Portfolio manager Cale Smith on investing, Spoke Funds®, and Islamorada in the Florida Keys.

A press release put out today by Tarpon Folio holding Contango:

Chairman and Chief Executive Officer, Kenneth R. Peak, addresses shareholders and investors.

Mr. Peak said, “I have received a number of inquiries from shareholders and interested investors regarding the potential impact on Contango Oil and Gas Company stemming from the recent explosion and sinking of the semi- submersible rig Deepwater Horizon, and the resultant oil spill. Rather than answering questions on an individual basis, I’ve decided to communicate directly with all our shareholders.

The short and accurate answer as to the impact on Contango from the spreading oil disaster is that there is no current impact on our offshore Gulf of Mexico (GOM) operations and there is no way to predict what changes might occur in the future for GOM exploration companies like Contango. Nor is there any way to know when such changes might occur or be implemented. I will, however, make several observations:

- Contango’s GOM operations and current prospects are concentrated entirely in water depths of less than 200 feet. The technology and operational risks required to drill in water of this depth have been available to the industry for over 30 years and do not pose the same kind of operating challenges as deep water drilling. Moreover, at depths of less than 200 feet it is possible to send divers directly to the mud line of the well bore. Will the Congress, the EPA, the MMS, and other regulatory agencies responsible for drafting rules and regulations differentiate between deep water and “shallow” water drilling? I do not know but it seems logical that they should.

- Most of our prospects are at depths of between 12,000 – 17,000 feet and are predominantly natural gas focused prospects with some associated condensate production. The condensate associated with offshore GOM natural gas production is typically in a range of 20 to 200 barrels of condensate per produced MMcfd (million cubic feet of natural gas produced per day). In other words a 20MMcfd gas well would typically not have more than 4,000 barrels of associated condensate per day (bopd). Further, the condensate associated with natural gas production typically has an API gravity of around 50 degrees. This high gravity condensate – which has a volatility and chemical composition more akin to diesel than crude oil – evaporates more quickly than crude oil and is more easily dispersed.

- Our natural gas focused exploration wells, while challenging and expensive, are not nearly as technologically difficult as ultra deep wells, i.e., greater than 20,000 feet. Thus the equipment and technology required to drill and produce reservoirs with depths of 12,000 – 17,000 feet are relatively established and readily available. A blow-out of any magnitude would present serious operational and financial challenges to any company and most certainly to Contango, but I believe the technology and solutions to gain control of a potential blow-out are more readily available for the medium depth wells Contango drills than either deep water or ultra deep wells.

- The oil spill is currently headed east towards Mississippi, Alabama and perhaps Florida, and is not expected to impact our operations. However, if the oil sheen were to reverse course and were to envelope our platforms, our wells would be required to be shut-in, until the sheen had been dispersed.

- We carry $75 million of well control insurance (8/8ths) in the event of a blow-out. This insurance would cover gaining control of the well as a result of a blow-out, re-drilling the well, pollution, cleanup and containment arising from an out of control well, and any resultant plugging and abandonment expense. We also carry $100 million of third-party liability insurance which includes sudden and accidental pollution liability. Recent proposed legislation could result in requirements for much greater insurance coverage that could extend as high as $10 billion. We would need to evaluate the cost and feasibility of obtaining such insurance.

There will never be a 100% risk free exploration and production operation for offshore, or on-shore drilling. On the other hand the United States routinely spends hundreds of billions of dollars and sacrifices the lives of our young men and women to protect our access to Middle East crude oil. Somewhere in the national debate that is going to take place as a result of this disaster, there must be recognition of our continued reliance upon the imported crude oil and gasoline that drives our economy and makes our life style possible. Alternative energy is important and can and should play an increasing role, but for the next 20 years I believe we will continue to rely on natural gas and crude oil. Indeed, with our now widely recognized 100 years of natural gas reserves available in the US, the arguments in favor of increasing the role of natural gas as a fuel for both power generation and for our transportation needs are becoming ever more compelling. My instincts are that the industry will be subject to increased scrutiny and regulation. Higher exploration and operating costs will inevitably follow, but I believe Contango is as well positioned as any company in the industry to adapt to these changes.

In conclusion, I would also like to add my condolences to the families of the 11 crew members who lost their lives in this terrible accident. All in the industry regret this disaster and the unfortunate impact it has and will have on many lives.”

This is the slideshow that Contango Oil & Gas CEO Ken Peak presented last Saturday night at the IIM first annual investor meeting at Holiday Isle in the Florida Keys. We own shares of Contango (MCF) in the Tarpon Folio.

