It was announced Wednesday that Magnum Hunter Resources (MHR) sold all of its Eagle Ford Shale properties for $401 million to Penn Virginia Corporation. CEO Gary Evans said of the transaction on the press release,
The announcement of the sale of this property today is 'bitter sweet' for our Management and Board. Our Company's entry into the Eagle Ford Shale initially began when we acquired Sharon Resources, Inc. back in September 2009 for $2.35 million, which was an all-stock transaction that resulted in 5.6% dilution of the Company at that time. Since the acquisition of Sharon, now known as Eagle Ford Hunter, the Company has deployed approximately $263 million of new capital for development in the Eagle Ford and has generated approximately $80 million of net cash flow from this region as of the beginning of this year. Based on the $401 million purchase price announced today and the net investment to-date, this implies over a two times return on capital invested over the past three years and an IRR in excess of 80%.
Gary states that the sale is 'bittersweet'. Based on the above numbers, I don't know how this sale is anything but sweet. Sure, Magnum Hunter was producing about 3,000 Boe/day net from their 43 gross wells in the Eagle Ford and sure, they had over 178 net identified locations from which to drill and sure, everyone knows that there is a very good probability of success when drilling in the Eagle Ford. And sure, they were in the oil window of the Eagle Ford which means they just sold apart from their Williston Basin leases, their most oily assets. However, from a valuation perspective, they just transformed their company. This should be viewed as a tremendous positive for Magnum Hunter and dare I say that their stock could double in the very near term.
Here is why this transaction transformed Magnum Hunter. Before the transaction, Magnum Hunter had a debt to equity ratio of 144%. For oil and gas companies, normal debt to equity ratios usually average about 100%. EOG Resources (EOG), Apache Resources (APA) and Devon Energy (DVN) have debt to equity ratios of 105%, 97%, and 103% respectively. After this transaction, if Magnum Hunter were to use all $400 Million to pay down debt, they would have a debt to equity ratio of about 80%! This means that the company has much more flexibility when deciding how to deploy its capital. For example, they could pursue more acquisitions.
However, let's say that the company chooses not to pursue more acquisitions, but rather use their cash to pay down debt and fund their capex program. (This is what the press release said they would use it for.) With that being the case, after this divestiture, they will now have a book value of about $1 billion. Whereas, they are trading around $4 with a market cap of $650 million. That means that after this transaction, they are going to be trading close to 65% of book value or a 35% discount. For an oil and gas company whose profile is centered around the Bakken Shale and the Marcellus Shale to trade at 65% of book value seems odd. Especially considering those are two the most prolific shales from both a producing and a rate of return perspective in the United States. Just look at Magnum Hunter's slide below comparing the rates of return for different shale plays and you will see that Magnum Hunter is located in the sweet spot when it comes to shale plays.
So what positions does Magnum Hunter have left after selling 19,000 net mineral acres to Penn Virginia (PVA)?
According to the latest company presentation, they still have 7,000 net mineral acres remaining in the Pearsall shale, 180,000 acres in the Williston Basin, and 467,000 acres in the Appalachia Basin. Of those Appalachia acres, 85,500 of them are in the Marcellus Shale, and 81,800 net acres are in the Utica Shale. All three of these shales provide excellent rates of return. For example, here is a chart that shows the sensitivity analysis of Magnum's IRR on a Marcellus Shale well.
Furthermore, Magnum Hunter has a good portfolio of midstream assets that also balance out its portfolio. Magnum Hunter has even spoken about spinning off their midstream assets into an MLP to provide even more cash to the balance sheet. There is likely one more divestiture coming in 2013 and that may be it.
Magnum Hunter is grossly undervalued at $4. In order for Magnum Hunter to be fairly valued, it should be trading closer to $6 based on future cash flows which are scheduled to grow at a strong pace. This chart from Credit Suisse that shows Magnum Hunter near the top of its class when projecting debt adjusted cash flow through 2014.
In conclusion, Magnum Hunter is worth a closer look based on the fundamentals. By the end of 2013, Magnum Hunter will be producing over 20,000 BOE/day even after the Eagle Ford sale. Ask yourself, does an oil company with a strong balance sheet that produces over 20,000 Boe/day deserve to be valued at $650 million. Put another way, should an oil company with a strong balance sheet trade close to 1.5x next years revenues when most oil companies trade closer to 3 or 4 times revenues? I would argue not.
In my next article, I will dig deeper and try to put an accurate value on Magnum Hunter Resources.
Additional disclosure: I initiated my MHR position on the news today.