An investment in Equal at or around the current price possesses nearly all the qualities we look for in a great investment. In particular (1) an unsustainable low valuation (both absolute and relative to peers) (2) a good, incentivized management team (3) near to medium-term operating momentum (4) an attractive, value-centric long-term business model (5) multiple internal and external high probability catalysts (which we expect will drive substantial near to medium-term upside) and (6) a situation where a variety of temporary issues converge to mask what we believe has been an impressive transformation in the company’s core business and future prospects.
Other attractive attributes of EQU include…
(1) Stable and highly visible revenue and cash flow stream
(2) Improving economics from an attractive asset base in well explored areas with well known economics (including all the Cardium, Viking, and Hunton plays)
(3) High likelihood of experiencing meaningful improvements in near-term profitability and cash flow
(4) New management team/Value-centric business model
(5) Reformed capital allocation Strategy. Going forward, Equal will focus on applying a value based strategy to the E&P industry by being opportunistic and exploiting the various structural inefficiencies available within the industry.
(6) A ~25% FCF* yield that (assuming flat $80 oil & flat $4.25 gas) is likely to grow at a 12-15%+ annual rate for the foreseeable future given the company’s deep inventory of liquids-rich, value accretive internal development opportunities.
(7) With 57% of Equal’s production flows coming from liquids, Equal is much better positioned than most North American E&Ps to exploit the current trend towards more valuable liquids volumes.
(8) Equal is well positioned to acquire more assets in the Hunton at a large discount to fair value from its bankrupt former JV partner Petroflow.
*CFO – Maint Capex
The current price implies a 2011E FCF Yield on EV of ~25%. That’s cheap, but almost impossibly so in our opinion after taking into account (1) the qualitative characteristics of Equal’s business (management, asset quality, etc.) and (2) it’s above average long-term growth potential.
In other words, given that EQU looks to be a good business that has a very high likelihood of generating an increasingly large amount of cash flows/share over the next 3-5+ years (i.e., that the current yield is likely to grow meaningfully from here), the current valuation is appears nonsensical. After all, today’s price implies that the market believes the company’s asset base is permanently impaired and/or it lacks a viable business model. That really is absurd. Put another way, not only is the market currently subscribing no value to Equal’s increasing oil production, ample high return drilling opportunities or the potential for nat gas prices to eventually rebound, it’s actually implying the business itself is essentially worthless.
Even assuming no multiple expansion, improving operating performance alone should provide investors with mid-teens returns over the next few years. That said, given the companies ~70% discount to the avg U.S and Canadian E&P and massive discount to its closest comp (PWE) relative to production, reserve, & drilling location multiples, multiple expansion seems almost assured at this point.
Brief Business Description:
Equal Energy (EQU) is a value-orientated Oil and gas exploration and production company based in Calgary, Alberta, Canada with its United States operations office in Oklahoma City, Oklahoma. Equal has a geographically diverse portfolio of oil and gas assets with producing properties located principally in Oklahoma, Alberta, British Columbia and Saskatchewan.
Production is comprised of approximately 57% crude oil and natural gas liquids and 43% natural gas as of Q3 2010. As of year-end 2009 EQU had 17 million barrels of oil equivalent (MMBOE) of net proved reserves which were 51% liquids weighted. Current production is $9,100 boe/day and the average remaining well life is 9 years.
2010 was a transitional year for Equal Energy. Effective June 1, 2010, the company completed its conversion to a corporation from a Canadian trust. As a part of this transition, Equal’s strategy shifts to growing production and reserves through the drill bit. By 2011, the company aims to have 500 potential horizontal drilling locations across four resource plays in North America.
On November 16, 2010, the company announced an estimated capital budget for 2011 of approximately $60 million. Equal’s 2011 growth capex is allocated 40% to the Viking play (light oil), 30% to the Cardium play (light oil) and 30% to the Hunton (rich gas). While all of Equal’s plays have attractive economics because of their exposure to liquids, the Hunton offers a free call option on natural gas prices, as a significant portion of the production flow is natural gas.
