The stock market is currently offering anyone who's paying attention an unusually attractive buying opportunity. The purchase of Equal Energy (EQU) equity at $2.78/share offers investors an expected 6-week return in the range of 47% - 57%, which corresponds to an expected annualized return in the range of 410% - 489%.
Furthermore, this extremely high expected short-term return is coupled with very good long-term downside protection, as the NAV of the underlying oil and gas assets is over $4/share even using a very conservative set of commodity price, discount rate, and production cost assumptions. Therefore, the probability of a permanent capital loss is very low.
EQU has been written up several times previously on Seeking Alpha, so please see the previous write-ups to get some more of the back-story. But basically, EQU is a junior oil/gas E&P company with operations split between Canada and the US. Its shares trade both on the TSX in Canada and on the NYSE in the US, and corporate headquarters is in Canada. EQU's market cap is around $97M, with ~$340K worth of shares traded per day. FY2011 revenue was ~$160M.
The two key things to realize about EQU are (1) the stock is significantly undervalued, and (2) there is a strong likelihood that a major near-term (probably within 6 weeks) catalyst will close the gap between current market price and intrinsic value. This near-term catalyst is the conclusion of the strategic review that was announced on May 3. Before I delve into further details about points (1) and (2), this is how I'm deriving this seems-too-good-to-be-true expected return:
As shown in the table above, there are two possible cases to consider: the "High Premium" case and the "Moderate Premium" case. In the High Premium case, EQU stock stays in the range of $2.50 - $3.30 during the next few weeks, and therefore the buyer/buyers would need to pay a high premium (50% - 100%) to reach an acquisition price acceptable to the EQU board and shareholders. In the Moderate Premium case, EQU stock rises significantly from current levels over the next few weeks, to a range of $3.30 - $3.85, which would make it easier for an acquirer to justify a ~$5.00 price to their shareholders or private owners.
To understand the dynamics of the strategic review that EQU is currently undergoing, it is crucial to realize that there are several viable positive outcomes besides the obvious one, which would be a full buyout of EQU equity at a large premium to the current market price. Another very positive outcome, which is more likely, is a sale of the Canadian assets to one buyer and the US assets to another.
In the event neither of those two possibilities occurs, however, there are two more possibilities to consider. The more likely of the two remaining options is sale of the Canadian assets and conversion of the remaining US assets into a dividend trust. The opposite is also possible - sale of the US assets and turning what remains into a much smaller oil-focused Canadian junior E&P.
The key takeaway from thinking about these various possibilities is the following: there are many ways to win and only one way to lose. The only way to lose, at least in the short term, is if the strategic review ends in complete failure with an announcement that the sale process has been canceled due to poor market conditions or something of that nature. But if any of the positive outcomes described above occurs, the investor stands to earn a substantial and very near-term capital gain.
It's also very important to realize that even if the "failure" scenario does occur, the loss is highly unlikely to be permanent since there's such a large margin of safety between current market price and a conservatively estimated NAV.
Why is a successful outcome likely?
The most important reason for the likely success of the strategic review is that EQU stock is significantly undervalued, and as a result the potential buyers can get a very good deal that should also be acceptable to the board and shareholders. I'll get into more detail later, but a conservative sum-of-the-parts analysis shows that a buyer paying $5.55/share for EQU equity is acquiring the Hunton/Mississippian assets at 5x (normalized) EBITDA (this assumes Canadian assets are sold off for ~$75M), while the likely buyers of these assets (e.g., MLPs) tend to trade closer to 8x.
Therefore, acquiring the Hunton/Mississippian assets would be very accretive for them if they pay for the acquisition in new shares. Furthermore, if it's not possible to liquidate all of the assets at a fair price, then sale of just the Canadian assets and conversion of the rest into a US-asset dividend trust should result in a significant re-rating of the stock.
I estimate that the resulting dividend trust could comfortably pay an annual dividend of $0.44/share (this will be derived later), so if such a partial asset sale and restructuring were announced, the stock should move to somewhere north of $4.40/share (i.e., ~10% dividend yield) in the near term. If the opposite occurs, which is sale of the US assets at around 5x (normalized) EBITDA and conversion of the rest into an oil-focused Canadian junior E&P, the equity of the restructured company should be worth over $5.00/share.
