Montage Resources: Too Many Buffalo At The Same Waterhole

Jan. 09, 2020 1:49 PM ETSouthwestern Energy Company (SWN)20 Comments8 Likes

Summary

  • This formerly natural gas producer now has significant oil production in a basin not known for oil production.
  • The "bankruptcy discount" clearly ran amok with this company.
  • New management clearly is running a far more financially conservative ship.
  • There is plenty of liquids rich acreage to keep the company busy for years. Stacked plays provide speculative upside to that scenario.
  • Enterprise value is dirt cheap. All that is needed for a better valuation is for management to continue doing what it is doing and wait for market recognition.
  • This idea was discussed in more depth with members of my private investing community, Oil & Gas Value Research. Get started today »

One of the problems with any commodity industry is that too many companies often have the same solution to a common problem. In the process of solving one problem, they create another problem. Too many buffaloes are heading in the same direction. Montage Resources (MR) appears to be part of the herd. It may have been in the lead to get more liquids. But that solution has way too many participants right now to solve individual company problems.

Usually, the solution is to have the lowest costs and highest revenue to weather the oncoming commodity storm of oversupply. The Marcellus and the Utica Shale basins may provide a good place to look for those types of companies as the current oversupply situation runs its course.

Montage Resources is a company that barely managed to avoid the fate of many competitors. The company is the result of the merger of Eclipse Resources (ECR) and Blue Ridge Mountain (OTC:BRMR) (the former Magnum Hunter Resources after bankruptcy). Eclipse Resources had a fair amount of debt for a natural gas producer while Blue Ridge Mountain had just eliminated the debt. Therefore, the merger provided the combined company with more cash flow to service the combined debt.

However, Mr. Market does not like a combination of a troubled company with a formerly bankrupt company despite the improved prospects after the combination. The "troubled" and "bankrupt" color the market evaluation of future prospects. Evidently, the lingering reputation of the past will provide an investment opportunity for the future. John Reinhert, CEO, who guided Blue Ridge through bankruptcy after Gary Evans left, now heads the combined company. Oleg Tolmachev became COO after he showed Eclipse how to drill some record long wells profitably in the basin.

That means both leaders who had the blame or reputation for getting their respective companies into a financial jam are gone. It is going to take the market a while to evaluate the new management and decide whether or not to tar (or label) the new management with the accomplishments of the past.

In the meantime, this company is heading the mass rush to more liquids for dry gas producers in the basin. It appears to be doing so with the lowest costs and most valuable liquids. As the industry "piles-on" to the more profitable acreage, investors can expect those value added prices to decrease when supply grows much faster than usual. Montage Resources appears to have the wherewithal to make it through the coming storm.

Source: Montage Resources November 2019, Corporate Presentation

This management headed for liquids as a way to pay down debt long before the merger was ever announced. After the merger, the new management assessed the combined inventory and high graded the prospects.

Increasing liquids can change costs. Often, there are incremental costs to separating out the various products into a sales price maximizing form for the group. Oftentimes, that sales maximizing process can vary with market conditions. Therefore, the costs of dry gas producers can be very different from those with liquids or other value added products. A lot depends upon the basin and the location in that basin. Therefore, investors need to watch both the cash flow and the margin generated. Sometimes, a great margin generates an insufficient cash flow because too much capital is needed to produce that great margin.

Source: Montage Resources November 2019, Corporate Presentation

The result of that high-grading is shown above. Investors need to hope that general and administrative as well as interest costs leave the company with sufficient profitability after those costs and others not included in the profitability calculation shown above are removed from the gross margin.

Now, the assumptions of $3 for gas are on the generous side to state the least. But the company is unlikely to lose money when the returns are that high even at significantly lower gas pricing. Plus, management can very quickly shift to drilling for more liquids as shown in the previous slide. There is years of prospects in both areas. Therefore, current liquids opportunities are not a problem. Plus, there is going to be some distressed competitors that will offer an acquisition opportunity.

Note that the oil price assumption is far more conservative. Oil is now a significant part of revenue. Many drillers in this basin talk about liquids, but those liquids are chiefly ethane. Ethane rejection or a lack of sufficient ethane demand is a problem. Without sufficient demand, ethane will remain in the gas stream to be sold as natural gas (for less money).

The presence of a significant amount of oil is a key competitive advantage for a formerly dry gas driller. That very profitable oil can mean the difference between surviving a period of oversupply and not making it. Oil is so much more profitable than gas per unit of measure that it generally increases profitability quite a bit in very small quantities.

Source: Montage Resources Third Quarter 2019, Earnings Press Release

Already the waterhole is looking overcrowded as both natural gas pricing and natural gas liquids pricing declined significantly in the latest quarter. This company, like Antero Resources (AR) has a commitment to the Shell (RDS.A) ethane cracker plant that is coming online in the near future. That will definitely help ethane pricing in the basin in the future. In the meantime, everyone in the industry as to "make-it" to that solution.

In the meantime, the move to liquids is definitely helping. But the lower pricing is blunting the expected benefits. Whenever gas pricing declines to the levels shown above, it is time for management to find a way to get to more profitable markets. Those market exist to the north, though capacity to those markets is strained for political reasons. There is also more accessible stronger market that this management is exploring. Most gas producing companies cannot withstand the gas pricing shown above for long periods of time.

