GeoMet (OTCQB:GMET) is an interesting event-driven opportunity for individual investors but before even considering it, I thought it was prudent to highlight some big risks with the company ahead of any discussion as opposed to the typical disclosures after the analysis. One can invest in GMET via its common equity or its preferred shares (GMETP) but keep in mind that GMET's market capitalization is currently just ~$12MM (assuming full dilution of GMETP) and trades at $0.14. This is a real company and has been mentioned of late on Seeking Alpha given the high level of M&A activity in the natural gas space. Keep in mind that a large portion of the stock is controlled by two energy focused firms - Yorktown and Sherwood Energy - and as a result this is the type of company whose stock is highly illiquid at current levels. I have been a long time holder of the stock but largely wrote it off until the past quarter where I believe there may be some value for the shareholders. Nonetheless, the significant shares held by the two controlling shareholders, business/bankruptcy risk, and small market cap make this a play solely for individual investors who can approach this understanding the risks, the overall catalysts that could be available for GMET, and invest/acquire shares in a very disciplined manner.
GMET is a coalbed methane operator, with operations in Alabama and the Central Appalachian Basin in Virginia and West Virginia. The stock has been demolished due to the challenging environment in recent years, hardly a surprise to anyone following a number of natural gas operators and the asset itself.
The multi year decline in natural gas (nat gas) prices crippled GMET but not quite in the way one would initially expect. GMET actually hedges a substantial portion (targets 50% of production but hedged a higher amount, currently 90% hedged in 2013 at $3.80/Mcf) of its production which actually has resulted in life saving cash flow, particularly in 2012. However, its credit facility is backed by the value of its nat gas assets whereby every six months the banks calculate the asset value against the credit facility. If nat gas prices compress significantly in a short period of time, all of a sudden the company can find itself in violation of its credit agreement.
That's the crux of GMET's problem. With nat gas prices so low, GMET's banking group calculated that the company's credit outstanding exceeded the value (at the time) of GMET's nat gas asset base in June 2012. This was somewhat anticlimactic as most investors had assumed that this would happen given where nat gas prices were. Nonetheless, in just six months, GMET's allowable borrowing base shrank from $180MM in December 2011 to $115MM in June 2012, due in large part to the collapse in nat gas prices.
GMET had $150MM drawn on its facility in June 2012, which resulted in a violation of its credit agreement, which stipulated a maximum borrowing base of $115MM. However, in August 2012, the banks amended the facility, and split it into two tranches - Tranche A and B. Tranche A was the "good" tranche in that it held the portion of the facility that matched GMET's borrowing base (what the banks calculated they could lend to GMET based on the price of nat gas) of $115MM while Tranche B held the excess credit extended - the deficiency. Since this amendment, GMET's cash flows have been used to solely pay down Tranche B, which currently stands at $22MM. In addition, the amended deal matures on April 1, 2014, meaning the clock is ticking on GMET to cure the deficiency and subsequently refinance the facility. One could elect to a put a fork in it at this point and move on but the interesting thing is that GMET has a potentially strong catalyst ahead of it that could give it enough breathing room for equity holders to significantly benefit.
I think the main issue holding back the stock is what I described above. Nobody wants to get involved with this company given those issues. However, if they can be addressed in a successful manner, one can find that GMET is a viable operator in the CBM space and participate in a small company when nat gas prices may be priced at attractive levels. Secondly, keep in mind that the only covenant attached to the facility is the maximum debt level so if GMET can cure the deficiency, I think this bankruptcy risk is largely mitigated.
GMET had hired Friedman Billings and Ramsey (FBR) earlier in 2012 to help sell the entire company but that proved unfruitful. I was not surprised given the debt issues surrounding GMET a potential buyer would have to absorb. However, I felt that piecemeal sales of GMET assets could actually bring about more value and in February 2013 GMET hired Lantana Oil & Gas Partners (LOGP) to help sell all of its interests in the BWB and Cahaba region.
LOGP will be trying to sell non-operating interests in 1,058 wells in the BWB. The wells have royalty and/or overriding royalty interests and 498 of the wells have a 15% working interest. LOGP is also trying to sell GMET's 100% working interest in its 252 Cahaba Basin wells. These assets represent 30% of GMET's net daily sales, 38% of its 2012 operating income, and 31% of its proved reserves.