The large number of viable transactions for EQU, any one of which is likely to unlock significant value for the shareholders, is currently being ignored by the stock market. The stock is being priced as though failure of the review is nearly certain, possibly because of the large number of Canadian junior E&P's that are currently up for sale or that have had failed strategic reviews.
I believe the market is making several mistakes here. First of all, although EQU is headquartered in Canada, the large majority of its asset value is in the US (Oklahoma). These two M&A markets are quite distinct. For example, MLPs may be very interested in EQU's Oklahoma assets but aren't allowed to acquire Canadian assets.
Similarly, the Private Equity (PE) market is much larger in the US than it is in Canada, so PE interest in EQU is more likely than it would be for a true Canadian junior. Furthermore, EQU's Canadian assets are in highly desirable oil-focused areas (Cardium and Viking), unlike many of the failed reviews associated with companies that are natural-gas focused. Some examples of potential acquirers of the US assets in Oklahoma are MLPs such as Atlas Resource Partners (ARP) and LRR Energy (LRE), private E&P New Dominion, and PE firms such as Riverstone Holdings, Apollo Investment Management, and Lime Rock Partners.
Note that ARP is already Equal's JV partner in the Mississippian and they've expressed privately that they want to control the full Mississippian position. Furthermore, they can certainly use their expensive stock (12x EBITDA) to buy assets, as they just did in May of this year when they acquired Titan Operating, LLC. Some examples of Canadian E&P's that may be interested in acquiring EQU's Cardium and Viking assets are Crescent Point (CSCTF), Pengrowth (PGH), and Whitecap Resources (SPGYF).
To get a feel for the expected time frame for this strategic review process, and to gauge how well it's going so far, here's a link to the summary of EQU provided by Scotia Waterous. Scotia Waterous is a prominent investment bank that's leading the sale of the US assets (Desjardins Securities is leading the sale of the Canadian assets).
As indicated in the Scotia Waterous introduction, EQU is open to a wide variety of corporate actions to enhance shareholder value, and the company is open to payment in stock or cash. The short-term time frame is evident from the dates listed in the document: VDR opens on or about June 11, 2012 (already occurred), Management Presentations and Physical Data Room week of June 18, 2012 (already occurred), and transaction Effective Date of July 1, 2012 (already occurred). It is my understanding that the "Effective Date" for a transaction of this type is typically within 30-45 days of the public announcement, so an announcement no later than mid-August is likely. This time frame is consistent with the roughly 3 months that it typically takes to complete such reviews, given that the review was announced on May 3.
There also appears to be strong interest in these oil/gas assets, both individually and collectively. For example, a June 14 note from PI financial confirmed "good interest" in a conference call with management. Furthermore, people close to the situation have confirmed that interest is strong for both the Canadian and US assets, and that management is actively proceeding with the presentation process. It is interesting to note that this strong interest was generated even in the face of an extremely challenging macroeconomic backdrop, and that over the past week there have been some positive developments in Europe that have caused commodity and stock markets to rise. This brightening of financial conditions increases the likelihood of a successful conclusion to the review process.
Investors should also consider the larger context behind this strategic review. First of all, this review was forced by a group of activist shareholders that controls close to 20% of the outstanding shares. These shareholders have made it clear that the status quo is unacceptable and that they expect a significant transaction to occur at the end of this process.
The review was announced within a week of appointing Dan Botterill as the new chairman of the board, so it's clear he was brought in for the purpose of managing this review process. Botterill has assured key shareholders that significant value will be unlocked at the end of the process, and he has a good track record in that regard. He managed his last strategic review between November 2009 and January 2010 very successfully as the CEO of Berens Energy, where he was able to achieve a 103% appreciation in the stock price between the day he announced the review and the day a deal was announced.
The rest of this write-up is intended to back up the midpoint pricing assumptions I've used to derive the 6-week expected return. The long-term commodity pricing assumptions I'm using are $85/bbl WTI Oil, $3.75/mcf Gas, and EQU's NGL mix priced at 40% of WTI ($34/bbl). I've chosen the Oil and Gas prices based on average 2013 futures prices, while also taking into account that the marginal cost of production for natural gas is around $3.50/mcf. So I believe these commodity price assumptions are quite reasonable. Note that EQU's NGL mix has historically been priced at ~55% of WTI, but it's been much weaker lately and I'm assuming that some of this weakness is permanent because of improvements in fracking technology and the associated increase in NGL supply.
