Did Hedge Fund Guru Phil Falcone Make the Right Call?

Everyday, traders around the world royally screw up. When this happens, the trader himself is typically the only person truly affected by the loss. In these volatile markets, individual traders are not the only ones in trouble; entire institutions like private equity firms and hedge funds are seeing their investments wasting away.

One popular example of bad 2011 performance is John Paulson, whose flagship fund is down about 40% this year. Known for personally netting about $4 billion in 2008, Paulson is a prime example who proves that no one can always outperform the market.

Recently, the Harbinger Group HRG announced that it increased its stake in North American Energy Partners NOA. When considering that the energy sector has been quite volatile in 2011, was this necessarily the best decision? We are all trying to attain alpha, but will North American Energy provide Harbinger adequate risk-adjusted returns?

I am not going to claim that I know finance better than these hedge fund professionals, but I am going to explain my point of view with historical trends. After all, all of these investors make six to seven figures per year while I make peanuts, comparatively.

North American Energy Partners is a small-cap firm that provides construction and mining firms services throughout their individual projects. The company sounds like it has a good business model. It is not directly affected by oil and natural gas prices, and even then, it probably hedges itself adequately against extreme fluctuations. It is also diversified and does not exclusively focus on natural gas or oil extraction, but also works with construction and mining operations.

Considering the timing of Harbinger's transaction, the fund is probably expecting returns to start accruing in the next quarter or two. Interestingly, North American Energy's performance has been waning the last few quarters, compared to historical performance.

Revenues have fluctuated over the last few quarters, which may be a result of the energy sector's inherent volatility. Either commodity prices were affected or the company could not garner enough contracts to maintain steady growth. Both probably plagued the company in 2011. First quarter margins were negative while the second quarter's margins were better as a result of lower 'cost of goods sold.' Operating expenses, however, increased from the first to second quarter. Operating income in both quarters was negative, although second quarter was better than the first. Subsequently, net income and EPS were negative in both quarters of 2011, while Q2 saw significant improvements.

North American Energy's statement of cash flows seems to show some positive signs for the last couple quarters. In 2010's fourth quarter, the company lost $14 million in cash from operating activities, primarily as a result of working capital. In Q1 2011, net income, receivables, and working capital negatively affected cash, but ended up breaking even. In the second quarter, net income and working capital detracted from cash, although the cash pile increased to $2 million.

Capital expenditures were high in Q4 2010 and Q1 2011, as a result of acquiring more property, plant, and equipment as well as the acquisition of Cyntech Corporation. The acquisition was completed and PP&E purchases were significantly lower in Q2 2011, saving North American Energy some cash. The company also issued a relatively low amount of debt and repaid a low amount in Q2 2011. In previous quarters, the firm would issue a couple hundred million dollars of debt and pay back a similar amount. The sudden decrease may indicate that the company has started to streamline its operations without the use of debt financing.

North American Energy's balance sheet is also critical to consider. Cash has been slowly increasing over the last couple quarters, by about $1 million increments. Receivables suddenly decreased in Q2 2011, down to $90 million from $128 million. Other current assets stayed fairly stagnant over the last few quarters. Property, plant, and equipment on the balance sheet increased modestly over the last two quarters; up to $511 million from $505 million. Interestingly, the cash flow statement showed larger figures, so capital expenditures may not have been fully recognized yet. Overall, assets have been contracting over the last several quarters.

Current liabilities were mostly stagnant for the last couple quarters. Long-term debt increased slightly, but other long-term liabilities decreased. Shareholders' equity decreased as a result of lower retained earnings; paid-in capital stayed the same.

Investors can also determine if Falcone's purchase was sound by looking at financial metrics. The company appears to be undervalued when considering price/book value and price/sales. North American Energy has a negative price/earnings because of its negative EPS. It has negative margins, while other energy companies typically have margins of about 10%.

Growth measures like revenue growth and EPS growth are also negative for North American Energy. Return on equity is about -21% while the industry average is about 10%. This may be a reflection of historical performance only and not future performance, but it should be considered nonetheless.

Phil Falcone is known across Wall Street as a shrewd investor, so his investment idea may very well work out. Fundamentals have not been positive over the last few quarters, although quarterly performance looks like it may be trending up. Investors should also consider year over year performance, which paints a worse picture for North American Energy. Metrics are not necessarily positive in every aspect, although some may consider the stock to be undervalued.

North American Energy Partners is currently trading at about $6.20, down almost 50% for the year.

ACTION ITEMS:

Bullish View:
Traders who believe that North American Energy Partners is an appropriate long investment might want to consider the following trades:

• Phil Falcone built a sizable position in the firm, which may be a positive sign for some investors.

• Quarterly performance appears to be trending upwards.

• Out of seven equity research analysts, only one had an 'underperform' or equivalent rating.

Bearish:
Traders who believe that North American Energy Partners is more suited for a short play may consider an alternate position:

• The company operates in a volatile industry with immense competition.

• The firm's financial statements, on a year-over-year basis, point to slowing growth.

• North American Energy's acquisition if Cyntech has yet to be accretive for the company; investors need to be aware that accretive affects may take a long time to be realized, if they ever will be realized.

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