MHR - Magnum Hunter Resources

[JAllen]

Has anyone looked at this or own it?  I'm struggling to see how they will come up with the cash flow they need for 2015.  They need at least $328M (interest  + preferred dividends + upstream capex) according to my calculations but will produce half or less than that in 2014 EBITDA, with oil at $90 for most of the year. 

 

Their production seems to be struggling with a bunch of it shut-in over the last few months.  They have to shut-in all the wells on a single pad in the Marcellus because of over-pressure potential with the other producing wells on the same pad.  They've also had air quality permit issues in WV that have prevented production there - not sure the exact reason, but it's been material.

 

They also had a blowout on Saturday in Ohio that is not under control still (no one hurt thankfully), which will further dampen their production.

 

Their 48.5% owned midstream subsidiary is the only silver lining it seems.  The Series-2 that Morgan Stanley owns has some sort of liquidation preference which I'm in the process of looking into.  If MS is first to cash out in an IPO, that will further postpone the few hundred million of cash that MHR needs.

[ItsAValueTrap]

I blogged about them before independent E&Ps collapsed.

 

http://wp.me/p1mOGr-Hm

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Magnum Hunter (MHR) short thesis

 

In the independent oil and gas space, I will happily bet against the high-cost operators.  I would argue that Magnum Hunter overpays insiders, wastes money on corporate aircraft, and has excessive G&A as a percentage of revenue.  This has contributed to Magnum Hunter’s track record of GAAP losses since current management took over in May 2009.

 

Market cap: $1.42B

% of float short: 18.2%

Cost of borrow: ~0.6%

The put options are somewhat liquid.

 

The Gary C Evans empire

 

Gary C Evans is Magnum Hunter’s CEO.  Evans is associated with the following companies:

 

    The “new” Magnum Hunter (ticker symbol MHR).  Current management took over in May 2009.  In July 2009 the predecessor company was renamed to Magnum Hunter.

    The “old” Magnum Hunter (ticker symbol MHRI).  Evans was the CEO though MHRI is unrelated to MHR except in name.  Old Magnum Hunter was merged with Cimarex (XEC) in 2005 in an all-stock deal worth around $2.1B.  Old Magnum Hunter shareholders actually did very, very well.

    TEL Offshore Trust (ticker symbol TELOZ).  Evans is a trustee.

    GreenHunter Resources (ticker symbol GRH).  Evans is the chairman and interim CEO.

    NovaVax (NVAX).  Evans is the chairman.  NovaVax is a development-stage pharma company.  The borrow is in the low single digits.

 

Old versus new Magnum Hunter

 

Shortly after Evans became the CEO of MHR, the company issued a press release stating the following:

 

    We intend to bring similar disciplines that were utilized so successfully at [“old”] Magnum Hunter, including low finding and development costs, low operating costs and corporate overhead, in order to generate superior investment returns to our shareholders. We plan to significantly expand the Company’s asset base through the opportunistic acquisition and operation of producing properties with additional low risk drilling and development drilling opportunities. In the near term, we will focus on acquisitions and development of predominately oil-based properties as we believe the current fundamentals of oil are currently superior to natural gas.

 

In my opinion, old Magnum Hunter really did have low corporate overhead.  Take a look at G&A as a percentage of revenue at MHRI:

 

YE1996: 7.46%

YE1997: 4.83%

YE1998: 5.76%

YE1999: 4.19%

YE2000: 4.79%

YE2001: 4.51%

YE2002:  5.00%

YE2003: 4.72%

YE2004:  4.48%

 

The new Magnum Hunter has much higher overhead (figures from the YE2012 and YE2009 10-Ks unless stated otherwise):

 

YE2008: 24.96%*

YE2009: 82.66%* (*current management took over in May 2009)

YE2010: 84.41%

YE2011: 55.33%

YE2012: 23.76%YE2013: 26.89% (YE2013 10-K)

 

While G&A as a percentage of revenue isn’t a perfect metric, there is clearly a night and day difference here.  The difference is partially explained by the use of corporate aircraft; the related party  disclosures section in the YE2012 10-K mentions that MHR is paying the CEO to rent a corporate jet:

 

    During 2012, 2011 and 2010, we rented an airplane for business use at various times from Pilatus Hunter, LLC, an entity 100% owned by Gary C. Evans, our chairman and chief executive officer. Airplane rental expenses totaled $174,000, $463,000 and $450,000 for the years ended December 31, 2012, 2011 and 2010, respectively.