Propane pricing at Conway, KS has been extremely weak lately for several reasons, including this year being the 4th warmest winter on record, increases in production, and a blowout in the spread with pricing at Mont Belvieu, TX due to transportation bottlenecks. This situation should improve later this year and in 2013 with a near-term tripling in export capacity, an expected normal winter, and new pipeline capacity such as Kinder-Morgan's Cochin pipeline that just came online and the DCP Midstream pipeline scheduled to come online in mid-2013.
The value of the US producing assets, which as of Q1 2012 were only in the Hunton since the Mississippian drilling hadn't begun yet, can be estimated as follows:
Q1 2012 Revenue, no hedge
Q1 2012 Royalties
Q1 2012 Production Expense
Q1 2012 Transportation Expense
Q1 2012 EBITDA, no G&A, no hedge
Production Expense Adjustment (2010 per-boe ave.)
Q1 2012 Adj EBITDA, no G&A, no hedge
Q1 2012 Realized Commodity Prices
Current Price Assumptions
Q1 2012 Production (bbls or mcf per day)
Price-Adj Quarterly EBITDA, no G&A, no hedge
Price-Adj Annual EBITDA, no G&A, no hedge
Estimated Annual G&A after acquisition synergies
Price-Adj Annual EBITDA, no hedge
Total Hunton Value
I made two adjustments of note in the above calculation. First, I reduced the Q1 2012 production expenses from $7.28/boe to the 2010 average of $5.69/boe. I believe this adjustment is justified because Hunton wells produce only water for the first few months after production starts, which increases average per-boe production costs. When new drilling stops, as it did in 2010 due to the Petroflow legal issues, per-boe production expenses decline. Since new drilling in the Hunton will probably be uneconomic for a while due to current commodity pricing, I believe the 2010 average is a more appropriate going-forward estimate. Second, I've assumed that if the Hunton assets are acquired by a larger player, then the G&A required to run the assets will be 50% of EQU's current total G&A, which includes both the US and Canadian assets, due to acquisition synergies and the assumption that the Canadian assets are sold off.
Note that the 5x Adj. EBITDA multiple is below average (I believe 6x is more common), so I'm assigning very little value to EQU's 13,000 net acres of undeveloped Hunton land, which is estimated to have 40+ net drilling locations. Although the Hunton is probably uneconomic to drill right now, the locations clearly have option value and if NG/NGL prices increase in the future, as many people expect, those locations will be very valuable. One last note: this $245M valuation for the US assets represents a large discount from stated PDP PV-10 reserve values of $327M (forecast prices) and $291M (constant pricing) as of 12/31/2011.
I'm assigning $18M of value to EQU's Mississippian land (30+ net locations), which is the valuation ARP applied in a recently signed JV agreement. I'm being conservative by not assigning any value to the southern Mississippian land in Logan County, which is very close to wells drilled by Devon (DVN) and Osage (OEDV) that have achieved strong production numbers, nor am I assigning any value to EQU's Oklahoma acreage that is prospective for the Woodford shale.
I'm estimating the value of EQU's Canadian assets to be around $75M. This figure is based on an estimated price-adjusted PDP PV-10 reserve value of $50M - $55M (using the constant pricing assumptions discussed above) and $20M - $25M of value for their Cardium (30+ locations) and Viking (100+ locations) undeveloped land. I believe this is a fairly conservative estimate for the following reasons. First of all, it's significantly less than the stated P+P PV-10 reserve value of $94.4M. Second, it corresponds to $55.8K/boepd based on Q1 2012 production of 1,344 boepd (82% light oil) and $14.71/boe of P+P reserves (including undeveloped land), which looks quite low in comparison to the following recent transactions: Crescent Point's May 3, 2012 acquisition of Cutpick (Viking) for $75.9K/boepd of production and $20.73/boe of P+P reserves, Raging River's April 19, 2012 acquisition of Dodsland (Viking) for $143.4K/boepd of production and $23.39/boe of P+P reserves, Whitecap's Feb. 2012 acquisition of Midway (Cardium/Viking) for $101.9K/boepd (70% oil) of production, and Whitecap's Dec. 2011 acquisition of Compass (Viking) for $71.4K/boepd (74% Oil) of production. The value estimate of $75M is also at the very low end of Desjardin's range of $75M - $95M published on May 4th.
