nor is it surprising if it were to seek a capital injection to expand its operations. AED is looking for capital, but what caught analysts by surprise is that AED has an outstanding bill from a Norwegian offshore drill-rig company for $41.5m. And it can’t pay. AED is seeking capital to pay out its creditors, before anything else. $41.5m? That’s a good night out for Twiggy Forest.

AED needs to spend money to get its production levels higher, which would then allow it to pay its bills, or vice versa. UBS has called it a Catch-22, for at the same time AED’s reserve estimates are being continually downgraded. UBS has thrown in the towel, dropping its target from its most recent $3.68 down to $1.16, and suggesting investors get out.

Deutsche Bank dropped its rating to Hold last week and its target from $9.25 to $3.75. Deutsche has yet to update following the Norwegian invoice announcement. And so has Macquarie, who has been at Neutral and silent since November, when it dropped its target from $9.09 to $5.42.

Credit Suisse’s resource analysts have also been silent since early this year, and are thus still registered with an Outperform rating and a $7.50 target. It’s no wonder AED is still on CS’s Top 20 list. But to be fair to those compilers, the list would have been finished before news of the outstanding $41.5m came to light.

AED had a shot, and so far it looks like it may have missed. That’s life in the big city. For analysts, well they can only work on the information they have. For investors, it has to be realised that not every speccy commodity explorer is going to come up trumps.

Apart from Cabcharge and AED Oil, the other small cap favourites of Credit Suisse include Tower NZ ((TWR)), Tower Australia ((TAL)), Henderson Group ((HGI)) and Australian Wealth Management ((AUW)) among financial stocks; and Oakton ((OKN)) and SMS Management & Technology ((SMX)) in the information technology sector. In the media sector the broker prefers Photon ((PGA)), Prime ((PRT)) and Austar ((AUN)), while Bradken ((BKN)) and Gunns ((GNS)) are selected under the label “Basic Materials / Mining services”.

This still leaves Pharmaxis ((PXS)) in the healthcare sector, McPherson’s ((MCP)), Fantastic ((FAN)) and Specialty Fashion ((SFH)) among retailers, plus Cardno ((CDD)) and Equinox ((EQN)) to complete the list.

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