Additionally, Equal announced last week that many of the key items related to the recent bankruptcy of its Hunton JV Partner have been successfully resolved. Equal now owns a 100% working interest in its Hunton acreage, allowing Equal to unilaterally determine drilling plans.
Equal’s new strategy focuses on exploiting its significant drilling opportunities in the Cardium & Viking light oil plays in Canada and the Hunton in Oklahoma which produces liquids-rich gas. Finally, management is evaluating the Mississippian potential of the ~20,000 net Hunton acres it owns around Grant County Oklahoma. This 20,000 net acres will very likely contain economic Mississippian shale, as Sandridge has already drilled Mississippian wells on all sides of it. The Mississippian provides a major new growth opportunity for Equal and could act as an explosive catalyst once the investment community learns of Equal’s exposure. Finally, it should be noted that management says they do not have any lease expiration issues.
Equal seeks to manage the risk to shareholders by following a number of operating principles which are intended to maximize flexibility and the ability to capitalize on opportunities.
These operating principles include:
Diversifying the source of production geographically so that Equal is less dependent on one market for production or one area for future development
Maintaining a reasonable balance among crude oil production, natural gas liquids production and natural gas production, so that Equal is less vulnerable to short term price fluctuations for any single commodity
Seeking high working interests, operatorship and ownership of associated infrastructure, so that Equal is better able to control the pace and timing of capital expenditures; and
Maintaining a multi-year inventory of lower-risk development projects so that Equal can fulfill its strategy of reinvesting in organic growth opportunities.
Why is it Mis-priced?
Recent Restructuring/Corporate Rebranding:
In our experience, any time the historical performance of a business doesn’t give a particularly good view of what the prospective performance of a business is likely to be, there is an outsized chance the market will mis-price the opportunity in question. Typically, such situations are created when a business is in the midst of a major change in corporate organization and/or capital structure, and where the implications of the changes are not well understood. This is definitely the case here.
In Equal’s case we have elements of each, as the company recently put the finishing touches on a comprehensive restructuring where they were able to both right-size the capital structure and undertake the requisite operational and financial enhancements necessary to finally put the company on firm footing once again. Fwiw, we think Equal’s ability to lower its cost structure, fix its balance sheet and revamp and transform its operating footprint over the last year or so has lead to a permanent improvement in the company’s operating performance and significantly better long-term growth prospects. Consider its history for a moment. When it was formerly known as Enterra, the company’s former management team put the company in a tenuous position through years of inept management. In a remarkable lack of foresight, the company was paying out dividends in excess of cash flow while failing to invest in significant drilling. This led to production declining and the company becoming increasingly burdened by its high debt load. The financial crisis and crash in energy prices drove the company near a breaking point from which its share price is still yet to recover. Fortunately, new management was brought in and has been repairing the company. It is worth noting that the company’s poor operating history was due to a series of prior management’s missteps and not due to poor asset quality. In fact, Equal maintains ownership in many high quality liquids-rich plays that are operated very profitably by many large E&P companies So again, through the combination of (1) an intelligent reallocation of cash flows (2) debt refinancing’s and (3) non-core asset sales, Equal’s new management team was able to repair Equal’s balance sheet and is just now beginning to invest in the company’s liquids-rich fields to grow production & reserves.
In addition, management has finally finished the company’s corporate conversion and rebranding to Equal Energy. We think this was an important milestone for a few reasons. First because we think the move puts an exclamation point on the company’s new character while simultaneously helping shed the stigma of its relatively checkered past. Also, given all of the time and effort that was required to clean up the mess that was left for them by the previous management team and to actually execute the conversion itself, we think it’s a pretty powerful indication of not only the new management team’s competence, but more importantly their dedication to the company itself and its new direction.
Second, the company has changed its strategy from current income to long-term value. Remember that as a Canadian income trust the company was required by law to pay out the majority of their income as dividends. In converting to a traditional C-Corp, EQU will be able to unlock the value that has been tied up as a result of EQU’s need to satisfy short-term income investors.
