In the first 2 articles of my series on Legend Oil and Gas (OTCPK:LOGL) (here and here), I made a case against the men leading the company based on their previous corporate involvement in 4 separate companies which were the subjects of pump and dump schemes utilizing numerous paid stock touts. In all 4 cases, these companies today stood between 87-95% below the peak prices realized during the “pump” stage of the schemes.
Although management is the foundation upon which a business is constructed, there are also other aspects of a business. To gain a full, 360-degree view of a company and its intrinsic value one must also examine the company itself, not just the men running it. Today I will analyze the corporate history and present-day business of Legend Oil and Gas. I will chronicle how, thanks to a combination of slick corporate transactions and a healthy dose of paid-pushing by stock promoters, Legend has arrived at the point where it is today: astonishingly overvalued and utilized like an ATM machine by its founders to personally extract funds at the expense of shareholders. I will illustrate that Legend is a marginal oil company with negligible business activities to date. Furthermore, despite the hype surrounding the recent acquisition of assets from International Sovereign Energy Corp., the assets’ questionable economics, newly created off-balance sheet liabilities and management’s greed ensure that this transaction will do little to enhance Legend’s dubious intrinsic value.
The Birth of Legend Oil: How James Vandeberg and Marshall Diamond-Goldberg Manufactured Millions of Dollars of Wealth on Paper in Their Names
Legend Oil and Gas was born on May 18, 2010 when James Vandeberg purchased an 82.44% interest in the common shares and 100% ownership of the preferred shares of a shell company called SIN Holdings (SNHI). The price ticket for the 6,000,000 common shares and 100,000 preferred shares was $191,000 and the seller was a man named Steve Sinohui. Based on this transaction, the implied full valuation for the company at this point was $231,684 ($191,000/0.8244). The transaction’s change of control filing is available here.
Sinohui’s declared disposition of ownership is viewable here and James Vandeberg’s initial statement of ownership can be accessed here. During the change of control transaction, 151,000 shares were also gifted to an undisclosed third party, which is described on page 14 of the 10-Q for Q2 2010. The preferred shares were also cancelled subsequent to the change of control. According to his statement of ownership, Vandeberg later cancelled 4,250,000 shares which left him with 1,599,000 shares.
Marshall Diamond-Goldberg entered the picture when he joined Legend in October 2010, as is described in that year’s 10-K:
On October 1, 2010, Mr. Vandeberg transferred 605,600 shares of restricted common stock of the Company held by him to Marlin Consulting Corp an entity wholly owned by Marshall Diamond-Goldberg. Mr. Vandeberg also gifted a total of 548,800 shares of restricted common stock of the Company to three other persons. These transactions resulted in Mr. Vandeberg owning 595,600 shares of restricted common stock an approximately 20% interest in the Company.
Also described in the same 10-K is an October 5, 2010 transaction where Legend did a 20-for-1 forward split of its stock, meaning each share in existence at that point became 20 new shares. Post-split, Diamond-Goldberg and Vandeberg owned 12,112,000 and 11,912,000 shares, respectively. In April 2011, they each cancelled half of their shares, according to form 4 filings here and here. Ultimately, Diamond-Goldberg and Vandeberg were left with with 6,056,000 and 5,956,000 shares, respectively. By the end of Q2 2011, Legend’s shares were trading at $2.07 per share, meaning that on paper, Diamond-Goldberg and Vandeberg’s stakes were worth $12.5 million and $12.3 million each.
What had fundamentally changed to justify the dramatic increase in the value of this former shell company of which 82.44% was purchased only 11 months earlier for $191,000?
The value of a company in the long run is based on a company’s assets and their ability to generate cash flow and profits. Therefore, examining Legend's 10-K for 2010 and 10-Q for Q2 2011 are good places to start looking for clues to the answer.
