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Antero Resources (AR) is an independent oil and gas exploration outfit with operations focused in the Appalachian basin. The company is one of the largest integrated NGL and natural gas producers in the United States. Antero Resources was one of the pioneer drillers in the now prolific Marcellus and Utica regions, drilling their first operated well in 2009. Rapid development of the Appalachian basin required a large build out of infrastructure. To facilitate this process, Antero Resources formed Antero Midstream Partners (AM) in 2012. Subsequently Antero Resources went on to file for an IPO 2013 and Antero Midstream Partners followed soon after with an MLP IPO in 2014. Antero Resources has owned a large portion of Antero Midstream Partners equity since inception of the entity.
All was well and good, until the oil and gas bubble began to violently burst in mid-2014. Since then independent E&P companies have seen their share prices halved, then halved again. Gas focused drillers like Antero have been hit particularly hard. The fundamentals of the oil and gas industry are complex and while I believe there is a long-term bullish case for several Appalachian gas focused producers, this piece will focus on a transitory opportunity unique to Antero Resources.
The Midstream Transaction - Simplification and Interest Alignment
In response to the magnitude of the share price decline, and what management likely believes to be a criminally undervalued Antero Resources common stock, the company began seeking strategic alternatives for the Antero Midstream MLP assets. On October 9, 2018 the company announced that management had found a solution: a simplification of the Midstream MLP assets via conversion to a C-Corp structure. Management believes that this simplification will unlock significant value for Antero Resources common stockholders. The deal is expected to close on March 12th, 2019.
Note that I will be evaluating the benefits of this transaction solely through the lens of an Antero Resources shareholder, there will be no cost benefit analysis from the perspective of a shareholder in the current or future midstream structure. This is a somewhat complex corporate transaction, to frame the analysis here is a graphic representation of the current and proposed corporate structures:
Source: Antero Resources' most recent company presentation, February 2019
At a high level the transaction is designed to simplify the Antero Midstream corporate structure. The Antero Midstream LP units and the Antero Midstream GP shares (AMGP) are being merged to create a new, unified, publicly traded Antero Midstream C-Corporation. In the process management is converting the controversial "Incentive Distribution Rights" and the Series B Profit Interests into Antero Midstream common shares. Additionally Antero Resources is reducing its stake in Antero Midstream in exchange for cash payment of $300m.
This transaction has multiple benefits for holders of Antero Resources common stock; we'll walk through them one by one.
Benefit No. 1: Cleaner Financial Reporting
An immediate benefit of the transaction is that it enhances the clarity of Antero Resource's financial reporting. Currently Antero Resources must account for its investment in Antero Midstream using the consolidated method. This is dictated by accounting rules; a majority ownership stake (53%) requires this treatment. After the transaction is complete a 31% equity stake will permit Antero Resources to report using the equity method of investment.
Presently, consolidated reporting makes it very difficult to compare the operational results of Antero Resources to its E&P peers. For example: the midstream asset has a higher leverage ratio compared to Antero Resources E&P division. As a result of consolidated reporting, stock screening services such as Bloomberg terminal often displays the consolidated leverage ratio as opposed to Antero Resource's stand-alone leverage ratio, which happens to be much lower. Simplified reporting will greatly improve the relevancy and visibility of Antero's E&P performance and balance sheet metrics.
Benefit No. 2: Elimination of the IDRs and Potential Conflicts of Interest
The second benefit of the consolidation effort is the elimination of what are known as "Incentive Distribution Rights." IDRs are a common feature among Master Limited Partnerships. The intent of an IDR is to incentivize the management of a midstream asset to increase the payouts to the limited partners (refer to the "Status Quo Structure" diagram, IDRs incentivize growing the payout to the Antero Midstream Partner LP units, of which Antero Resources owns 53%). Often they are structured in a way that allows the IDR holders to benefit disproportionately as distributions rise. Taken from Antero's Q4 2018 results, here is how that works in practice:
Source: Antero Resources, emphasis mine
As you can see the limited partners (the portion Antero Resources owns) annual distribution grew 30% year over year while the IDR distributions (owned by Antero management) grew by 104%! Importantly Antero Midstream derives nearly all of its revenue from servicing Antero Resources. By this point you should start to see the issue. A potential conflict of interest exists: it is very lucrative for Antero management to grow the midstream payout portion, as their IDR payouts increase even faster. They could theoretically be incentivized to overspend at Antero Resources to increase the midstream profitability and payout.
Now, I am not suggesting that management has done this, in fact I think this management team is highly capable; that being said, the perception of conflict is still there. The simplification transaction removes this potential conflict entirely. The IDRs cease to exist. This both lowers the cost of capital for the midstream asset and increases the potential payout to holders of Antero Midstream common stock, of which Antero Resources will still own 31% upon closing.
