Miller Energy Resources (NYSE: MILL) provides a powerful combination of the characteristics that deep value investors prize:
- Extremely cheap: trading at a 70%+ discount to a very conservative estimate of its oil & gas assets in a safe, favorable geography
- Superbly aligned management: executives and directors own over 20% of the outstanding shares, and insiders have purchased more shares very recently. Executive compensation is closely tied to achieving revenue and profitability targets
- Safely financed: the company has low leverage and has a credit agreement in place for its current business plans
- Catalysts: Achieving production milestones in upcoming quarters will result in massive increase in operating cash flow, reveal its cheapness, and get past recent stumbles
Miller Energy Resources, headquartered in Knoxville, Tennessee had a long operating history as an oil and gas exploration & production company in the Appalachian region and continues to be one of the major producers in the region.
Miller's breakthrough moment was its consummation of one of the savviest deals ever seen in the industry: the 2009 acquisition of the Alaska Cook Inlet assets from the bankruptcy proceedings of Pacific Energy Resources after Pacific succumbed to the credit crisis. For merely $5 million, Miller purchased assets that cost hundreds of millions to build!
It is important to note that Miller is not merely a speculation about potential oil in the ground. These were formerly producing wells that were shut-in, and are now being worked-over with even more modern and efficient processes. Furthermore, Miller picked up hundreds of miles of geologic seismographic data on the deposits that underpin additional probable and possible resources. These Alaska assets now comprise the overwhelming majority of Miller's resource base and its primary mission is to unlock the value of these assets.
How did Miller pull this off? At first we were skeptical. But the answer, we realized, was a combination of keen insight and excellent timing.
The insight: Miller's geologists familiar with Alaska's Cook Inlet crafted a deal that carved away money-losing assets that were encumbered with legacy liabilities such as abandonment costs amounting to hundreds of millions of dollars.
The timing was also fortuitous. In the aftermath of the credit crisis, most oil and gas players were playing defense rather than offense, especially as oil prices crashed from $147 per barrel in mid-2008 to under $50 per barrel. Also, the resources in play, while impressive in their own right, were too small to move the needle for the majors who are increasingly focused on 'elephant' sized fields. Indeed, players like Chevron (CVX) had been divesting assets in the Cook Inlet. Other players were too slow in their maneuvers in bankruptcy court. In this context, Miller's nimble dealmakers were able to consummate the deal of the century, and there is no doubt or dispute about its ownership of these assets.
Beyond its ability for fantastic capital allocation and deal-making, Miller has been successful in achieving key near term priorities: obtaining financing and ramping up Alaska operations.
On the financing side, Miller was able to obtain a $100 million credit facility from Guggenheim without a dilutive equity raise. This will provide Miller with the capacity to achieve its near-term ambitions for getting Alaska operations ramped up. Since Miller executives have plenty of skin in the game, it is not surprising they strove hard for a good deal for shareholders.
Miller's Alaskan subsidiary, Cook Inlet Energy, is a solid operation, doing a great job of beating its targets for production. Miller's state of the art Osprey platform and its tight cluster of operations, and a seasoned local manager, David Hall, are making it an efficient, low cost operator in its market.
The market opportunity for Miller in Alaska's Cook Inlet is also very favorable. Unlike the lower 48 states, where a crippling gas glut has emerged, this region of Alaska actually faces a gas shortage. Natural gas prices there are more than twice those of the lower 48, making production more lucrative. Anchorage, Alaska's largest city, depends on Cook Inlet gas. With other burgeoning industries such as mining coming online, the energy demands of the area will increase. As a result, Alaska has laid out the red carpet for energy companies, providing generous incentives including a 40% state refund on money spent for drilling and exploration. Also, unlike most other US states, Alaska actually has a massive budget surplus and an impeccable credit rating. This fosters a predictable and friendly locale for energy companies such as Miller.
Let's take a closer look at Miller's oil and gas assets. The value of these assets is represented by the so-called "PV-10" of its proven, probable and possible resources. The PV-10 is the present value of the net cash flows (discounted at 10% per annum) expected to be generated by the company's resources. Miller's Alaska reserve estimates were compiled by Ralph E. Davis Associates, a highly reputed reservoir engineering firm that has been in business since 1924.