During 2010, but after the change of control transaction, the company received $900,000 in funds based on 2 unregistered private placements to undisclosed foreign investors documented on page 40 of the 10-K:
On October 26, 2010, the Company sold 1,300,000 Units to a foreign investor in exchange for $650,000, or a per Unit price of $0.50. One Unit consists of one share of restricted common stock and one warrant to purchase an additional share of common stock at $0.50 per share for a period of 3 years.
On December 3, 2010, the Company issued 500,000 shares of restricted common stock to a foreign investor in exchange for $250,000, or a per share price of $0.50.
During 2011, there was an infusion of $400,000 of cash into the company via 2 unregistered private placements to undisclosed foreign investors described on page 21 of the 10-Q:
On February 2, 2011, the Company completed an offering and sale of 300,000 units at a price of $0.50 per unit, for a total of $150,000 in proceeds, to one foreign investor residing outside of the United States. This offering was exempt from registration pursuant to Regulation S under the Securities Act of 1933, as amended (rules governing offers and sales of securities made outside of the United States without registration). Each unit consisted of one share of restricted common stock and one warrant to purchase an additional share of common stock of the Company at $0.50 per share with a term of three years. As of June 30, 2011, no warrants had been exercised.
On April 28, 2011, the Company completed an offering and sale of 250,000 units at $1.00 per unit, for a total of $250,000 in proceeds, to one foreign investor residing outside of the United States. This offering was exempt from registration pursuant to Regulation S under the Securities Act of 1933, as amended (rules governing offers and sales of securities made outside of the United States without registration). Each unit consisted of one share of restricted common stock and one warrant to purchase an additional share of common stock of the Company at $1.00 per share with a term of three years.
We can also see via the cash flow statements in the 10-K and the 10-Q that until that point, the warrants issued in 2010 and 2011 had still not been exercised. Based on these fund-raising transactions, the company’s overall valuation should have increased by $1.3 million, the total amount of funds raised. This gives Legend a theoretical “at-cost” valuation of $1,531,684 ($1.3M in funds raised + the shell deal’s implied valuation of $231,684).
In the time period from change of control through the end of Q2 2011, Legend used some of the funds raised to acquire properties, as can be seen in the cash flow statements of the 10-K and 10-Q. In 2010, Legend spent $628,600 purchasing properties and in the first 6 months of 2011 it spent $171,774. These transactions would not lead to an increase in the total book value of the company since they just represent a reclassification of cash assets into property assets.
As I will show, an increase in the intrinsic value of these properties during this period cannot justify the increase in valuation that occurred through Q2 2011. The cash flow statements disclose that there was no additional investment into the properties up to that point. Since there was no additional investment in the properties, it cannot logically be the case that the increase in value they experienced was due to a major change in their status as producers. Additionally, without any incremental investment in exploration, their underlying reserve numbers also should not have changed.
Between October 29, 2010 when Legend purchased its first property and July 1, 2011 the price of oil increased from $81.43 to $94.94. This could justify some increase in the fair-value of the properties which would translate into a fair value for the company that was somewhat higher than the $1.53 million “at-cost” value assigned earlier. Yet the market capitalization of Legend had increased to $97.3 million, based on the 47.0 million shares outstanding as of June 30, 2011. This represents an increase vs. the “at-cost” value of 6259.5%, or 62.5 times. Oil markets have consistently experienced the kind of volatility that occurred between October 29, 2010 and June 30, 2011 for many years now and it is unlikely that any seller would sell an asset to Legend that would increase in value 6259.5% in 8 months based on a short-term $13.51 increase in the price of oil and no additional discoveries.
It is unreasonable to argue that the intrinsic value of the company could have increased by $97 million based on the material developments that occurred at the company itself or within the oil market at large. A $1.3 million infusion of capital and $800K spent purchasing properties is certainly not sufficient to justify an increase in valuation from $231,684 to over $97 million by the end of Q2 2011. What was most likely supporting the unreasonable stock price was the powerful mix of a tightly-held and manipulated float, coupled with several concurrent paid-for stock promotion campaigns via online email blasts and conventional “snail-mailers”. The first was by James Rapholz documented here in March 2011 and then came another by Eric Dany in April 2011. By searching Google for results from a specific time period, May 18, 2010 – June 30, 2011, we can establish that paid stock promoter Don McShane also began touting Legend’s stock during this period.
