Forest Oil Corporation (NYSE:FST) is an oil company that is asset rich but debt laden in Texas. Previous public non-pro write-ups have done an average job of describing the company but failed to capture the events in last two months. This post will cover a highly crowded special situations trade by hedge funders that has backfired, resulting in a very attractive opportunity. This is the most interesting opportunity I've seen so far and is worthy to be a case study in a Greenblatt or Klarman book.
In a nutshell, FST has become a huge hedge fund battleground between credit arbs/ quant shops and fundamental investors, The arb trade involves shorting the corporate debt and buying stock to BLOCK the merger by voting against in the proxy, gaining more on the short than the loss on the long. The fundamental trade exploits recent changes to the merger agreement and the significant undervaluation of the FST assets despite the massively dilutive merger. I strongly believe a long on FST will deliver outsized risk adjusted returns. The merger consummation acts as a catalyst, is almost guaranteed to pass, and will close within 3 months (2014 Q4).
Arb Trade: "Block Dat Merger"
Let's start by analyzing what the hedge funds are doing and look at it in more detail to figure out its sheer brilliance and weakness. Knowing why their trade failed is key to understanding why the fundamental trade opportunity exists. The following is the 3 month stock chart for FST.
I'm not going to bore you guys with the details prior to the merger agreement but the capital structure is important. FST used to have a pretty sizable market cap ($4-5 billion) but it has always been fairly leveraged in terms of a straight Debt/Mkt Cap and Debt/Equity calculation.
In April 2014, the capital structure was roughly 800 mil debt and 200-250 million market cap. The company was running short on liquidity and people feared a default. The debt was trading at the mid 80's to reflect these fears.
In May 2014, FST announced a merger with Sabine, a private company. Sabine would acquire FST in an all stock arrangement. The passage of the merger required a 2/3 majority of all outstanding shares. Bond prices immediately jumped to par to reflect the belief that the default risk had subsided.
Now this is the delicious part.
A few quant shops and credit funds had the following idea; short the debt, buy stock to "Block Dat Merger," gain on debt, lose on the stock. Who are these funds? Oh just Saba, Citadel, AQR, Renaissance, and a dozen other shops crowding in a $200 mil market cap company. The trade works because there is so much more debt than equity, so the losses on equity would be miniscule compared to the gains on the debt short. Meanwhile, everyone thought the stock popped because the default risk had been eliminated. The following spreadsheet output illustrates the trade;
So this trade actually GENERATED $190 upfront and made us a profit of $46.8. In practice, people went real deep and bought CDS with the extra money to leverage up on the bond short. Alternatively, they could have invested the initial CF in commercial paper to get 25-35bps annualized. The $46.8 significantly understates expected gains on the trade. The "Block Dat Merger" trade has nothing to do with business fundamentals and in theory delivers a market uncorrelated return. They'd profit if the business defaults or becomes more distressed by buying equity! This is highly counterintuitive.
And to convince you guys that a merger block would tank equities and bonds, look to the middle of June in the stock chart. A rumor on wall street was spread that Sabine's financing package fell apart and the merger would be pulled. The stock and bonds tanked. Sabine issued a filing that dismissed the rumor the following day and both stock and bonds rallied. The merger is critical to understanding the trade and market reactions.
For our beginning investors, a reverse repo is when we make a secured loan against a financial asset. We are paid interest on the loan but must pass interest from the asset back to the original borrower. We get the right to short the collateral and simply return the collateral at maturity and pay interperiod interest if we short.
What went wrong
The general perception of the management members is that they are highly incompetent. A 5 year stock chart, in addition to other mishaps, should convince us of that. At first, everyone was happy because of the rising share prices. Managers thought they did their jobs well and fundamental investors thought the liquidity problem was solved.
However, savvy financiers (probably JP Morgan capital markets and M&A guys doing their jobs) notified management of the "Block Dat Merger" trade. On July 9th, the merger agreement was amended. The merger only required a 50% majority of voting shares and management inserted control provisions to prevent hedge funders from acquiring more than a 5% stake. The "Block" trade became more expensive and less likely to pan out. Furthermore, it was heavily likely that management would amend the agreement to further ensure passage if the hedge funders did not back off.