Last but not least, the conversion creates – much like the underlying dynamics associated with when-issued shares – a small window of time (usually 2 or 3 months) where an opportunistic investor can essentially “front run” a shareholder base conversion from income-seeking retirees to a more traditional institutional shareholder base. As the company establishes a track record as a traditional E&P we expect increasing analyst coverage and institutional buying to begin driving Equal’s share price towards a more normalized level. There are very few situations where one has the chance to analyze/invest in opportunities before it starts to show up on the radar screens of more “mainstream” investors. This is one of those opportunities.
Remember that for all intents and purposes no one is really aware that this company even exists at the moment, as management hasn’t gotten the chance yet to really introduce and educate the institutional investment community on Equal’s various virtues. Our guess is once the institutional community gets wind of the qualitative and quantitative characteristics of this investment during management’s upcoming roadshow (i.e., not only its price but the quality of management, it’s diverse collection of attractive assets, its highly visible and significant growth trajectory, etc.), the current mis-pricing won’t last long.
Trust Conversion/Non Economic Selling:
EQU’s recent conversion from a trust to a corporation likely lead to a healthy amount of non-economic selling as the company’s dividend focused retail investors jumped ship for reasons unrelated to the company’s intrinsic business value.
Another possible explanation for EQU’s discounted valuation is that EQU’s Hunton acreage was, up until a few weeks ago, operated via a joint-venture with Petroflow Energy, a company that had slipped into bankruptcy following the collapse of oil and gas prices several years ago. While Equal continued to receive their fair share of production while Petroflow was in bankruptcy, it wasn’t allowed to drill any of the acreage until the bankruptcy was resolved. The elimination of this overhang should, with time, help to unlock substantial value for the company’s shareholders, particularly as the value of this acreage has increased substantially over the last couple of years given the drilling results that have been produced by such companies as SandRidge and Chesapeake. The Hunton’s significant NGL production and the northern section’s exposure to the upcoming Mississippian oil shale play mean that there is a significant amount of unappreciated asset value..
As things stand today, the only remaining issue that the company faces related to the bankruptcy of Petroflow involves around $15 million in Petroflow receivables currently owed to EQU. Equal’s management believes it will receive what the company is owed and has stated that, either way, the outcome of this issue shouldn’t be material to the company as the majority of the funds have already been written off.
Ironically, we think that this issue might actually end up turning out to be a very good thing for EQU given that the company might be able to buy Petroflow’s assets through the bankruptcy process at what will almost certainly be distressed prices. Given that Equal is an operator and owner of a significant amount of the infrastructure in the area, EQU would appear to be in a strong position to make a strong bid for these assets.
Historical Results Significantly Understate Normalized Economics & Growth Potential:
Revamped Strategy/Approach to Capital Allocation – Equal’s historical focus on income generation as in income trust has given way to a unique, differentiated strategy centered on the opportunistic acquisition of undervalued assets, typically where (1) there’s little competition and/or (2) they can utilize their smaller size to exploit the weaknesses of their much larger, less thoughtful competitors. Nice J. Examples of this approach include purchase properties below replacement costs and/or exploiting proved undeveloped reserves that are non-core to larger E&P companies by connecting these leaseholds to their existing infrastructure in place. Going forward, acquisitions are targeted at 30%+ IRR’s.
Keep in mind that the companies large inventory of undeveloped, high quality acreage should provide them with a deep pipeline of highly accretive reinvestment opportunity, & should allow them to grow organically (i.e. through the internal development of existing land vs. acquisition) for years to come.
Positive Mix Shift – Management’s decision awhile back to tactically exploit the huge oil/nat gas pricing differential has been an intelligent one in our opinion. By utilizing the excess cash derived from their stable, lower margin gas wells to fuel the company’s strategic investments in higher margin oil wells and areas with high levels of NGL’s, management is slowly succeeding in transforming the underlying earnings power and reinvestment opportunities of the business for the better.
Again, as higher margin oil and NGL’s become an increasingly large % of its assets and cash flows over the next few years, EQU should benefit by generating increasing amounts of FCF/share and by the inevitable NAV re-rate that results.
