This Time Isn't Different - Miller Energy Is A Short

| About: Miller Energy (MILL)

Miller Energy Resources (NYSE:MILL) is an oil and gas exploration and production company primarily focused on the Cook Inlet area of Alaska. On 12/10/2009, MILL acquired Cook Inlet Energy, consisting of the former Alaskan assets of Pacific Energy Resources, in a competitive bankruptcy auction, paying less than $5 million. Immediately after, MILL wrote the value of the assets up to $480 million, booking a pre-tax gain on the acquisition of $460 million.

This unusual transaction and the dubious background of Miller's management and financial partners has been covered in articles from The Street Sweeper, and I would recommend you read them for additional background information, however I believe a brief history of these assets is useful. The Cook Inlet assets that Miller currently owns were originally acquired and developed by Forcenergy in the late 90s. Forcenergy went bankrupt and eventually merged with Forrest Oil Corp in 2000. Forest then sold the Alaskan assets of Forcenergy to Pacific Energy in 2007, and Pacific Energy went bankrupt in early 2009, finally selling a group of their Alaska assets to Miller Energy.

This article will take a closer look at the flawed assumptions MILL and their investors are using to derive the company's reserve value, as well as the shaky financial footing the company is currently on, both of which should concern current and potential investors in MILL, especially if history repeats itself.

Reserve Report Assumptions

Since MILL is currently generating large losses, and low production relative to its current market capitalization, it's clear that investors are valuing the company based primarily on their undeveloped reserves, and those reserves' prospects for future, profitable production. This could prove incredibly risky should current assumptions about the value of these undeveloped reserves prove to be faulty.

MILL attached a reserve report by Ralph E. Davis Associates to their most recent 10-K filing breaking out the reserves of their Alaskan properties (containing the vast majority of the company's total reserves) in more detail.

The report breaks out reserves, and assumed future revenues, expense and cash flows by developed-producing, developed non-producing, and undeveloped reserve categories. This table is reproduced below:

The present value of the expected net income from Miller's proved reserves using a discount rate of 10% is $446.726 million, which is likely what attracts investors to the stock, even though 80% of this value is tied to the company's undeveloped reserves. As an aside, it would likely be imprudent for investors to use a 10% discount rate when valuing Miller's reserves since the company's cost of capital is much higher (their senior debt has an interest rate of 18%).

From here, dividing the revenue and expense data points by the barrels of reserves can highlight the per barrel operating assumptions utilized in the company's reserve report, the result of which is displayed below. For example, the "Operating Costs / Boe" under the "Producing" column is calculated by dividing the total operating costs under the producing column and dividing it by the number of total barrels in the producing column.

Oddly, currently producing reserves have an assumed operating cost of $49.58 per barrel, which is around what Miller has reported in their recent results, however proved developed but non-producing reserves are expected to have far lower operating costs of $13.31 per barrel, and undeveloped reserves are assumed to cost only $5.57 per barrel. This seems absurdly low since operating costs of $5.57 per barrel would be amongst the lowest in the country, especially when Forest Oil Corp noted that the Cook Inlet had higher operating costs than other properties in the US.

Finally, the estimated development costs seem equally illogical. Capital costs for reserves that are already developed but not currently producing are $19.32 per barrel, yet capital costs for completely undeveloped reserves are assumed to somehow be less than a 1/2 the cost for developed non-producing costs. It is likely that both the capital costs and operating costs for the company's undeveloped reserves will be far higher than is currently assumed making the true present value of these assets a fraction of that assumed in the report.

Miller's reserve assumptions have also received scrutiny from the SEC as demonstrated by several CORRESP files over the last two years, ultimately requiring MILL to restate their 2011 and 2010 reserves.

The best response from MILL bulls would be that as production increases, the company will lower costs with scale. However, this ignores the fact Pacific Energy's Alaska division (the predecessor assets that are now Miller's Alaskan assets) had operating costs of $44.33 per barrel in 2009 (equivalent to Miller's operating costs per year in 2011) despite producing more than 4,000 barrels of oil equivalents per day (approximately 4 times larger than Miller's current production rate).

Relative Valuation

Even if one ignores the company's long history of operating losses, and take Miller's reserve assumptions at face value, assuming they are able to successfully raise the massive amounts of capital required to fully convert their undeveloped reserves to producing status without severely diluting shareholders, the company would still be dramatically overvalued at today's price.

