Tuesday, 3 September 2013

Antares Energy

Amidst the barrage of results in reporting season, I think one announcement has gone a little unappreciated. That was the news that Antares Energy (AZZ) had moved from a Letter of Intent to a binding Purchase and Sale Agreement to sell all of their Permian oil and gas assets for $300 million USD (for this post, I'll use the current exchange rate of 1 AUD = 0.903 USD, so that's $332.1 million AUD). I couldn't believe my eyes when I saw that the market capitalisation was $131 million, and this price had fallen over 6% on that day. Well it turns out that I was right not to trust my eyes, as further inspection reduced the attractiveness of this investment, but not enough to hold me back from purchasing.

First, a little background to AZZ. Back in around 2007, the management had almost sent the US focused oil and gas company bankrupt as their 'three year Strategic Plan' failed, recording a loss of $37 million, negative equity of 5 million, and negative cash flow. Shortly thereafter, the share price fell from over $1.00 to below 4 cents, and a shakeup of management occurred. A reversal in fortunes occurred as debt was brought under control and the operational side improved, with the share price rocketing back upwards to over 80 cents at one point. In FY2010, they announced that Chesapeake Energy was going to buy out the Yellow Rose and Bluebonnet assets that Antares Energy held for $200 million USD, of which $156.2 million USD would go to Antares for their proportional ownership. Further bolstering financials, 50.5 million shares were issued at an average price of $0.62, and management soon bought back 20.5 million shares at an average price of below $0.40. This action essentially netted them a profit of $4.5 million on the shares they bought back, which is a big tick in my book. And they've continued to do this, repurchasing 43.3 million shares in total for an average price of $0.413.

With a newly found cash pile, AZZ spent around $160 million on three projects in the Permian basin of West Texas in 2011 which are shale plays, and as you may know, the United States has benefitted from a shale gas boom in recent years. Reserves have grown significantly since then and this brings us to the present, where AZZ is expected to sell these assets on or before 15th January 2014 to an unnamed company (for commercially sensitive reasons). How much of the recent success is attributable to the shale gas boom and how much of it is due to good management I'm not sure, but either way, I give credit to their foresight in buying into the Permian basin when they did. From a terrible position in 2007 to being offered $332.1 million is quite an achievement.

Now, that $332.1 million isn't entirely going to be in the hands of shareholders. To begin with, AZZ currently has debt of $41 million USD and according to their most recent quarterly report, cash of $7.5 million AUD, giving net debt of $37.9 million AUD. Upon sale, the entire debt facility will be reduced to zero, leaving the only other major liability being the convertible notes. There are 10 million convertible notes on issue which have a face value of $2.00, with each note being convertible into 3 shares - i.e. it becomes economical to convert into equity at a share price above $0.66. If none of these notes convert into shares, that's an extra $20 million of debt that will have to be paid eventually (total conversion adds 30 million shares to the existing 255 million, having a similarly negative impact through dilution of shareholder interests). Although some brokers have been trying to guess about the tax consequences of the sale, throwing around figures of $25 or $35 million or even $60 million, I spoke with the chairman and CEO James Cruickshack over the phone, who surprisingly indicated to me that he expects Antares to pay zero tax from the sale. This is because Section 1031 United States Internal Revenue code allows businesses like Antares to dodge the capital gains tax if they purchase another asset within 180 days of the sale. Even if they don't purchase something else within that timeframe, Antares has until December 31 2014 to utilise any production/exploration costs as a tax deduction, so that in either scenario, no tax will be payable. And finally, there are the transaction costs, which I'll take as an extra $15 million (Mr Cruickshank mentioned the difficulty in determining the transaction costs, but confirmed that this number was in the ballpark range).

So there are a few scenarios which could happen:

1. The deal goes ahead and AZZ finds another asset in the Permian region or elsewhere to purchase (no convertible notes change into equity). Their net cash would be 332.1-37.9-20-15 = $259.2 million, or with 255 million shares on issue, net cash of $1.02 per share, double the current share price of $0.515. Should AZZ trade at this price when the sale is completed, a doubling of your money in 4-5 months is nothing to sneeze at.

2. Same as scenario 1 but all notes are converted into equity instead. Net cash would be $20 million higher as this convertible note liability would be gone, but shares on issue would be 285 million, giving net cash of $0.98 per share. (note: if only some of the notes are converted, the net cash per share will lie between these first two scenarios).