Just like that, the "Block Dat Merger" trade fell apart. In the last few months, huge selling pressures from the credit arbs/quant shops have depressed the stock price below the pre-announcement value despite the merger passage likelihood increasing. I'm going to repeat that: unwinding pressures the stock down despite a more likely passage of the merger.
Fundamental Trade, Code Name: Value
So we still need to figure out a way to value what FST is worth on a fundamental basis. My assumptions are pulled from the JP Morgan M&A fair value opinion numbers and a few comps in the natural resources space in Texas of similar size. My base case consists of the merger passing, while my bull case consists of an orderly wind down of company as a stand-alone entity without merging:
As you can see, the merger dilutes current shareholders by 20% or so. This is probably a reasonable price to pay for liquidity and rescue financing. Sabine gets high quality assets, a reverse IPO, and economies of scale. FST gets rescue financing and becomes a mid-sized company with an implied equity valuation of 600-700 million (current market cap divided by pro forma ownership of combined entity) in addition to balance sheet deleveraging.
Neither of my valuation methods really fully takes into account FST/Sabine's ownership of considerable unexplored acreages. Ideally, I think a straight up liquidation analysis consisting of the summation of proven reserves value and the unexplored acreages value will fetch the highest valuation. However, it is highly unlikely that FST/ the combined entity will engage in full liquidations.
While I usually prefer to choose a "best and final" method to value a company, I think a blended scenario is appropriate because Sabine intends to sell assets to deleverage, which favors the proven reserves metric, AND operate core assets for production, which favors the production metric.
Q2 Results, Accounting Delay, and Merger Implications
Q2 (8/11/14) was a bust, with production, earnings, and cash burn missing estimates. All this is baked in and adjusted for in the above analysis. What we actually care about is the 10Q delay due to "control deficiencies."
Based on my reading of the 8k, it seems the issue is on the IT side and management giving accounting personnel access to different sections that fall outside of accounting staff mandates. Management also failed to properly maintain segregation of duties for the accounting software programers. However, it seems like management has been cooperative and actually worked with Ernest & Young since the 10K on the problem. Initially, the auditor and management didn't think it was important. But regulators stepped in and forced re-evaluation.
My reading of the incident is that it was just another case of a highly incompetent and lazy management. Management has been cooperative and E&Y actually thought the deficiencies were not material when first identified.
The implications of the 10Q delay on the merger is another issue. If Sabine and its experiened PE owner First Reserve did their due diligence well, they should have already known about these issues when they spoke with E&Y. Sabine can terminate if it determines a reps and warranties breach from FST. One of them is a material misrepresentation of financials. However, Sabine confirmed its dedication to the merger in July, when merger docs were changed to fend off hedge funders, and August, when the preliminary proxy came out. Economics are maintained the same. Furthermore, the delay was quickly resolved by the 10Q release, further reinforcing the view that the delay was not particularly material.
Given that E&Y knew about the issue for a while and did not originally think the issue could be material and Sabine proceeded with the merger documents as of 8/07/14, I think the chances of the merger going through are quite high. In addition, FST's assets are hard physical land and reserves. Accounting cannot financially engineer additional acreages or barrels of oil. The valuation should be robust.
Finally, the auditor is highly competent, unlike management. Overall, I am not concerned about the delayed 10Q and remain optimistic about merger passage.
I personally went pretty deep and hold a sizable portion of my net worth in FST. So the story is that a bunch of smart guys found a very smart arb that exploits the distressed situation, corporate governance issues, and incompetent management. Unfortunately, management found out.
In the conservative base-case analysis, the equity could be 50-300% higher within 6 months, especially since Sabine intends to deleverage and focus on production of core drills.
The probability of FST being fairly price is 0: The stock is a highly complex and misunderstood special situation. Its terrible TTM performance, negative book equity, micro cap -> mid cap upgrade, deep discount to NAV, and hedge fund forced unwinding is the type of situation that fundamental guys dream about. The risk-reward is highly asymmetrical.
Disclosure: The author is long FST.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.