SM Energy (NYSE:SM) hit the news wires by announcing a sizable acquisition at a time when the oil market is still in turmoil. The market seems to applaud the deal as I question the premium being paid for assets which are not producing a lot currently. The deal results in 25% dilution for equity holders while leverage is going up, not very promising things to look forward to in this environment.
Given the troubles in the industry and the questionable nature of the deal, I stick to the sidelines as SM continues to bleed money (like the rest of the sector), while I do not like the latest move as well.
Who Is SM?
SM Energy has set itself a strategic objective to grow DACF per share through the cycle. DACF stands for debt adjusted cash flow and I guess that investors should be happy that at least it tries to maximize this on a per share basis.
A focus on great assets, financial discipline and operational excellence should support this objective.
SM is currently active in three areas being the Bakken, Wolfcamp/Spraberry and Eagle Ford. Production runs around 150,000 barrels of oil-equivalent per day, of which just 30% is oil. 45% of production takes place in the form of natural gas and the remainder in NGL.
Just like the rest of the sector, SM has been under pressure from the turmoil in the energy sector. While the company has in part been financed with debt, its first bond maturities are only up in 2021. During the turmoil at the start of the year, SM opportunistically bought back nearly $50 million in bonds at 65 cents on the dollar, recognizing a roughly $15 million gain as it believed these securities were undervalued.
At the end of 2014, proven reserves stood around 550 million barrels of oil-equivalent, a number which has been negatively revised to 470 million barrels by the end of 2015 amidst lower prices. These levels are still sufficient to maintain current production levels for another 8-9 years. While reserves are very important, it should be said that continued technological progress does tend to push these estimates higher over time.
The Current State And Cost Of Production
SM produced little over 157,000 barrels of oil-equivalent for the second quarter, marking nice improvements on a sequential basis. The company sold its production at a blended average price of $20.35 per barrel if we do not take into account hedges. These hedges were, however, in place and boosted the actual realizations to $27.45 per barrel.
What is a bit worrying is that realizations for oil (excluding hedges) came in at just $39 per barrel at a time when benchmark prices averaged around $45 for the quarter.
This means that actual product revenues amounted to just $291 million for the quarter. These revenues only went so far in order to cover the cost base. Production costs totaled $149 million, exploration costs came in at $13 million, G&A costs amounted to another $28 million and other costs came in at $5 million. Generally, all these costs are cash costs, combined amounting to $195 million.
The issue is that deprecation and depletion charges came in at $211 million, suggesting that the business lost $115 million before we consider the quarterly interest bill of nearly $35 million. With unhedged losses running at nearly $10 per barrel of oil-equivalent, it is clear that much work is ahead to break even at a time when WTI averaged $45 for the quarter and unhedged realizations came in at around $20 per barrel. This suggests that oil will probably need to top $60 before break-even is within sight, even if some of the newer wells have better economics.
This shows that losses come in at $150 million if we exclude the impact of hedges, although they did contribute positively to the quarterly results. The company itself calculated adjusted losses of $30 million. It should be stated that SM has some hedges in place to cover the majority of 2016 production and roughly half of that for 2017. That being said, we also could simply look at the unrealized prices and add the mark-to-market value of the hedge book to the cash holdings of the firm.
On June 30, when oil still traded around $48 instead, SM reported derivative assets of $260 million, although derivative liabilities of $170 million appear on the balance sheet as well. Net derivative assets of $90 million have in all likelihood risen by quite a bit following the recent drop in WTI prices. Living off the credit line, and operating with total debt of $2.6 billion, net debt is seen around $2.5 billion.
Given the losses, any debt load is obviously on the high side. If we use the operating loss rate of $115 million before taking into account hedges, and adding back depreciation charges, EBITDA comes in at just $100 million a quarter. This is equivalent to roughly a 6 times leverage ratio if we annualize this number. The company itself comes up with an EBITDAX number of $217 million, as this number actually does take into account some hedges. If this number is annualized, leverage is seen around 3 times.
The bright spot is that the current losses are in part offset by net divestitures in the business, even if that is not sustainable. Annualized depreciation charges come in around $850 million, surpassing the estimated capital spending budget of $670 million for the year by nearly $200 million.
Adding To The Base?
After recently announcing two small divestitures with a worth of $172 million (still have to close), SM has decided now is the right time to add to the asset base.
With net debt standing around $2.5 billion and operations continuing to lose money, it does not seem prudent to expand the operating base. Yet SM is spending $980 million in order to acquire nearly 25,000 net acres in the Midland basin. These assets were previously owned by Rock Oil.
The price seems relatively steep, representing roughly 22% of SM's enterprise valuation. At the same time, production will go up by just 4,900 barrels of oil-equivalent per day, adding just 3% to the current production rate. It should be said that the majority of this production takes place in the form of oil.
Given the very modest production of the acquired assets, both absolute and relative leverage ratios are set to increase. To offset this concern, SM is issuing 16 million shares. Assuming an issue price of $30, and assuming that the greenshoe option is exercised, this could raise over half a billion. SM will furthermore issue $150 million in convertible notes, as the remainder will probably be financed with credit line facilities.
A Questionable Deal Seems Welcomed By Investors
Given the turmoil in which the oil industry currently still exists, it seems foolish to swap 22% of the enterprise value in order to gain 3% production. In order to defend the deal, the quality of the acquired assets should be very good. While it is true that Permian-based assets are among the most valuable, the purchase price of roughly $40,000 per acre seems very rich.
Note that large players have a presence in the Permian as well. Apache (NYSE:APA) holds 3.3 million gross acres in the area. Assuming a 50% net ownership of 1.6 million acres, those assets could be worth $64 billion if we assume the $40,000 per acre multiple. Note that Apache's enterprise valuation only comes in at $27 billion and that the company has a lot of other assets as well.
Occidental (NYSE:OXY) has 2.5 million net acres in the area, suggesting a $100 billion valuation assuming the multiples paid by SM are appropriate. Again, this exceeds the $60 billion enterprise valuation of Occidental while it does not attribute any value to the other assets of the business.
The market reaction to the deal is puzzling as well. At first, sales fell by roughly $2 per share, or 6-7% in response to the deal in a move which is equivalent to $150 million in value going up into smoke. While that could be explained by the premium paid for the assets, shares actually ended the day 6% higher, having added almost $150 million in value if we include the newly issued shares.
Shares of SM have been all over the place over the past decade. After peaking at $90 in 2014, shares hit a low of $7 at the start of the year. Ever since they increased by a factor of 4 times gain, now trading in the low-thirties. While the acquired assets are of high quality, I question the high price being paid and the increase in leverage following the deal, while equity investors will see real dilution as well.
I question the asset trading capabilities of management, which is now happy to fork over nearly a billion for 25,000 acres with production of less than 5,000 barrels of oil-equivalent per day. The quality of these assets has to be superior as the company just closed the $172 million sale of assets in Dakota and Montana with production of 3,300 barrels of oil-equivalent per day on nearly 80,000 acres. Furthermore, the deal tag even excluded the waterflood assets in New Mexico which were included in the deal price as well.
For me, shares remain an avoid unless real tangible benefits can be seen. While the acquired assets might be great, leverage is on the increase, profits are not in sight yet and management has few long-term claims to have created value.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.