For example, Miller's proved reserves totaled 9.294 million barrels of oil equivalent (NYSE:BOE) as of their most recent fiscal year end. Comparing this to the company's current enterprise value (the sum of a company's market cap and their net debt) of $255 million, yields an EV / BOE of $27.43, meaning investors are valuing each barrel of reserve (developed and undeveloped) at $27.43 for MILL. This is very expensive, especially when compared to much larger, more diversified, and lower cost peers who have already spent the capital to develop a much higher percentage of their reserves. The following table compares MILL to Apache Corp (NYSE:APA), Devon Energy (NYSE:DVN), Chesapeake Energy (NYSE:CHK) and Buccaneer Energy (NYSE:BCC).

Buccaneer Energy (trading on the Australian stock change under the ticker symbol BCC) is the most directly comparable company. Buccaneer Energy is focused on the Cook Inlet area of Alaska (the same area as MILL), and even uses the same company as MILL to complete their reserve reports (Ralph E. Davis). Buccaneer actually has a greater amount of proved reserves than MILL, and in the second quarter, had nearly equal production levels, yet they trade for nearly 1/3 the valuation MILL does. If Miller's enterprise value fell to the same level as Buccaneer's, MILL's stock price would fall by over 75% to $1.21 per share.

Debt Troubles

MILL entered into a new debt facility with Apollo Investment Corporation on 6/29/2012. The facility allows for an initial borrowing base of $55 million and initial availability of $40 million, with the remaining $15 million only available when MILL demonstrates that it can raise $15 million in additional equity. MILL immediately borrowed the $40 million initially available, and is seeking to unlock the remaining $15 million under the credit facility by selling $15 million in preferred stock. The facility has an interest rate of 18%, which would imply an interest expense of nearly $10 million annually (assuming $55 million is eventually borrowed). This is far in excess of any historic operating earnings MILL has generated thus far, calling into question their ability to service this debt. These fears were confirmed in Miller's most recent quarterly report for the three months ending 7/31/2012, in which the company said they expected to not be in compliance with the credit facility's covenants on the first measurement date.

MILL claimed in their most recent earnings call that the upcoming covenant miss was due to a simple delay in construction of their rig, but the company has been a serial offender in over-promising and under-delivering on production growth. For example, looking at one of the company's presentations from 2 years ago, they projected increasing production to over 5,000 barrels of oil equivalents per day by the end of 2011. For the quarter ending July 31, 2012 production averaged less than 1,000 boe / day.

On the earnings call, MILL disclosed their estimated capital spending levels once they started the full drilling program would be $8 million a month, or $24 million a quarter. This means that even with the additional $30 million in capital the company is seeking, it would not provide for more than 4 months of drilling.

Preferred Stock

Investors buying into the company's recent preferred stock offerings should also be concerned. MILL recently sold 25,750 shares of Series B Preferred Stock, and issued warrants to purchase 128,750 shares of common stock, exercisable at $5.28 per share, to the purchasers of the preferred stock for gross proceeds of $2.575 million. The company is currently in the process of offering series C preferred stock which will have a 10.75% yield and will be convertible into shares of MILL at $10 / share. The issues listed above should concern investors in each preferred class since they have a derivative exposure to the stock (either through warrants or conversion features), and the company's ability to service their credit facility directly impacts whether MILL can make cash payments on the preferred stock.

As noted in the preferred stock prospectus, MILL is only allowed to make cash dividend payments to holders of the preferred stock if they are in compliance with the Capital Covenants of their credit facility, which as discussed earlier, MILL does not expect to meet at the first measurement date. On 9/26/2012 MILL filed an amendment to their credit facility that moves back the first covenant measurement date, and allows the company to create a cash reserve from which the company can make preferred dividend payments for one year, regardless of covenant violations. This piggy bank that has been set aside to make one year of preferred dividend payments, might initially give the illusion that MILL can service their debt and dividend payments, but ultimately this should not fill investors with confidence.

Finally, potential preferred stock investors should ask themselves whether an at-risk 10-12% in a subordinated, preferred stock is adequate compensation when Apollo is receiving an 18% interest rate for a secured debt position.

Disclosure: I am short MILL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.