We can now put all the pieces together to arrive at an overall valuation:
Canadian Assets (Cardium + Viking + Clair)
Equity Value (Million)
Per Share Equity Value
In the expected return calculation given at the beginning of this write-up, I use $5/share as the midpoint price per share because I have other valuation models that give lower numbers. My most conservative NAV model gives a valuation of $4.18/share and a less pessimistic one yields $4.72/share. Both of those NAV models explicitly take the Asset Retirement Obligation (ARO) into account, whereas the sum-of-the-parts valuation given above assumes that the ARO is already included in each component part. My most conservative NAV model also assumes that production costs remain the same as those assumed in the 2011 AIF even though my assumed constant commodity prices are significantly lower, while the less pessimistic model assumes that production costs scale proportionally with commodity prices. So a blend of all these valuation models gives a midpoint estimate of around ~$5/share.
Dividend Trust Details
One option that's still very much on the table is to sell the Canadian assets and restructure the remaining corporation into a Canadian dividend trust that owns foreign-only assets, as originally proposed by the activist shareholder group. Such a structure would take advantage of a loophole in the recently changed Canadian tax laws, which eliminated the corporate tax exemption for most Canadian energy trusts. There was an exemption made for those Canadian energy trusts that own only foreign assets, so companies such as Parallel Energy Trust (PLT) and Eagle Energy Trust (EGL) were set up to take advantage of this loophole. If EQU follows a similar path, how much of a sustainable dividend could it distribute? The idea would be to let the Hunton deplete until NG/NGL prices recover, and in the meantime drill the Mississippian using cash flow from operations. There needs to be enough new Mississippian drilling to compensate for the Hunton EBITDA decline in order to keep distributions to shareholders flat over time. Here's an estimate of what the dividend trust's cash flow and balance sheet would look like:
Price-Adj. U.S. EBITDA, no G&A, no hedge
Price-Adj. U.S. EBITDA, no hedge
Convertible Debentures @ 6.75%
Bank Credit Line @ 3.24%
Working Capital Surplus
Initial Net Debt
Sale of Canadian Assets
Post-Transaction Net Debt
Net Debt / EBITDA
EBITDA / Interest
Cash Flow From Operations
Net Debt / Cash Flow
In the calculation given above, I've assumed that the Canadian assets are sold for $75M and that $25M of that cash is used for a tender offer to buy back shares at $4/share, leaving 28.75M shares outstanding. The remainder is used to pay down debt. That leaves the trust with a very strong balance sheet, with an EBITDA / Interest coverage ratio of 10.0x and a Net Debt / EBITDA leverage ratio of 2.0x. My $47M EBITDA estimate assumes the same commodity prices as before and that the ratio of G&A to Revenue stays at current levels. It is difficult to accurately estimate how much of the cash flow can be safely distributed to the shareholders, while reinvesting enough in new Mississippian drilling to compensate for the Hunton decline, without more information than I have access to. But here's a very simple way to estimate it.
Current Price-Adj PDP PV10
After-G&A Price-Adj PDP PV10
Excess Annual Cash Flow, Assuming Flat Production
Maintenance Capital Spending (Processing, etc.)
Distributable Cash Flow
Distributable Cash Flow Per Share
I estimate that the PV-10 value of the Hunton PDP reserves, after being adjusted for my assumed commodity prices, is $221.2M. The G&A load estimated above was $6.96M / $53.95M = 12.9%, which implies that the after-G&A PV-10 value is $192.6M. Well, if we can assume that the after-G&A IRR for the new Mississippian drilling is at least 10% per year (and there's plenty of evidence that it's actually much higher than that at current commodity prices), then it should be possible to "flatten out" the initially large but declining Hunton cash flows by recycling the cash back into Mississippian drilling, and there should be at least $19.3M of flat annual cash flow left over for equity and debt holders. After subtracting $4.5M in interest payments and an estimated $2M of "maintenance capex" for ancillary capitalized costs such as maintenance of processing facilities, major well work-overs, etc., there should be $12.5M left over for shareholders, or $0.44/share.
In my experience it's rare for the stock market to make such a major mistake about the likelihood of a positive outcome for something that's only about 6 weeks into the future, but I believe that's exactly what's happening. From all the evidence I can see, the market is giving you a *really* good chance to earn an exceptionally high expected IRR with a very low probability of permanent capital loss.
Disclosure: I am long EQU.