Current Oil Production is Negligible with Poor Development Results to Date
So far, we have examined the history of Legend Oil through June 30, 2010. Let us now examine the state of the company today based on their most recent 10-Q and relevant subsequent filings. For their Kansas property, the single producing property as of the 10-Q for Q3 2011, Legend revealed:
Oil production (“bbls”) increased 62.5% during the three months ended September 30, 2011, as compared to the three months ended June 30, 2011 (see table above). Production increased due to the completion of drilling three wells, the recompletion of the drilling of a fourth well, and general streamlining and improvements to our existing well operations.
While this might sound impressive, oil production in nominal terms grew by only 3.5 Barrels of Oil Equivalent per Day (“BOEPD”). With an average operating margin in 2011 of $18.52/BOE, this adds a mere $23.6K of operating margin on an annualized basis. These gains should also not be viewed as existing in perpetuity because over time, they are likely to experience declines and increased water content vs. oil without additional capital spending. Based on the daily production rate achieved in Q3 2011 of 9.2 BOEPD and an average operating margin per barrel (“netback”) of $18.52/BOE for the first 9 months of the year, which is actually higher than Q3's netback, on an annualized basis Legend Oil is on track to produce a total operating margin of $62,190 (9.2 BOEPD x 365 Days x $18.52/BOE).
I want to note that Legend’s operating margin of $18.52/BOE also seems to be exaggerated based on other figures in their financials. Based on the table found on Page 21 of their 10-Q, Legend produced 1877.4 BOE in the first 9 months of 2011. Additionally, in their income statement they disclose oil revenue of $162,854 and lease operating expenses of $136,814. This equates to an average sale price of $86.74/BOE and lease operating expense of $72.87/BOE. Subtracting the operating expenses from the revenue we arrive at an operating margin figure of $13.87/BOE, not $18.52/BOE as Legend states in the table on Page 21. These inconsistencies may be indicative of larger issues related to the accuracy of Legend’s supplemental disclosures, but for analysis’ sake I will give them the benefit of the doubt and simply use the higher figure here because given how little oil they are producing, it doesn’t matter to the overall investment thesis.
Since purchasing them, Legend has not spent any money exploring its non-producing properties. The 10-Q discloses on page 17 that it holds a 10% working interest in these North Dakota properties. Based on the subsequent acquisition of International Sovereign Energy, it does not currently possess the financial ability to even commit to a single well here which is disclosed on page 17 of the 10-Q as having a potential cost of $600,000 ($6M x 10%). Additionally, Legend has never disclosed the identity of the holder(s) of the 90% working interest in the properties in either in a press release related to the properties or a 10-Q. This is very suspicious and in the best case scenario represents remarkably deficient disclosure.
Overall, as of September 30, 2011, the company had a figure of $62,200 representing annualized cash flow from their producing oil properties. Furthermore, the operating margin referred to here has absolutely no allocation of overhead or general and administrative expenses. This is an important distinction because relative to its scale, Legend Oil currently has sky-high G&A expenses.
Poor Operating Results Have Little Connection with Excessive Executive Salary
Contrast meagre operating results such as those outlined with the salaries paid to executives at Legend Oil, and it becomes apparent that there is a large disconnect and perhaps very little direct relationship between the business performance of the company and executive compensation. Legend announced in their most recent 10-Q:
Effective July 1, 2011, the Board of Directors increased the amount of compensation paid to our President, Mr. Diamond-Goldberg, from $8,400 per month to $26,250 per month, which amount is being paid to Marlin Consulting Corp., of which Mr. Diamond-Goldberg is sole owner. Under the consulting services agreement, Mr. Diamond-Goldberg is also entitled to a “gross-up” to cover applicable taxes. Also effective July 1, 2011, the Board of Directors increased the amount of compensation paid to our Chief Financial Officer, Mr. Vandeberg, from $5,000 per month to $20,833 per month.
