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Introduction

Equal Energy (NYSE:EQU) is currently in the final stages of an ongoing strategic review that has been the subject of several prior articles authored both by myself and Nawar Alsaadi, the leader of the activist shareholder group that has been lobbying for change. Equal's shares remain significantly undervalued. As will be shown in much more detail below, $6.20/share is a reasonable mid-point estimate for Equal's long term fair value, while the shares currently trade at around $3.30/share. Furthermore, several hard catalysts should force this valuation gap to close in the near term. These hard catalysts include the following: (A) conclusion of the strategic review and an announcement of a corporate restructuring into a dividend trust, expected by the end of this month; (B) announcement of a significant stock buyback by the end of this year; (C) sharply increased propane prices by mid-2013; and (D) an initial dividend announcement expected by early 2013. If it takes 8 months for the valuation gap to close significantly, and it's unlikely it will take that long, that would represent a roughly 132% annualized expected IRR on an EQU investment made today. That is an uncommonly attractive investment opportunity, in my opinion.

So far things have gone pretty much as expected when I wrote my previous article about Equal, except that the strategic review has taken about 3-4 months longer than anticipated. Three asset sales have now closed - Mississippian/Northern Hunton, Viking, and Cardium - and the final Canadian asset sale, which is a combination of the Canadian royalty stream and tax pools, is expected to close by the end of this month. The Viking sold for less than I was expecting due to an asset retirement obligation not fully taken into account, but the Cardium sold for significantly more than I had estimated. If the remaining Canadian assets sell for ~$8M ($5M for the royalty interests + $3M for the tax pools), then Canada will have sold for a total of $15.4M (Viking) + $62M (Cardium) + $8M (royalty interests plus tax pools) = $85.4M, which is above the $75M estimate I used in my previous article. The Mississippian and Northern Hunton assets sold for $40M, which means that by the end of this month Equal will have raised a total of $85.4M + $40M = $125.4M in cash. That's a lot of money for a company of this size. So far management has used all of that cash to reduce net debt, and as a result the balance sheet has improved dramatically. However, as will be shown in great detail later, I believe that management has gone too far in the direction of deleveraging and that at this point it's very much in the shareholders interests to prudently re-leverage the balance sheet by repurchasing around $30M of undervalued EQU shares.

In the remainder of this article I will provide details of the model we're using to predict Equal's sustainable dividend per share and market valuation after it has been restructured into a tax-advantaged dividend trust, either a US MLP or a Canadian Trust ("Mutual Fund Trust").

Central Hunton Model

After the rest of the Canadian assets are sold, Equal's sole remaining producing asset will be the Central Hunton. We are modeling Central Hunton production, revenue, and expenses as follows.

 TotalOilNGLNG
Production (bbls or mcf per day)7,7982093,63023,760
Long-Term Price Assumptions $ 87.00$ 39.15$ 4.25
Quarterly Oil, NGL, NG Revenue$ 23.84$ 1.66$ 12.97$ 9.21
Royalties$ (5.96)   
Production Expense$ (4.48)   
Transportation Expense$ (0.14)   
Quarterly Long-Term EBITDA, no G&A$ 13.26   
Annual Long-Term EBITDA, no G&A$ 53.03   
Annual G&A$ (8.0)   
Annual Long-Term EBITDA$ 45.0   
Source: Q3 2012 Financial Report and 9/24/2012 Press Release

One very important assumption made in the table above is that annual cash G&A expense going forward will be approximately $8M/year. In Q1 of 2012, before the temporary expenses caused by the strategic review started being incurred, annualized cash G&A was running at about $12M/year. We believe this 33% expected reduction is appropriate because the inefficiencies caused by the US/Canada operations split have been eliminated due to the sale of all Canadian assets, US operational efficiency should be improved due to geographic concentration in Central Oklahoma, total production has decreased by 25% compared to Q1 2012 due to asset sales, and comparable Canadian foreign-asset trusts have lower corporate cost structures than what we're estimating for Equal (e.g., Parallel Energy Trust has annualized G&A of around $7M per year).

It should also be mentioned that discussions with a private operator in the Hunton have confirmed that if Equal's Central Oklahoma assets were operated as a private O&G company, G&A could be reduced to something closer to $4M per year rather than $8M. So suffice it to say that we view $8M as an upper bound on what is an acceptable level of G&A going forward, and we hope it will end up being considerably below that level once the cost structure is optimized.

The long-term commodity price assumptions are obviously a key part of this analysis as well. Our assumptions for oil and natural gas shouldn't be too controversial, as the futures markets are predicting $89.90 WTI oil and $4.02 HH gas in 2013, while the longer term futures contracts indicate a slightly lower oil price and a somewhat higher gas price for dates out to 2020. The long-term NGL pricing assumption of $39.15/bbl, on the other hand, requires some more explanation. Futures market pricing for Q4 2012 indicates a Conway propane price of $0.79/gallon = $33.29/bbl, and if we assume that Equal realizes around 90% of that for its NGL barrel (which is reasonable when propane is priced so low compared to WTI), then that works out to $29.96/bbl. That's obviously much lower than the $39.15/bbl assumption used in the table above. Similarly, futures market pricing for 2013 indicates an average Conway propane price of $34.68/bbl, which implies an NGL realization of around $31.21/bbl - again, much lower than our long-term assumption.