Significant Natural Gas Exposure:
With overall sentiment regarding all things natural gas wildly negative, it shouldn’t surprise anyone that investors are apprehensive to invest in what has quickly become a near universally loathed industry. Yet with natural gas prices as depressed as they are (and EQU as cheap as it is), we think the natural gas aspect of this opportunity is a meaningful positive as (1) we think Equal will continue to thrive even if we assume no change in the underlying operating environment (i.e., we will very likely make money here regardless of whether prices do or do not stay depressed) and (2) any meaningful rebound in prices would provide a substantial upside kicker given EQU’s substantial exposure to natural gas (providing essentially a free call option should natural gas prices eventually rebound).
Equal is somewhat unique in that half of its production is in Canada and the other half is in the US. Most E&Ps are heavily focused in one country as investor bases tend to be focused on their home country. Also, the largely unknown Hunton play has not gathered the significant industry attention of the big unconventional plays because of the Hunton’s small size. In addition to attractive economics, the Hunton has the unique characteristic of being naturally fractured. This means that expensive hydraulic fracturing services is are not needed to achieve high rates of return. As hydraulic fracturing costs tend to be volatile and increasingly expensive and environmental concerns continue to rise this feature becomes increasingly favorable.
We value EQU looking at the company ’s value from three different perspectives: absolute return based on cash flow estimates, PV-10 versus peers, and production/reserves multiples versus peers.
Put simply, we think that in buying Equal today, one is essentially purchasing $1 worth of high quality growing assets at ~$0.40. While Equal deserved to be trading at a severe discount to fair value during its liquidity crisis a couple years ago, now that management has strengthened the balance sheet and refocused on growing production we think the company should be trading closer to traditional peer valuation metrics.
Essentially, what makes this idea particularly attractive is that Equal’s existing large production base is a known low-risk easy to value asset. Equal’s core properties are located next to the core properties of other major E&P companies such as Sandridge & Penn West. As Equal no longer is financially distressed or being run by a poor management team, Equal should be valued more in line with peers that own acreage with similar economics that are adjacent to Equal. Even without looking at peer valuations, the underlying economics of the company’s asset base are quite attractive given that the average IRR on Equal’s well-explored properties in the Cardium, Viking and Hunton are between 25% and 45% at $80 oil and $4.25 gas. The IRRs are likely 80% or higher for the Mississippian, according to estimates from Sandridge and Chesapeake (again at $80 oil). Also important in our mind is the long-life of the company’s production. It would take ~9 years at current run-rates for Equal’s existing developed reserves to be depleted.
Absolute Valuation Approach – $15.14 Target
From a cash flow perspective, a purchase of Equal at its current price (~$7.00) would generate a roughly 20% annual cash return on investment solely from the company’s current developed asset base. We believe investors are essentially receiving a +400 current well inventory with +30% IRRs for free.
Given the above, we feel comfortable stating that Equal’s existing reserve base will be able to generate stable, high margin cash flows for the next decade, even assuming the company never puts another dime towards growth capital expenditures. The key takeaway here is that Equal’s developed assets provide Equal’s shareholders with several years (10+ years, depending on well decline rates) of significant and recurring cash flows, which are being used to fuel additional high return investments. Essentially, Equal is a .40 cent dollar that is growing at around a 15% annual rate (at $80 oil & 4.25 gas) for at least the next 5-6 years. Beyond 6 years (at which point the FCF yield on the current price will have grown to +50%), the drilling inventory in the Viking will be depleted. However, we believe the company should easily be able to find additional high-IRR inventories before the Viking inventories run out (such as in the still developing Mississippian shale play.)
