J.M. Dutton & Associates

Special in Seattle: Interview with Dutton & Associates' Les Childres

Dutton & Associates senior analyst Les Childress is best known for his work covering the energy industry and community banks. An unlikely pair, but for Childress living in Seattle, there's a geographical advantage to covering these industries, and the range also fits his eclectic style. If it's a story difficult to get one's arms around, it's probably a story for Childress, who likes companies across a range of industries with special situations that fall outside the radar of sell-side analysts.

You write on a range of industries, but you're best known for your work in community banking and energy. How did you get involved in these areas?

This has been, at least until recently, a very stable region economically with numerous software, chip, aerospace, and healthcare companies at my disposal to follow on a research basis, so it's been exciting to be able to look at all these companies. Banks are a reflection, so to speak, of the economic health of this region, and there happen to be a lot of community banks in the Pacific Northwest. In addition, Seattle's proximity to the Western Canadian provinces of British Columbia and Alberta allows me to be very close to many of the independent Canadian oil and gas companies based in Edmonton, Calgary and Vancouver.

You cut your teeth in energy research down in Texas.

That's right. When I first started in the securities business as a junior analyst many years ago, I learned the energy business from an analyst's perspective by listening to a senior energy analyst and to a research director at Schneider, Bernet & Hickman in Dallas. The firm's research specialty was the independent oil and gas companies based principally Texas.

I later went on to work on the buy-side with Composite Research and Management, a mutual fund group in Seattle, where I had coverage of the energy sector, with particular emphasis on the oil and gas production companies in the S&P 500 and some of the internationals like Shell. In the mid-80s, while I was research director at Harper McLean, I began to focus on the Canadian oil and gas companies as well as smaller-cap U.S. companies.

Was there much coverage of Canadian companies then?

No. This was at a time when there was concern about excess energy supply and falling demand in the U.S. Prices were at historic lows. Canadian natural gas supply was an afterthought, even though most Canadian gas is piped to the U.S. I'd made a research visit to Calgary and Edmonton to look at the Canadian natural gas producers for the first time, and I concluded that Canadian natural gas and oil companies would be a very interesting area of research coverage if and when demand recovered. In the event of a natural catastrophe or disruption of foreign supplies of some sort, my theory was that Canada would be a great source of swing supply, so to speak, and that has been borne out, I believe, over time. However, I believe Canada could actually become a permanent or long-term source of energy supply for the U.S. There's an enormous amount of energy in very large reservoirs of oil and gas, shale, oil sands and tarsands in Canada, and the U.S. policy makers, as well as analysts have probably underestimated how much energy is actually there. The potential supply of hydrocarbon reserves in Northern Canada exceeds that of Saudi Arabia. It will require higher prices and technology to get it to the surface.

What companies did you cover there and in the U.S.?

Nexen, which originally was Canadian Oxy, was a company I followed for many years. Renaissance Energy, Ranger Oil, Shell Canada and Gulf Canada were others I followed, and Alberta Energy is a company I've liked for a long time. Another company I've liked for four or five years is West Coast Energy, a pipeline company based In Vancouver.

In the U.S. I don't follow many large energy companies, as they have plenty of sell side coverage. I'm more interested in the smaller oil and gas producers, basically the independents in the U.S. and Canada.

Such as?

Cross Timbers is a good story and Mexco Energy (MEXC) is one I like a lot. I've written a report on Mexco and am in the process of developing an update report on the company. It's a very small cap company but I'm very optimistic about their short and intermediate term prospects. They have a very unique way of adding to their reserve base. They acquire existing prospects after they have had a chance to evaluate the engineering. Many of these prospects, which have actually been producing wells for many years, are located in long-established basins and are in the last stages of their decline curve, but there are actually hydrocarbon shows further up the hole that have never really been successfully tested and production developed. Mexco's approach is basically to take existing wells that have been producing in one formation and ascertain whether or not there are oil and gas reserves further up the hole in a different formation. They have been pretty successful in doing that to date. Mexco is more of a special situation company inside the energy patch.

What do you mean by special situation?

The company has an approach of adding to their reserve base that we just don't see that much anymore. A lot of the smaller oil and gas companies are really wildcat driven -- their primary focus is drilling wells in unproven areas. Mexco's special situation aspect is they increase their reserve base through reserve evaluation, through engineering, as opposed to wildcat drilling. They add to their land base by being smart buyers. It is a small company with conservative management and a discipline in what they do -- it's a good business model. Analysts and investors should really spend some time to get to know the company beyond the financials.

Do special situations tend to be the common theme in the many areas you cover?

Yes. I think my research approach fits very well with what is required of a special situations analyst. Special situations, in a very broad way, include turnarounds of companies that have done well, but for some reason have stumbled and have been out of favor for a long time, and simply haven't gained investor confidence because they haven't delivered financial results to warrant their interest. Safeco is a good example. Or they don't easily fit a particular sector, and thus don't show up on screens. Examples might be Trendwest Resorts or Orphan Medical. I think a special situation sometimes is a company that's a fallen angel with a lot of cash and low or no debt that's somehow dropped off radar screens of most of the investment community, particularly the sell-side research community. It could even mean a significant change in management, or an announced merger that is not fully understood, or even a company with accounting issues.