 

The true cost of corporate aircraft will be higher as there are other costs to operating the aircraft.  Another explanation for the high overhead is that insider salaries for officers and directors are much higher at the new Magnum Hunter versus the old Magnum Hunter.  (You can read the DEF 14A filings for yourself on SEC EDGAR.)  I have no idea where the rest of the G&A is going.

 

To me, it is pretty bizarre that the same CEO can run such different companies.  A potential explanation is that Evans got a free ride from those surrounding him.  For example, Richard R Frazier was the COO of Magnum Hunter and may very well be incredibly talented.  Evans liked him enough to name Frazier as the CEO of Magnum Hunter shortly prior to the merger with Cimarex.  After finalizing the sale/merger in June 2005, Frazier went on to start Keystone Petroleum in November 2005.  The Keystone website highlights the company’s performance [emphasis added]:

 

    Keystone’s initial drilling project was the “Wolfberry” play in West Texas. After drilling 25 wells on Keystone’s acreage, the company sold those wells along with approximately 26,000 acres in two major sales and several minor ones. The Partnership’s business was essentially completed in November, 2011, resulting in a “return on investment” to the investors of 5.42 to 1 in less than 6 years.

 

Richard Frazier potentially explains why the old Magnum Hunter is so different compared to the new Magnum Hunter.  The old company had low corporate overhead and seems to have been very good at keeping their F&D costs down.

TELOZ

 

TELOZ owns a royalty on various offshore oil and gas wells.  Currently, the royalty is not distributing cash and therefore TELOZ is not distributing cash.  In 2011 the Trust sold 20% of its royalty, for $1.6M in gross proceeds and $1.486M net proceeds.  The gross proceeds imply a valuation of $8M for the royalty.

 

TELOZ’s G&A is nearly a million dollars a year:

 

YE2012: $721,053

YE2011: $894,113

YE2010: $911,245

 

This overhead is a massive headwind for shareholders.  Almost a million dollars worth of overhead versus roughly $8M in assets is effectively a very high management fee.  In my opinion, the trustees should liquidate the trust and give the proceeds to shareholders.  I’m not sure why they have avoided this move.

 

Gary Evans is one of the three trustees of the trust.  In 2003, he was paid $41,366 to act as a trustee according to MHRI’s proxy.  His salary went up from 2001, when it was only $33,240.  Are the trustees avoiding a liquidation simply so they can collect a salary?  I don’t know.

GRH

 

Like MHR, GRH has a track record of GAAP losses year after year.  Its share price performance since its IPO has been poor:

 

green-hunter-performance

NVAZ

 

Gary Evans has been on NovaVax’s board since April 2005.  While one could criticize NovaVax’s corporate governance practices, they are not entirely unreasonable.  Evans’ share ownership relative to his director’s salary is very high.  He owns roughly 702,558 shares of NovaVax (current value $4,271K) versus his total compensation of ~$77k.  The ratio is 55:1.

 

Insider compensation for officers ($3,224k) and directors ($434k) combined is around $3,658k for YE2012.  It is a little on the high side at 4.6% of the company’s book value of $80.24M as of YE2012.  (Granted, key insider compensation relative to the company’s book value is not the best metric in the world.)

 

Mr. Evans sits on NovaVax’s audit committee.  I find this ironic because Magnum Hunter restated its financials in the past and had to deal with internal control problems.

Track Record

 

One way of looking at Evan’s skill in running Magnum Hunter is in terms of GAAP profitability.

 

At YE2009, the company had raised around $72.441M in equity and had an accumulated deficit of $33.136M.

