It is difficult to overemphasize the importance for Penn Virginia (PVA) of the highly successful $775 million debt financing transaction that the company priced after the close yesterday. The offering removes the not so insignificant funding uncertainty related to the Magnum Hunter (MHR) asset acquisition announced last week and, based on my estimate, provides an extra $45-$50 million of much needed liquidity relative to the initially announced financing structure. The offering was upsized from the initial $400 million to include a refinancing of existing bonds and bears at an attractive 8.5% coupon (priced at par) - an outstanding result. The proceeds will be used to tender for the company's $300 million face amount of 10.375% Senior Notes due 2016 and fund the Magnum Hunter acquisition.
The equity market should take note: the bond offering was very well received by the debt markets, despite the Caa1 rating from Moody's and a one-notch credit downgrade yesterday, and saw a very firm pricing.
The New Penn Virginia
Following the $400 million acquisition of Magnum Hunter's assets, the company now has critical mass in the Eagle Ford's prime section and significantly larger capitalization. Both factors should bring the name onto many investors' radar screens: the stock is emerging as essentially an Eagle Ford pure play distinguished by high quality acreage and moderate valuation. (On a pro forma basis, the stock is trading at 3.8x-4.3x FV / 2013 Pro Forma EBITDA, based on my estimate, which includes annualized EBITDA from acquired properties. I must caution however, that a NAV-based approach is typically required for valuing high-decline properties. I will discuss the NAV valuation of the stock in my follow up note.)
The pro forma 54,000 net acres are largely contiguous, blocked up and operated, and are located mostly within the highly sought-after volatile oil window, not far from some of the most prolific and publicized wells drilled by EOG Resources (EOG) in Gonzales County. While at first glance the size of the acreage position may appear not very large, potential for high-density development and attractive economics of this predominantly oil-producing area make the asset highly valuable. Oil potential in other zones, including Pearsall and Upper Eagle Ford, also exists.
Once a Haynesville high flier, Penn Virginia has struggled in the aftermath of the rapid deterioration of natural gas fundamentals and has seen its stock price demolished (the company's stock traded above $70 per share back in 2008). Penn Virginia has sold some of its legacy assets, issued dilutive equity, and almost completely refocused its strategy on the Eagle Ford horizontal oil play (de minimis amount of capital is currently being directed to other operating areas, which include the Granite Wash, Cotton Valley, Haynesville, and Selma Chalk).
Penn Virginia's current market capitalization is just $260 million (pro forma for the Magnum Hunter transaction), however the company's Firm Value is substantially larger due to its high leverage - approximately $1.5 billion on a pro forma basis. The Firm Value consists of approximately $1.1 billion of pro forma debt, $115 million of perpetual convertible preferred ($6 conversion price), and $260 million of equity (based on $4.00 per share and 65.1 million shares outstanding which includes 10 million shares assumed to be issued to MHR).
The mostly debt-financed acquisition of Magnum Hunter's properties was a gutsy move by Penn Virginia and has already cost the company a credit downgrade. (On Monday, Moody's cut Penn Virginia's corporate family rating to B3 from B2, citing the company's high leverage and limited production and proved reserve base. Senior Unsecured Rating was cut to a worrisome and typically very expensive for new debt issuance Caa1 rating from B3. Preferred rating was cut from B3-PD to B2-PD. Moody's does not expect positive rating action in 2013.)
I would note that the company's assets are more than sufficient to cover its debt. The PV-10 value of pro forma proved developed reserves is approximately $0.9 billion, based on my estimate using $4/MMBtu pricing for natural gas (the PV-10 value based on the SEC pricing is just under $0.8 billion). The PV-10 is split roughly half and half between the Eagle Ford and other areas. In addition, the ~420 potential drilling locations that the company has identified in the Eagle Ford (equates to a conservative ~100-acre spacing) can have an M&A valuation of over $0.5 billion, using the MHR transaction metrics. On a fully developed basis, the PV-10 value of the undrilled Eagle Ford potential can be substantially higher. The company's undeveloped prospects outside the Eagle Ford may also have some realizable value.
As the company's Caa1 bond rating clearly indicates, investing in Penn Virginia would not be for the faint of heart (a high risk investment that requires detailed understanding not only of the underlying assets and business plan but also the leverage aspect of the story). Having said that, the stock represents a high-octane option on the company's ability to execute well through the current rough patch (which may last for some time, until non-core assets are sold to bring leverage down to a more manageable level or until the Eagle Ford program turns cash flow positive in about two years, based on the indicated operating plan). Assuming positive operating results, the upside to the stock can be significant.
Leverage and liquidity remain the biggest challenge Penn Virginia is currently facing. While the company's 2013 budget appears funded, liquidity will remain very tight and funding sources for a portion of 2014 budget gap are yet to be identified. The company plans a 6-rig development program in 2013 for its Eagle Ford program (4 operated rigs and 2 non-operated rigs), with a total company-wide budget for the year of $457 million (midpoint of the guidance) versus operating cash flow of ~$230 million (my midpoint estimate based on EBITDA guidance of $295-$350 million). The ~$225 million outspending may lead to the company using up the larger part of the availability under its ~$287 million credit facility post the acquisition by the end of 2013. If the Eagle Ford drilling program continues to show strong results, as it has so far, it is possible that the company's borrowing base under its revolver will be increased, which should help to bridge the expected ~$100 million budget deficit in 2014. Drilling cost reductions and strong drilling performance also have potential to add internally generated funds.
