Timely Idea: Compton Petroleum (Toronto: CMT, OTC: CMZPF)

[manualofideas]

We posted the following idea on Seeking Alpha this morning, and I thought it might be good to share it here as well.  Compton is based in Canada and has been hitting value screens for some time, so some of you may already know it well.  Would love your feedback on the idea.

 

Compton Petroleum (CMZPF.PK)  announced the successful completion of a major balance sheet recapitalization after the market close yesterday. We expect Compton's deeply undervalued common equity to attract incremental investor interest following this catalytic event.

 

This morning at 8:20 AM ET, Compton CEO Tim Granger is scheduled to present at the Peters & Co. 2010 North American Oil & Gas Conference. The presentation will be available at http://phx.corporate-ir.net/phoenix.zhtml?c=69018&p=irol-EventDetails&EventId=3107656

 

Why is yesterday's bondholder consent for Compton's proposed recapitalization so significant? The recapitalization is the final step in a series of actions taken by Compton management to delever a balance sheet that became unsustainable in the face of depressed natural gas prices. Compton now moves from being a "distressed equity" to a natural gas exploration and production company with large, underappreciated reserves and a balance sheet that can support profitable growth.

 

The steps taken by management over the past year have cut net debt from roughly $900 million as of June 30, 2009 to roughly $400 million post-recapitalization. This is a managable amount for a company with tangible assets of more than $1.8 billion and operations that are strongly cash-generative pre-capex. While Compton was forced to issue equity along the way, CEO Granger deserves credit for accomplishing much of the debt reduction without equity dilution. Compton sold an overriding royalty interest and several non-core assets for cash at implied valuations well in excess of the company's trading multiples, generating value in the process.

 

How much upside does Compton offer investors? This is up for debate and will no doubt depend on the extent to which natural gas prices rebound in the future. However, the equity value compression Compton suffered simply because it was viewed as a distressed equity should now be removed. Investors should once again feel comfortable valuing Compton common stock by putting a valuation on the entire enterprise and then subtracting the amount of net debt. Compton's most recent annual information form filed with Canadian securities regulators discloses an after-tax PV-10 of proved reserves of $1.0 billion. Subtracting the post-recap net debt, we arrive at an equity value of roughly $600 million or $2.28 per share, representing upside of nearly 350% versus yesterday's closing price of $0.51 per share. The after-tax PV-10 of proved and probable (2P) reserves is disclosed as $1.4 billion, implying an equity value of $1.0 billion or $6.45 per share (based on 263 million shares outstanding). Depending on the timing of this upside, it could be reduced somewhat by the exercise of up to 138 million warrants, which have an out-of-the-money strike price of $1.55 per share and expire on October 5, 2011.

 

If the just-completed recap is such a positive catalyst, why did Compton shares decline so precipitously after the recap proposal was first announced on July 19th?  Actually, the beginning of the recent decline in Compton's stock price from $0.81 per share on June 18th to as low as $0.39 per share on August 27th coincided with the company's announcement that it intended to discontinue its dual listing on the Toronto Stock Exchange and the New York Stock Exchange, opting to stay listed solely on the TSE. The U.S. delisting notice was followed by a flood of selling by U.S.-based investors, even though the single formal listing saves the company millions and Compton shares continue to trade in the U.S. in the over-the-counter market under ticker symbol CMZPF.

 

As the selling in Compton shares accelerated, investors became nervous about the proposed recapitalization, despite the fact that Compton had a strong hand since it had just raised cash through asset sales and was offering debt holders $184 million of cash as a component of the recap. Nonetheless, because of a technical covenant breach due to errors in giving debt holders notices of past asset sales, investors apparently became nervous that debt holders could go so far as to force the company into bankruptcy. Finally, a $45 million convert that is part of the recap contained no fixed conversion price, making it look like a "toxic" instrument. Investors apparently ignored the fact that Compton had negotiated the convert in a way that forced debt holders to convert if Compton wanted them to do so, but also gave Compton the option of redeeming the convert for cash, thereby forgoing any equity dilution. Given Compton's positive cash generation and the ability to raise cash by selling a minor non-core asset for at least $45 million, we believe it is highly likely the company will indeed choose to redeem the convert for cash prior to September 2011.

