Author’s Note: I initially wrote this piece in mid February, but due to my job I needed to give my employer the opportunity to act on this information first. Now that they have had ample time, im free to post it here. Luckily, the shares have only gotten cheaper since I first wrote the piece, dropping from the $7.50 referenced below, to $6.85. This gives you guys an even stronger entry point.
Lone Pine Resources (LPR) is an oil and gas spinoff of the US based company, Forest Oil. LPR is the old Canadian assets of Forest, and comprises the old management team of their Canadian division. Forest executing the spinoff by first IPOing 20% of the shares this past June and then spinning off the remaining shares to Forest shareholders on September 30th, 2011. As you know if you read this site, I love looking at spinoff investment opportunities and Lone Pine caught my eye.
Spinoffs are generally undervalued as the shareholder who ends up owning the company often never chose to invest in it, or sometimes can’t even legally hold it. In the case of LPR, while it is listed on both the NYSE and TSX, it is a Canadian company and that may restrict institutional investors with a US only mandate. As well, it is a good deal smaller than forest with a market cap around $630 million, well below the $3 billion Forest market cap when Lone Pine IPOed. This is another reason investors may have been forced to indiscriminately sell their LPR shares.
Thus when LPR debuted, it never received much support. They IPOed at $13 a share (and initially shopped it around at $18 to $20), and it drifted lower, with the selling pressure augmenting on September 30th. It hit a low of around $5.50 a share in October. I managed to average in at around $6.00 Since then it has rebounded a bit, to $7.40 but is still grossly undervalued.
First, the reasons for the spinoff. Lone Pine management explains that they wanted the spinoff for 3 reasons. The first 2 are often heard as justifications for spinoffs, focused management and getting the underlying value a better multiple. Canadian oil and gas companies tend to trade for higher valuations than their US counterparts and the board of Forest felt that by spinning out LPR, a Canadian pure play, they could get a better valuation. The 3rd reason given was that LPR had plenty of growth and expansion potential, but wasn’t provided with an adequate capex budget by Forest, who only tended to reinvest what it took to maintain production levels. LPR management felt that if spun out and given direct access to capital markets that they could grow the company.
Immediately after the spinoff, LPR tanked. It dtopped from its IPO price of $13 to as low as 5.45 intraday (I managed tp pic some up there, and I am averaged in at $6.00). Since hitting that low it has rebounded some, but still sits at $7.50 a share for a market cap of $637 million and debt of $330 million for an enterprise value of $965 million.
A big part of that drop in price is because Lone Pine is perceived as a natural gas play, and natural gas prices have been hitting fresh multiyear lows every other day over the past few months. In 2011 around 80% of Lone Pine’s production was natural gas, 19% light crude and 1% liquids from Nat gas such as butane and methane. So anyone looking at LPR in 2011 would clearly call this a gas play and say the selloff and low valuation is justified, but is it?
That 20% of light crude production grew immensely in 2011 and looking at the average is misleading. In the first quarter of the year, crude was 14% of production, and by the end of the year it had grown to 27%. Lone Pine is putting its 2012 entire capex budget into developing their oil play in Alberta. And it is good, high quality oil. On a WTI price of $100 a barrel, LPR has a netback, or free cash, of $80. That’s extremely high and a lot higher than what you normally see in Alberta with the oil sands. This light oil comes from region that they have developed called Evi. Right after the IPO the company announced that they acquired more acres on the play, and as of now have a total of 100 sections left to drill. Shortly after that announcement, management released some well results from their 2011 drilling program in the Evi, and the results look good. Initial production rates are coming in above sell side estimates, and decline rates at the 60 and 90 day marks are also beating expectations. But we better hope for Lone Pine to have a lot of oil inventory to drill since gas prices may stay low for awhile.
Those 100 sections of land should keep Lone Pine busy drilling for at least 10 years. Currently LPR is using 6 wells per section spacing, meaning a drilling inventory of about 600 wells. In 2011 they drilled just short of 50 wells in the region, and their capex plans for 2012 call for another 47 wells to be drilled. So even with a decently aggressive drilling schedule in 2012 they have over 10 years of drilling inventory to work through. Further, they have recently been experimenting with 10 wells per section and have been getting promising results. As a result, they may have the option to downspace to 10 wells a section and increase their drilling inventory. Evi will keep them busy for a long time should natural gas supply continue to keep prices down.
Their 2012 drilling program that I mentioned above is entirely dedicated to oil. A few weeks ago management came out with their 2012 forecasts, and I think the street was a bit disappointed because Lone Pine forecast 2012 average production flat with the 2011 exit rate. Normally companies always like to grow production, especially in their early years. But management decided to forego all gas development in 2012, due to the terrible economics at $2.50 gas. Thus the entire capital budget, which is $210 million at the midpoint of the guided range, will go to developing Evi and to pay for G&A and maintenance of existing wells.