Proven Reserves (P1):
10.4 million BOE
PV-10: $396 million
Probable Resources (P2):
7.9 million BOE
PV-10: $259 million
Possible Resources (P3):
30.8 million BOE
PV-10: 596.9 million
To be ultra-conservative, let's focus only on Miller's proven reserves. This would disregard not only the massive probable and possible resources, but also Miller's valuable infrastructure, such as its processing facilities and modern equipment. Using Miller's diluted share count of 40 million shares, this equates to an intrinsic value of $9.76 per share. Over time, a valuation of over $20 per share would not be surprising, as some of the probable and possible assets get classified as proved reserves and some of its mid-stream assets get monetized.
At its price of about $3 per share, Miller is trading at a 70% discount to even this ultra-conservative valuation!
As point of comparison, exploration & production focused oil companies (such as Miller's neighbor in the Cook Inlet, Apache) routinely trade at large premiums (40% to 80%) to the present value of their proved oil and gas reserves. This is not even including shale plays that trade at multiples of their proven reserve base. This gives a glimpse of how conservative the valuation above really is.
What is even more interesting is that Miller's valuation is not a "someday, maybe" number. On its most recent quarterly earnings call, the company provided detailed milestones, literally on a well-by-well basis. The company indicated that production would exceed a run-rate of 4,000 barrels per day exiting calendar 2012. At this production rate the company will amply demonstrate that it deserves a market cap exceeding the P1 value above. The company will then gush cash flow that the company can use to obtain cheaper financing and reward shareholders by unlocking the value of its P2 and P3 resources.
The company is currently in the process of assembling and deploying a brand new rig on its offshore Osprey platform (owning their own rig provides much greater operational flexibility). They have laid out several highly specific milestones. Let's take a closer look at these upcoming production milestones detailed by Miller's management team in the recent call:
|Well Name||Target Production (boe/day)||Timeline|
Investors can measure and hold the company's management accountable to these well-defined milestones.
Why is Miller so cheap? Well, the market took a while to warm to the new kid on the block with humble origins. But the company was making strides toward playing on a bigger stage. It recently upgraded its auditor to a Big 4 firm, KPMG, and also got listed on the NYSE. By late July 2011 the stock price had an impressive rise to over $8.
In late July 2011, TheStreetSweeper, a firm with a short position in Miller's shares, posted a sensationalist, disparaging article about Miller on Seeking Alpha. The article cast doubt on Miller's accounting practices, noting that its auditor KPMG had not yet approved its financial statements, and speculated that this amounted to a default on its debt covenants. It also indulged in character attacks on some of Miller's top executives.
The stock market, already panicked about the US debt ceiling debacle, sold off Miller shares. In its haste to quell the article's allegations, Miller management rushed out its10-K. Unfortunately this haste compounded its woes since the financials had actually not yet been blessed by the auditor.
Miller remedied its missteps in just a few weeks. The company issued an amended 10-K with financials fully approved by KPMG. Miller's creditors re-affirmed their commitment to the company and waived any notion of default. Our conversations with Ralph E. Davis Associates, Miller's independent reserve engineers, also affirmed the value of Miller's oil and gas assets. In this Fall, top Miller executives including its CEO, its President, its top Alaska Manager and several board directors have purchased hundreds of thousands of dollars in Miller shares. The company is also upgrading the caliber of its financial team to avoid such future issues.
These very reassuring developments have helped Miller's stock price recover slightly from its lows, but the whole incident still casts a pall on the stock price, and provides value investors with a fantastic opportunity.
While we believe that value is its own catalyst, it is valuable to note that there are significant near-term catalysts that could re-price the stock up toward its intrinsic value:
- Progress in achieving its Alaska milestones. Over the next few quarters, the company should achieve a production run-rate that validates its proved reserve valuation.
- If the shares remain undervalued even after the company cranks out large positive free cash flow, we would expect stock repurchases to take place to further enhance intrinsic value per share. Management is well-aligned with shareholders, and has strong financial acumen. The current President, David Voyticky, founded the value investing hedge fund Red Mountain Capital. The CEO, Scott Boruff is a former investment banker and crafted the "deal of the century" buyout of Pacific Energy's Alaska assets.
- Achieving the higher production rates and cash flows will also enable Miller to dramatically lower its cost of debt. This will further boost profitability and help Miller explore and develop its vast probable and possible reserve base.
- Buyout possibilities - the Cook Inlet has seen acquisition activity in recent years. As Miller enhances production and cash flows, buyout interest from private equity firms or larger independents such as Apache (which owns other fields in the Cook Inlet) should emerge.
KMF Investments may hold a position in the securities mentioned in this article.