MFC Industrial update 7/23/12
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.