Range Resources: New Home On The Range

| About: Range Resources (RRC)

Summary

Examining Range Resources acquisition of Memorial Resource Development.

Increased cash flow came at the expense of decreased reserves on a debt adjusted per share basis.

Terryville complex affords lower differentials and an opportunity for increasing productive acreage.

Range Resources (NYSE:RRC) comprises a small part of our natural gas portfolio, and with the recent closing of its Memorial Resource (NASDAQ:MRD) acquisition we've decided to share a few thoughts.

Analysts have interpreted this acquisition as a deleveraging transaction. We largely agree with that conclusion, with the caveat that the longer-term benefit has yet to be seen. Diversifying the company's drilling away from the Marcellus region and potentially increasing its Louisiana acreage could prove beneficial. For existing shareholders, however, the new expanded drilling options meant increasing share count by 30%. Let's walk through the transaction.

Expanding Beyond the Marcellus

The biggest disadvantage for Marcellus-shale drillers has historically been the transportation constraints caused by the lack of adequate takeaway capacity. As such, Marcellus drillers often see natural gas prices that are lower than the Henry Hub national benchmark. The recent regulatory hurdles faced by Williams (NYSE:WMB) on the Atlantic Sunrise pipeline and by Cabot Oil & Gas (NYSE:COG) on the Constitution pipeline highlight the challenges companies are having to bring in additional transportation capacity to the region.

By acquiring Memorial, RRC diversifies its portfolio and acquires a second area to drill, namely the Cotton Valley formation in Northern Louisiana.

The Acquisition

So what did we actually get as part of the Memorial acquisition? Since the announcement of RRC's Memorial acquisition, RRC has included this slide in its investor presentations.

Click to enlarge

This essentially shows a pro forma increase in the combined company's production by almost 30%. In turn, cash flow per share also increases by 43%. We re-ran the numbers to account for the debt, and since both companies were similarly capitalized (with debt to equity ratios of 3:1), we see similar results on a debt adjusted cash flow basis (i.e., an increase of 43%).

Cash flow per share

Increase / (Decrease)

Debt adjusted cash flow per share

Increase / (Decrease)

Pre-Merger (RRC Standalone)

$2.24

-

$1.58

-

Post-Merger

$3.20

43%

$2.25

43%

Click to enlarge

This increase in cash flow, however, did not come cheaply.

Based on the estimated number of shares RRC and Memorial had at the close of Q2, we surmise an addition 77M shares of RRC were issued. The Form S-4 filing confirmed this assumption and provided that existing RRC and former-Memorial stockholders will own approximately 69% and 31% of RRC, respectively, following the merger.

2016 Q2 Share Count

Diluted

RRC Shares as of Q2 2016 (Diluted)

170,081,406

MRD Shares as of Q2 2016 (Diluted)

203,948,000

Exchange Ratio

0.375

RRC Shares Issued for MRD Shares

76,480,500

170,081,406

Total Share Count Post-Exchange

246,561,906

Legacy-MRD Shareholders Ownership of RRC

31%

RRC Shareholders Ownership of RRC

69%

Click to enlarge

Thus, RRC essentially sold 30% of the company to increase current year cash flow by 43%.

Let's take a look at reserves. The chart below shows the total amount of proved reserves and proved developed reserves.

Proved Reserves

Range Resources

Memorial

Combined

Inc/(Decr)

Natural Gas

6,277,697

973,814

7,251,511

16%

NGL

549,135

54,160

603,295

10%

Oil

53,193

13,154

66,347

25%

Total (Mmcfe)

9,891,665

1,377,698

11,269,363

14%

Proved Developed Reserves

Natural Gas

3,376,165

443,983

3,820,148

13%

NGL

309,306

24,583

333,889

8%

Oil

31,679

6,101

37,780

19%

Total (Mmcfe)

5,422,075

628,087

6,050,162

12%

Click to enlarge

Notice that on a proved reserve basis, the Memorial acquisition increased proved reserves by 14%, and on a PDP basis total reserves increased by 12%? Coupled with the increase cash flow above, this would seem favorable at first glance. The stock-for-stock acquisition, however, means that RRC ended up "giving away" more inventory than it received (via the share issuance), in exchange for enhanced cash flow today (i.e., 30% ownership for a 14%/12% increase in reserves).

In truth, RRC has one of the best inventory of reserves on a per share basis. Thus, anytime RRC issues shares to acquire another company or asset, it will likely be dilutive from an reserves per share standpoint. In this case, Memorial has arguably 10 years of inventory on a proved reserves basis, whereas RRC has almost double that. Consequently, on a debt adjusted share basis, proved reserves and proved developed reserves were sure to fall, and they did so by +20%.

RRC

MRD

Total

Increase / (Decrease)

Estimated Proved Reserves (Mmcfe)

9,891,665

1,377,698

11,269,363

Growth in proved reserves per debt adjusted shares

0.042

0.013

0.033

(22%)

Estimated Proved Developed Reserves (Mmcfe)

5,422,075

628,087

6,050,162

Growth in proved developed reserves per debt adjusted shares

0.023

0.006

0.018

(23%)

Click to enlarge

Three Benefits

Three things, however, were positive factors. The first was the low/no-premium paid for Memorial. RRC proposed the 0.375 exchange ratio on April 26, 2016 during the negotiations, which represented an approximately 12% premium to the price of Memorial common stock. (see Form S-4 filing). This ratio was ultimately the exchange ratio agreed upon by the parties.

We believe the "premium" paid by RRC was in fact not a premium given. Memorial's G&A expenditures were approximately 11.7% of sales for 2015 (i.e., $46.3M (less $2.2M for certain acquisition related expenses)/revenue of $374.0M). Post-acquisition, RRC will almost certainly eliminate Memorial's duplicative overhead, and Memorial's G&A expense will be eliminated to bolster the bottom line going forward. Cost synergies are usually much easier to achieve and maintain than revenue synergies, thus the higher price is negated by the higher profitability.

Second, MRD's 220,000 net acres of stacked pay potential in the Terryville complex helps diversify RRC away from the transportation constrained Marcellus play. RRC had guided to a $0.25-$0.35/MMbtu differential to NYMEX for 2017, but this was pre-acquisition. Given MRD sees a $0.08/MMbtu differential, RRC's differential post-merger should gradually improve as RRC shifts more drilling to the Terryville complex.

Third, there could be a potential for RRC to prove up additional acreage in Northern Louisiana. Any additional efficiency savings RRC can generate from the now larger drilling portfolio can be spent to drill step-out wells and expand the potential acreage. MRD began to do this in 2015, and continued drilling horizontal wells in 2016. From its initial IPO in 2014, the company increased land acreage from 52,000 to 220,000, which bodes well for future increases.

Click to enlarge

Ultimately, despite the share issuances, we think the acquisition overall was positive. If natural gas prices (UNG, UGAZ) continue to move higher, RRC could shift more of its production to Lousiana to gain exposure to the rising tide; an option that didn't exist a month ago with its transportation constrained Marcellus inventory.

Lastly, our initial observation is that IRRs for both the Marcellus - Dry Gas and Terryville - Upper Red areas are fairly close, but we'll await additional data post-merger and RRC's Q3 conference call to confirm this. We're also hoping to understand a bit more for how RRC will allocate capital between the two plays, and what that decision involves.

As always, we welcome your comments. If you would like to read more of our articles, please be sure to hit the "Follow" button above.

Disclosure: I am/we are long RRC AND COG.

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.