I also have some video clips of Ken’s speech that are currently being edited. I will post them as soon as they’re ready.

This site and the above are for educational and informational purposes only. Nothing contained here should be construed by anyone as an invitation or solicitation to buy or sell any security. This site does not contain personalized legal, tax, investment, or financial advice. Users of this site should consult with a qualified adviser to obtain advice suited to their personal circumstances. Any links provided here to other web sites are for informational purposes only.

Two press releases came out this morning of interest to Tarpon Folio investors.

The first is that Contango announced a successful new natural gas well with production expected to be 20 million cubic feet equivalent per day…or a 25% increase over the company’s current production. Good on ya, Ken Peak. Here’s the press release.

The second bit of news is that Tarpon Folio holding Alcon is being bought by Novartis.

Or, more accurately, Novartis would like to take control of Alcon by buying Nestlé’s majority stake for $28.1 billion, raising its own stake to 77 percent, and said it would like to acquire the rest, currently owned by minority shareholders like the merry band of Tarpon Folio investors (my words) by offering 2.8 Novartis shares for every outstanding Alcon share.

Here’s more from the NY Times. And here’s what I said about Alcon in my Letter to Tarpon Folio investors last July:

By all measures Alcon is a wonderful business. It’s the world’s largest eye care company, with sales in 2008 of $6.3 billion and profits of $2 billion. It has the broadest portfolio of eye care products in three key categories: surgical, pharmaceutical and consumer eye care. If you’ve ever had contact lenses and reached for the Opti-Free, you’re already familiar with one of Alcon’s products. Based in Switzerland but originally founded in Texas back in 1945, the company now does business in 180 countries.

Alcon has a leadership position in the cataract market, helping to prevent blindness and restore sight among those patients that make up the 25 million people affected by cataracts each year. The firm’s Infiniti system, used to remove the eye lens during surgery, represents a big upfront investment and requires loads of training, making hospitals and surgeons reluctant to switch. Similar advantages exist in Alcon’s intraocular lens business, and its large opthalmic drug portfolio targets only a handful of diseases, so the same salespeople can sell each drug. That saves the company a bundle.

Since going public in 2002, Alcon has averaged returns on invested capital of greater than 40% a year. So it clearly benefits from the high switching costs of its products as well as the efficiencies of cross-selling. While its revenues are susceptible to cuts in government health-care spending, that should be at least partially mitigated due to a dramatic expected increase in eye-related diseases as baby boomers age and new emerging markets get better access to health care.

Here’s the thing about Alcon, though: none of the above really matters to us the next few years. The business described above really just provides us with a margin of safety in the event I’m wrong about certain future events that will enable us to profit further from owning Alcon shares. But I like our odds very much.

What Makes This Situation Special?

I probably couldn’t tell a ophthalmic viscosurgical device from a toric intraocular lens if either one fell into my conch chowder. So why would I so brashly ignore that earlier “stay in your circle” advice we got from the world’s greatest investor? Because Alcon is an example of what is called “special situation investing” – and, yes, Buffett used to be quite active in these opportunities, too, some time ago.

Special situation investing involves taking a position in a company based primarily on certain advantageous circumstances, as opposed to relying exclusively on fundamental research. You probably didn’t realize it, but the Tarpon Folio contains several special situation investments, including – please excuse the jargon – a spin-off, a broken IPO, and a disguised recapitalization. Alcon came public as a “carve-out”, another kind of special situation, but now it is of interest as a likely merger arbitrage case. I’ll explain each term more in future letters. For now, here is what makes the Alcon opportunity so compelling.

Public shareholders like you and I hold about 23% of Alcon’s shares. Currently, 52% of Alcon is owned by Nestle. In April of last year, the company Novartis bought a 25% stake in Alcon from Nestle in exchange for $11 billion and an option to buy out all the rest of Nestle’s Alcon shares beginning in 2010.

Then, last fall, the credit crisis happened and Alcon’s shares plummeted even further after missing an earnings forecast. This represented a tremendous opportunity for anyone who had been paying attention while, say, pounding caffeine as he studied various companies to include in a new fund to be named after a fish.

Despite being a great business, I was most excited about Alcon last fall – and still am today – because of the terms of Nestle’s deal with Novartis. In short, starting on January 1, 2010 and for a period of 19 months, the rest of Alcon shares are likely to be sold to Novartis in one of two ways:

1 – Novartis may either exercise a call option to buy Nestle’s remaining stake in Alcon for $181 a share; or

2 – Nestle may exercise a put option to sell its Alcon shares to Novartis at the lower of $181 a share or a premium of 20.5% over the market price.