Executives both more than tripled their salaries and in nominal terms Diamond-Goldberg and Vandeberg are making $315,000 and $250,000 per year respectively, or $565K in total. These generous salaries are in spite of the fact that Legend Oil had oil revenue of only $163K in the 9 months of 2011.
From a corporate governance standpoint, this is made worse because the board of directors, a corporate entity that is supposed to protect shareholders, consists only of James Vandeberg and Marshall Diamond-Goldberg. This isn’t to say a similar transaction wouldn’t still be approved with a larger board in place, since additional board members who in reality are willing to be subjugated to management aren’t too hard to find. Still, it is worthy of noting that these officers/directors are the only legal gatekeepers to an ostensibly public company and are at the same time giving themselves large raises in salary significantly above and beyond what the company can support.
The executives/directors of Legend Oil appear to run the company in a kleptocratic and dictatorial manner, looting the entire company cash flow without any shareholder recourse. Based on their new salaries, executives Marshall Diamond-Goldberg and James Vandeberg are on track to pay themselves significantly more than the company's producing properties have been able to generate in operating margin on an annualized basis. This results in a projected annualized cash flow shortfall due to executive salaries of approximately $500K.
Assets Recently Acquired from Quasi-Related Party Are Marginal, Result in Significant Off-Balance Sheet Liabilities and Primarily Serve to Enrich Insiders
On October 20, 2011, Legend Oil filed an amended 8-K with respect to the closing of a previously announced agreement to acquire the majority of the producing assets of International Sovereign Energy Corp. (“ISEC”), a company which was listed on the Toronto Stock Exchange but recently elected to delist and relist on the NEX, the lowest-tier Canadian stock market. I call ISEC a quasi-related party because Marshall Diamond-Goldberg served as a director for the company until July 1, 2011, 2 months before the acquisition was announced.
The original price agreed upon was to be $9.5 million in cash and 3.75M common shares. However, the 8-K/A reveals that:
The net purchase price for the Sovereign Assets paid at closing was CA$8,905,031 in cash and 3,552,516 Common Shares. At closing, the purchase price was adjusted, on a pro-rata basis, for each Boepd (barrel of crude oil equivalent per day) that Sovereign’s monthly average Boepd production during the month of August 2011 was below the threshold production level of 300 Boepd, as provided in further detail in Article 4 of the Asset Purchase Agreement. This resulted in a downward adjustment to the purchase price at closing, reducing the cash portion to CA$9,105,031 and reducing the number of Common Shares to 3,552,516 shares. Also at closing, Sovereign made a working capital adjustment payment in the amount of CA$200,000 to Legend Canada in accordance with the Asset Purchase Agreement, which reduced the net cash portion of the purchase price to CA$8,905,031.
Looking at the original asset purchase agreement available here we can see that based on Article 4.1 found on page 14:
The Purchase Price will be reduced, by the Per Barrel Value, for each barrel of oil equivalent by which the August Monthly Average is below the Threshold Production, in an equal amount of cash and Common Shares valued at US$2.00 per Share.
Based on page 5 of the asset purchase agreement we can see that: “’Per Barrel Value’ means that each barrel of oil equivalent shall have a value of fifty six thousand, six hundred and sixty seven dollars ($56,667) for the purposes of Section 4.1”. So we can arrive at the assets’ August average production rate shortfall in BOEPD by taking the cash portion of the downward adjustment of $394,969, dividing by the $56,667 Per Barrel Value and then multiplying that by 2, since only half of the Per Barrel Value is measured in cash. We arrive at a production rate shortfall of 14 BOEPD, which means that the average August production of the assets was 286 BOEPD.
