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Greece, Graham and Natural Gas - Quicksilver Resources

Quicksilver (KWK) aka Mercury, is a great name for a company drilling for natural gas. While the word "mercurial" is used to refer to something volatile, GuruFocus members are probably more interested in Mercury (greek: Hermes) as a harbinger of wealth. I believe the company is aptly named on both counts.

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.

Why?

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.

35024_1337796529SnxF.png

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.

35024_1337854815yJgc.png

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.

Earnings power

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.

Catalysts

IPO of the new MLP as planned

U.S. Natgas prices going north

Specific risk

Prolonged depressed natgas prices

Slowdown of M&A activity in the space

Banking crisis and credit crunch

Family matters

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.


Disclosure

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.

Read more

Recent 10-k.

How new wells lose their fizz.

The number of American natgas wells.

Rig count.

M&A activity.

An introduction to natgas

About the author:

batbeer2
I define intrinsic value as the price I would gladly pay to own the business outright. With current management in place. For most stocks, that value is 0. As of September 2012, I'm the author of the monthly Buffett-Munger Best Bargains Newsletter. I can be reached at fvandenbroek AT gurufocus DOT com

Visit batbeer2's Website


Rating: 4.1/5 (26 votes)

Comments

gusto.duel
Gusto.duel - 1 year ago
Batbeer,

Are the buyers of such assets, like the ones KWK develops, well capitalized?

Capital availability at buyers made KWK business model possible.

But buyers may become scarce unless:

- gas price rises (sooner rather than later)

- capital continues to be available (despite low gas prices, large upfront capex, etc)

Shale gas was very fashionable for providers of finance and enthusiasm ran high (hence capital availability). If providers of finance will cast a sharper eye on numbers will capital continue to be available?

A contrarian view, trying to cool off expectation with regard to "shale gas revolution" is presented by Arthur Berman http://www.theoildrum.com/node/8212.

Capital availability (hence M&A) might become an issue for shale gas players.

Why not invest in natural gas directly? Its current price provides a good risk reward ratio... (historically and if one agrees that the breakeven price for most shale gas players is anywhere above 5$ as Berman's analysis suggests)

batbeer2
Batbeer2 premium member - 1 year ago
Hi Gusto.duel

>> If providers of finance will cast a sharper eye on numbers will capital continue to be available?

Yes. I believe it would be temporary but it would still be a major problem for Quicksilver.

Having said that, I think productive wells and distribution pipelines are going to be liquid assets under most conditions of the economy and/or financial markets. Shell, BP etc. may want to follow XOM. They have heaps of cash.

Also, they plan to IPO a new MLP. That's a somewhat different capital market.

>> Why not invest in natural gas directly? Its current price provides a good risk reward ratio...

That is not my thing. I sent this analysis to a friend who does do that stuff though.

P.S.

Thanks for the link. It's worth reading. Twice.

Berman believes there's a fair chance production of current wells will drop off faster than the "old" models predict. Such a scenario would be great for Quicksilver. They have a lot of reserves and acreage as compared to current production. It's production players with high FCF that you would have to worry about if Berman is right.

Production drops faster in the face of consistent demand, Quicksilver drills some holes in the massive amount of acreage they own, proves there's gas down there at less than $ 10.... sells the wells.... rinse, repeat.

Natgas is still very much cheaper than oil and now even coal. Even at $ 11, demand should be strong. I know that for a fact since it's less than I'm paying today.
heldman
Heldman premium member - 1 year ago
I'd agree with most of what's been said...however, to be fair, you neglected to mention their top of the market Alliance acquisition for $1 billion, which saddled the company with debt...there is substantial value here and Mr. Market will eventually come around
batbeer2
Batbeer2 premium member - 1 year ago
Hi Heldman,

Good point. For the convenience of others, here's a link to the bare facts of that deal.