Penn Virginia's Eagle Ford Position Looks Attractive
The high quality of Penn Virginia's existing and acquired acreage is confirmed by results from over a hundred producing wells drilled to date. Penn Virginia has 71 producing wells on its acreage and estimates EURs at >400 MBoe per well in Gonzales County and >500 MBoe in Lavaca County. Reserve mix at year end 2012 was 82% oil, 10% NGLs and 8% gas.
Magnum Hunter drilling results are consistent with Penn Virginia's. Penn Virginia's management attributes the somewhat higher IP rates seen on Magnum Hunter blocks to a slightly gassier production mix and longer laterals and believes that EURs are very comparable between the two operations.
Penn Virginia's and Magnum Hunter's acreage blocks are located at the northeast edge of the play's volatile oil/condensate trend. The area is somewhat less delineated than the central section of the play (see the well density map below). Given that a distance of just ten miles may make a big difference for well productivity in the Eagle Ford, some geological risk still exists for certain portions of Penn Virginia's acreage, particularly in Lavaca County. However, the larger portion of the acreage has been fully de-risked, and the remaining geological uncertainties are, in my view, moderate. Importantly, Penn Virginia has indicated that the delineation wells they have recently drilled at the southern and eastern edges of their acreage in Lavaca County have been very strong. One of the wells, according to management, was the company's second strongest well they have drilled in the Eagle Ford and showed a high oil yield.
As the map at the top of this section shows, Penn Virginia's acreage is "on trend" with and immediately adjacent to EOG's and Marathon Oil's (MRO) acreage blocks (EOG is shown in green and Marathon in blue). EOG has drilled some of its most prolific wells in the area. The four wells on EOG's Boothe and Burrow leases had spectacular IP rates:
- Boothe #1H: 5,380 b/d of oil + 625 b/d of NGLs + 3.6 MMcf/d of gas
- Boothe #2H: 3,810 b/d of oil + 525 b/d of NGLs + 3.0 MMcf/d of gas
- Burrow #1H: 5,424 b/d of oil + 600 b/d of NGLs + 3.5 MMcf/d of gas
- Burrow #2H: 6,331 b/d of oil + 713 b/d of NGLs + 4.1 MMcf/d of gas
For reference, EOG has guided towards 400-450 MBoe net EUR per well for their entire Eagle Ford operation which implies 500-600 MBoe EUR on a gross basis.
Well results from Marathon Oil provide another positive confirmation data point for Penn Virginia's acreage. A map shown in Marathon's latest presentation captures the larger part of Penn Virginia's and Magnum Hunter's acreage as "core" (the map below). The slide below also shows very strong well results on Marathon's South Barnhart acreage where the company's four most recent wells had average 30-day IP rate of 1,378 Boe/d.
Magnum Hunter Acquisition Is Attractively Priced
From a valuation perspective, Penn Virginia's Magnum Hunter acquisition looks very attractive. PV-10 value of proved developed reserves associated with the properties is $156 million. The properties include gathering infrastructure. Implied acquisition cost per undeveloped location is less than $1.5 million (169 net locations on ~100-acre spacing; the acreage may offer substantial additional downspacing upside as well as oil potential in multiple zones). Implied acquisition cost per undeveloped acre is less than $15,000. These metrics compare favorably to other similar transactions in the Eagle Ford "core."
In their presentation, Magnum Hunter has provided drilling economics estimates which indicate 50%-60% IRRs and $7-$8 million PV-10 per well based on today's oil price environment. This leaves a very comfortable cushion for return on investment for Penn Virginia.
It remains quite remarkable that Penn Virginia and not one of the larger, deep-pocketed operators with adjacent acreage - which include EOG, Marathon and ConocoPhillips (COP) - ended up with the ownership of what appears to be a high quality asset package.
Pro Forma Financials
Well Costs Need To Come Down
High drilling and completion cost is an issue that Penn Virginia still needs to address. The company recognizes that its current well costs of $9.1 million in Gonzales County and $10.1 million in Lavaca County are high and have significant room to come down. During the acquisition conference call, management commented that they expect to lower their costs as the year goes on. Completion costs are expected to decrease from $1 million to $1.5 million as the company's pumping service contract rolls off. Management also expects lower rig dayrates as some of its 3-year rig contracts roll over. The company expects "some fairly drastic changes in our cost coming down as we get into the second half of the year." At the moment, the company's guidance reflects the higher well cost.
The cost reduction is clearly needed. Comparison with the "leading edge" $6 million cost per well demonstrated by EOG - who is admittedly the most cost-efficient operator in the play with an estimated $1-$1.5 million "edge" over its peers - is particularly striking.
The Magnum Hunter acquisition is indeed a transformational transaction for Penn Virginia, as the company now has a large, high quality asset platform to execute on. Financial leverage may be a positive from a return perspective, if the company manages to avoid dilutive equity issuance in the next two years and executes well at the operating level.
The stock may look very different already twelve months from now, with stronger production and cash flow, fully delineated acreage, reduced drilling and operating costs, and much improved credit metrics.
The stock price, which is currently "compressed" by credit-related issues, has potential to deliver substantial upside. However, significant execution, funding and dilution risks remain.
Disclaimer: This article discusses only few of many critically important considerations related to potential investment in any of Penn Virginia's securities and cannot be a basis for investment decisions. This article is not an investment recommendation. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. This article is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.