We can gain additional information about the operating metrics of these producing assets by looking at the Sedar filings, Canada’s equivalent to SEC filings, available for ISEC. In the Q3 2011 Management’s Discussion and Analysis section (.pdf), we learn that “ISR’s production for the nine months ended September 30, 2011 averaged 74% gas and 26% oil and natural gas liquids (“NGL”) production.” This is material information because it shows that ISEC is heavily weighted towards natural gas production which yields a significantly lower price per BOE than oil or NGL and also experiences steeper decline rates.
We can see on page 9 of the report (.pdf) that the assets acquired have a rapidly declining production profile having produced 292 BOEPD in Q3 2011 vs. 457 BOEPD in Q3 2011 amid “sizeable losses in gas production with the Boundary Lake and Berwyn fields ongoing water concerns.” We can also note on page 11 that the operating netback achieved by these assets was $16.66/BOE during Q3 2011. Using this number and multiplying by the most recent production rate we know, August’s 286 BOEPD, we arrive at an annualized operating cash flow for the properties of $1,739,137.
This amount is prior to any allocation for associated G&A expenses which is important to note because Legend has stated its acquisition of the properties required it to hire 2 full-time employees, a petroleum engineer in the position of Manager of Engineering and a Controller to manage the day to day operations. Although the salaries of these individuals has not been disclosed, this is likely to result in at least another $200k in annual overhead for Legend.
It is also important to examine the financing structure of the acquisition itself because it has major implications to the residual value of the assets for shareholders. The acquisition was in part financed by a commercial Line of Credit from National Bank of Canada (“NBC”). Note the disclosure on page 13 of the 8-K/A:
On October 19, 2011, Legend Canada drew down CA$5.4 million on its CA$6.0 million credit facility with the National Bank of Canada. The Bank has the right to demand repayment of the loan at any time. We currently do not have sufficient cash assets to repay the loan in full if the Bank were to demand repayment. We may not have sufficient funds to repay the loan if it is called earlier than we plan. In such a case, we would be forced to sell assets or renegotiate with the Bank. The loan is secured by security interests in all of the assets of Legend Canada, including the Sovereign Assets. In addition, the CA$6.0 million borrowing base under this credit facility is subject to an annual review by the Bank and there is no assurance that the available credit facility will continue to be available or whether it will be reduced. The next review is scheduled to occur on or before January 1, 2012.
NBC’s interest is fully secured against the properties, which by themselves do have a value associated with the positive future cash flows. In the offering document issued by NBC, it reveals that if there were any issue or default by Legend in respect to the Line of Credit, National Bank’s right to seize the property is backed up by a “$25,000,000 Debenture with a floating charge over all assets of the Borrower” which shall, “be registered in Alberta in a first priority position, subject only to Permitted Encumbrances.” The drawn portion of the Line of Credit has an associated floating interest rate of 4%, based on 1% above NBC’s “Prime Rate”, now at 3%. The undrawn portion is subject to a charge of 0.25% per year. Based on the $5.4 million already drawn, this translates to $217,500 of interest expense per year.
After applying these interest charges ($217.5K), the current shortfall in Legend’s ability to pay executive salaries ($500K), and the additional overhead of 2 new full-time employees (~$200K), it appears as though shareholders will likely be left with perhaps $821,637 or about 47% of annualized cash flow from the acquisition.
The acquisition of these assets has also saddled the company with a significant off-balance sheet liability in the form of a put option on the shares given to ISEC in the transaction. Page 13 of the acquisition’s 8-K/A reveals that if Legend is not listed on an exchange more senior than the OTCBB by March 31, 2012, that ISEC can force Legend to redeem the 3,552,516 shares exchanged in the transaction for $2.00/share, payable in cash. This translates to over $7 million dollars and based on Legend’s post-acquisition cash position of less than $1 million, if ISEC were to exercise this put option, it would bankrupt the company. I suggest that in light of much of the information presented in this series of articles, it is highly unlikely that Legend will be able to make good on the commitment to up-list its stock and there is a high chance this put option could come into play.
