Future Looks Bright For Gear Energy

| About: Gear Energy (GENGF)
This article is now exclusive for PRO subscribers.

Summary

Don Gray, chairman of the board is also chairman of the board of Peyto. Other board members have unusually deep experience so this board should be extremely active.

The light oil acquisition should transform the future profitability prospects of the company.

A projected exit rate of more than 6,000 BOE per day combined with the expected cash flow increases make this stock a bargain. The experienced management is free.

The money from the sale of stock was mostly deposited into the bank to save interest and will be withdrawn as needed against increasing production.

The third quarter corporate netback was very close to the amount of the previous year, a very unusual accomplishment given the commodity price decreases.

Every now and then there are executives than can successfully run more than one company at the same time. While not a common occurrence, the experience that these executives have often lowers the risk of an otherwise very speculative investment.

Source: Gear Energy November, 2016, Investor Presentation

Not only is the chairman of (Adobe download) Peyto Energy Trust (OTCPK:PEYUF) chairman of the board, but the current president of Raging River Exploration (OTC:RRENF) is also another board member. So the board of Gear Energy (OTCPK:GENGF) is going to be very active, very effective, and will raise the odds of this company succeeding tremendously. The rest of this board has experience that is not typically seen with a company of this size, so expect this company to grow quickly and profitably.

Gear Energy started off the fiscal year as a heavy oil producer in the Alberta-Saskatchewan areas of Canada. However, earlier in the year, management took the opportunity to acquire some light oil business.

"Gear Energy Ltd. ("Gear") (TSX:GXE) and Striker Exploration Corp. ("Striker") (TSX VENTURE:SKX) are pleased to announce that they have entered into a definitive agreement (the "Arrangement Agreement") providing for the acquisition by Gear of all the issued and outstanding common shares of Striker (the "Striker Shares") pursuant to a plan of arrangement under the Business Corporations Act (Alberta) (the "Arrangement"). In addition, Gear has entered into an agreement for a C$15 million bought deal financing and has received a term sheet for a pro forma C$50 million senior secured revolving credit facilities to be provided on closing of the Arrangement. The bought deal financing is not subject to the completion of the Arrangement. In addition, the board of directors of Gear has approved an increase in the capital budget to C$12.5 million for 2016 conditional upon completion of the Arrangement."

The estimated value of the deal was more than C$60 million. The financing was later increased to a little more than C$20 million. The two deals more than doubled the shares outstanding. Gear was looking for some diversification away from heavy oil. The combined company has better cash flow and much better ratios.

Source: Gear Energy November, 2016, Investor Presentation

In the past, this company had a low cost structure (Adobe download) that allowed generous profits when oil prices were much higher. But that debt to cash flow ratio was going from comfortable to straitjacket in the first quarter when commodity prices dropped again. The progress noted in the second slide reversed. The acquisition gives the company another way to maintain production during severe commodity price downturns. That may be important when cash flow margins contract.

One of the things experienced managements appear to have in common is the uncanny knack to jump start a company that the market leaves for dead. In this case, production was declining as the profit margin contraction really prevented new drilling for awhile. So even though the two deals diluted shareholders quite a bit, the company now has far better cash flow for the remaining debt and money to fund repairs and drilling for production increases. More importantly, shareholders have a stake in the combined company. This is in contrast to managements that literally do nothing until the company has no choice but to sell itself or reorganize.

Source: Gear Energy 3rd Quarter Management Discussion And Analysis

As shown above, the heavy oil production was declining precipitously (Adobe download), even alarmingly. Low commodity prices really crimped profitability to next to nothing for awhile. The company did resume drilling again as prices improved. But conservative managements such as this one are inclined to fix problems like cash flow ratio immediately so that the problem will not recur in the future. The long term debt-to-cash flow ratio is not the worst by far, but it was out of line enough that management took action. That is a sign of experienced and good management.

