Outlook for the U.S. stock markets and interest rates
1999 Stock Outlook: Review and Update
Outlook for Ex-Soviet Equities
Outlook for Small- and Microcap Sectors
Outlook for Initial Public Offerings
Outlook for Global Stock Markets
Outlook for Russian Equities
I was dead wrong on Russia. I had believed that Russia would withstand the Asian contagion. In the end, Russia was hit even harder than Asia. It's painful to watch huge profits evaporate. It's even more painful to watch big losses materialize. The question is: What do we do now.
If you believe the mainstream media, Russia is reverting to communism. In fact, Russia is reverting to Gorbachevism -- middling policies that accomplish nothing and hurt everything. What will be the end result? In my view, there is a clear inevitability: the gradual return to reformism triggered by incessant begging for IMF money.
Hyperinflation is equally inevitable. But a return to communism is not. The guy on the street hates communism. But he also hates the current chaos. Remember: Russians are used to suffering. Listen to Rimsky-Korsakov. Read Dostoyevksi. Russians are doomed. But they always find redemption. Russians had hyperinflation in 1992. Six years ago, the situation was just as grim -- right before the greatest bull market in recent history...
The odds of the nationalization of private assets are very small. The smartest Russian experts I know don't view renationalization as a serious threat. If there is any credible renationalization threat, it applies to giant companies with giant unpaid tax debts (Lukoil, UES, Gazprom) -- the very companies we have avoided. To handicap this outside chance of the renationalization of giant tax debtors, I am downgrading the Morgan Stanley Russia and East Europe Fund (RNE-NYSE) to a sell on any rally over US$11. I continue to recommend a dollar-cost averaging approach with Surgutneftegaz (SGUZY-OTC) and Mosenergo (AOMOY-OTC).
Russian stocks have already rallied 400% off the lows. Some kind of correction is likely to occur during the cold Russian winter. I am planning to return to Russia in the early spring to see what's going on myself. But after the correction, a gradual rebuilding of the equity market will continue. With companies trading at 1x earnings, the downside is limited.
The worst is over for Russian stocks. The weak hands have been cleansed from the market. The banks' portfolios have been liquidated. Some large Russian funds have been liquidated. Russian trading desks at the large investment banks are all but shut down. There's no one left to sell.
Taipan believes that hyperinflation will be bullish for Russian equities. The money has to go somewhere, and the government bond market no longer exists. 1994 was a year of both hyperinflation and rising stock prices in dollar terms. Specific high quality Russian stocks will begin the rebound to 1997 trading levels.
Surgutneftegaz ADR (SGUZY-OTC)
Surgutneftegaz (SGUZY-ADR) is the only profitable oil company in Russia. In fact, Surgutneftegaz is one of the few profitable enterprises in any sector in Russia. At 1x earnings, the stock is as cheap as it's going to get.
If SGUZY can make a profit in this crisis environment, it will grow like crazy as soon as the economy turns around. SGUZY's robust cash flow will finance the 1999 capital budget, ensuring continued growth in production.
SGUZY has US$1 billion in net cash on its balance sheet. Before the ruble devaluation, management dumped its Russian government bonds and switched to U.S. dollars. These guys are geniuses. In the last quarter, SGUZY wrote off US$500 million in cash. The cash was held at Uneximbank before it collapsed. However, SGUZY may get the cash back: The word is that SGUZY's president called up the Uneximbank's president and said: "Get me my money or I'll kill you." This is the kind of man I want running my Russian oil company.
At these distressed levels, SGUZY is an incredible bargain. If you take the net cash out of the market cap, you can buy the 8 billion barrels of oil reserves for free. The catalysts for a tradeable rebound in the stock, aside from a general improvement in the Russian market, will be the international audit of the company's oil reserves and separate U.S. GAAP audit of SGUZY's accounts.
SGUZY is a strong buy at current levels. My three-year target for the ADR is US$25.
Mosenergo ADR (AOMOY-OTC)
Mosenergo (AOMOY-OTC) is one of the few investible companies in Russia. AOMOY is Moscow's electric utility. No matter how ugly the Russian crisis, AOMOY will remain in business. Since it's a utility, AOMOY offers diversification outside of the energy sector. When foreign investors return to Russia, AOMOY will be one of the first stocks they buy.
Earnings and cashflow are deteriorating. Bad receivables are increasing. This inevitable in a crisis economy. But Mosenergo's assets are worth more than US$2 per ADR. If this were a Western company, it would trade at US$50 per ADR. The ADR price is ridiculous.
Moscow will remain the most prosperous city in Russia. It doesn't make sense to sell AOMOY at current levels. I recommend using a dollar-cost averaging approach on severe weakness. My three-year target for the ADR is US$30.