It's also worth noting that they subsequently spun out Alliance's midstream assets (bought for $ 27m) to Crestwood (KGS) for roughly $ 85m .
batbeer2
Batbeer2 premium member - 1 year ago
From Southeastern's recent letter (Mason Hawkins):

Quicksilver gained 8% in the quarter but was the largest detractor to the Fund’s YTD results with the stock down 19%.While the market remains skeptical that the company will monetize some of its assets amid depressed natural gas prices, recent comparable deals in Texas and British Columbia make our appraisal of Quicksilver’s assets look too conservative. We believe the Darden family will successfully pursue value recognition, and we added to our stake.
batbeer2
Batbeer2 premium member - 1 year ago
Shares are much cheaper now than they were when I wrote this.

Nevertheless, todays transaction confirms the value of the assets.

swnyc2
Swnyc2 - 1 year ago
Dear Batbeer2,

There was a recent compelling analysis on KWK that arrives at a much lower value for its assets than you do in your article. I was wondering if you had seen it and what your thoughts were?

Regards,

batbeer2
Batbeer2 premium member - 1 year ago
Hi Swnyc2,

If I find the time, I'll do an updated analysis of KWK. Whereas I do stand by my original value thesis, I made significant errors analyzing the dynamics of the business.

As for the article you point to, thanks! That's a decent article.

The author points out that the recent transaction implies the assets in the Barnett shale alone are worth 1.8B. Roughy 450m of which is now sitting as cold cash on KWK's books. KWK can do all sorts of things with that including retiring some debt currently yielding 11%.

That's roughly $ 50m of interest expense eliminated from the income statement.

The SA article assigns no value to non-producing assets. For many decades, the Darden family has been buying acreage in the US and Canada. They then proceed to drill some holes and sell the assets at a meaningful profit later on. I think this time is probably not different.

swnyc2
Swnyc2 - 1 year ago
Dear Batbeer2,

Thanks for responding! While I'm very interested in your updated analysis, I'd be very grateful if in the meantime you could describe what the "significant errors" were in your past analysis of the business - if you could even just list them briefly that would be fine. I'm curious as to what has changed.

I know you're quite busy. I have very much enjoyed your past contributions to gurufocus - such as your articles on COCO, QUAD, KWK - as well as your interesting comments on many other articles. (You once mentioned posting your thoughts on INTC, which I'm hoping to have the chance to read some time in the near future.)

FYI, you are one of the principle reasons for my visiting this site!

Regards,

batbeer2
Batbeer2 premium member - 1 year ago
Hi Swnyc,

Thanks for the kind words.

One of the main points of my article was that less drilling for gas would cause the price of gas to go up. This has obviously taken longer than I expected.

I underestimated the impact of the amount of natgas rigs produce while drilling for oil. As rigs started drilling for oil, they never sopped producing gas. I thing this is the main reason gas prices haven't shot up as I expected.

That was a mistake.
swnyc2
Swnyc2 - 11 months ago
Batbeer2,

It looks like one of your catalysts is gone. KWK decided not to go with the IPO on the new MLP as they had planned.

I wonder what will happen next?

swnyc2
Swnyc2 - 10 months ago
Batbeer2,

There was a recent article on this site about CHK here.

Same basic thesis. Gas prices are bound to go up eventually.

I agree. Low domestic prices mean domestic use will continue to increase -- and the U.S. government recently approved a station to be built in Texas for its export. While it may take longer to happen than you originally thought, I still think it will happen in the next year or two.

My main concern is debt - and what happens if interest rates go up? In a high interest environment, debt service may increase and depending on asset prices, these companies may not be able to sell enough to pay down their loans.....

One thing missing from your review was a comparison with the other players in the industry, such as CHK. So many times, a thesis is shared by multiple companies that share the same space. For example in your discussion of COCO, you revealed some nice features that distinguished it from other companies such as APOL. While some investors may prefer to diversify and invest in a basket of stocks, I prefer to invest in the better value.

Two potential advantages of KWK are 1) it's smaller (so maybe a better takeover target) and 2) management holds a large amount of stock.

When you did your research in KWK, did you have any thoughts about how it compared to CHK or others in this space?

batbeer2
Batbeer2 premium member - 10 months ago
>> did you have any thoughts about how it compared to CHK or others in this space?