Notice that a relatively minor amount of higher priced light oil enabled the company to maintain its average pricing when compared to the third quarter of the previous year. Plus in times of really hostile conditions, a low cost light oil producer can still drill for oil and increase production. That may be not true for a pure (theoretically perfect) heavy oil producer even with the lowest cost in the industry. Those pricing discounts really hurt when commodity prices are low. This company has great costs but there are probably lower cost producers, so the declining production and compressing margins combined with the debt probably motivated management to diversify with an acquisition.

Source: Gear Energy 3rd Quarter Management Discussion And Analysis

The operating netback was decent (Adobe download) even before the hedging gains. The transaction costs relate to acquisitions and are considered non-recurring. They are definitely not operational costs. Though the corporate netback has decreased for the year, management has found a way to stabilize the quarterly comparison. Plus operating costs are decreasing when compared to the previous year. Diversification often brings a period of learning and cost challenges, but management experience may eliminate that challenge.

More importantly, the acquisition sharply increased liquidity. Long term debt decreased and the combined obtained a new bank line of credit. Though there is a scheduled redetermination, the resumption of drilling and the stronger commodity prices should aid the process. There are now more than 190 million shares outstanding. So purchases of significant positions of the stock should be much easier than previously. The sale of stock and the acquisition for stock should lead to a period of price weakness that may soon be ending.

Management is expected to report a production increase in the fourth quarter (to more than 6,000 BOE) plus the acquisition related expenses should be fading, so the bottom line should improve. Plus continuing production improvements across the industry should also lead to decreased costs. Management now has the option to drill more light oil wells and increase the percentage of light oil produced which should also increase the operating netback in the future.

Source: Gear Energy 3rd Quarter Management Discussion And Analysis

Since production was running considerably(Adobe download) below the guidance shown above, investors should expect and management has guided to an exit rate in excess of 6,000 BOE for the fiscal year. The light oil production will jump considerably above the annual guidance for the fourth quarter and remain there for the next fiscal year. As long as management can contain costs, as they are guiding, then the cash flow ratio projections shown on an earlier slide are very achievable, maybe even conservative.

Source: Gear Energy November, 2016, Investor Presentation

So for investors who watch cash flow (Adobe download), this company's cash flow is about to advance considerably. The latest cash flow figures had about C$2 million in one time transaction costs and probably some repair and operational integration costs. This management raised C$20 million, so expect costs to be high in the beginning, but also expect this management to require an adequate return on that money raised beginning with the first quarter of 2017 at the very latest.

To meet the cash flow guidance, the fourth quarter cash flow needs to be about C$10 million. Plus the first quarter will fully benefit from a lot of new production. So cash flow could easily begin the year with a C$12.5 million or so first quarter and increase from there.

Source: Gear Energy November, 2016, Investor Presentation

Cash flow for the latest nine months was roughly (Adobe download) C$.10 per share. So the current stock price appears to be in line with a very reasonable stock price-to-cash flow ratio. But the acquisition, the cash raised through the equity offering, and the resumption of drilling of activity could easily double that cash flow figure quickly. This company drills very cheap wells, so a stock price double over the next 12 months (provided oil prices cooperate a little bit and don't dive and sustain that dive) appears very realistic. The slides above detail some of the cost savings already achieved. Plus this company is increasing production from a very small figure, so rapid production growth with this experienced management is probably a reasonable expectation.

The slides above show some very good costs. But the first quarter low oil prices squeezed the company margins. Heavy Oil production was literally "discounted to death" for awhile. Now with the recent price rally, the company can hedge production and drill for some fairly profitable returns. Maybe the latest cost savings will minimize the hedging need. Management needs to be assured of getting back the money paid for new wells quickly and then can "let the profits run". As shown above, the heavy oil program is underway, and beginning results have become apparent.

Source: Gear Energy November, 2016, Investor Presentation

As shown above, management has plans for more profitable wells in the future than were drilled in the past. Already, the preliminary costs show decent returns on wells drilled so far. Management intends to improve those returns. Investors should probably expect a few test wells, with far more predictable drilling in the second half of the next fiscal year. The important point is that initial well results could vary quite a bit positively or negatively from the final optimal results. This management specializes in low cost optimal results and has the experience to get to those great results fairly quickly.