Having said all of the above about NGL pricing, it's important to understand that on a long term historical basis Equal has normally realized between 45%-55% of WTI for its NGL barrel and we're using the low end of that range, 45% of WTI, to derive the assumed NGL price of $39.15/bbl. Furthermore, a closer investigation of the price of propane in 2011, 2012, and what is expected in 2013 increases our confidence in this NGL pricing assumption. Please see this article for a more detailed discussion of propane inventories and prices, but a very quick summary is that the lack of winter in 2011/2012, increased liquids-rich shale gas drilling, and a transportation capacity deficit in the mid-continent region caused an enormous glut of propane to develop in 2012 and the spread between Conway and Mont Belvieu pricing to blow out.

All of the above factors are currently in the process of reversing, including the following: expectations for a normal winter; increased petrochemical demand for propane due to depressed pricing; the new DCP pipeline coming on line to carry NGLs from the mid-continent to Mont Belvieu; and most importantly of all, a tripling of export capacity due to the EPD and Targa export terminal expansions in 2013 and the fact that US propane is now priced at about a 50% discount to international propane, an arbitrage gap that is unsustainable over the long term. Recent research notes put out by Merrill Lynch and JP Morgan confirm this propane analysis. If Mont Belvieu propane averages around $1.25/gallon in 2013, which is a pretty conservative assumption given that it varied between $1.30 and $1.60 in 2011, and we assume a $0.10/gallon discount at Conway, then we can estimate that Conway propane will average around $1.15/gallon = $48.30/bbl in 2013. Therefore, to hit our $39.15/bbl NGL target Equal would need to realize around 81% of Conway propane for its NGL barrel, which is very reasonable given the historical data found here on Slide 10. In summary then, we believe that the NGL pricing assumption of 45% of WTI is valid for 2013 and is probably too low over the longer term, once ethane pricing reverts to its normal historical relationship with the other NGLs.

Balance Sheet Strength

What follows is an analysis of Equal's balance sheet as of November 2, 2013. I've assumed that the remaining Canadian assets will be sold for approximately $8M by the end of this month.

Convertible Debentures @ 6.75%$ 45.0
Bank Credit Line @ 3.24%$ -
Working Capital Deficit (Surplus)$ (10.0)
Initial Net Debt$ 35.0
Sale of Remaining Canadian Assets$ (8.0)
Tender Offer$ 30.0
Post-Transaction Net Debt$ 57
Net Debt / EBITDA1.3
Annual Interest$ (3.4)
EBITDA / Interest13.1
Cash Flow From Operations$ 41.6
Net Debt / Cash Flow1.4
  
Tender Offer Price (per share)$ 5.00
Number of Shares Bought Back (million)6.0
Number of Shares Left Outstanding29.0

Source: 9/24/12 Press Release and analysis given above

As shown in the table above, the balance sheet can easily support a $30M stock buyback (listed as "tender offer" in the table) while maintaining a very prudent 1.4x Debt/CF ratio. This Debt/CF ratio assumes the commodity prices given previously, but even if we use more conservative pricing assumptions the balance sheet remains very strong. For example, if we use 2013 strip pricing for natural gas and Conway propane (even though there's very good reason to believe the futures market is wrong about 2013 propane pricing), and we assume a 90% NGL realization with respect to Conway propane, then the Debt/CF ratio goes up to 1.8x. That's still a very prudent level of debt compared to the average dividend paying Canadian O&G company, which has a Debt/CF ratio of around 2.7x according to TD Securities.

Dutch Auction Tender Offer

We believe that the most efficient and accretive method to re-leverage Equal's balance sheet is through the use of a $30M Dutch Auction tender offer, with a cap of $5/share as the maximum price the company is willing to pay for shares that are tendered. This proposal has been forwarded to the appropriate executives at Equal. If enough shareholders are willing to tender their shares at a price significantly below $5, then the stock's long-term fair value may end up being significantly higher than what is shown in the analysis below, since there will be fewer than 29M shares outstanding.

Sustainable Dividend and Market Valuation

The following table shows how we derive the sustainable dividend and mid-point fair value estimate of $6.20/share for EQU stock.