In this case I didn't do a competitive analysis or an analysis of the space.

Indeed I usually do.... food for thought. I simply didn't think about it at the time.

I did own some CHK for a while but that was more of a contrarian bet. McClendon wasn't doing anything illegal or unusual (as his peers were pointing out) yet the stock was cut in half.
swnyc2
Swnyc2 - 9 months ago
Batbeer2,

KWK's stock price has decreasedby 65% since you first submitted your article.

This is even as gas prices have increased moderately during the same time.

While it may be true that it's taken longer for natural gas prices to recover, KWK recently monetized its assets as expected.

So eventually, I would think KWK's stock would go up.

However it continues to go down.

I was wondering why and if you had any thoughts?

Could this be due to recent interest rate increases, which at some point will divert additional cash to interest expense?

batbeer2
Batbeer2 premium member - 9 months ago
Hi Swnyc2,

>> I was wondering why

So am I. Two reasons come to mind:

1) I guess the market is not happy that KWK needs to sell a lot of debt now. With Southeastern there to backstop any bids, I think they will pull through.

Cemex, Level 3... Southeastern often buys the bonds of the companies in their portfolio when they're strapped for cash. They extract a good interest and also protect the value of the stock. Berkowitz and Buffett (USG) too will keep their holdings out of bankruptcy by buying bonds if no one else will.

2) KWK was hoping to connect some of their fields to Canada. The permits for that pipeline never materialized and that road is now closed.

As for my thoughts.... I'm not happy about how the business is now at the mercy of the bond buyers. The risk I missed was that my thesis depended too much on the timing of the firming of natgas prices and a stable market for KWK's assets. The Dardens have always been able to sell assets to take care of the debt but that obviously depends as much on the skill of management as the willingness of buyers (big oil). That was knowable.

The maturity profile of the debt introduced a very specific "time" risk. I recently did some work on NSC. Also a lot of debt but a significant chunk of that doesn't come due this century.

Or PostNL.... lots of debt but they can service interest for a decade before management needs to think about the needs of bondholders.

With KWK, the problems could and did come within a year.

In short, KWK is not generating enough cash now to service the debt. This means management is going to do whatever they must to keep bondholders happy. That's not necessarily what makes shareholders happy.

If I find the time, I'll do an autopsy. While I'm still confident the shares have value far in excess of current prices, I wouldn't submit this idea today. Even at current prices. The reason for that is because I believe bondholders have control. It's up to management to steer the company back into the hands of shareholders. That is precisely what they are trying to do but that's not where I like to invest.


Hope this makes some sense.
swnyc2
Swnyc2 - 8 months ago
Batbeer2,

I'm watching KWK's stock fizzle, and I must confess, I'm still trying to understand it.

At this point, the land assets have to be worth more than market cap plus debt.

They have a few years before the debt comes due.

And, given the Darden';s large stake in the company, they will sell assets when they have to before then to avoid bankruptcy.

What am I missing?

Am I crazy, or is this not a good buy?

batbeer2
Batbeer2 premium member - 8 months ago
Hi Swnyc2,

I think you're right. I reckon the assets are worth much more than the EV and they've pushed back the maturity profile of the bonds.... beware though, you don't know who owns the debt.

Just imagine the Dardens themselves own the debt. If that's the case, it doesn't matter to them if the company goes BK. Either way they own the thing. A classic ploy.

I'm not saying this is the case, but it is a possibility. Maybe Southeastern owns a chunk of that debt (should be in their recent letter then). If so, I would say it's safe. If not, I think it's critical to find out who has been buying that debt. If it's Icahn or Third Avenue I wouldn't be comfortable. They often buy the debt to end up with the equity.

For myself, I'm just disappointed by the way management has consistently been very clear about their plans and subsequently failed to deliver on them in time. Now I don't know what to believe.

Come to think of it, if the bonds are traded, they may be an interesting buy no?

KWK's outlook improves a bit and the yield gets cut in half.... that's decent return.

If I find the time, I'll look into the bonds myself. If I see anything, I'll let you know.

Please leave your comment:


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