At YE2012, the company had raised around $735.477M in equity and had an accumulated deficit of $586.365M.

In those three years, the company raised $663.036M in equity and generated GAAP losses of $553.229M.  Magnum Hunter has managed to lose almost everything that it has raised.

 

However, I would note a few things:

 

    Magnum Hunter was arguably unlucky.  They were heavily invested in shale gas.  Most unconventional shale companies have been losing their shirts due to an industry-wide oversupply of shale gas and low prices.  (I’d point out that most shale gas companies receive significantly lower prices than Henry Hub prices due to price differentials, so things are worse than what Henry Hub pricing suggests.)

    Compounding #1 was the fact that Magnum Hunter was leveraged to the hilt.  Like old Magnum Hunter, the company’s most expensive debt was in the ballpark of 10%.

    GAAP can sometimes cause distortions.  Many oil and gas companies have earnings not reflected on their balance sheets, especially if they use successful efforts accounting.

 

#2 is arguably a bad strategy.  I’m a fan of the late Ken Peak (of Contango Oil and Gas) and think that too much debt is dangerous.  As well, it is extremely difficult for Magnum Hunter to consistently beat its cost of capital on its most expensive debt (usually 8-10%+).

 

#1 doesn’t fully explain how Magnum Hunter racked up GAAP losses so quickly.  I would argue that Magnum Hunter is not good at finding gas cheaply.  It has taken many impairments on bad acreage where the company has let the lease expire.  And as mentioned previously, the excessive corporate overhead makes it difficult to earn profits.

 

As far as GAAP distortions go, we could make an adjustment for the book value of the company’s oil and gas assets versus the standardized measure.  As of YE2013 (and before the sale of Eagle Ford assets):

 

Book value of oil and natural gas properties minus DD&A is $1,225M.

The standardized measure is $844.5M.

The difference is $380.5M.

 

What’s happening here is that book value is actually greater than the standardized measure figure.  If we could assume that the standardized measure is accurate (unfortunately it never is), then Magnum Hunter’s book value of $450M as of YE2012 is overstated.  Adjusted book value would be $69.5M versus a market cap of roughly $1.41B.

Problems with the standardized measure

 

In theory, the standardized measure is supposed to be overly conservative.

 

    It does not include probable or possible reserves.  Only proved reserves.

    The discount rate of 10% is nearly always more conservative than what a buyer would pay for the assets.

    If the futures curve is in contango, then the standardized measure will be too conservative.

    In theory, the PV-10 estimate of a reserve is supposed to be on the conservative side 90% of the time and on the aggressive side 10% of the time.

 

In practice, the standardized measure is almost always inflated.  There are a number of ways to inflate the numbers.  The real problem is that there are virtually no consequences for inflating reserves.  The reserve engineer won’t get kicked out of their professional organization or barred from doing future reserve estimates.  I’m not aware of anybody being fined for doing it.  There’s practically zero downside.  Because this is the current situation is a magnet for fraud, I am extremely skeptical about estimated reserves.  I would argue that reserve estimations tend to be more aggressive when it comes to promotional CEOs who fly around on corporate jets and are constantly selling shares.

Are Magnum Hunter’s reserves being inflated?  It’s hard to say.  Like most independent oil and gas companies, it releases very little technical data so there’s really no way for me to perform a high level of due diligence.  One issue I see is that $96M out of the $708M in proved developed reserves are PDNPs.  In my opinion, this practice of recording PDNPs for unconventional shale assets is dubious (my CHK post has a slightly longer explanation).Ultimately, I have no idea if Magnum Hunter’s reserve engineering will turn out to be overly conservative or aggressive.

Capital structure

 

Historically, Magnum Hunter has constantly been selling shares and issuing debt.  Generally speaking, I am extremely skeptical about companies that do this.

 

Here’s how Magnum Hunter’s capital structure stands as of YE2013:

 

$876M: Long term debt.  The most expensive debt here is a second lien term loan for Eureka Hunter Pipeline with an interest rate of 12.5%.

