RSP Permian (NYSE:RSPP) is actively joining the M&A frenzy in the US shale market. The company announced the acquisition of Silver Hill, as the large deal did not cause a major move in its stock price which is trading around all-time highs.
The deal, which is equivalent to 50% of the standalone value of RSP, looks appealing if you look at the comparative numbers in terms of production, inventory and acreage. That being said, this deal and the standalone valuation of RSP are expensive in absolute terms, certainly if you consider actual profitability and production numbers.
The good thing is that RSP has partially locked in the relative attractiveness of the acquired assets by issuing stock, as leverage will increase quite a bit given the roughly 50% cash component.
I believe that the market is overvaluing quality in this low price environment, as these multiples are getting way too steep. On the other hand, continued technological advancements and the issuance of stock at even higher levels make such stocks a dangerous short, creating a fascinating story to follow.
Who Is RSP?
RSP has 63,000 net acres in the Midland Basin, yet it has 262,000 ¨effective¨ net acres, as much of the net acreage has multiple layers in the ground. These positions provide the company with 2,600 horizontal drilling opportunities.
Current production runs at 35,000 barrels of oil equivalent per day, or close to 13 million barrels per year. With proven reserves standing at 159 million barrels of oil equivalent, RSP has solid reserves although the potential reserves are much greater than the proven numbers. It is noteworthy that production is increasing at a rapid pace, averaging just 21,000 barrels of oil equivalent per day in 2014.
Somewhat disappointing given the recent run-up in prices is the fact that two-thirds of production is hedged at an average of $43.50 per barrel. This will hurt the balance sheet a big in Q3 as the company will face some derivative losses given the recent run-up in prices.
The Own Valuation Vs. Silver Hill
RSP ended the second quarter with $33 million in cash and $700 million in debt, for a net debt load of $667 million. The 100.2 million outstanding shares trade at $42, an all-time high. This gives the company an equity valuation of $4.2 billion, as the overall valuation increases towards $4.9 billion if one includes net debt.
This valuation is equivalent to $31 for each barrel of oil equivalent in terms of reserves, $140,000 for each barrel of oil equivalent being produced each day, and $19,000 for each effective acre under control.
Through July of this year, RSP made some smaller acquisitions at a cost of $55 million, adding 2,180 net acres and production of 500 barrels of oil equivalent per day. That suggested a $25,000 multiple for each net acre and $110,000 price tag for each barrel of oil-equivalent being produced each day at the moment.
The $2.4 billion purchase of Silver Hill is a much larger deal. Silver Hill is a combination of two companies which combined own 41,000 net acres in the Loving and Winkler counties in Texas, producing 15,000 barrels of oil equivalent per day through 58 wells.
That suggests that RSP paid $58,000 per net acre, which marks a discount from the $78,000 valuation of RSP itself based on the actual acreage, thereby not accounting double layers. Based on current production levels, RSP is paying $160,000 for each barrel of oil equivalent being produced per day, equivalent to its own valuation.
The real appeal is seen in the multiples paid for the 250,000 net acres. This suggests that RSP paid $10,000 for each net acre, marking a nearly 50% discount compared to its own valuation. The deal will furthermore more than double the number of drilling locations to nearly 6,000, indicating that these locations are bought on the (relative) cheap as well.
Given the relative discount of the purchase, in terms of acreage and drilling locations, investors should like the deal. This is certainly the case as RSP will finance roughly 50% of the purchase with the issuance of 31 million ¨expensive¨ shares, as well as pay out $1.25 billion in cash.
The cash component will nearly triple the net debt load of RSP towards $1.9 billion. Including dilution, the 131 million shares of RSP value equity at $5.9 billion, creating a formidable player with a $7.8 billion capitalization.
Investors hardly reacted to the sizable deal as shares were essentially trading flat in response to the news. Perhaps, investors worry about the increase in debt, as this debt load will triple, thereby increasing relative leverage ratios.
Adding It All Together
Pro forma production currently runs at 50,000 barrels of oil equivalent per day, as continued production gains are anticipated going further.
Despite this rapid increase in production, a near $8 billion enterprise valuation still implies that each barrel being produced each day is valued at nearly $150,000. This is a huge multiple in this environment, even if production is set to continue to rise in the future and drilling inventory remains very large.
Investors appear to be willing to pay high multiples for low-cost locations, as RSP has favorable economics. The company posted an adjusted loss of merely $3.8 million in Q2, equivalent to $1.50 per barrel of oil equivalent. Given the recent run-up towards $50 per barrel, it is fair to say that the company is now profitable, making some competitors very jealous.
While the absolute valuations are sky-high, the good thing is that half of the transaction sum is paid for in terms of RSP's stock, which is actually valued at higher multiples. In that respect, it makes sense to pursue the deal although the 50% cash component results in much higher leverage at $1.9 billion.
RSP posted EBITDAX of $59 million for the second quarter. The continued ramp-up of production and recovery in oil prices might boost that number to $90-100 million a quarter, or at roughly $350-$400 million per year. Adding in $150-$200 million from the acquisition, EBITDAX is seen around $550 million. This suggests that leverage ratios increase towards 3.5 times EBITDAX.
While I appreciate the low cost of production and quality acreage, everything has a price. Leverage is high, and while the company can probably sustain this on the back of its assets and low cost of production, actually allowing for current profits at $50 per barrel, I have real concerns. The concern is basically the valuation. Note that the quest for quality in the shale business seems almost out of control with shares having doubled from 2014 until now, even as oil prices are still cut in half.
Shares remain not interesting at all based on fundamental reasons, at least in my opinion, as momentum keeps rewarding quality names, with quality being defined as low cost production. I think that has the potential to run out as well, although these players can use expensive currency (stock) to pursue more deals, making outright short positions quite risky as well. I will await the story for RSP and some of its peers with great interest going forward, but for now I refrain to get involved.
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.