It is Fixed Income Friday at the Raptor!

music selection:  “Evening Star” — Dragonforce

The markets are closed today for the Good Friday holiday.  I was busy yesterday in preparation however placing a limit order for a distressed bond.  I bid 90.5000 on (CUSIP: 34984VAB6).  The bond is trading near that valuation and I hope to get a fill.  Why FET?

Forum has demonstrated that it can produce sufficient amounts of free cash flow selling oilfield service equipment even when the price of oil is as low as 40 dollars a barrel.  The new normal in my opinion, and that of my old oilfield coworkers, is that domestic crude will be range bound for decades between 40 and 70 dollars a barrel.  Shale production is very easy to turn on and off and serves as the perfect swing barrel.  A lot of production becomes unprofitable below 40, placing a floor on the rig count at that level.  Prices above 60 has essentially even the weakest players minting cash and results in a rapid increase in drilling activity, thus providing a ceiling on pricing.  This relative certainty is going to lead to a slowly expanding domestic crude industry.

Forum is one of the few players in the industry that has a management that turned to focusing on free cash flow over growth early in the cycle.  They have been consistently profitable across the pricing cycle.  Management has also shifted its product mix.  Previously, they were highly dependent on equipment with a highly cyclical nature.  Today, about three fourths of revenue comes from consumable items that see good volume through down cycles, thus ensuring robust cash flow.  For the past two years management has run with negative free cash flow to build inventory.  The stock has been punished and management has seen the error of its ways and promises to return to its historical focus on positive free cash flow.

Those of you playing the home game are probably asking yourselves, can these guys pay me back if I buy their bonds.  My estimate based on projected cash flow now that the company is no longer building inventory is interest is covered about five times over.  I usually start feeling very confident at two times interest coverage.  This company is currently in really good shape.

You have to consider the worst case scenario with bonds because the outcome is binary: you either get your principal back or suffer through a bankruptcy with uncertain recovery.  Most bankruptcies are “reorganizations”.  In this scenario, bond holders usually get some mix of new bonds with an extended maturity and equity.  I have often seen full recovery after some time with this scenario and a few multibaggers where the new equity that is debt free soars and is later acquired by a competitor for a premium.  Common shareholders usually get jack.  I assume the unlikely case that a bankruptcy will go to liquidation.  Unfortunately, most of the “assets” on this balance sheet are intangible and won’t convert to cash in a liquidation.  Still, assuming a 50% discount to book value in a “fire sale” I estimate 36% cash recovery for bond holders.

The bankruptcy scenario only happens if there is an *extended* period of sub 40 oil.  Otherwise, the company will have sufficient cash flow to support refinancing their bonds.  I consider this unlikely as Forum’s customers stop drilling at 40 resulting in a commodity price rebound and renewed drilling activity.  Long term, the ‘new normal’ is probably mid 50’s domestic crude.  So my most likely scenario is getting repaid in full at maturity or even selling the bond back into the market for about par to boost annualized return and allow the raising of cash for better opportunities when the credit cycle finally turns.

The limit order is to buy the FET 6.25% coupon bond due 1OCT2021 for 90.5000.  The coupon yield would thus be 6.91%, a fair price to be paid to wait for a very safe investment.  If the order were to fill today, the yield to maturity would be 11.19% which is a very good return for what is essentially a mortal lock.  I expect to do better if the oil cycle gives us a period of a few months above 70 dollars a barrel.  The stock price and bond will both rise.  Getting out at par before maturity only boosts yield to maturity.  For example, closing at par one year from now would yield over 17% annualized yield.  I’d be delighted with that return as it beats what is often available on “good” options and equity plays.

ACTION TO TAKE: Buy 34984VAB6 for up to 90.5000.  Hold to maturity or sell early whenever you can get par or better.

Devour your prey raptors!