$136M: Series A Convertible Preferred Units of Eureka Hunter Holdings.  Cumulative distribution rate 8.0%.

$100M: Series C Cumulative Perpetual Preferred Stock.  Cumulative dividend rate 10.25%.

$221M: Series D Cumulative Preferred Stock.  Cumulative dividend rate 8.0%.

$95M: Series E Cumulative Convertible Preferred Stock.  Cumulative dividend rate 8.0%.

$1408M: Common stock.  170.687M shares outstanding.

Warrants:  There are ~17M warrants outstanding with a strike price of $8.50/warrant.  As well, there is a much smaller number of other warrants and options.

 

There are no significant debt maturities in 2014 and 2015.  In 2016, there is $224M in debt due.

The warrants

 

In 2011 and 2013, the company issued 1 warrant for every 10 common shares.  The stated reason was to ‘congratulate’ shareholders (press release).

 

    “Our Board of Directors has granted this dividend to our shareholders of record as a form of appreciation to both old and new shareholders alike.  We are appreciative of the confidence reflected by these shareholders in supporting our Company as we embark on a new era of growth in the unconventional shale plays where we are actively developing this resource.”

 

In my opinion, the warrants don’t really make sense from a business perspective.  Size is an anchor on performance.  If the company is good and genuinely investing capital at 20-50% IRRs (as suggested in company presentations), then dilution is a bad idea for shareholders.  If the company isn’t that good, then raising capital will only help to pay Magnum Hunter’s massive G&A costs.

 

The company’s stated explanation doesn’t make sense.

The debt

 

I’m surprised that the company’s subsidiary Eureka Hunter is borrowing at 12.5% (on a non-recourse basis).  This suggests to me that Eureka Hunter may be distressed.  It is also extremely unusual to borrow at such a high interest rate to build a midstream asset; midstream assets are generally seen as lower risk and lower reward than upstream assets.

 

Magnum Hunter itself has a high cost of capital and strikes me as distressed.  Companies that borrow at extremely high interest rates tend to be on their way towards bankruptcy.  (I suppose that Sirius XM is an exception.)

How much is the equity worth? / Valuation

 

Earlier, I stated that “adjusted book value would be $69.5M versus a market cap of roughly $1.41B”.  For some reason, the Series D and E preferred stock are lumped into shareholders’ equity.  These series of preferred are not convertible into common stock and have a liquidation preference ahead of the common shareholders.  I think that it would be more accurate to subtract the preferred stock out of shareholders’ equity.

 

$69.5M – $221M – $95M = -$246.5M

 

By this calculation, the equity is underwater.  Obviously the equity cannot be worth less than 0.  There is some option value to the equity at the very least.

 

However, it seems to me that Hunter Magnum common shares are slightly overvalued.

[tredd]

There was a lot of movement after the end of the third quarter. I'm having a tough time piecing together what the pro forma balance sheet looks like. I think it's important as the terms of the new credit agreement require the company to maintain a current ratio >= 1.0x. As of 9/30/14, it was 0.4x.

 

Other than normal operations and the associated cash burn, here's what I have impacting the balance sheet:

 

1. Midstream investment will no longer be consolidated

2. Fully drawing down the $340MM second lien loan

3. Repay the $256MM original revolver

4. Can now access a $50MM first lien revolver

5. $85MM sale of Bakken asset

 

Based on 2, 3 and 5, MHR should have $169MM of additional cash with another $50MM available from the revolver.

 

The CEO stated on the call:

 

Liquidity, as of November 4, 2014, Magnum Hunter had total liquidity of $136.7 million, comprised of $47.7 million of availability under our senior revolving credit facility and $89 million of cash on hand at September 30.

 

You guys probably noticed that on October 22 we announced that we had closed on two new facilities and completely refinanced it to – the prior revolving credit facility. The new facilities consist of a $50 million senior secured first lien reserve base revolving credit facility, maturing at four years after the closing date, and then a second lien, $340 million senior secured loan maturing at five years. The proceeds have been used to repay all outstanding borrowings on the company's prior revolving credit facilities of approximately $241 million.