In either case, large amounts of Alcon shares are likely to change hands at prices that will either be $181 a share, or if lower, still 20.5% above whatever price the shares trade at the week before Nestle may decide to “put” its shares to Novartis. Here’s the SEC filing that announces the transaction.

This brings up two questions:

1 – If two savvy billion-dollar institutions with decades of experience in this industry mutually agree that the true value of Alcon shares is really $181 each – might that not be a reasonable assessment of the intrinsic value of those shares?

2 – If you owned 77% of something but couldn’t guarantee you’d completely maximize the benefit you derived from it, wouldn’t you just buy the rest of it, too?

I think the answer to both questions is a big ol’ “yes.” As a result, I believe the odds are high that investors in Alcon shares at prices similar to today’s (around $130 a share) will make at a minimum a 20% return on their investment over the next few years – and likely sooner rather than later.

What Are The Odds Of Success?

I believe we have a 75% probability of seeing at least a 20% return on our Alcon shares within the next two years due to this transaction. Importantly, that return would be regardless of whatever the broader stock market does.

If Alcon shares rise from their current $130 level to $181, we’ll make more than that 20% without a transaction. If the transaction falls through, we still own shares in a great company that appears significantly undervalued. And should changes in U.S. healthcare policy spark consolidation in the industry, it seems likely that Alcon might make an attractive candidate for another eventual suitor.

Both Nestle and Novartis have recently expressed their intent to honor the terms of the existing agreement. Ironically, the higher Alcon’s share price climbs in the interim, the higher the probability the transaction will be completed. That’s because the only potential sticking point in the deal would appear to be the price. With Novartis paying $143 per share for its Alcon stake last April, the closer shares trade to that level, the less grounds Novartis should have to renegotiate in any case.

The acquisition of Alcon also looks to be a strategic necessity for Novartis, which presumably wants to reduce its reliance on its biggest-selling drugs, the hypertension treatment Diovan and the cancer drug Gleevec, since they will be losing patent protection in the next few years.

In addition, Nestle clearly holds the position of strength in this deal, as the returns it is earning on its stake in Alcon are significantly higher than the low interest it would earn on the cash it received from selling Alcon. Nestle appears in no rush to unload its shares, while Novartis is constrained a bit in its own operations by this agreement because it must retain enough cash on hand to buy Nestle’s Alcon stake on little notice after January 1st, when Nestle could exercise its put option and force the sale. That’s why I think the sale will happen earlier in the year – it’s handcuffing Novartis a bit.

I believe that high probability above may become a near certainty, as Novartis will likely be inclined to simply buy out the remaining public shareholders as part of the Nestle transaction. Why? I’ll spare you a discussion of consolidated accounting methods, but think of it like this:

The economic value of Alcon to Novartis is not the profit that shows up in its (sort of) combined results. The real value of Alcon to Novartis is in being able to redeploy those profits internally any way Novartis sees fit. And as long as Novartis has us pesky public shareholders hanging around, we might represent a risk of gumming up the plans for those profits.

So, Novartis will probably eventually offer to buy us out, too. And I think we already have a pretty defensible opinion about what our shares should be worth to them, no?

What Happens Next?

Simply put, we wait and see. As long as Alcon shares trade below $181 per share (they’re near $130 today) we have little incentive to do anything else. In the meantime, we’ll collect dividends of just under 3% from an undervalued company with world class products, strong competitive advantages and superior economics.

You can sign up to receive my monthly letters here, and view my 2009 letters here. Also, to see what stocks are in the Tarpon Folio now, sign-up here.

Note: The implied purchase price for minority shareholders in the Alcon deal above is $153 per share, which is lower than where the stock last closed…but it’s nonetheless considerably higher than Tarpon’s original purchase price of $73. I’m also positive on the announcement today as I think it’s a safe bet that the independent directors on Alcon’s board will push for a higher price. The market seems to believe this, too, with shares trading at $157 at noon today. Plus, Novartis is a cash machine with a growing dividend, huge presence in generics and an attractive pipeline. I’m not an expert in pharma by any means, but I can think of worse things than backing into Novartis shares through this deal.

This site and the above are for educational and informational purposes only. Nothing contained here should be construed by anyone as an invitation or solicitation to buy or sell any security. This site does not contain personalized legal, tax, investment, or financial advice. Users of this site should consult with a qualified adviser to obtain advice suited to their personal circumstances. Any links provided here to other web sites are for informational purposes only.