To the credit of this company, the liquids has enabled a profit in the latest quarter. Clearly, things can get worse before the balance sheet and company are financially strained. After the last few years, management cannot wait for that strain to happen.

Source: Montage Resources November 2019, Corporate Presentation

The company currently has probably one of the highest percentage of liquids produced in the race to find more liquids in the basin. As such, it has some of the better margins in the industry for a formerly dry gas producer. Not only that, but management has managed to maintain those low dry gas processing costs while increasing the amount of liquids as a percentage of production. That ability does wonderful things for margin while lowering the corporate breakeven.

Even more important is the formal notice above that this is a stacked play as shown above. This basin is known for its dry gas and liquids rich gas production. However, some of those intervals contain oil. As the industry continues to improve production and well design techniques, the oil production from this basin will become significant in the future. Those intervals may or may not be profitable at current pricing. What is known at the current time is that the current development involves the most profitable intervals. Therefore, a somewhat speculative opportunity currently exists to produce more oil from oil rich intervals.

Margins

Wide margins are a sign of safety during the current industry downturn. This buffalo appears to be in good shape at the crowded waterhole.

Source: Montage Resources Third Quarter 2019, Earnings Press Release

Even during the latest period of weak pricing, the margin after most expenses, including administrative and expenses, is still 42%. That is clearly among some of the best margins shown by formerly dry gas producing companies.

Cash flow appears to be in very good shape for the debt levels. EBITDAX is currently more than half of the long term debt amount. This is not the kind of ratio you would expect for a combined company with a history of financial stress.

More importantly, the growth in oil production was running near 50% when compared to the previous year. Even though oil production is relatively low at less than 10 MBOD, that rapid growth will continue to improve margins which will offset the weak pricing of other products.

Summary

This company is well located in one of the lowest cost gas producing basins in the industry. At the same time, management is leading the industry towards more liquids production in the basin. Clearly, this company has a head start that is leading to far better margins than many competitors. More importantly management found a significant amount of oil that is far more profitable to produce than either ethane or natural gas.

Source: Montage Resources Third Quarter 2019, Earnings Press Release

The oil production shown above already represents about one-quarter of revenue. Any oil price rally will provide some much needed relief from lower natural gas and other weak commodity pricing. The percentage of oil produce will clearly be growing for some time even if total production does not grow. That should provide a source of cash flow and earnings growth during the lowest part of the current gas pricing downturn.

Help appears to be on the way in the form of a declining rig count. But the market is worried about a recession. Such a recession should be relatively mild compared to the 2008 event. However, right now the market is pricing in something far worse.

Source: Seeking Alpha Website January 8, 2020

The stock price has about doubled from its summer lows. Nonetheless, the cash flow from operating activities should exceed $250 million this year.

Source: Montage Resources Third Quarter 2019 10-Q

Cash flow has been steadily increasing all year as merger expenses declined and oil production has increased as a total percentage of production. Therefore, the fourth quarter should be the largest cash flow event of the fiscal year due to high oil production and seasonally strong natural gas pricing. Even a warm winter should provide better natural gas pricing than was the case this past summer.

Given the above conditions, this company is priced with an enterprise value of about 3 times the expected cash flow. The fourth quarter annualized cash flow would calculate to an enterprise value heading towards two times cash flow. That is unusually cheap for a company with these conservative metrics and decent growth prospects.

In the five year horizon, this company could be priced at one time expected cash flow five years from now. Much depends upon industry conditions between now and then. But all that is necessary for that cash flow to happen in the future is continued growth and the movement towards a higher liquids percentage of production.

Continued undervaluation could lead to this company becoming a takeover candidate. The new management is clearly running this combined company far differently than the predecessor managements. Prudent financial planning appears to be the rule of the future.

A gas producer with the financial metrics shown above will be a safe investment to be considered by a variety of risk averse investors. The time to buy to minimize downside risk is during a period of weak pricing. This company already has a solution to better profits in the form of a growing percentage of oil production. Therefore, this management probably will not need stronger natural gas pricing to report improved profitability in the future.

This stock will easily double from the current price over the next five year period. It should probably do better than that as a far more average valuation would be an enterprise value of about 8 times cash flow once the industry gets out of the doghouse and the next upswing in the industry cycle begins.

The company also benefits from a change in perception as the liquids production continues to increase. In the future, Mr. Market probably will not see this company as a "gas producer" due to the significant production of liquids. That will be a second way shareholders will benefit in the future.

I analyze oil and gas companies like Montage Resources and related companies in my service, Oil & Gas Value Research, where I look for undervalued names in the oil and gas space. I break down everything you need to know about these companies - the balance sheet, competitive position and development prospects. This article is an example of what I do. But for Oil & Gas Value Research members, they get it first and they get analysis on some companies that is not published on the free site. Interested? Sign up here for a free two-week trial.

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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.

Additional disclosure: I may initiate a position in MR at any time without further notice.
Disclaimer: I am not an investment advisor, and this article is not meant to be a recommendation of the purchase or sale of stock. Investors are advised to review all company documents and press releases to see if the company fits their own investment qualifications.

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