 

Cash at 9/30 was $43MM so his $89MM figure obviously includes something that happened between 9/30 and 11/3.

 

There's a chance the numbers he's quoting including all the adjustments I mentioned above (with the exception of #1 likely) and cash burn during quarter has been that great. If that's the case, it's really tough for me to see them hitting that 1.0x current ratio covenant.

 

The wild card is accounting for the pipeline asset. Moving from consolidation to the equity method will have an unknown impact. They don't publish the pipeline's balance sheet but do show that it had $3MM of cash at 9/30. You'd have to guess on the other current asset and current liability line items. I'd imagine that as they are moving for an IPO in 1H, they'll include the new pipeline line item in current assets as "investment in ----". I'm not sure on the accounting for converting from consolidation to equity method. Usually equity method records at cost then adjusts based on profits less dividends. I would point out that the pipeline has recorded losses in each year which would impact its book value.

 

Of course all of this might be moot if MHR gets a waiver but it obviously does not help it access needed liquidity. I'd be curious if anyone else has taken a look at this analysis or can see anything obviously wrong with my thoughts.

 

[ItsAValueTrap]

MHR 05/15/2020 bonds trading at a 15.839% yield.  Price of 78.500, coupon of 9.75%.  CCC credit rating.

 

The bond markets definitely have doubts about the company.  It doesn't look like the bonds are pricing in imminent collapse though.

[tredd]

I would tend to agree in your statement.

 

I actually think the bonds are pretty well covered with basically just the $50MM senior revolver and the $340MM 2nd lien term loan ahead of them. MHR's interest in the pipeline asset might cover those entirely. There's obviously value in the Marcellus/Utica acreage and perhaps the remaining Williston assets can be sold eventually. I wouldn't speculate on precise valuation but $470MM ($78.5) for Utica/Marcellus + Williston seems reasonable.

 

I guess I'm more interested in further down the capital structure with $300MM+ of preferreds out and equity with a market cap of $600MM+. Similar to John, it's tough for me to figure out how they fund 2015.

[Jurgis]

IMHO, MHR common and pref definitely have risk of losses. I might be interested in bonds if they were cheaper. I'd not buy prefs/common. But then again I don't trust Gary Evans since the auditor debacle, so I might be prejudiced. :)

[tredd]

Yea, I'm looking at this on the short side. Preferreds look interesting given defined downside. C's are trading at $21 but have a 10.25% dividend. Catalyst would be halting dividends early in the year to preserve capital. I believe the Cs and Ds have dividend preference over the Es but Es trade awful.

[tredd]

I’m completely out of my comfort zone when it comes to analyzing E&P companies. I’ve put together some very back-of-the-envelope estimates for a 2015 quarter. I’d really appreciate it if someone could point out any dumb assumptions I’m making or obvious errors.

 

- I’ve ignored:

o Williston crude production

   May be sold at some point

   I don’t believe MHR has any crude hedges in place in 2015

   Based on the well-site IRRs in the company’s own investor presentation, I think it is generous to claim that MHR’s Bakken production breaks even at $55 WTI spot

o Eureka Hunter earnings

   The asset will no longer be consolidated and will instead be shown using the equity method

   MHR does not get to push up any of the cashflow  produced from the pipeline

o Oilfield services

   It remains to be seen how much this segment is affected by lower crude

   If it is cashflow positive, it will likely be marginal

 

- Production of 32Kboe/d based on CEO guidance

o Approximately 90% gas

o I have my doubts that this will be reach or is sustainable

 

- Hedging is per CEO statements and 9/30/14 10-Q

 

- NGL price = $25 boe

o I’ll be honest, this is just a guess

 

- Production cost per Mcfe = $2.25

o CEO has said that their gas production is profitable down to $2.25

o I’m giving them the benefit of the doubt that this statement referred to Henry Hub pricing and already factored in a Marcellus discount. Some Marcellus operators have been selling natural gas at sub $2s/Mcfe

 

 

http://i.imgur.com/HVnBdmQ.png

 

I feel as though I’m being extremely conservative with my assumptions here but I can’t seem to figure out how this company remains solvent in 2015. They have an average of $30MM of interest payments and preferred dividends per quarter. This does not even factor in well development costs which have been $320MM YTD 9/30/14. Assuming they can cut development to $35MM/quarter, I’m still forecasting a cash burn of $60MM each quarter.