 

Compton shares have embarked on a rebound over the past week, presumably as investors began to realize that the recapitalization transaction was likely to win bondholder approval after all. This is indeed what happended yesterday, paving the way for a fact-based rather than a fear-based valuation of the company. As facts prevail, we believe Compton will finally start delivering the performance that shareholders have been denied for too long.

 

Disclosure: Long CMZPF.PK

[Myth465]

Thanks for the idea. I looked at Compton over the last few years and the debt always worried me. It seems as though they have solved that problem. My issue now is natural gas stinks and will probably stink for a while, and Canadian natural is even worse due to the discount.

 

The cash flow that Compton was always known for has been hurt by the fall in gas and at 85% you really need a rebound for this to work. I really like Sandridge given they have oil and gas.

 

With that said its cheap and your math looks interesting so I plan to dig a bit deeper. Thanks again.

[Uccmal]

Thanks for the idea!

 

I too will dig deeper.  I guess the big question is whether or not they can bring in enough cash to cover working capital and service the debt with gas at Aeco: 3.50 or lower.

 

I dont really see an upside catalyst for natural gas at the moment.  Heating season is looking less and less promising with each passing day.  The economy is not running on all cylinders.  Power generation from gas takes too long to make reasonable future predictions. 

 

Thanks again.

[Uccmal]

The above being said I was reading that the oil sands in Alta are booming again.  In order to attract labour the companies are offsetting housing prices by constructing their own stock. 

 

 

They use natural gas in the upgraders. 

[Myth465]

They use natural gas in the upgraders. 

 

This is true and gives Canada a good place to put that gas now that the US is awash in it. I think LNG needs to take off. Im always shocked when I see $8 gas in Europe and Asia. With Europe getting into Shale though who knows how long that will last.

 

The wild card will be fracing environmental issues and what they do to the industry.

[PlanMaestro]

ManualofIdeas, as always jumping the gun on great obscure small caps (GRVY and STC before). No need to share watchlist ideas so soon  ;)

[manualofideas]

ManualofIdeas, as always jumping the gun on great obscure small caps (GRVY and STC before). No need to share watchlist ideas so soon  ;)

 

Probably jumping the gun again, but here is a rather positive press release Compton put out after the market close on Friday: 

http://finance.yahoo.com/news/COMPTON-RECEIVES-COURT-cnw-3607051477.html?x=0&.v=1

 

It reinforces the idea that the company is unlikely to issue any shares in connection with the new $45 million convertible note.  Instead, the note will likely be redeemed for cash from a future asset sale.  Once investors understand that shareholders will not be diluted, Compton's common stock should do quite well.  But, once again, we don't want to jump the gun here, so everyone please take this with a big grain of salt and do your own work.  ;)

 

Disclosure: Long Compton.

[PlanMaestro]

 

It reinforces the idea that the company is unlikely to issue any shares in connection with the new $45 million convertible note.  Instead, the note will likely be redeemed for cash from a future asset sale. 

 

Thanks for the update manualofideas, you know I am fan of your work.

[Myth465]

Hi all, just saw the VIC writeup on this and am thinking about it again. I still hate gas but am a sucker for cheap.

 

Have you guys thought about the bonds. Seems like an easy way to earn 14% and if you are wrong you get the assets.

[PlanMaestro]

Have you guys thought about the bonds. Seems like an easy way to earn 14% and if you are wrong you get the assets.

 

Third Avenue/Whitman has them and made a very persuasive argument for it in one of his latest letters

[Myth465]

Compton seems to be in a bad position. They generate cash but have to reinvest it in the business. Looks like Capex is the same as cash flow. I could be wrong, perhaps cash flow is free cash flow after investments. They would do well by purchasing their debt back at 85 cents on the dollar, though I dont think they can.

[PlanMaestro]

Looks like Capex is the same as cash flow. I could be wrong, perhaps cash flow is free cash flow after investments.

 

I think that is what they are projecting, but part of the capex is growth capex.