Equal Energy (NYSE:EQU) is currently in the midst of a struggle between an intransigent executive management team and its shareholders.
- On November 27th, Equal's management concluded the strategic review that started on May 3rd (at the request of our shareholder's group).
- We then issued our first press release.
- Management responded with another press release.
- We responded with our second press release.
So we thought this would be a good time to clearly explain our stand on the key corporate governance and capital allocation policies involved. At the heart of our stand on these issues is a very simple idea: we want executive management to treat shareholder money as if it were their own. We think Equal's recently completed strategic review provides a very interesting case study of what can happen when there is a misalignment of interests between a corporation's executive management team and its shareholders and when the management team is apparently unfamiliar with sound capital allocation principles.
Equal's strategic review ended after management successfully sold off the company's Canadian assets so the company could focus on its Oklahoma assets with a reduced cost structure. This was exactly what our shareholder's group had been encouraging them to do, and we were actually quite pleased with the job management did on that portion of their task. They raised a total of $130M from the assets sales, an amount that exceeded our estimates, and we were optimistic about a shareholder friendly conclusion to the strategic review. We were expecting them to announce a restructuring of the company into a tax-advantaged Canadian dividend trust (a "Foreign Asset Income Trust", or FAIT), to implement a significant stock buyback, and to set an initial annual dividend based on reasonable long term commodity price assumptions coupled with a sensible capital spending budget. Unfortunately, management did none of the above.
Under-Levered Balance Sheet
Before the strategic review started, Equal had a Debt/Cash Flow (D/CF) ratio of 2.7x, which was exactly the same as that of the average dividend paying Canadian oil and gas company according to a TD Securities note from November 8, 2012. As noted in our press release, we did support some amount of balance sheet deleveraging due to the volatility and difficulty of hedging NGLs, but we were shocked to see that management had decided to deleverage all the way from 2.7x down to 0.7x, resulting in an unjustifiably under-levered balance sheet. Management claimed their "advisors" said they must de-lever that much in order to be "prudent", but the reality of the situation is exposed by what they said next. They said they decided against the income-oriented dividend trust structure we had proposed, and had instead settled on a hybrid dividend/growth E&P "model". Since their chosen model was at least partially a growth oriented one, they also announced that they were "considering" using their newfound $150M of cash and available credit for so-called accretive acquisitions.
Our collective jaw dropped in shock. First of all, they were telling us that after raising $130M in cash they had decided to give us, the shareholders, nothing except $7M in dividends stretched over the full year 2013. What makes this decision so odd is that management acknowledges that the stock is severely undervalued, which is why the strategic review was initiated in the first place. But instead of returning cash to shareholders by repurchasing undervalued shares, which we estimate would increase NAV/share by at least $1.09/share for each $1/share spent on a buyback (based on NAV/share of $6.49 and the current stock price of $3.11), they thought it more "prudent" to retain all of our cash so they could consider so-called accretive acquisitions.
One interesting facet of this whole story is that the chairman of the board, who was the person we were negotiating with throughout this process, owns a grand total of 6K shares. I own 105K shares and Mr. Alsaadi owns about 1.65M shares, which means I own 17.5 times more than the chairman and Mr. Alsaadi owns 275 times more. Shareholders controlling approximately 30% of the outstanding shares have indicated support for our group, which means our group is aligned with 1,750 times more shares than the chairman owns. Yet after we requested a significant share buyback in a press release, management followed up with their own press release dismissing us as "a couple of bloggers" and said shareholders should ignore us. We just find the whole situation sort of odd, where a person who owns practically no equity stake in the company whatsoever is the one who decided to withhold $130M from the shareholders and forces us to beg for at least some of our own money.
It should also be mentioned that management's insistence on maintaining such an under-levered balance sheet, coupled with a severely undervalued stock, may very well result in a leveraged buyout at an unfairly low price. We've been hearing increasingly loud whispers that such offers are in the making, and while we would view any such actions positively if they forced management to take the steps we've outlined as a defense, we worry that management's intransigence may result in outside parties being able to effectively steal these assets by bidding at an unfairly low price and borrowing most of the money to do so.
Corporate Structure and IRR
Their stated rationale for selecting a hybrid income/growth E&P corporate structure, rather than converting into a tax-efficient Canadian FAIT, is similarly nonsensical. They explained that because they expect Natural Gas Liquid (NGL) prices to remain at historically low levels for a while, the dividend they could afford to pay out would not be "competitive" and therefore a full-yield "model" was not the proper way to "package" these assets. They also said the market for such FAITs is "soft" at the moment. This same sort of jargon was echoed in several sell-side analyst reports after the review conclusion.