 

Despite this, the company still has a market cap of $675MM and preferreds and bonds are trading at a beat up but still healthy level. What am I missing here?

[Guest wellmont]

if i did this sort of trade i would long the bonds and short the pref.

[JAllen]

I agree that they have a huge funding gap - $200-$300 million or so.  I don't know how they will stay solvent either. 

 

 

The senior notes have a debt / EBITDAX ratio covenant of 4.5 declining to 4.0 over the next few quarters, if I recall correctly.  This means they need to be generating something greater than $200 million of EBITDA.  I think they will have generated $140-$150 in 2014 with oil at $90+ most of the year.  The new credit facility and second lien are more lenient but still require that 1:1 current ratio, 2.5X what it was at the end of last quarter.  They did sell $55 million of Eureka units 12/18 (pursuant to the November agreement with MSI), in case you had missed that, so they generated some cash there.  Frankly, this is probably how they will generate their cash - by selling down their Eureka stake - assuming MSI is going to be willing to continue purchasing MHR's stake.  One additional thing to point out: MSI is buying MHR's Series A-1 units that immediately convert to preferred equity with a liquidation preference.

 

 

I modeled out $50 million EBITDA for next year.  Of course there were tons of assumptions involved - the primary one aside from prices (I used $53, $3.20 and $23) is daily production, which I assumed would increase 50% from the third quarter of 2014 to 24,000 MCFe/day for the whole year.  I think this is conservative too.  Doing this I got $137 million for 2015 revenue.  Their preferred dividends and debt interest are ~$127 million /year, so yeah, I don't have any idea how this company is going to fund their drilling except for continuing to sell down their Eureka stake.

 

 

Everyone says their pipeline will save them. Probably most people don't realize their stake is subordinate to MSI now.  Also Eureka's largest customer is MHR itself who's had major production issues over the past few months which doesn't bode well for IPO pricing. 

 

 

One thing I've been wondering is: why have they waited to IPO the pipeline if it's so great?  My guess is they want the Eureka financials to show consistent growth, but with this quarter's production issues with half their production shut-in for months, I don't think it bodes well for Eureka's financial results.  My guess is that MSI will take advantage of MHR's distress when it comes to purchasing more Eureka (assuming they want to keep investing in Eureka).  I'm sure they know the financial state of the MHR parent.

 

 

Something to look up is the revenue model MHR pays Eureka - fee-based or PoP.

[JAllen]

Tredd: Doesn't your model show 17,000 MMCFe per quarter which is 68,000 annually, multiplied by at least the price of gas, is $3 * 68,000, which is at least $204 million for revenue, right?

 

 

That would be more consistent with what I came up with, though I used a lower average production number because of their recent persistent production difficulties.

 

 

I used LOE as 50% of revenue and G&A at 15% of revenue, which of course ignores a whole host of other costs this company will actually have to arrive at ~$50 million of 2015 EBITDA.

 

 

One thing I should note, and I can't really handicap this, is SWN's purchase of the CHK assets in northern WV for $12K an acre.  If you think MHR's acreage there is worth something in that ballpark, then MHR could be trading at fairly-valued levels to slightly underpriced, on a purely net asset value basis, of course.  It is possible that they just haven't ramped production enough and that a better capitalized operator would like to purchase their acreage.  Evaluating the acreage quality is obviously much more out of our circle than analyzing the finances of the company.

 

 

One more thing to add is that the CHK/SWN deal was agreed to prior to the oil price decline, which has punished the price of NGLs a bit, so perhaps that same acreage isn't worth quite as much today.  But quite a bit of MHR's and SWN's deal acreage overlaps which made shorting the pref and common lots less attractive.  Their cash issues are certain though.