Penn West: The Chickens Have Come Home To Roost

| About: Penn West (PWE)


Penn West announces a management-initiated internal review of accounting practices.

This is a major negative event for the stock.

I would avoid Penn West until this matter is resolved.

With what can only be described as bad news, Penn West Petroleum (NYSE:PWE) today announced that it was initiating a voluntary internal review of accounting practices. The company noted that this review has not yet been completed. However, the company has concluded that certain historical financial statements and related management's discussion and analysis ("MD&A") must be restated.

What exactly happened?

While the press release is somewhat vague, when reading between the lines, we can gather a few key facts.

First, and likely most importantly, the company noted that:

The senior finance and accounting personnel believed responsible for the adoption and use of these practices have ceased to be employed by the Company.

In addition, Rick George, Chairman of the Board, noted that:

We have acted quickly and effectively to review our accounting practices. We will take the steps necessary to correct our historical financial statements and we will take appropriate steps to ensure that we avoid a similar situation in the future.

According the press release, the review arises from accounting practices that came to the attention of Penn West's CFO David Dyck, who only came on board on May 1, 2014. Mr. Dyck replaced Todd Takeyasu, who had stepped down from that role back on March 24, 2014.

The company's management then recommended to the BODs that an Audit Committee be put together in order to conduct an independent review. The Audit Committee consists of:

solely independent directors, retained independent Canadian and U.S. legal counsel, and an independent forensic accounting firm, to assist the Audit Committee in conducting its review.

Furthermore, the Audit Committee and its advisors have been examining and focusing on:

certain entries which appear to have been made to reduce operating costs and increase the Company's reported capital expenditures and royalty expense, and that appear to have been made without adequate supporting documentation. The accounting practices under review involve the capitalization of certain operating costs as property, plant and equipment, the income statement classification of certain costs and credits, and the timing of certain accruals relating to production, operating costs and capital. The review currently covers 2014 and the four previous fiscal years.

To put this in English, it appears as if previous financial statements have been fudging the numbers, lowering operating costs and misclassifying them as either royalty or capital expenditures. This would in effect boost the funds flow from operations ("FFO") number.

From the release, the preliminary findings from the review to date are as follows:

  • For the fiscal year 2013, the Audit Committee and its independent advisors have identified approximately $70 million in operating expenses that were reclassified to property, plant and equipment as capital expenditures without adequate support. For the fiscal year 2012, approximately $111 million in operating expenses were reclassified to property, plant and equipment as capital expenditures without adequate support. As a result, the property, plant and equipment balances recorded on the Company's balance sheets in those fiscal years appear to be overstated.
  • For each of the fiscal years 2012 and 2013, the Audit Committee and its independent advisors have identified approximately $100 million in operating expenses that were incorrectly reclassified as royalty expenses. This reclassification had no impact on net income or funds flow.

Note that the company stressed that these are preliminary figures and could change. In addition, the accounting practices were ongoing in years prior to 2012. However, the these are "quantitatively less significant."

How will this news impact Penn West?

To put it mildly, this is a major negative event for Penn West. Among the items mentioned in the release:

1) Penn West will be delaying its Q2 2014 earnings report.

2) Penn West will be restating its prior year financial statements for the years ended December 31, 2012 and 2013. It may also need to restate other financial documents and related MD&A.

3) As a result, Penn West's historical financial statements, reports, and other MD&A should not be relied upon.

4) Penn West will likely need to reduce its prior year reported capital expenditures, property, plant and equipment balances, royalty expenses and depletion expense and increase operating expenses.

5) Penn West may also need to revise its current year capital expenditure guidance and royalty expense assumptions and increase its operating cost assumptions

6) Penn West may need to reduce its 2014 funds flow ("FFO") guidance

7). Penn West now believes it may no longer be in compliance with certain of its covenants under its unsecured, revolving syndicated bank facility and the terms of its senior unsecured notes, subject to any applicable cure periods.

8) Penn West has established a blackout on trading by directors, officers and other insiders of Penn West and intends to continue the blackout until the Q2 filings and Restated Financials have been filed.

9) Regarding the dividend, Penn West expects to declare its Q3 dividend when it approves and files its Q2 2014 financial results


As I noted in a previous article, Penn West's senior management team was an absolute mess in early 2013, when longtime CEO Murray Nunns was essentially kicked out.

Furthermore, only a few weeks earlier, four senior officers left the company abruptly, including the former COO Hilary Foulkes, the top operations engineer Thane Jensen, and 2 other senior VPs ( James Burns - Corporate Planning and Wendy Henkelman - Treasury).

Penn West then brought in the very experienced, no nonsense, former Marathon Petroleum (NYSE:MRO) COO David Roberts as the new CEO. In a short time, Mr. Roberts had cleaned house, laying off a large chunk of employees, getting rid of the dead-weight legacy assets, and refocusing Penn West as a high-netback light oil company.

To that effect, Mr. Roberts noted the following regarding the current state of Penn West in light of the accounting concerns:

We continue to build on the substantial operational and structural improvements we have made to the business in the past year, which we have communicated in a separate release today that speaks to our operating performance through the second quarter. If you read that release, you will find that our asset quality and execution capability remain strong, our long-term plan for the Company remains intact, and importantly today, we are on target to deliver on our promises to our stakeholders. As a result of the improvements we have made to the business in the past year, we are a more resilient organization today.

However, while I did turn bullish Penn West after the very solid Q1 performance, this news has made me do a 180 degree turn.

Unfortunately, my previous view that Penn West was in the past a chronically mismanaged company turned out to be correct. The chickens have come home to roost for this stock. I would avoid Penn West until this matter is resolved.

Disclaimer: The opinions in this article are for informational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned. Please do your own due diligence before making any investment decision.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.