The hiring of LOGP is significant because that firm sold assets for Constellation Energy Partners (CEP) in the BWB just a month or two before they were engaged by GMET. LOGP sold CEP's interests in Robinsons Bend Production II and Robinsons Bend Operating II (RB) to Castleton Commodities Upstream LLC (Castleton) for $63MM. RB are located in the BWB and encompass 500 operating natural gas wells with leasehold interests and infrastructure. CEP hired LOGP in October 2012 and within a few months CEP's assets were sold with the deal closing at the end of February 2013, which suggests very strong appetite for these types of assets in the BWB. This is positive for GMET given its assets share a number of similarities but also some potential differences that could result in a more attractive valuation.
First, when speaking with CBM operators one will find that the RB location is generally less favorable than the White Oak Creek, Short Creek, and Blue Creek areas where GMET's BWB assets are located. Second, CEP's wells were operating while the majority of GMET's assets for sale are non-operating. In non-operating wells, the operating partner takes on the bulk of costs and expenses associated with the well, resulting in lower total production expenses on a per Mcf basis so the Mcf yield is higher. Basically non-operating wells can offer higher margins and thus should command higher valuations. The table below presents how CEP's RB assets stack up against GMET's assets for sale based on what one can infer from public filings and my expectation of potential valuation.
The CEP and GMET assets are comparable in terms of geography and production. The big difference and wild card relates to the operating/non-operating status and the types of potential buyers that would be interested. One of the challenges with GMET is that there are two distinct assets for sale - the non-operating BWB assets and the 100% working interest Cahaba basin wells - and I would expect the BWB assets to command a higher valuation than the Cahaba wells given the higher level of operating/capital required with 100% working interest wells.
Market participants know that RB sale represented all of CEP's Black Warrior Basin operations. If one refers to its most recent 10-K, CEP states that there was 49.4Bcf of proved reserves as part of its BWB operations, which equates to a $1.28/Bcf valuation based on the $63MM sale price. Using this metric, one would arrive at a $55MM valuation for GMET's Alabama assets. This is obviously subject to a number of granular comparison beyond public information as it relates to these assets compared to RB but overall we're in the same formation, GMET has arguably more favorable locations within the BWB, and a good portion of what's for sale is less capital intensive which should yield potentially better valuation. GMET indicated that the assets for sale represent 38% of 2012 operating income, which would be about $8.9MM of EBITDA. A $55MM valuation would equate to about 6.0x EBITDA which was generated off very depressed nat gas prices.
As of 2012 year-end, GMET had $7MM in cash and $139MM in debt. Assuming a $55MM sale price, debt would be reduced to $84MM and Adjusted EBITDA on a pro forma basis for the sale would be about $15MM. GMET would have roughly $84MM of debt and $77MM of net debt after the sale, which would equate to net leverage of 5.3x. Most importantly, Tranche B would be retired as well as a substantial portion of Tranche A and GMET's deficiency would be cured and the overhang on the stock removed. The borrowing base deficiency has been the primary issue surrounding GMET and I believe with the overhang of that risk removed, the stock could establish a "normalized" valuation as market observers consider the equity might be worth more than virtually zero.
LOGP was able to move the RB assets through a relatively short period of time and I suspect they are working with GMET under the same expectation of strong investor appetite for Alabama-based CBM assets. This could make for interesting timing because June 2013 would be the next time the banks establish a borrowing base determination. The chart below shows historical nat gas contract settlements and the correlation between GMET stock price and the significant crash from June 2011 through April 2012 is pretty apparent. GMET stock did not rebound similar to nat gas pricing because the company was "stuck" due to the borrowing base deficiency.
However, if an acceptable asset sale occurs and the deficiency is cured, I would imagine the new borrowing base could provide a bit more breathing room when it is recalculated in June. Recall that GMET's borrowing base at December 2011 was $180MM, which corresponds to settlement prices in the $3.50 range. In April 2012 the Henry Hub spot price closed at $1.825/ MMBtu, its lowest level in over ten years. Nat gas prices are now getting close to the 2011 levels so while I don't expect a huge upward revision in GMET's borrowing base, even a slight increase of a few percent would be welcome as it relates to GMET. In addition, NYMEX nat gas futures have continued to move upwards, buoyed by inventory data by the EIA. Obviously the new borrowing base would be determined on the reserves post the sale of Alabama assets but any sign of additional breathing room in terms of the difference between the borrowing base and post sale debt outstanding would be another positive catalyst.
