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MFC Industrial update 7/23/12

July 25, 2012

Was Michael Smith listening to the plea for action in my recent semi-annual review? Well, whether he was or not, we’ve now got something to chew on. Two weeks ago on July 9 MFC announced an offer to purchase all the outstanding shares of Compton Petroleum for CDN $1.25 per share, a total consideration for Compton shareholders of about $33 million. MFC has also committed to contribute $30 million in equity capital to Compton once the takeover is finalized. The bid is not contingent on financing, as MFC has enough cash to finance the entire deal several times over, but is contingent on at least 2/3 of Compton shareholders accepting the offer. The press release also announced that MFC had purchased 6.5 million warrants at $1.25 convertible on a one-for-one basis into Compton common shares, and had entered into a lockup agreement with parties controlling about 54% of the outstanding Compton common shares. This will be a friendly takeover as the Compton Board has recommended acceptance of the offer. It looks quite likely that the takeover will be completed; If MFC converts its warrants into Compton common shares, MFC would own over 63% of the outstanding Compton shares, thus needing only 4.5% of the currently outstanding non-lockup shares to tender in order to reach the 66 2/3% threshold. Once MFC owns 2/3 of the outstanding shares, under Canadian law the company can initiate a second step takeover in which they force the remaining shareholders to accept a buyout. So, barring a superior competing offer (above $1.55/share), the deal should go through. The tender offer period expires on August 16 so there is still a month of potential developments.

OK. Now that we know that the takeover is likely, should we, as MFC shareholders, be pleased? At first blush buying Compton at this price might look like a steal; At the end of the 1Q 2012 Compton had a per-share book value of $10.54. Does that mean MFC is paying $1.25 for something with a value of $10.54? Well, not exactly. Compton, after all, is primarily in the Gas exploration and production business, and we all know what a terrible business that is today with natural gas prices at historic lows. Furthermore, the capital structure at Compton is in a shambles: the company has been through two reorganizations in as many years. The last one was completed less than a year ago;  bondholders converted all remaining non-bank debt to equity, with previous equity owners retaining only a sliver of the recapitalized company. Subsequent to the reorganization the company had only asset-based bank debt to provide needed financing. But with gas prices falling this year, asset values in the gas patch followed suit, and the company’s reliance on bank debt has put it in difficulty again. At year-end 2011 the company had a $140 million line of credit, of which $113 million was drawn down. The draw down had increased to $125 million by the end of the first quarter, but when the semi-annual credit review was completed in April, the line of credit was reduced to $110 million. This meant that Compton had 30 days to repay any amount over the new $110 million limit. Compton was yet further in debt by the time the new credit limit was established, and, with the lender providing extensions to the cure period, by the end of June had $30 million to repay to become compliant. It appears Compton management’s focus was not so much on stemming the cash bleed (maybe funds were already committed) as looking to asset sales for excess cash to repay lenders. But asset sales don’t happen overnight in the best of times, and when you’re a forced seller, the sharks come out. In May Compton did what all companies in trouble do, they took on an ‘advisor’ to develop a plan to improve liquidity. I’m not sure, given continuing weakness of gas prices, what this could have meant except devise a plan to sell assets or sell the whole company. In early July before the MFC tender announcement Compton did, in fact, announce an asset sale worth $17 million that would close by the end of July, proceeds from which would be used to partially repay the outstanding credit balance. Obviously that wasn’t enough to cure the borrowing position let alone provide funding going forward. My guess is that there was a lot of frustration on all sides. Management was unhappy about at having to liquidate carefully accumulated assets at fire sale prices, lenders were getting near the end of their tolerance for further cure period extensions, and erstwhile bondholders were wondering what the heck they were doing holding a penny stock. (Most bondholders have no desire to hold equity at all, much less an illiquid penny stock, thus the 54% lockup). So why the MFC deal? Why not a sale to another oil & gas company? One reason may be that management had a clear incentive to find a buyer outside the industry;  purchase by a larger oil & gas company could only mean management would quickly become redundant. That kind of buyer would be looking at assets in the ground and calculating how much overhead (personnel) could be cut. So long executive offices!

Those may be the reasons the deal came together, but we haven’t answered the question whether the purchase is a good one for MFC shareholders. Let me say straight off that I don’t have enough expertise in the oil and gas area to determine the intrinsic value of Compton’s assets. What I can say from a strategic perspective is that 1) I like a purchase of assets at historically low prices, 2) MFC has some expertise in the commodity business so this isn’t completely outside their playing field, 3) perhaps, worst case, there could be a strategy to purchase the assets in bulk at a distress sale and then sell them off piecemeal for a profit, and 4) while this may be a role of the dice (who knows where gas prices will be a year from now) MFC is not betting the ranch; the total investment will be about CDN $75 million ($33 for the outstanding shares, $8 million for the warrants, $30 million additional investment and I’ve estimated $4 million for transaction costs), or less than 25% of MFC’s current cash hoard. MFC could, of course, lose more than $75 million as they continue funding cash flow negative operations but there does appear to be considerable potential upside on these assets. The EV implied by the tender offer of CDN $185 ($110 million debt plus the purchase price plus warrants and cash infusion) is less than 1/4 the EV of the company 2 ½ years ago (end of 2009). True, there have been some asset sales in the interim and values have plummeted with the fall of natural gas prices, but is the company really worth less than 25% of what it was 2 ½ years ago? Maybe Mr. Market is exaggerating on the downside the way he does on the upside!