Light oil is forecast to be about 16% of the fourth quarter production. Successful results on this new acreage could lead to more acquisitions and a further increase in the light oil percentage of total production. So this acquisition has the ability to transform the company and its future prospects. The heavy oil business has good costs also, but the attraction of the light oil business is the higher prices. Those prices should lead to larger profit margins.

Summary

Source: Gear Energy November, 2016, Investor Presentation

Gear Energy was a very profitable heavy oil (Adobe download) producer that got crunched (financially) in the first quarter. Even with low debt and great operating costs, the cash flow ratios became unacceptable. Since then management has made an acquisition into light oil and raised cash to fund increased operational activities.

The cash raised was deposited against the bank line debt outstanding. I can be borrowed later as the company executes its capital program. Though there is some periodic credit line re-evaluation processes, the very conservative ratios that the combined company has should ensure that the credit line is not cut.

The one time acquisition associated costs should now disappear beginning with the first quarter of 2017 (and possibly for the fourth quarter of 2016). As shown above, the light oil acquisition should transform the company's prospects as well as some profit protection during future cyclical downturns.

There is always the risk of sustained commodity price downturns, but the latest round of bankruptcies should mitigate that risk. The OPEC deal may or may not hold, but either way prices probably bottomed in the first quarter. The experienced management should minimize the risk of sustained operational challenges or recurring operational mistakes. The hedging program can be expanded if needed. That management should also be able to engineer a faster growth trajectory.

The resumption of drilling as well as the new leases should lead to a very quick doubling of cash flow. Production in the fourth quarter could be 20% higher than the third quarter. In fact, if management turns optimistic enough, production could double next year from the pre-acquisition levels. While the quarterly growth rate will slow, the company has the credit line to increase production significantly next year if commodity prices just maintain the current trading range. Cost cutting and operational improvements are increasing profitability significantly.

Source: Gear Energy November, 2016, Investor Presentation

Management has also opportunistically purchased (Adobe download) new leases. There are a lot of distressed sellers currently, and several managements have commented on the high quality of prospects available at reasonable prices. Any of the recent acquisitions could likely transform the company as well as the prospect of future transformative acquisitions. The board and company management have unusually deep experience for a company of this size. So investors should expect more significant acquisitions in the future. Sometimes, the most valuable asset is not on the balance sheet. In this case, the stock looks particularly cheap going forward and the very experienced management comes for free.

The balance sheet is very strong. Long term debt is classified as current because the bank line matures next year. But the latest cash flow ratios show that a new bank line will be easily negotiated and so the maturity should not concern investors. There is a scheduled redetermination before the end of the year, but there is more than adequate credit availability and the credit line is not expected to change materially from the amount set after the acquisition. If anything, results from the latest wells combined with the recent commodity price rally and OPEC headlines should enable a far less stressful process.

This company does keep some cash on the balance sheet, but it also deposited much of the recent proceeds in the bank. Since the company does have a covenant concerning the working capital, management will probably choose to keep some cash in complying places. It will then draw the proceeds from the credit line as needed. This is a little more conservative as an increasing credit balance will have more production and greater cash flow as protection. Besides, if commodity prices stay where they are, and operating costs continue to decrease, then more debt may not be necessary as cash flow increases.

For a speculative stock, this company has a much better defined future and deeper management than many companies its size. Financial leverage is low and operating netbacks are unusually high. Cash flow is already increasing. The stock price could easily double over the next year and have more potential after that. It should probably at least double again over the following four years. The kiq financial leverage , and the cheap shallow wells ensure a very quick response to changing industry conditions. This company could probably easily obtain a larger bank line if necessary. The financing is in place for a very significant production increase if industry conditions permit. Since this is a very low cost producer, permitting industry conditions will cover a very wide range. The future is very bright for this company.

There is about C$14 million of convertible debentures that will provide a one time future dilution (roughly less than 10% ) at a premium to the current stock price. But the largest dilution is largely behind shareholders.

Disclaimer: I am not an investment advisor and this is not a recommendation to buy or sell a security. Investors are recommended to read all of the company's filings and press releases as well as do their own research to determine if the company fits their own investment objectives and risk portfolios.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.