Market Buzz - Remember Me? Oil Sands Service & Infrastructure Stocks Remain Good Long-Term Opportunities for Savvy Investors – Stock Picks Coming…

While we have certainly made a great deal of cash for clients recommending Energy Service & Infrastructure stocks that are exposed to the potential West Coast LNG boom and plan to make a great deal more, oils sand infrastructure stocks, once market darlings, have been given the cold shoulder of late.

Perhaps it is environmental sentiment, current infrastructure bottlenecks in the Western Canadian Sedimentary Basin (WCSB) or just the inherent nature of investors to gravitate towards the shiny new toy. Whatever it is, we see a push for big exposure to the “potential” of West Coast LNG and little talk of what appears to be more certain cash flows in Alberta’s Oil Sands.

This we believe is both a mistake and an opportunity. While Oil Sands projects may not be the cheapest on a production basis, these are long-life assets that promise to kick out billions in cash flow annually. More importantly for our thesis, they will require massive ongoing expenditures.

Not everyone is ignoring this segment at present. In fact, one of the savviest of them all, Warren Buffett, through Berkshire Hathaway, recently bought Alberta electricity transmission company Altalink for about $3.2 billion. Altalink, which owns and operates about half of Alberta’s high-voltage transmission grid, is well positioned long-term to participate indirectly in Alberta’s Oil Sands driven growth. Last summer, Berkshire Hathaway surprised a number of investors by sinking more than $500 million into Suncor Energy (SU:TSX) – one of the largest Oil Sands producers – as a long-term value play.

Some of our greatest investments have come in companies that operate in segments that were not the markets shiny new toy or businesses. However, they all supplied a product or service with sustainable long-term demand which produced and promised to continue to produce us cash.

We believe investors currently have an opportunity to circle back to the Canadian Oil Sands and focus on those supporting the massive current and scheduled production facilities as they come online over the next several decades. First, let’s go over some background material.

Canada’s Oil Reserves and Production Rates

The percentage of total oil supply derived from unconventional sources is forecast by the IEA to grow from 3.2% of total oil supply in 2010 to 10.2% in 2035. This substantial increase is a key contributor to the IEA’s expectation that Oil Sands will grow its output from 1.5 million bbl/d in 2010 to 4.5 million bbl/d in 2035.

With an estimated 175 billion barrels of economically recoverable oil (source: Oil & Gas Journal), Canada holds the third largest proven oil reserves in the world. The vast majority of the country's resource (i.e. 170 billion barrels, or 97%) comes from the Alberta Oil Sands, representing one of the world's largest reserve base open to private sector investment.

The Oil Sands are an important resource base as they make up approximately 55% of the investable reserves left worldwide. Steam assisted gravity drainage (SAGD), one of the most commonly used Oil Sands extraction methods, or other in situ extraction methods, are expected to be the method for approximately 80% of the total Oil Sands reserves. Investable reserves are those reserves that are not controlled by governments or OPEC (approximately 80% non-investable), which collectively represent approximately 20% of total global oil reserves (Source: "The Facts on: Oil Sands"; Canadian Association of Petroleum Producers, November 2012).

These non-investable reserves are not available for private development. The following graph sets out the percent of global oil reserves that are accessible to private development and the geographic location of such reserves.

The Oil Sands are estimated to hold 1.8 billion barrels of economically recoverable bitumen of which 80% is expected to be recovered through in situ recovery methods, including SAGD. (source: CAPP and ERCB Alberta's Energy Reserves & Supply/Demand Outlook report, June 20, 2012 and IEA oil market report).

Opportunity in Boring, But Profitable Maintenance Capital

The Canadian Association of Petroleum Producers (CAPP) estimated that capital expenditures reached $23.0 billion in 2013, up from $18.1 billion in 2008 and $22.7 billion in 2011. In addition to initial capital expenditures to develop and construct an Oil Sands project, ongoing operating and maintenance capital requirements are significant.

In 2010, the ERCB estimated that total Oil Sands operating costs (including upgrades) totaled $13.3 billion, or $23 per barrel per day, and total operational spending reached $15 billion in 2011. One of the more significant maintenance capital expenditure categories relates to building replacement pads at the production facilities.

Approximately 2-3 replacement pads are required to be constructed each year for every 35,000 bbl/d of production, for which management estimates its potential revenue opportunity is approximately $1.0 - $3.0 million per pad. This cost category alone represents annual recurring revenue market potential of over $120 million at current in situ production levels of 0.8 million bbl/d, which would increase to over $300 million if in situ production levels hit over 2.0 million bbl/d as projected in 2021. Other key sustaining capital expenditures include civil works and infrastructure such as roads and piping corridors. The following graph sets out the historical and forecasted capital and operating expenditures for in situ Oil Sands operations.

Savvy investors like Buffett, who love cash flow, particularly when it is underappreciated, are buying into this segment. In fact, just last week, one of our very successful long-term Focus BUY recommendations for premium clients made what we think to be a very astute purchase of a company which currently services the strong Oil Sands service segment.

That company is Mosaic Capital Corporation (M:TSX-V). The same company which has seen its shares jump over 323% in just over 2-years since our original recommendation. And the same company we recommended at just over $6.00 at the 2013 World Outlook Conference which doubled in the past year to trade currently at $12.50.

Industry: Investment Company - Industrial Businesses
Recommended: March 2012
Recommendation Price: $2.95
Current Price: $12.00
Market Cap: $95,316,000
Shares Outstanding: 7,943,000
Fully Diluted: 8,409,000

Mosaic Capital Corporation is an investment company that owns a portfolio of established niche businesses based in Western Canada. The company is focused on identifying, acquiring, and managing businesses that generate strong, sustainable cash flow from their operations.