Benefit No. 3: $300m Cash and the Resumption of the Buyback Program
When this transaction was announced on Oct. 9 Antero Resources simultaneously announced the initiation of a share buyback program. The authorized $600m buyback program began in 4Q18. Management repurchased roughly 9 million shares in November and December for an average price of $14.10. Spending $130m management was able to reduce shares outstanding by 3%. The only issue is that shares are now trading at $7.80. Management has not repurchased any shares since the fourth quarter. In my estimation they are now wisely waiting until completing the midstream spinout to resume the repurchase program. If management thought this company was undervalued at $14.10 a share I imagine they are itching to ramp up repurchases at $7.75-$8 a share as soon as possible.
By reducing the amount of relatively expensive midstream ownership from 53% to 31% management can stretch the buyback program further by repurchasing a greater proportional amount of the cheap E&P division versus the more expensive midstream business. The $300m cash windfall and midstream divestment will be the trigger for resuming large buybacks. Current market cap of Antero Resources is $2.39b as of writing; the $470m remaining repurchase allocation would further reduce share count by 20% at current prices.
The benefits of the transaction are nice but what most entices me about this situation is the current valuation of Antero Resources common stock and the significant disconnect this transaction surfaces. Using the deal parameters and market prices as of the March 8, 2019, close I quickly derived the following market value of Antero Resources equity in the new Antero Midstream, post-transaction:
Antero Resources' current market cap is ~$2.4 billion as of 3/8/19 close. In addition to the $2.25 billion stake in the new Antero Midstream C-Corp, Antero Resources has a valuable hedge book. Comprised of derivatives used for hedging commodity prices, the fair value of the portfolio as of 12/31/2018 was a net asset of $607 million. The value of the derivative portfolio can be found on page 79 of Antero's recently filed form 10-K.
Using Antero Resources' stand-alone financial disclosures we can ascertain the amount of debt that should be considered in valuation of the E&P business. Here are selected financial metrics, reported on a stand-alone basis. This is what Antero Resources' financial reporting will look like post transaction, as opposed to the consolidated basis which is status quo reporting. Again, this exhibit can be found on page 69 of Antero's 10-K:
Source: Antero Resources
Focusing on liabilities we can see that Antero's current assets and liabilities roughly offset each other. Long-term debt and other liabilities total $4.54 billion for the E&P division of Antero as of year end 2018.
The most important asset of any oil and gas company is the value of the stuff they can still pull out of the ground. Each year the SEC requires oil and gas companies contract third party engineering firms to audit the value of their natural resource reserves according to a specific formula. Here are Antero's results as of year-end 2018 and reported in the 10-K, pages 5 and 6:
Source: Antero Resources
One set of relevant variables for the value of the reserves include the pricing inputs. These are the 12-month average prices used to compute the values for each year:
- 2016: $2.31 natural gas, $13.58 per Bbl of NGLs, $42.68 WTI
- 2017: $2.91 natural gas, $20.40 per Bbl of NGLs, $45.35 WTI
- 2018: $2.93 natural gas, $25.05 per Bbl NGLs, $56.62 WTI
The independently audited after-tax value of Antero's reserve profile ranges from $3.28 billion in an abysmal pricing environment to $10.48 in a more robust year. Note that drilling improvements and reserve additions have been made so even if commodity prices declined to 2016 lows the reserve profile would likely still be worth a good deal more than that low end number.
The estimated three-year average after-tax value of Antero's reserves is $7.46 billion.
Summing up the valuation:
I believe this simple valuation to be relatively conservative. Smoothing the value of reserves builds a margin of safety. Additionally the values of Antero's reserves are discounted to present value per SEC requirements. Midstream assets and the derivative portfolio valuations are based on market prices, which incorporate a discount rate. Antero's future debt obligations were not discounted to present value; using the face value of the liabilities is another conservative choice. Antero Resources owns assets other than the three core assets we evaluated for valuation purposes. In this simple model those assets were not considered, although they certainly have some monetary value.
The completion of the Antero midstream simplification transaction on March 12 will pave several pathways to a higher share price for Antero Resources. Improved financial reporting, alignment of interests, and most importantly restarting the buyback program, all looming catalysts that also provide long-term structural benefits to Antero. Traders looking for a short-term play have near term tailwinds, particularly with the imminent resumption of share buybacks. Value investors with a longer investment horizon can buy a solid business at fire sale prices. The value proposition that Antero Resources offers at current prices is just too tempting to ignore.
Disclosure: I am/we are long AR. 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.