TyumanAviaTrans ADR (TYAVY-OTC)
TymenAviaTrans (TYAVY-OTC) is the most attractive speculative small cap in Russia. There's almost zero liquidity in the stock or the ADR, but there's tremendous value in the company. Since the worst-case scenario is liquidation, and since the minimum liquidation value is US$20, the ADR is an excellent bet.
Trading in TYAVY won't pick up until the Russian market comes back from the dead. Small stocks are always the last to rally. But the company's cost rationalization program should offset and slowdown in passenger traffic. While oil company capex has been tightened, oil companies are still doing business.
At 1x EBIDTA and 95% below liquidation value, the ADR is an excellent speculative value play. I recommend holding a small position in TYAVY for the inevitable Russian recovery.
Hurricane damage control: Hurricane Hydrocarbons (HHLAF-NASDAQ)
Hurricane (HHLAF) has turned into a shocking disaster in terms of stock performance. The stock is down 80% since my initial coverage. Every label you could put on HHLAF turned into a liability: oil, Russia, small caps, Canadian resource stocks -- everything associated with this company turned ugly over the course of 1998.
The former CEO was terrible at managing investor expectations -- including mine. The production, revenue, and EBITDA targets hinted at by the CEO were based on assumptions that fell apart. The company's rail terminal with China is six months behind schedule. The production targets (barrels/day) were also proven to be totally unrealistic. The company's aggressive capex program depleted the cash balance, but was unmatched by any big improvement in operational performance.
What utterly destroyed the stock was HHLAF's war with the Shymkent refinery. The former CEO believed (and apparently had every reason to believe) that he would gain control of Shymkent. Remember, HHLAF sends all its production to Shymkent, while 80% of Shymkent's business is refining HHLAF's crude. There's an obvious synergy between the two enterprises. The former owners of Shymkent were failing to live up to the terms of their license. Elements in the Kazakh government wanted HHLAF to take over the refinery.
The problem, in my view, was that the former CEO operated with the arrogant assumption that HHLAF would gain control of the refinery. As a result, HHLAF never bothered to develop alternative refining options. HHLAF became 100% dependent on Shymkent.
When Shymkent became hostile, and when HHLAF's tentative plans for acquiring the refinery fell apart, the hubris of HHLAF's position became apparent. Shymkent used declining world prices as an excuse to gouge HHLAF -- and there was nothing HHLAF could do about it. Shymkent even threatened to process cheap Russian oil instead of HHLAF's (which is a pure bluff: the cheap oil doesn't exist. It would also spell political suicide for a Kazakh refinery in front of January's national elections). To dig the screws into HHLAF even deeper, Shymkent refused to pay up its accounts payable due to HHLAF.
HHLAF appealed to the national Anti-Monopoly Commission. A ruling may be imminent. On November 11, 1998, HHLAF and Shymkent entered into an agreement to resolve some of these issues. Shymkent agreed to pay up its overdue payable. Also, HHLAF switched from selling all of its crude to the refinery to selling the refined products directly to customers.
At current levels, the stock is ridiculous -- even factoring in all the negative internal and external issues. At US$1.50 per share, HHLAF is priced as if it were about to go out of business. HHLAF owns almost half a billion barrels of high quality oil in a strategic location in central/eastern Kazakhstan. The reserves are worth more than a US$70 million market cap. This is a company that is doing US$38.9 million per quarter in sales (and that on a horrendous quarter)! Any company with that much oil is a bargain at 1.5x EBITDA.
HHLAF is taking corrective action to get the company back on track. The former CEO resigned. All capital spending is being eliminated. The workforce is being reduced. Expenses are being cut to the bone. Once these corrective actions are fully implemented, the company should withstand the current hostile macroeconomic environment -- and prosper during the inevitable recovery.
The biggest driver of the stock will be a potential sale of the company. The board hired DLJ to explore "strategic alternatives." The best strategic alternative would be to sell the entire company to an oil giant with deep pockets and interests in Kazakhstan. The most likely candidates are Phillips Petroleum or Chevron. HHLAF is a compelling value for a strategic buyer at these absurd levels.
In my view, US$5 to $7 is a realistic price for a takeover of the company. The best strategy is to dollar cost average with the stock trading at preposterously low levels.
HHLAF is a strong buy at current levels.
Thicker than blood: Xoma (XOMA-NASDAQ)
1998 has been a terrible year for biotech investors. Third-tier biotech has been hit the hardest. Since development-stage biotechs are cash hungry, stock prices can be destroyed by a hostile equity market.
Xoma (XOMA-NASDAQ) is the strongest development-stage biotech story I have ever seen. XOMA's management is world class. The current management has been slashing costs, minimizing dilutive equity offerings, and buying stock in the open market.
Neuprex, XOMA's lead product, is a potential blockbuster. Neuprex kills bacteria and neutralizes endotoxins -- the key to saving people with sepsis-related indications. In my view, if Neuprex gets approved for one of the broader applications, it will become standard in first-aid kits in every hospital in the world. At the very least, Neuprex will be a US$2 billion drug.