Event

Early last week, Mosaic reported an agreement to acquire a 70% interest in the businesses being carried on by Streamline Mechanical (1981) Ltd. and Streamline Projects Inc.

Impact: Positive

Details

Streamline Acquisition

Streamline provides site maintenance services and civil construction services to Alberta’s energy sector, working with both Canadian and International energy companies. Streamline is currently engaged in connection with, among others, the Suncor Fort Hills Project and the Syncrude Mildred Lake Mine project. Services include:

1. Energy Infrastructure Civil Construction, including:
• Excavation
• Drainage
• Construction of roadways and pads
• Maintenance of roadways (including snow removal and dust control)
2. General site services
• Mechanical installation services
• Construction and maintenance of temporary facilities
• Underground sewer, water, gas and communications infrastructure installation services
• Manufacturing and installation of potable water and sewage systems
• Materials management
• Clearing and grubbing
• Vacuum truck services

Key Numbers

Cost: As Mosaic often structures its’ acquisitions, on completion, Mosaic will own 70% of the partnership that owns Streamline and members of management will own the remaining 30%. Mosaic’s cost of acquisition includes $12.6 million in cash, the assumption by the partnership of $4 million of debt and up to $3.5 million in contingent consideration over the next 3 years, the payment of which is dependent upon the business meeting or exceeding certain financial performance targets.

For the year ended September 30, 2013, Streamline had revenues of approximately $50 million.

The company is expected to be immediately accretive to Mosaic’s free cash flow and distributable cash per common share. Closing of the transaction is anticipated to occur on or about June 1, 2014. The acquisition is expected to be immediately accretive to Mosaic’s free cash flow and distributable cash per common share.

Conclusion

Management believes that Streamline will continue to benefit in the coming years from the billions of dollars in construction and maintenance spending in Alberta’s Oil Sands due to both the large size and long-term nature of these projects.

Mosaic targets purchasing its businesses in the range of 3-5 times EBITDA or cash flow and we expect the Streamline transaction will go through in the mid range of this level or at close to net asset value as the company was private without a formal “for sale” sign hanging on the door and held $4 million in debt. Given this, we expect the acquisition could add in the range of $4.5 million or north of $0.50 per share in EBITDA to Mosaic, making it smartly accretive.

We continue HOLD our long-term positions in Mosaic and see the company as a long-term BUY for investors with a 2-5 year time horizon.

Our Latest Focus BUY Recommendation – Benefitting Currently from Strong & Growing Oil Sands Spending + a 7% Dividend!

While spending can be project driven and as a result lumpy, the growth in this region forecasted over the next decade is staggering. The Alberta Government is currently tracking 39 major projects in the South Athabasca Region – In Situ. The projects include an estimated 110 individual phases varying in size from 1,000 bbl/d to greater than 100,000 bbl/d. Each of these phases is forecasted to be under construction through to 2025 and many will continue to require the services provided by our next Focus BUY recommendation – scheduled to be released in our 2014 Special Small-Cap Breakthrough/Turnaround Report (to all Small-Cap Premium Clients).

The company in question was formed with the specific objective of creating an integrated resource maintenance, logistics and civil services business through a buy and build growth strategy. The company intends to have a primary focus: (i) in the in situ production segment of the Oil Sands (of which one of the most commonly used extraction methods is steam assisted gravity drainage (SAGD); (ii) in the mining production segment of the Oil Sands; and (iii) in the traditional mining industry. The company has a geographic focus in the Oil Sands SAGD region primarily south of Fort McMurray, Alberta and the Oil Sands mining region primarily north of Fort McMurray, Alberta and intends to expand its focus to include the three Northern Canadian territories.

This Oil Sands service company is virtually unknown. Its’ core business grew revenues from $13.69 million in 2010 to $67.17 million in 2013. The company’s trailing (last 12-month) EBITDA on a pro-forma basis was in the range of $14.5, or $1.29 per share basic ($0.90 diluted). This gives the company a trailing price-to-EBITDA ratio of under 3 (under 4 diluted), which is attractive.

Expenditures by Oil Sands production companies can be classified into three categories: initial capital, sustaining capital and maintenance expenditures. Based on Canadian Energy Research Institute (CERI) estimates, our Breakthrough selections expects that the sustaining capital expenditures in the SAGD market will grow from the current year into the next decade by greater than 400%, as reflected in the chart below. Sustaining capital and maintenance expenditures represent approximately 60% of this company’s revenue. Initial capital expenditures represent the remaining approximately 40% of revenue.

The company’s revenue from sustaining capital and maintenance expenditures is currently derived from three customers supporting a current combined 100,000 bbl/d of production. These customers have publicly announced plans to produce more than a combined 700,000 bbl/d of production within the next ten years and management expects that the market for services such as road development, construction of productions pads, piping corridors, accesses and ponds, plant site and infrastructure civil works, drainage services and maintenance of constructed earthworks could significantly increase over the next decade.

Of course, these statistics and even the current successes do not guarantee future success. But, they certainly can add to the long-term potential of the investment.

This is what we endeavor to uncover for investors on an annual basis in our Small-Cap Growth & Value stock research. In a 12-18 month period, identify just 8-10 quality growing, profitable stocks that trade at low to reasonable valuations and give you a higher probability of beating the market long term.

Look for the release of our 2014 Special Small-Cap Breakthrough/Turnaround Report for the full report on this attractive and underfollowed Oil Sands service stock along with a number of other quality small-cap growth and value selections in June.

Until then, profitable investing to you.