Business and History
Frank Darden founded Mercury 1963. The family took the company public in 1999 and renamed it Quicksilver. The Dardens remain the largest shareholder even today. Glenn Darden is CEO and his brother Thomas chairs the board.
At its core, the company creates value for shareholders by acquiring cheap land, drilling some holes in the ground that spit out a lot of natural gas (or oil) and selling the now-productive assets at a the right price. This probably explains why the company is headed by a geologist.
Today, the company has approximately 500 employees. Its headquarters are located in Fort Worth, Texas. Shares are traded on the NYSE.
Competition and Outlook
Quicksilver competes with the likes of Exxon, Devon, Chesapeake and Encana. The company produces 400 million cubic feet of natural gas on 2.8 trillion cubic feet of proven reserves.
On average, the U.S. produces some 70 billion cubic feet of natural gas a day.
Exxon became the largest player in the space after the acquisition of XTO in 2009. At the time, XTO was producing roughly 2.5 billion cubic feet of natural gas per day on proved reserves of 13 trillion cubic feet. This juggernaut now produces roughly 4 billion cubic feet of natural gas daily.
Chesapeake Energy has the rights to roughly 15 trillion cubic feet of proved natural gas reserves. From that, the company produces 2.5 billion cubic feet of gas per day. That’s about 3% of daily U.S. demand.
In the space, we also find Devon and Encana. They're producing 2 billion cubic feet on reserves of roughly 10 trillion.
All have loads of debt against a minimum of cash. Most have consistent negative FCF. They spend much more on capex than they are earning from operations.
With natural gas prices at decade lows, investors are dumping their shares expecting these companies to default on their debt soon. Meanwhile, there’s a lot of M&A activity. Knowledgeable buyers are picking up assets at multiples of book value, and banks are providing the necessary credit.
1) There are roughly 0.5 million wells producing natural gas in the U.S.
2) Wells behave like a bottle of Coca-Cola. After five years, they've lost 75% of their fizz.
3) From 2005 to 2010, there were roughly 1,500 rigs drilling for gas. On average, they completed some 25,000 wells per annum.
4) Today there are 600 active rigs drilling for natural gas.
From this I draw two conclusions:
1) There are about 100,000 wells that are less than five years old. These young wells produce roughly 40 % of the U.S.'s natural gas.
2) There are roughly 400,000 wells more than five years old.
Six hundred active rigs implies that in five years we have fewer wells and the average age will be higher. With "just" 50,000 wells less than five years old, production will be down by about 20%.
So here’s my prediction for the industry: The above scenario predicting 20% less production is precisely what is not going to happen. Something will give.
T Boone says it's the price of natural gas.
Balance sheet and profitability
At first glance, the numbers look appaling. There’s $ 2 billion of debt yielding some 9%. Much of it comes due in 2015. There’s no cash, just $ 3.5 billion of net PP&E.
With cash from operations of roughly $250 million, the company could conceivably service its debt if they spent nothing on capex. But... they’re spending $650 million on capex which leaves a huge hole.
Are the Dardens driving the family business into the ground? Hint: No.
FCF has been negative for as long as anyone cares to remember. This hasn’t stopped them from retiring some $700 million of interest bearing debt since 2008 while investing heavily in PP&E.
The trick here is that GAAP FCF is meaningless. Remember, the company buys land, drills holes to prove there’s gas and subsequently sells the assets at a profit. They have a lot of recurring non-recurring events that the accountant refuses to acknowledge as cash from operations. As long as they stick with that business model, cash from operations will never cover the cost of capex.
To get an idea of their owner earnings, you have to add back the value of the assets they sell at regular intervals. In 2010 they sold Crestwood (aka Quicksilver Gas Services) for 700 million. Last year, they got rid of their remaining interest in Breitburn Energy (BBEP) for roughly $250 million and this year they are creating an MLP of roughly 18% of their Barnett-shale assets. They expect to raise $400 million. With the funds, Quicksilver intends to retire almost half of its $940 million in callable debt by the end of 2012.
Add back the cash value of these recurring non-recurring events and you’ll find the company produces “adjusted FCF” of roughly $250 million per annum. That, on average, is what they had left after paying the interest on their debt and paying for their absurdly high and discretionary capital expenditure.
For what it’s worth, it’s a cycle they’ve been on for five decades.
Management and performance
In a decade, book value per share has risen sevenfold.
I draw two conclusions:
1) Unless the Darden family has suddenly become dumber, the property they own is probably worth significantly more than the stated book value.
2) The consistent rapid growth of book value per share indicates superior management performance.
Glenn Darden serves as CEO, his brother is chairman of the board while his sister is a member. Before joining Quicksilver, Glenn worked as a geologist for Mitchell (now Devon).
Per annum, Glenn is paid about $4 million. He and his family own 30% of shares outstanding. This means the CEO and his siblings, each, have roughly 20 times their salary tied up in stock. How would you feel if you had 20 times your annual income tied up in a stock on your 56th birthday?
Sixty-five percent of the CEO’s salary is in the form of stocks and options that become worth less if the stock price tanks.
In short, we have a group of experienced and competent managers behaving like owners. They are.
Value and Price
There are 175 million shares outstanding. At $4.5, the company sells for $785 million. Mr. Market offers us a company that compounds book value per share at an IRR of 20% for 0.6 times book.
Owner earnings is the cash you have left after you pay for the wages, the upkeep of your business and the interest on your debt. You can use owner earnings to retire debt, invest for growth or take a long vacation. Since December of 2008, the company has retired about $700 million of debt.
That’s roughly $200 million of cash per annum that they obviously had left. Meanwhile, they spent a huge amount on growth (capex) implying $200 million is a conservative estimate of normalized owner earnings. On a market cap of $ 785 million, the company sells for less than 4 times owner earnings (> 25% yield).
Fair market value
Based on production of 400 million versus 2500 million, the 2009 acquisition of XTO by XOM for $40 billion (debt included) implies KWK is worth $ 6.5 billion (including debt) => $4.5 billion for the equity => $25 per share. Using proved reserves instead (3 Tcf versus 13 Tcf) would get you a higher number.
More recently, EnCana sold similar Barnett shale assets for $1 billion. On production of 125 million cubic feet, this implies Quicksilver is worth $3.2 billion => $ 7 per share after backing out $ 2 Billion of debt. Again, using proved reserves as a base would get you a higher value.
Last year, the Dardens themselves offered to buy out shareholders at $16 per share. I presume they know what the company is worth.
Why is this cheap?
Some myopic analysts say Quicksilver needs to improve operating cash flow or default on its debt. This is simply not going to happen. The company hasn't done that historically and I don’t expect this time to be different.
One more thing
The true investor welcomes volatility. Ben Graham explained why in Chapter 8 of "The Intelligent Investor." There he introduced "Mr. Market," an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic depressive this chap is, the greater the opportunities available to the investor.
In short: Volatility is your friend. I submit there are few things as volatile as natural gas.
This is not a recommendation to buy or sell anything. I owned shares of Chesapeake at the time of writing. I had no position in any of the other stocks mentioned.