So the ultimate question is what could GMET be worth with the borrowing base deficiency removed? If the Alabama assets are sold for $55MM, GMET's pro forma balance sheet would carry about $77MM in net debt and I would expect adjusted EBITDA of roughly $15MM. One should note that GMET paid down $20MM of debt despite a horrific nat gas pricing environment in 2012 and continues to pay down debt each month. As a result, by June 2013 I'd expect another $3-5MM of debt to have been paid down as the auction process proceeds. So overall, net debt as of June 2013 could be around $70MM-75MM.
The Alabama assets represent 31% of GMET's proved reserves meaning GMET would have 95 Bcf post sale. I used a crude estimation shown in the table below whereby I compared the borrowing base in 2011 and 2012 against GMET's proved reserves in Bcf. I would expect that current gas prices and their trajectory based on NYMEX gas futures would mean that the post sale borrowing base would be around $85MM-$90MM if not higher, meaning GMET post sale would be within its borrowing base. One thing to note is that GMET took a 47.1 Bcf writedown to its reserves in 2012 due to the price of natural gas. This was in addition to a 57.2 Bcf writedown the company recognized in 2011 related to proved undeveloped reserves GMET felt were uneconomical in the 2011 natural gas environment. Here's the kicker though, the writedown was based on these reserves being uneconomical over the next five years. The reserves are still there - owned by GMET - but written down entirely due to a challenging pricing environment from 2011 - 2012. I think there's a lot of hidden value, even if those reserves can't be revised upward, that GMET can point to with lenders and investors as gas prices improve.
While some might point to a small difference between the likely new borrowing base and what GMET's overall debt balances would be post sale, it's important to keep in mind that CEP went through a similar situation. Since closing on the RB transaction, CEP's debt is roughly $34MM and its borrowing base now stands at $38MM. However, reviewing CEP's stock action once news of its sale came out, it was clear that market participants began focusing on the long-term CEP story with the overhang of debt issues removed.
If GMET can successfully complete a sale of its Alabama assets at a $50+MM valuation, its solvency risk will largely be resolved. The table below presents where I think GMET equity could be worth if a sale as discussed above is completed and the blue highlights what I believe to be a reasonable valuation. Note that GMET is currently valued at 6.0x EV/EBITDA and 1.04x EV/Bcf reserves. This valuation is based on its current distressed situation and low pricing for nat gas assets. Under the scenario I highlighted in blue, GMET at a $30MM market cap would still be valued slightly less than it currently is now based on its post sale Bcf and just a half turn more in terms of EV/EBITDA, despite being in much better shape.
There are also a few other considerations to factor that could make the case for a higher valuation. GMET like a number of nat gas plays has had to recognize significant asset write downs. As previously mentioned, GMET like a number of nat gas participants incurred significant writedowns to its reserves in recent years. The reserves are still there - owned by GMET - but written down entirely due to a challenging pricing environment from 2011 - 2012. Further, accounting rules prohibit these assets from being written up so even if pricing improves, GMET can't write up the value of its reserves.
So under a truly normalized basis, I could see GMET post sale valued over $60MM in market cap. The reason being, on an EV/EBITDA basis the market, as is typical with cyclical names, would asses a higher valuation to trough operating performance (cyclical cos tend to have low multiples when their operating performance is greatest and vice versa). Secondly, while the EV/Bcf valuation would be about 1.4x, this would be based only on book Bcf which has incurred massive impairments. If you adjust for impairments and only focus on depletion, the EV/Bcf valuation would be much cheaper.
Obviously GMET management has a lot to pull off in the coming weeks but if they can, I think there's a lot of hidden value and market participants, such as potential buyers of GMET's Alabama properties, are likely to start paying attention. Right now nat gas assets are getting a good bid in the M&A market which is helping defray the risks of a number of nat gas companies' capital structures. If buyers are starting to invest privately via M&A transactions, it could suggest the overall outlook for nat gas is improving. If this improvement can continue there could be a solid case for valuation improvement for nat gas plays such as GMET. One can invest in GMET via the stock or GMETP preferred shares but given the current price and solvency situation for GMET I have assumed full dilution (GMETP recovery = nil, stock and preferreds are equal). Keep in mind, however, that GMET is still a risky play and its future largely rests on this sale.