So let's analyze their reasoning to see if it makes sense. What they're trying to say is that because NGL prices in the mid-continent region (i.e., Conway, KS) are currently extremely low compared to WTI oil and compared to international NGL prices, and management expects them to stay that way for a couple of years (we disagree on that point but let's set that aside for the moment), the distributable cash flow (which is cash flow from operations minus capital spending required to hold current production flat) would be too small in a "full income model". In other words, they thought that the stock price would end up being low if the market assigned a typical dividend yield to such a trust. Therefore, they decided such a model was inappropriate and opted instead for a hybrid income/growth E&P structure along with "consideration" of so-called accretive acquisitions. The claim was that the market would assign the stock a lower dividend yield when placed in this class of hybrid income/growth E&P stocks, since such companies offer a combination of current yield plus future growth, and therefore the stock price would end up higher this way.
Well, before we get into more details on why their logic is so fallacious and disingenuous, it might be instructive to point out that EQU stock closed at $3.52 on the day the strategic review conclusion was announced (it was announced after the market closed) and the stock is now at $3.11, which is a 12% drop. So it seems the stock market is about as unimpressed with management's logic as we are.
The primary factor that should be considered when determining whether an O&G asset is appropriate for a dividend trust is the IRR of new drilling opportunities. O&G companies with undeveloped assets that offer compellingly high IRRs, which means the return on internal re-investment opportunities far exceeds that available to stock market investors generally, should not pay any dividends at all. For these companies, shareholder wealth is maximized by recycling all cash flow from operations back into new capital spending to grow production. Other O&G assets, such as Equal's Hunton asset in Oklahoma, offer "ok" IRR's under normalized commodity price assumptions but are not high enough to warrant much if any capital spending on production growth. So we think it's pretty clear that the Hunton is a good candidate for a dividend trust, which is optimized to deliver steady dividends to investors in a tax-efficient manner and where capital spending on production growth is minimal.
We find it disturbing that in management's discussions with us and industry analysts on their choice of corporate structure, they made real-world decisions with real-world consequences based on an erroneous guess of how the stock market would react in the short term. They used the low returns currently being earned on past capital spending, which is the root cause of the low distributable cash flow, as their justification for avoiding an income-oriented model and choosing a growth oriented one that requires even more capital spending. Could there possibly be a better example of upside-down logic?
It's also worth mentioning that if management really cared about the stock price they never would have retained $150M worth of cash and available credit, discussed the potential for future acquisitions, and failed to discuss the potential for massively accretive future share repurchases. Those were extremely shareholder-unfriendly decisions that give the strong appearance of a management team far more interested in empire building than in doing what's in the best interests of the shareholders.
Excessive Capital Spending
As I've said we're more optimistic than management about NGL prices in 2013 and 2014. However, let's set that aside because it's secondary to the main point we're trying to make here. In terms of decline rate, management says they're currently seeing a decline in the "14-15%" range but they think the decline may accelerate next year since they didn't do much drilling this year and some wells may be about to exit the "flat production phase" and enter the "exponential decline phase". Therefore, they told us they're working with a 16% decline rate and this number was confirmed in a recent analyst report. We're not convinced they're taking proper account of the "hyperbolic decline phase" that provides a counteracting effect, but again - let's set that difference aside since it's secondary to our main point and work with management's stated 16% decline rate.
Current production is 7,800 boe/d, so using management's stated decline rate they would need to replace 1,248 boe/d to keep production flat. Each Hunton well initially produces 150 boe/d on average, so that corresponds to 8.3 wells. Since the actual number of wells drilled must be an integer, we believe management should drill at most 8 wells in 2013. That means we might expect a very slight production decline by the end of 2013 - perhaps 48 boe/d, which means production may decline from 7,800 boe/d to 7,752 boe/d. That's an insignificant production decline in our opinion, and given how low NGL pricing is right now and management's rather pessimistic view on propane in 2013 and 2014, a 48 boe/d decline is absolutely nothing to worry about. Furthermore, our drilling plan will more than replace the reserves produced during 2013. Our 8 well drilling plan would require approximately $28.8M including maintenance capital spending.
Management, on the other hand, says they want to drill 10 new wells in 2013, which means growing production from 7,800 boe/d to 8,052 boe/d, this despite the fact that NGL pricing is extremely low and they expect it to remain that way for the next two years. The cost of management's economically unjustifiable capital spending budget is $36M, or $7.2M more than our plan. Just to put that number in perspective, management's announced 2013 dividend is $7M per year. So the cash saved on implementing our capital spending plan rather than theirs could be used to more than double the 2013 dividend.