Let’s take a look at the operating company:

Average daily production at during 1Q 2012 of 12,569 boe (84% gas, 16% liquids), down 13% from the same period in the prior year. The downward trend in production has been going on for several years, both because of asset sales and because of capital expenditure constraints. I wouldn’t expect the trend to change until natural gas prices begin to harden, which may not be so far away given we are at historic low prices and the see-saw nature of natural gas pricing.

Proven and Probable reserves at the end of 2011 were 76 million barrels of oil equivalent (boe). I calculate that shareholders were paying about $1.50 (EV [market cap plus debt] of about $3.00) per boe at the end of 2011. The MFC tender offer, adjusting for the Bigoray asset sale in early July and assuming exploration in the first half of the year replaced gas and liquids production, prices Compton in terms of boe at about $.56 (EV of about $2.50).  Is this cheap or expensive? I’m going to do a second post on that as soon as I look at some comparables.

In the meantime, Mr. Market has not given a definitive vote on the acquisition. MFC shares, which have been languishing well below book value for the past 6 months, initially jumped over 5% on the news. Since then, however, they have retreated along with the broader market. The outcome of the takeover hinges on how soon the natural gas market will turn up and when it does, how high prices will go. If prices return above $4 or $5 per Mcf during the next year, the acquisition could turn out very well for MFC. If not, the question is whether MFC will have the staying power to wait it out. Personally, I feel we have already hit the lows and hold other gas stocks like Chesapeak (CHK) in other accounts.

  1. It seems like it might be easier and safer to simply buy Contango Oil & Gas?

    Here’s the thing that I don’t like about MFC.
    1- Historically, the operating performance of its businesses hasn’t been great. If you strip out the “returns” from its merchant banking (it spun off with assets with book value far below actual value and slowly reported profits when these discrepancies were recognized) and just look at the free cash flow of its operating businesses, the returns have been ok but nothing phenomenal. Its commodity business sucks up huge amounts of capital with not-so-great returns. And, it is exposed to tail risks (it will lose money in years like 2008).
    2- Its iron ore royalty has done amazingly. (Ok, so this is mostly because the price of iron ore has skyrocketed.) Yet there is very little information on this key asset. If the mine is being expanded, then the royalty will be worth a lot more.
    3- Contango probably has better management in oil/gas/NGL E&P. Ken Peak has an amazing track record and receives technical advice from Juneau Exploration. Whereas MFC has a not-so-great record in operating performance and little E&P experience.
    4- Historically, Michael Smith has not demonstrated phenomenal capital allocation. It hasn’t been bad but it hasn’t been stellar. Book value/share has grown but that is because his company was spun off with assets with extremely deflated book value. And this is related to…
    5- Serious corporate governance issues, which I believe you have covered on this blog.

    Both MFC and Contango are slightly cheap in my opinion. Contango has been buying back shares in the past few years (though they will probably stop because they can buy BOEs cheaper by investing in distressed assets) while MFC has not. Contango has far superior management.

    And I don’t think Mr. Market is overreacting to Compton’s share price. Canadian natural gas producers are among the highest cost in the business (Compton is higher than normal because they sold royalties on their land). The fall in natural gas prices has been unbelievable. And Compton happened to be leveraged, so they got hit really hard by that. Ken Peak talks about how leverage has killed a lot of E&P companies… Compton is an example. He also states in one of his presentations that the independent E&P sector has a very poor history of profitability (also, it’s unusual for CEOs to say bad things about their own sector).

    *I used to own MFC but then I sold it. I’ve bought and sold Contango/MCF in the past… I currently own call options on it.

    • Glenn,

      Thanks for your in-depth comments. I did own Contango until four months ago. I bought in mid 2010 just after the company announced its asset writedown, because this was a ‘glitch’ in my book. My investment thesis was based on investor overreaction, not on the intrinsic value of the assets. When the shares recovered I should have sold but I became enamored of management and the company’s low cost position. I still made a good return but not as good as it should have been. Chalk it up as a learning experience!

      What I’m still trying to evaluate now, however, is not whether Contango is better than Compton. I’ll agree with you right off that Ken Peaks is certainly a better manager and strategist by far than anyone at Compton. The past is prologue! The question I’m trying to answer is whether to continue to hold MFC Industrial after its purchase of Compton. I took a position in MFC primarily because of its discount to book value and large cash position. The purchase of Compton changes that.

      Compton, as you state, is a high cost producer that is operationally leveraged because of its royalties. There are two sides of the coin here. If gas prices turn, the operational leverage will work to MFC’s advantage. For me, the question is not whether gas prices will turn upward but when and by how much. I need to understand whether MFC purchased Compton at enough of a discount to defray the risk that the upturn could take awhile, but I’m not sure exactly how to do that.