3. The deal goes ahead, and the entirety of the proceeds from the sale are returned to shareholders as a capital return. I consider this scenario rather unlikely given that management has previously bought more oil and gas assets with their proceeds, extended the maturity date on the convertible notes to October 2023, and after all, who voluntarily puts themselves out of a job? A more likely situation is the continued buyback of shares if they are cheap. (see *)

4. The deal falls through, perhaps due to shareholders not voting in favour of the sale, although I view this cause as unlikely. Another reason may be that the secret counterparty won't be able to pay, although the Board of Antares is confident that "they have the financial capacity and desire to complete the transaction". They also remind investors that they have a "100% perfect history in closing all transactions announced to the market". If for whatever reason it does fall through, the share price may drop substantially, but I am speculating that the market won't continue to assign such a low valuation to AZZ now that someone has offered them $332 million for their assets. There is also a purchase price adjustment clause in the agreement which says that if an adjustment is to be made to the purchase price if there is a 'Defect' found (eg. non compliance with environmental regulations), it will be no more than 10% of the purchase price. This means there is a $33.2 million downside to the figures I have outlined above, or $0.13 per share.

I would be quite happy with any of the first three scenarios, but there are some extra risks involved. Most obvious is the possibility of an adverse change in the AUD/USD exchange rate. If the exchange rate were to reach parity again, the net cash to AZZ would be $216.5 million AUD under scenario 1, or $0.85 per share. On the other hand, if the Aussie dollar continues to depreciate against the US dollar, net cash in Australian dollars would increase.

The second risk entails a bit of speculation on what the market will do in the short/medium term, which is something I try to avoid. Will the market value AZZ at precisely the net cash figures I have calculated? I went back to the last time Antares sold their assets and found that it traded at almost exactly its net cash per share. However, one cannot assume that this will be the case again, with the likelihood being that a discount will be placed on the valuation of AZZ since it will probably purchase another asset rather than pay out the cash to shareholders. In any case, I don't believe for a second that the market should value AZZ at just $0.515 and I expect that this mispricing will be corrected as January 2014 arrives.

The final risk is that the new acquisition/s will be a bad one, as acquisitions so often tend to be. I think this risk is somewhat mitigated by the fact that management are playing from a position of strength, not weakness (for example due to debt), in selling their Permian assets, and therefore are able to be opportunistic with their purchase. Who knows, the reason for this sale may have been because they have already identified a better opportunity. And as I highlighted above, current management have shown they are able to add considerable value through the acquisition of the Permian assets, so perhaps the market should in fact be placing a premium on the value of their net cash. Furthermore, directors hold 14 million shares, giving them an incentive not to squander shareholder money, and impressively, no director has sold a share since 2004. Nevertheless, an overpriced acquisition is certainly possible. I won't be around to see the next oil and gas play succeed or fail as I view this sector as out of my circle of competence, but I feel that I know enough in this situation to feel fairly confident about a short/medium term investment which relies on the market recognising fair value soon.

While this may not be a typical long term value investment for me due to the shorter time horizon and valuation based on net cash rather than future earnings, I still feel comfortable with this purchase given the considerable margin of safety provided by the cash in the bank. In the end, it is quite simple: if someone offered you a bank account with $259 in it, would you refuse the opportunity to take it off their hands for $131?

* Mr Cruickshank expressed his preference to me for continuing to buying back shares over a capital return or paying dividends as the easiest and most effective way to return money to shareholders, as long as the net tangible assets of the company exceed its share price and there are sufficient sellers on the market to repurchase shares. I agree with this approach taken, and see it as a sign of good management. To illustrate, lets assume a business has a share price of $1.00, 100 million shares outstanding, and its sole asset was net cash of $200 million, giving net cash per share of $2.00 (not dissimilar to the share price/net cash disparity that exists for AZZ). If management were to buy back 20 million of those shares at $1.00, that would reduce shares outstanding to 80 million, net cash to $180 million, and therefore increase net cash per share to $2.25. This really is buying $1.00 bills (or coins in the case of Australia) for 50 cents. The converse is also true: if shares were being bought back at a share price higher than the net cash, value would be destroyed. This gives me further confidence that management won't do something exceedingly silly with the funds they will receive. You might expect these principles to be obvious to CEOs and directors, but all too often I see shares being bought back at any price, without a justification as to whether the shares are undervalued or not.

** After giving further thought to the possible downside risk, and concluding there was little to no risk of significant capital loss, I subsequently bought an additional 1943 shares in AZZ at $0.515 on the 6th of September, 2013. 

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