Compton Petroleum (OTC:CMZPF) announced the successful completion of a major balance sheet recapitalization after the market close yesterday. We expect Compton's deeply undervalued common equity to attract incremental investor interest following this catalytic event.
This morning at 8:20 AM ET, Compton CEO Tim Granger is scheduled to present at the Peters & Co. 2010 North American Oil & Gas Conference. The presentation will be available here.
Why is yesterday's bondholder consent for Compton's proposed recapitalization so significant? The recapitalization is the final step in a series of actions taken by Compton management to delever a balance sheet that became unsustainable in the face of depressed natural gas prices. Compton now moves from being a "distressed equity" to a natural gas exploration and production company with large, underappreciated reserves and a balance sheet that can support profitable growth.
The steps taken by management over the past year have cut net debt from roughly $900 million as of June 30, 2009 to roughly $400 million post-recapitalization. This is a managable amount for a company with tangible assets of more than $1.8 billion and operations that are strongly cash-generative pre-capex. While Compton was forced to issue equity along the way, CEO Granger deserves credit for accomplishing much of the debt reduction without equity dilution. Compton sold an overriding royalty interest and several non-core assets for cash at implied valuations well in excess of the company's trading multiples, generating value in the process.
How much upside does Compton offer investors? This is up for debate and will no doubt depend on the extent to which natural gas prices rebound in the future. However, the equity value compression Compton suffered simply because it was viewed as a distressed equity should now be removed. Investors should once again feel comfortable valuing Compton common stock by putting a valuation on the entire enterprise and then subtracting the amount of net debt. Compton's most recent annual information form filed with Canadian securities regulators discloses an after-tax PV-10 of proved reserves of $1.0 billion. Subtracting the post-recap net debt, we arrive at an equity value of roughly $600 million or $2.28 per share, representing upside of nearly 350% versus yesterday's closing price of $0.51 per share. The after-tax PV-10 of proved and probable (2P) reserves is disclosed as $1.4 billion, implying an equity value of $1.0 billion or $6.45 per share (based on 263 million shares outstanding). Depending on the timing of this upside, it could be reduced somewhat by the exercise of up to 138 million warrants, which have an out-of-the-money strike price of $1.55 per share and expire on October 5, 2011.
If the just-completed recap is such a positive catalyst, why did Compton shares decline so precipitously after the recap proposal was first announced on July 19th? Actually, the beginning of the recent decline in Compton's stock price from $0.81 per share on June 18th to as low as $0.39 per share on August 27th coincided with the company's announcement that it intended to discontinue its dual listing on the Toronto Stock Exchange and the New York Stock Exchange, opting to stay listed solely on the TSE. The U.S. delisting notice was followed by a flood of selling by U.S.-based investors, even though the single formal listing saves the company millions and Compton shares continue to trade in the U.S. in the over-the-counter market under ticker symbol CMZPF.
As the selling in Compton shares accelerated, investors became nervous about the proposed recapitalization, despite the fact that Compton had a strong hand since it had just raised cash through asset sales and was offering debt holders $184 million of cash as a component of the recap. Nonetheless, because of a technical covenant breach due to errors in giving debt holders notices of past asset sales, investors apparently became nervous that debt holders could go so far as to force the company into bankruptcy. Finally, a $45 million convert that is part of the recap contained no fixed conversion price, making it look like a "toxic" instrument. Investors apparently ignored the fact that Compton had negotiated the convert in a way that forced debt holders to convert if Compton wanted them to do so, but also gave Compton the option of redeeming the convert for cash, thereby forgoing any equity dilution. Given Compton's positive cash generation and the ability to raise cash by selling a minor non-core asset for at least $45 million, we believe it is highly likely the company will indeed choose to redeem the convert for cash prior to September 2011.
Compton shares have embarked on a rebound over the past week, presumably as investors began to realize that the recapitalization transaction was likely to win bondholder approval after all. This is indeed what happended yesterday, paving the way for a fact-based rather than a fear-based valuation of the company. As facts prevail, we believe Compton will finally start delivering the performance that shareholders have been denied for too long.
Disclosure: Long CMZPF.PK