Thus while the overall production numbers won’t change much year over year, the quality of the production will get much more attractive. Lone Pine is entering the year with a 27% oil weighting, and should exit the year with a 40% weighting. Some rough math means that oil production will start at 4.5k barrels a day and end at 6.5k barrels a day, a pretty nice increase off that capex budget. This should increase cash flows to Lone Pine greatly, since gas, even though it is the bulk of 2011 the production numbers, still brought in a minority of the revenues.
The company estimates that based on those production numbers, and using $3.75 gas and $95 WTI they will have cash flow of $190 million. But $3.75 gas seems like a pipe dream from 2010 you say. It actually is a pretty reasonable number when you consider Lone Pine’s hedges in place for 2012. They have contracts for 40% of their total gas production averaged at $5.09. So to get to $3.75 they only need to average $2.85 on their non hedged sales. Looking at the nat gas forward curve which starts at $2.50 in March and gets to $3.50 by the end of the year, I think that assumption is reasonable. They also have hedges in place for 55% of their oil, at $102 a barrel. So based on current pricing coupled with that hedge price, it seems $95 is a pretty low estimate. A more reasonable estimate is $100 for the year, which would mean average prices on their non hedged sales of around $97. This incremental cash flow of $5 a barrel on their 5.5k average daily volume leads to an extra $10 million in cash flow. Even if they only realized an average WTI price of $80 on their non hedged sales, their cash flow would still be $184 million. And to be honest I can’t really envision a 2012 where oil drops much below that. A severe slowdown in the economy would be needed, which would be followed by Bernanke using QE3,4,5..which would directly support the price of oil. So based on the above I’m going to use $200 million as the cash flow number for 2012.
With capex at $210 million and free cash of $200 million, the debt load will increase. Lone Pine already has $330 million in debt. They just announced a $200 million 5 year bond, yielding 10 3/8% (which I think is a great buy), and as such will lower their line of credit from the bank from 425 to 375 million to account for the bonds and now have $240 million in borrowing capacity, should they need it. But the result of their expensive yet more stable financing means they really don’t need to worry about funding their capex anymore. The small $10 million increase in debt this year should be the plateau (debt will probably peak in Q3 at around $350 million) before they start to generate cash flows in excess of capital needs in 2013.
So now to come up with a value for LPR. Most junior to mid oil and gas company trade at a multiple of EV/EBITDA of between 5-7 depending on how gassy the company is and on stability of operations, dividends, debt levels, reserve life of the asset ect. Lone pine has an ok reserve life, a heavyish debt load at x1.65 2012 free cash (healthy is 1x, heavy is 2x or more), is unlikely to pay a dividend until 2013 and currently has a 73% gas weighting. So there is a lot of hair on the story and it is fair to give Lone Pine only a 5x multiple on their 200mm in free cash.
However even at the low end of the multiple Lone Pine seems to be slightly below fair value. 200 x 5 = $1 billion enterprise value which gives us a share price around 8$. This is obviously not too far from the current price of $7.50 and would make Lone Pine a pass.
When one looks out a bit into the future though, the shares become more compelling. Like I mentioned earlier, Lone Pine should end the year with a 40% oil weighting. Assuming $200 million in capex in 2013, and similar declines (declines should actually improve yoy as the heavy 2011 drill program is a lower weighting of the oil portfolio), LPR should be able to get production up another 2k barrels a day to average 7.5k a day. Using the same $3.75 gas pricing and $100 WTI (both based on forward curve pricing for 2013) this equates to $255 million in free cash, enough to fund capex and pay down some debt. This would also mean that Lone Pine would end the year with a 50% oil weighting, enough to shake the stigma of being a gas heavy company. So by the end of 2013, Lone Pine could be changed into a company with debt 1.1x cash flows, a 50/50 oil gas mix, ok reserve life, and very close to the introduction of a dividend (covenants on bond issue prevent LPR from issuing a dividend until debt is rated investment grade, which should be a2014 event based on cash flow projections). This could get them a multiple of 6x cash flows, which would mean $255 x 6 = $1.530 billion EV or around $14.75 a share. Thus my price target for Jan 1st, 2014 is $14.75, about a 100% return from current levels.
Longer term, you get the upside of a call option on nat gas prices coming back in 2015+ and Lone Pine’s vast gas development potential. Until then, oil will carry the weight.
Below are some sensitivity analyses under different oil price levels and production numbers.