My approach to research is very eclectic. I don't eliminate a company because it doesn't fit a "style". I look at growth situations, and I look at value situations with equal interest. I go into each assignment with absolutely no bias about the company. The challenge in a special situation, no matter the market cap, is being able to determine the issues and the story. Sometimes there is no story; it's just out of favor and cheap. But whatever it is, I somehow must properly communicate the story and being able to do that concisely.

What do you do to get to know a company and to value it?

How I value a company obviously varies. However, again, I tend to be eclectic. A high P/E company, for example, doesn't bother me if it has the growth to support the price earnings multiple. I'm looking for smart and ethical management able to execute. I'm always interested in a company that's got a unique product, typically with a very sound balance sheet. I like Starbucks, a very large market cap company, but it's a one-of-a-kind company, very unique. I've followed it for many years. A lot of people probably wouldn't waste their time recommending such a high P/E company and the bear case is predicated on market saturation, but I think there's plenty of growth left on a worldwide basis.

One thing I do that a lot of analysts don't do is that, generally speaking, I choose not to get as close to management as a lot of other analysts. That may sound odd, but my reasoning is I don't want to be spoon-fed. I want to do my own work. I want to develop my own model and my own opinion about the company's prospects. Frankly, for far too long I think both sides of Wall Street have been spoon-fed, and willingly so, because they're after the investment banking or want a position in the next financing.

How did you get involved in covering community banks?

This grew out of my emphasis on special situations. When a lot of the large banks merged with each other that were based in this region -- Seattle First National Bank, Rainier Bank, Puget Sound National Bank -- the result of those very large mergers created a cottage industry, so to speak, of community banks. I ended up picking up coverage of a few of them basically on a special situation basis, and then more and more sprouted up as time went by. Today I follow nearly all of the publicly traded Pacific Northwest regional banks and thrifts.

This has been a great-performing group.

It has. Even last year, in what was a terrible overall stock market performance, we don't have any stock in our coverage universe that performed any worse than about 12% or 13%. We have several up 40-50% in one year. I couldn't be any happier about what performance has been for this group in this region.

What is your outlook for the group?

There are challenges ahead. I think the group is still very attractive, but I don't think it will perform as well in 2002 as it has the past two years. That's driven by the fact that the economy in Oregon and Washington is in much different shape today than it was previously. Unemployment in Oregon is the highest in the country, and Washington is second highest. There were a lot of high-tech companies that faded into non-existence: dot-coms and telecommunications and telecommunications support businesses. The major downturn in commercial aerospace and airframes also hit us pretty hard, especially since September. Commercial loan demand in Q1 will be lower than a year ago, I think. But I do think these banks will have overall decent performance in 2002. A lot of these banks sensed early on that, with a slowing economy, they would need to increase their reserves, and that's what they've done. They added to the reserves base as fast as they could because non-performing assets have accelerated.

What's your outlook for the energy sector?

It may be toward the end of the year when we see the best performance, but I think this year is going to be very good. Oil and gas prices have been pretty volatile lately, and although we have seen energy prices rise a little bit in the last few days, much of that driven by concerns about Middle East unrest, I think the outlook for natural gas producers is going to be good in late '02 and even better in '03.

I think demand will increase as we enter economic recovery, and we seem to have some indications of that now. I'm not as concerned about what oil prices do or not. I'm looking potentially down the road for oil prices and natural gas prices to decouple from one another. It's always been the theory that whatever oil prices do, so will natural gas prices, but I think going forward it will be a very different picture. There are deliverability and capacity issues in natural gas that don't affect oil. I can't think of one major energy facility in the State of California, for example, that won't be fired by natural gas. We have substantial natural gas reverses in the U.S. and in Canada, so I don't think in the long term the supply of the resource is an issue. Prices will rise because the decline curve in many basins in increasing. Some of the smaller energy companies, in particular, are very well positioned.

How so?

These smaller companies' reserve additions don't have to come about by locating the next big reserve basin. That's frankly what the very large, international companies have to do -- they have to find enormous quantities of reserves to add to their base. Which means they have to drill for oil and gas all over the globe and make major discoveries, and that gets harder and harder to do as we go through time. It requires greater technology or, alternatively they can buy the barrels on Wall Street, which has been the case recently.

For large companies that are domestic, they're all banking for an energy policy that will allow them to drill in Arnwr, and I'm not sure that's going to happen. But I know one thing: For the smaller oil and gas companies, it won't matter to them whether Arnwr is opened up for oil and gas drilling or not. They are going to do just fine, because there are enough undeveloped domestic reserves in the lower 48 states to keep them very busy for many years to come and even more in Western Canada.