The Berkshire Hathaway Model: Allocate Capital Just Like a Private Operator Does
The various facts and figures discussed above, and the differences between what we want done and what management wants to do, can really all be boiled down to the following: we want management to treat shareholder money as if it were their own. We found it intriguing that in private discussions with industry analysts about our capital allocation concepts and how they contrasted with management's, they readily admitted that no private operator in the Hunton would grow production in 2013 if they held management's view on 2013 and 2014 NGL pricing. As a matter of fact, a private operator would likely allow production to decline more than the negligible 48 boe/d associated with our plan. Why? Because it would be their own money they're spending on drilling capex that may very well turn out to be uneconomic, not someone else's money.
There's a great existence proof that it's possible for a publicly traded company to allocate capital the same way as privately operated companies do: Berkshire Hathaway (NYSE:BRK.B). Warren Buffett has always treated shareholder money as if it was his own, and he makes all capital allocation decisions precisely as a private operator would. As a matter of fact, most of the subsidiaries inside Berkshire Hathaway used to be privately run companies, so the "corporate DNA" of the company is set up this way. So we'd like Equal Energy to be run like that - where capital allocation and corporate structure decisions are made using sound economic and financial principles.
What Would Our Plan Mean for Equal Shareholders in 2013?
One interesting thing about allocating capital as we're suggesting is that we think it's pretty likely that the stock market would, in fact, react very positively to what we're proposing. This should not be used as the rationale for our proposed capital allocation policies, but it is worth pointing out that we see absolutely no conflict between allocating capital as a private operator would and the stock's likely short term reaction. Our proposals are for shareholder friendly actions, and shareholder friendly actions typically result in the stock price going up.
First of all, as noted in our press release we're calling for a $30M stock buyback implemented as a Dutch auction tender offer, with a price range between $3.50 and $4.50 per share. That would leave the company with $53M of net debt. If this buyback is implemented soon, while NGL prices are still very depressed, we think it's possible the Dutch auction would fill at the lower end of our range. But just to be conservative, let's assume it fills at the midpoint of our proposed range, or $4.00/share. (Note: we'd prefer it to fill at as low a price as possible because that would maximize the post-tender offer NAV/share for the shareholders who don't tender their shares.) That would leave 27.5M shares outstanding.
We believe that the annual dividend should be set using reasonably conservative long term commodity price assumptions. Management has indicated that our long term commodity price assumptions of $86/bbl WTI Oil, $39.60/bbl NGL, and $4.25/MMbtu HH natural gas are reasonable, but they are more conservative in regard to their 2013 and 2014 assumptions. So let's see what happens if we set the annual dividend according to our long term pricing assumptions but management is right about 2013 and 2014. We estimate long-term DACF of $45.3M and long-term Cash Flow of $42.0M. As noted above our total capex budget is $28.8M, which means that distributable cash flow is $13.2M. Therefore, the long-term sustainable dividend is $13.2M/27.5M shares = $0.48/share. We'd like to ask the reader to stop and think about that for a second. The stock is currently trading at $3.11/share with an announced annual dividend of $0.20/share. Any guesses as to what would happen to the stock if the announced annual dividend were increased to $0.48/share?
Now let's see what happens to the balance sheet over the next few years. Assuming the tender offer takes place either late this year or early next year, the Debt/CF ratio for 2013 would be $53M/$33M = 1.6x, which is very far below the 2.7x average Debt/CF ratio cited above. What about 2014? Well, in our plan the 2013 dividend exceeds distributable cash flow by $9.3M, so net debt would increase to $62.3M by year end 2013. Using management's stated propane price estimate of $1.05/gallon in 2014, we'd estimate 2014 DACF of $40M and 2014 Cash Flow of $36.4M. So the 2014 Debt/CF ratio would go up to $62.3M/$36.4M = 1.7x, still well within prudent limits. The 2014 dividend exceeds distributable cash flow by $5.6M, so net debt would increase to $67.9M by year end 2014. Our estimates and management's estimates converge in 2015 at around $45.3M of DACF which in our plan corresponds to $41.5M of Cash Flow. So 2015 Debt/CF ends up at 1.6x, back to where it started in 2013. Furthermore, the dividend now very closely approximates distributable cash flow which means it's sustainable.
The three main things we've called for in this article - a significant share buyback, a reduced capital spending budget, and an increased dividend payment - all flow naturally from one simple concept: management should treat shareholder money as if it were their own. They should allocate capital just like a private operator does. We know it's possible for a public company to behave this way since we have Berkshire Hathaway as the model to emulate, and we know what happens to shareholder wealth when management behaves as Warren Buffett does.