      As to your 4th point, I’m not sure that I agree that Michael Smith’s capital allocation skills are mediocre (“not bad but not stellar”). It appears to me that financial results of his companies are very lumpy; the past four years have been nothing to write home about but before the financial crisis they look pretty good to me (see at seeking alpha 8/30/11). He unfortunately distracted himself with all these spinoffs and recombinations at a time when the financial markets were going through a good bit of turmoil; I’d call that bad timing or bad luck.

      I do agree with you on the lack of transparency at MFC. It’s one reason I have been reconsidering my position in the company over the past year. I even reduced my position by 20% in May based on the lack of communication coming out of the newly combined company. However, I did know about the transparency problem when I invested and I hate to sell a position when I think the shares are trading well below intrinsic value; that was my stance on MFC before the tender for Compton. I’ll try to address my valuation of Compton in the next post and hope that you will provide some further critiques.

      • Hmm I suppose the real way of valuing Comption would be a discounted future cash flow approach. You would need to know the expected decline curves of their wells. Unfortunately, E&P companies often do not report these. (They could also fudge the figure since the engineers are only making an educated guess about future production.)

        An easier less accurate method would be to assume a certain % decline. If you assume any kind of reasonable production decline, I don’t think Compton looks that good at current prices. Free cash flow as reported in the MD&A on SEDAR is -$3.581M for the latest quarter. When well production declines in the future, this figure might be lower. On the other, there is a strong contango in the natgas market so you might see a 18%/year increase in natgas prices. Most of Compton’s revenues come from liquids and I don’t know the futures curve from that.

        2- My gut feeling is that it is a leveraged bet on natural gas going to $6-7.

        The balance sheet looks terrible with current assets of $25M versus total liabilities of $346M. The land is worth something… but right now Compton is not completing a lot of new wells because (presumably) the current economics don’t make sense. The existing wells are having a hard time churning out reasonable free cash flow. (FCF is a generous metric for Compton as their overall production has been declining a lot as they haven’t been investing enough in new wells to keep production up.)

        Their assets have salvage value that isn’t in the current assets of $25M… it is over $100M according to the MD&A. (I don’t know much in this area so I don’t know if that is reasonable.)

        The current value of the land might be looked at as an option on natgas prices going up a lot. Right now very little of that land will be developed because the economics don’t make sense. In the future the economics might make sense.

  2. Kyle permalink

    Why on earth would you strip out the returns from his merchant banking activities? The two most recent transactions indicate smith hasn’t changed his stripes. He doesn’t take the passive “Buy great businesses at a reasonable price”, he’s a Vulture. It’s much easier to get companies to the deal table if they don’t think MFC is going to strip the assets and liquidate it. Owning stable & sustainable operating companies is great, but its really hard to find them at a reasonable price. The spinoffs are the most tax efficient way to pay the shareholders. Agree 100% on the transparency and governance, but to say he has a poor capital allocation history is ridiculous.

    • If you look carefully at MFC financial before it merged with Terra Nova… MFC spun off from its parent with a lot of assets that were valued on the books for very little.

      In the past I wrote an email with the following:
      “I believe that Michael Smith’s modus operandi is to spinoff a company and have the parent company give really good deals to Smith’s flagship stock (i.e. MFCAF) with really good deals. For example, if you read the related party transaction sections of KHD/TTT, you see that MFCAF has agreements to entitle it to various fees, call option on MFC corporate services, preferred shares at very attractive terms to MFCAF, etc. etc. I would attribute MFCAF’s phenomenal growth in book value to these deals, as they were carried at 0 book value even though their value is much higher than 0. Considering that most of these deals are no longer in place (other than a few million in fees that MFCAF receives from TTT), I wouldn’t expect MFCAF’s book value to continue growing at such a phenomenal pace. Also, I find it a bit misleading/promotional of Smith to highlight MFCAF’s incredible growth in book value… MFCAF was engineered to have a very low book value in the first place.”

      Most of MFC’s growth in book value came from adjustments in book value to spinoff-related assets. You’ll have to read the 10-K for the MFCAF predecssor company carefully (just skip to the related party transactions).

      Once you make that adjustment, you realize that his capital allocation is not as stellar as it seems to appear. He didn’t really grow capital at a rate of 20%+. It’s somewhere in the single digits (which is not bad anyways).

      2- Unfortunately there is no spinoff coming. I was hoping that he would be up to his old tricks and create a really undervalued spinoff. (Maybe my hopes are a little perverse :/ )

  3. I guess I was wrong about the iron ore royalty. See Cliffs quarterly results:

    Click to access 707207.pdf

    The Wabush mine has high operating costs ($133/t cash costs) and is very marginal. The royalty isn’t anywhere as good as I thought it was. In Q2 of 2012, Cliffs received $128.39/t for its Eastern Canadian iron ore production (though the Wabush output receives a higher price than the Bloom Lake output since the Wabush mine produces pellets and BL produces fines; Wabush pellets have elevated manganese and receive a lower price than other pellets).

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