The acquisition also serves as a further illustration of the depths of management’s greed. Based on the information found on page 53 in the 8-K/A, Legend’s board of directors, which consists only of management, decided to award themselves a cash bonus of $110,000 for concluding the transaction. This is highly irregular and greedy considering that if they were truly creating value via this acquisition, management’s substantial existing share position would stand to benefit.
Overall, the acquisition of assets from ISEC will do little to enhance the value of Legend Oil and Gas. Based on their current production profile and rapid ongoing field declines, the ISEC assets acquired by Legend are marginal. Furthermore, due to of the aforementioned adjustments, the majority of associated after-interest cash flows have already been effectively earmarked away from shareholders. Finally, the off-balance sheet liability created as a result of this transaction presents the very real possibility of bankrupting Legend Oil within 4 months.
Arriving at a Fair Valuation for Legend Oil
Based on its current production in Kansas and the ISEC assets in Canada, Legend Oil can probably produce about $900K in operating cash flow after applying G&A and interest expenses. Applying a multiple of 10x, which is generous based on the various associated liabilities and management’s track record, we arrive at a total value for the equity of the company of approximately $9 million or $0.18/share based on 50.58 million shares outstanding.
If they were to be separated from the current management Legend Oil’s assets would probably be able to unlock some additional value, since via their inflated salaries, Diamond-Goldberg and Vandeberg are currently on track to consume over 30% of the cash flows produced from the properties. A decent point of reference is the third-party petroleum engineering reserve reports which assign a net asset value (“NAV”) to the properties themselves. For the Kansas Assets, this amounts to $956,000 based on the third-party report prepared by KLH consulting. Looking at the report prepared by InSite Petroleum Consultants on the ISEC assets, using the same 10% discount rate applied in the KLH report, the NAV of the Canadian assets amounts to $15,384,400. Finally, for the North Dakota leases, although the company has done absolutely nothing to prove the existence of oil here or enhance the value of these assets thus far, to be generous let us assume that these leases have increased in value 100% since their purchase earlier this year, giving us a value of $343,548.
Kansas Assets - $956,000
ISEC Assets - $15,384,400
North Dakota Assets - $343,548
Enterprise Value Based on Net Asset Value - $16,683,948
Less: Outstanding Debt - $5,400,000
Value of Equity - $11,283,948
Using this NAV, we arrive at a value for Legend’s equity of $0.22/share based on 50.58 million shares outstanding. Both cases illustrate that at Friday’s closing price of $1.59/share, Legend is substantially overvalued.
Today I have examined Legend Oil and Gas itself, documented its history of management greed, paid-promoter hype and evaluated the underlying intrinsic value of its assets. In Legend’s most recent press release, Marshall Diamond-Goldberg seems very proud to have “grown the company from zero production to over 300 BOEPD in less than one year.” Upon closer examination, one realizes that less than 10 BOEPD of this growth is organic growth “from the drill bit”, the majority being derived from a questionable corporate transaction. Based on its intrinsic value, Legend currently justifies only 11.3 - 13.8% of the current market capitalization. Conversely, Legend’s Stock currently has 86.2 - 88.7% downside based on this intrinsic value. That said, due to its off-balance sheet liabilities, Legend faces the real possibility of bankruptcy and 100% downside 4 months from now.
I had intended for Part 3 to be the final in this series, but upon closer examination of all the data it has become clear that the content of what I had originally planned to cover in Part 3 is so substantial that it ought to be covered over 2 reports. Therefore, Part 4 of the series will present concluding arguments, as yet unexplored supporting evidence that Legend Oil’s stock is the subject of a pump and dump scheme, and several instances where specific corporate malfeasance committed to date by Legend Oil and its executives merits an SEC trading halt of the stock.
Disclosure: I am short OTCPK:LOGL.