Capex for Flat Production$ 22.2
Maintenance Capex (including land)$ 5.3
Required Dividend Growth Rate2.5%
Implied Production Growth Rate1.4%
Capex for Production Growth$ 2.1
Distributable Cash Flow$ 12.02
Payout Percentage100%
Dividend$ 12.02
Dividend Per Share$ 0.414
Interest Savings From Debenture Redemp.$ 1.6
Div. Per Sh. After Deb. Redemp.$ 0.469
Required Dividend Yield7.50%
Stock Price Before Deb. Redemp.$ 5.52
Stock Price After Deb. Redemp.$ 6.25

The most important item in this dividend analysis is the capex required to keep production flat. The company has not yet disclosed the Reserve Life Index (RLI) of the Central Oklahoma Proved Producing (PDP) reserves, but we estimate it to be around 7.75 years based upon information disclosed by Scotia Waterous when their website contained information about Equal. Use of this inferred PDP RLI, combined with adjustments made to reconcile the 2011 AIF with the ~16% decline rate observed when Equal operated both the Northern and Central Oklahoma assets but didn't drill any new wells due to the legal dispute with Petroflow, yields our estimated effective decline rate of 14.7% per year for the Central Oklahoma (Hunton) asset.

Previously disclosed information on Equal's website indicates ~150 boe/d of initial production per Hunton well, which implies that 7,800 * 0.147 / 150 = ~7.7 wells must be drilled each year to keep production flat. Each well costs $2.9M (including an allocation for periodic water disposal well drilling), which results in the $22.2M flat-production capex estimate. Maintenance capex of $5.3M is consistent with previous guidance from management, as it represents around 17.9% of the estimated total capex budget. We've also allocated $2.1M of growth capex in order to achieve an expected dividend growth rate of 2.5% per year (assuming constant commodity prices), which is a reasonable expectation for an equity that's assigned a 7.5% dividend yield by the market (i.e., 7.5% yield + 2.5% growth = 10% expected annual total return).

It should be noted that 7.5% is the average dividend yield for US MLPs, so this is by no means an aggressive valuation assumption. Furthermore, if we assume a very low 2% inflation rate going forward, which is a very conservative assumption given the historically unprecedented amount of money printing going on at central banks around the world, then the expected total return becomes 12% per year. Considering that 10-Yr US Treasurys are currently yielding around 1.7%, this seems like a very conservative required return assumption.

The company currently has $45M of 6.75% convertible debentures outstanding. These debentures can be redeemed on April 1, 2014, and since that debt can be refinanced with lower cost bank debt (3.24%), we assume the company will do so. That will save $1.6M per year of interest payments, and we expect that savings to be distributed to the shareholders in the form of increased dividend payments starting in 2014. Since the increased dividends should be permanent starting in 2014, the stock is worth the post-debenture-redemption valuation of $6.25/share, less the first-year deficit of $1.6M / 29M shares = $0.05/share, or around $6.20/share today.

Sensitivity Analysis

Clearly the above fair-value estimate of $6.25/share is dependent upon many different parameters. Three of the more important of those parameters are varied in what follows, so that the reader can get a sense for how fair value changes with different parameter choices.

First up is the buyback amount. As shown in the table below, the fair value of the stock ranges from $5.31 - $6.96, using the given assumptions, when the buyback amount is varied from $0 - $50M.

EQU Stock Price vs. Buyback @$5/share
(WTI=$87, NG=$4.25, NGL=45% of WTI, 7.5% Dividend Yield)

It should be noted that the above sensitivity analysis assumes the dividend yield required by equity investors is independent of the Debt/CF ratio. Clearly that assumption is not strictly true, since as a company becomes more leveraged the cash flows to equity become riskier, but I believe this assumption is at least approximately true provided that the Debt/CF ratio remains at well-below average levels. In other words, at a certain point there is nothing more to be gained by deleveraging, and while a certain amount of deleveraging was appropriate as part of Equal's restructuring process given its previously excessive debt load, it is now in the shareholders' best interests to prudently re-leverage the balance sheet.

The following matrix shows how EQU fair value changes as a function of natural gas and NGL commodity price assumptions, holding WTI constant at $87/bbl and the buyback amount at $30M.

EQU Stock Price (WTI=$87, $30M Buyback @$5/share, 7.5% Dividend Yield)

(click to enlarge)

Please note that the matrix elements shaded in gray represent run-off valuations rather than going-concern valuations. That is, if there were good reason to assume that commodity prices would remain at those low levels (e.g., NGL at 35% of WTI) indefinitely, then it would not make economic sense to recycle cash flow from operations back into new Hunton drilling to keep production flat; at that point it would make more sense to let the wells decline and pay out all cash flows to equity and debt holders. The details of that run-off calculation are beyond the scope of this article, but I can provide those details to any interested reader (and I should also note that this calculation does take into account that there is some level of required G&A even in a run-off scenario).

Conclusion

To be sure I have covered a lot of very detailed ground in this article, and I hope that at least some of you made it to the end! The bottom line is that EQU is a very undervalued stock and there's good reason to believe that the large gap between current market price and fair value will close within 8 months. It is also important for investors to understand that Equal's management is aware of this article and that key shareholders are expecting the go-forward G&A, capex budget, share buyback amount, and initial dividend per share to be in the range outlined above.

Source: Equal Energy: Still Undervalued With Several Near-Term Catalysts