January is a critical month for XOMA shareholders. The FDA may decide to let XOMA do an "early stop" on its pivotal Phase III trials for Neuprex for Meningococcemia. Since the next step would be a Biologics License Application (BLA), this would be very bullish for the stock. Also, Genentech has the option to continue the hu1124 collaboration with XOMA. The combination of these two events could pop XOMA to US$8 or higher.
My 2000 target for XOMA is US$16 per share. The current low price of the stock is an excellent entry point for contrarian speculators. I recommend using a dollar-cost averaging approach during severe price weakness.
Market cap sustained with bad logic and sweet nothings: Hemispherx Biopharma (HEB-AMEX)
After returning from a presentation of Hemispherx Biopharma (HEB-AMEX), I remain more skeptical than ever towards the stock price of the company. Hemispherx seems more interested in attacking short sellers than developing biopharmaceutical compounds.
The CEO told me he expected to file a New Drug Application for Ampligen, HEB's lead drug, in Europe before completing the Phase III trials for Chronic Fatigue Syndrome (CFS). Players in the industry tell me that Phase III trials are required in Europe to get an NDA approved, as they are in the US. The stock could go up short-term on an announcement of an NDA application in Europe, but the long-term trend for the stock will likely remain down.
Irrespective of the merits of HEB's technology, the market cap of US$160 million, or $260 million on a fully diluted basis, is way too high relative to the peer group.
If you believe the so-called analysts who follow the stock, CFS is a US$10 billion market. This is utterly preposterous. 1999 Viagra sales projections (the biggest blockbuster ever!) are only US$1.5 billion. There's no way that an exotic niche market is 560% bigger than IMPOTENCE. No way! These guys need their heads examined.
Just add up the some of the best selling pharmaceutical blockbusters on the market: Viagra (US$1.5 billion in global sales, Norvask (US$1.2 billion global sales), Procardia/xl (US$700 million in sales), Cardura (US$325 million in sales), and Zithromax (US$715 million in sales). The total sales of these five blockbuster drugs adds up to under US$5 billion. Only a lunatic would fantasize that a single drug for CFS would be worth double the total sales of five blockbusters!
The most rational methodology for valuing development stage biotechs (other than comparison to the peer group) is market cap as a multiple of five year cumulative R&D. If a biotech company has value, it's in the R&D. As a rule of thumb, venture capital investors don't like to pay more than 5x 5-year cumulative R&D. Anything under 2x 5-year cumulative R&D is an excellent bargain. 1x 5-year cumulative R&D is insanely cheap...
Also, you can compare R&D expenditure as percentage of total cash burn. The higher the number, the more efficient the biotech company at investing capital. The lower the number, the more capital is vaporized on overhead and salaries. Take a look at an analysis of the biotech companies I follow:
| Symbol | Fully diluted market cap | R&D/cash burn | Market cap/5-year cum. R&D |
| XOMA | US$154,000,000 | 91% | 1.9 |
| SHMN | US$64,000,000 | 84% | 0.7 |
| AVAN | US$60,500,000 | 68% | 1.0 |
| HEB | US$258,375,000 | 69% | 25.8 |
As a hedge against long exposure to other biotech stocks, shorting Hemispherx makes sense. Instead of shorting the stock outright, you could buy puts on the stock. The puts trade on the American Stock Exchange, and are a safer way to bet on a decline in the stock.
HEB is speculative short on any rally over US$8.
Best buy in the Middle East: Aramex (ARMXF-NASDAQ)
Aramex (ARMXF-NASDAQ) is the dominant shipping franchise in the Middle East. It seems like every time I travel, I stumble across a new ARMXF office. After meeting with top brass and inspecting corporate headquarters in the Jordan, I became a strong supporter of the stock.
Since my initial recommendation, revenues and earnings have grown every quarter. ARMXF has expanded into new markets, including Sri Lanka and Bangledesh. The company has expanded its presence in major markets, including the Indian subcontinent and Saudi Arabia.
Freight forwarding and overnight express services are the backbone of the global economy. As the only play on Middle Eastern growth listed on a U.S. exchange, ARMXF is a great story. Run by visionary industry veterans, ARMXF is one of the most solid emerging market plays I know.
At 3x QUARTERLY revenue, the stock is ludicrously undervalued. At 10x forward earnings, the stock is a screaming buy. With zero debt and US$11 million in cash, ARMXF is in excellent financial condition.
To improve liquidity in the stock and raise cash for investments, ARMXF did a one million share secondary offering at US$13.125. After the offering, emerging markets collapsed -- and the additional liquidity accelerated the decline. To create shareholder value, the company authorized a 200,000 share repurchase program. The announcement stabilized the stock in the US$6 to $9 range.
Based on a projected 25 p/e on 2000 earnings, ARMXF will trade in the US30s over the next twelve to eighteen months. The current weakness is an excellent opportunity to lower your cost basis.