… And enterprise valuations much closer to peak than share prices
Market cap versus share prices – they should tell the same story and give a view of
future cashflows. While market cap provides an estimate of the total value of future
earnings, the share price also describes how the cake has been divided. For UK
banks this distinction is important. Although UK bank share prices are a long way
from their peak, their market capitalisation is above Jan 2008 levels. This suggests
to us the market believes the value of future cashflows is similar today to what it
was back then, a time of plump dividends and when the credit crisis was “just” a
minor wholesale market dislocation. In contrast, we are now managing the fall-out
from a synchronised global downturn with NPLs and impairments still rising.

The European banks sector has rallied 36% in the last month driven by Q1
earnings and hopes for an early economic recovery.

This has pushed the historical tangible book multiple to 1.2 times from a
trough of 0.6 times in February.

Furthermore, we forecast just 7% average ROTE over the next two years, and
see downside risk to this. In particular, we worry that forced deleveraging and
margin pressure will push pre-provision profits below 2007 levels—we currently
assume 2009 and 2010 PPP are 9% higher than 2007.

In addition, we assume impairment charges peak at 1.5%, similar to the early
1990s, but in practice given the correlation of this downturn across geographies
and higher loss given default it could be notably higher.

We are upgrading our Intertek estimates for 2009
We are upgrading our Intertek estimates for 2009 by 8% for 2009, principally due to a much stronger consumer division, where we now expect organic growth of around 20% and maintained margins.

Legislation driving growth
The consumer division is likely to gain from the introduction of the Consumer Protection Act in the US which would significantly boost the workload of testing companies. We see this potential growth as being sustainable, as we expect individual states may look to add their own legislation over and above that of the federal laws.

The construction loans business, which employs 54 people, has been excluded from the transaction and will be retained by Wolseley. The Group intends to continue to operate the business but to effect a phased reduction in the portfolio over the next 2-3 years. It expects to continue to undertake selective lending to allow for an orderly reduction in the scope of the business. The portfolio will also be reduced through a phased withdrawal from selected markets to position the business for a possible future sale. Consequently, the majority of the construction loan management team will be retained.

For the year ended 31 July 2008 the Stock business being transferred to Newco generated revenue of $US 2,561 million (£1,280 million) and a trading loss of $US 119 million (£59 million). It had gross assets at 31 July 2008 of $US 1,354 million (£682 million) and net assets of $US 960 million (£484 million).

US Building Materials operation, Stock, has been put into joint venture with Gores
Group (private equity). Wolseley will retain 49%, and also will retain the US
construction loans operation (loans of £291m at end January 2009).

Financial implications are complex. 2008 and 2009 EBIT in Stock is now classed as
discontinued, so removed from the P&L (and covenants, which provides greater
headroom) and from May 2009 onwards Stock will be a below the line item. The group points to £175m exceptional writedown on Stock’s assets, and further (non-cash) provision on construction loans. Our figures below assume that in 2010 Stock makes a loss of some £100m (down from 2009 due to cost benefits and likely major restructuring of the NewCo).

The advantages of this deal are that it:
(1) will remove around £170m of losses (in our estimates) from its P&L (which compares to Group trading profit range of around £300-390m when looking at consensus). In other words the Group’s trading
profits jump some 50% on the back of this deconsolidation/sale. Factoring in the equity accounted losses we see an earnings enhancement of up to 50% ahead of any further cost savings. A pre-tax exceptional
loss of no more than £175m is expected on the back of this transaction, although an impairment of construction loans books still needs to be determined;

(3) removes a very cyclical business from its portfolio. We have been highly doubtful of this business over the years given its very volatile pricing on the back of the lumber price. Removing this business should make the remaining businesses less exposed to the new housing side and more exposed to the
more stable RM&I side of construction;

(4) makes the Group more biddable. Competitors have generally disliked STOCK, but liked Ferguson and its other businesses across Europe. The removal of STOCK should therefore also increase the industry’s appetite for the overall company, although we clearly don’t say that anything is imminent for a
while; and

(5) provides more covenants headroom for the Group. The transaction actually provides some £375m
more headroom for the Group, which comes handy in an environment where debt could still remain an
issue.

But, one well does not tell you enough. Sounds like they used heavy drilling fluid to make sure that the well does not blow out. This meant that when it turned out that the reservoir pressure was low, all of that fluid went into the reservoir and clogged it up.

With a bit of luck, that is a spectacular field, but it may turn out to be a merely good one. I’d value it at $15-$25 per barrel of reserves depending on the PSA and royalty terms, so a market cap of 1bn GBP is about right (assuming their other assets are worthless). It is the kind of find that makes people invest in the small-midcap oil cos: 90%+ of them fail miserably, but the ones that make it give you an excellent return.

Moreover, despite the discoveries made so far, both regions still offer material upside potential. In Kurdistan, near term activity will focus on proving up reserves at Miran West. However, there is another structure on the licence, Miran East, which although slightly smaller than Miran West, could potentially contain 2 bn barrels of oil-in-place, and has been significantly derisked by success at Miran West. In Uganda, Heritage will recommence drilling on Block 1 in Q3 2009, targeting high impact prospects such as Buffalo East, with prospective resources of 250 mmboe.