Management’s capital expenditure guidance breakdown is as follows:, 40% to the Viking and 30% each to the Hunton & Cardium). At $80 oil and $4.25 gas the IRRs of the Cardium (25%), Viking (45%) and Hunton (25%) plays we see a total capex IRR of ~ 33%. Given Equal’s existing production base and the rate of return on reinvestment, we think an investment in Equal’s at or near $7/share carries an expected annualized return of 34%. By taking the view that an appropriate return for an investment with this level of visibility and quality of assets should be in the neighborhood of 15%, we believe the equity should be worth ~$15/per share, assuming conversion of the $45 million notes at $9 per share. For a detailed review of this valuation scenario please see the attached spreadsheet.
|Equal Energy Return Calc|
|Net Debt (assuming conversion)||$100.00|
|Plus: Int. Savings from Conversion||$2.00|
|Less: Maintenance Cap Ex||-$5.00|
|Free Cash Flow||$57.00|
|Annual Production Decline||9%|
|FCF Yield Adj. for Decline||16.06%|
|Asset Play Returns|
|Return on Invested Capital||33.0%|
|Cost of Capital||15%|
|% of Yield Invested New Wells||82.5%|
|Expected Return from New Wells||29.14%|
|% of Yield Invested in land||17.5%|
|Expected Return from Land Purchase||2.82%|
|Current Share Price||$7.00|
|Required Return||Target $||% Return|
Penn West and Sandridge are probably the most comparable publicly traded peers. Penn West is a large Canadian trust that recently converted to a corporation which has substantial acreage near Equal in the Cardium & Viking plays. Penn West also has a similar liquids-weighted production mix (66% liquids vs 57% liquids at Equal) and has the benefit of also being a Canadian E&P. We feel Penn West is the best comparison because Canadian E&Ps tend to trade at a discount to US E&Ps and Equal’s highest profile assets are large assets in Penn West’s portfolio. We look at Penn West for our peer multiple comparisons. Sandridge is the best peer for Equal’s Hunton acreage because Equal’s Northern 20,000 Hunton net acres are surrounded by Sandridge’s acreage where Sandridge is drilling Mississippian shale wells.
By adding up the NPV-10 of all the drilling locations then adding the Canadian (forecast prices method) PV-10 of the proved reserves at 12/31/2009, we observe that PWE and EQU are trading at drastically different valuations.
The NPVs are assuming $80 oil and $4.25 gas for EQU and $80 oil and $4.35 gas for PWE. While EQU and PWE are in the same plays in Canada they have slightly different well projections. PWE has slightly higher forecast PV-10s for its Cardium & Viking wells. This is a testament to EQU’s conservative projections. PWE projects that they can drill wells cheaper than EQU is assuming, likely due to increased economies of scale. EQU seems to be using slightly higher projected prices for projecting the PV-10 of the current production base. As an example, PWE is forecasting $101.58 oil in 2019 while EQU is forecasting $107.60 oil in 2019. We reduce EQU’s PV-10 value by 5% to adjust for the assumed higher prices.
Penn West NPV Valuation
Cardium 2.45 million per well; 2500 well locations = 4.9 billion
Amaranth 1.35 million per well; 1500 well locations = 2.025 billion
Colorado/Viking 2.25 million per well; 1000 well locations = 2.25 billion
Carbonates 3.85 million per well ; 400 well locations = 1.54 billion
NPV-10 of all drilling locations = 10.715 billion
PV-10 of proved reserves (forecast prices method) at 12/31/2010 = 8.989 billion
Projected Enterprise Value = 19.704 billion
Less Debt = 2.56 billion
Projected Equity Value = 17.144 billion
Current PWE Equity Value = 12.9 billion
Projected PWE Equity Value / Current PWE Equity Value = 1.329x
Equal NPV Relative Valuation
Cardium 2.0 million per well; 30 well locations = 60 million
Viking 1.5 million per well; 60 well locations = 135 million
Hunton 0.9 million per well; 350 well locations = 315 million
NPV-10 of all drilling locations = 510 million
PV-10 of proved reserves (forecast prices method) at 12/31/2010 = 325 million *.95 = 308.75 million
Projected Enterprise Value = 818.75 million
Less Debt (assuming coversion of $45m of $9 debentures) = 100 million
Projected Equity Value = 718.75 million
Current Equity Value ($7 per share) = 231 million Projected Equity Value/Current Equity Value = 3.111x
EQU Projected Equity Value at PWE multiple of 1.329x = 540.3 million
540 million divided by 33 million shares (assuming conversion) = $16.40