ADVANTAGE OIL & GAS LTD AAV
February 21, 2012 - 12:14pm EST by
cnk123
2012 2013
Price: 4.04 EPS $0.00 $0.00
Shares Out. (in M): 166 P/E 0.0x 0.0x
Market Cap (in $M): 670 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 930 TEV/EBIT 0.0x 0.0x

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Description

Advantage Oil & Gas (TSX: AAV, "AAV" or "Advantage")

Thesis:

Macro headwinds and misperceptions regarding the Company's leverage and ability to weather a prolonged downturn in natural gas prices have led to AAV's Montney natural gas asset ("Glacier") being materially undervalued in the context of the Company's enterprise value, precedent transactions and comparable companies. Recent precedent transactions and corporate activity continue to highlight the significant strategic value of the Company's Glacier asset with numerous potential catalysts over the near and intermediate term which drive the potential for a material increase in the Company's equity value, current depressed natural gas prices notwithstanding. Given current valuation, there appears to be highly asymmetric return potential with minimal downside risks and a number of near and intermediate term catalysts to drive value creation. 

Brief Company Background:

The Company is an intermediate exploration and production (E&P) company with operations throughout Alberta.  The Company had average production ~23,000 boe/d (92% gas) as at September 30, 2012 growing to a Company forecasted 29,000 boe/d in June 2012 owing to a gas plant expansion at its Glacier asset which represents ~68% of current production increasing to ~80% by June 2012.  The Company also maintains approximately 7,700 boe/d in non-core production, 55% of which is liquids rich natural gas, the balance of which is CBM production (shallow gas).  Additionally, the Company owns 63% (29.450 mm shares) of Longview Oil Corp (TSX: LNV, "LNV" "Longview") which was spun out of AAV in April 2011, on a pre-tax basis, the value of those shares is ~$308 mm or ~33% of AAV's current EV. 

Basic capital structure summary below (in mm's except per share amounts unless otherwise noted):

Current Price:     $4.04

Basic S/O:           165.9

Market Cap:       $670.4

Net Debt (E):      $260.4

EV:                   $930.8

A couple key notes:

-Net debt listed above includes ~$86 mm in a convertible debenture issue due Jan 2015 with conversion price of $8.60 / share. 
-Net debt includes the refinancing of $63 mm of 2 seperate convertible debenture issues in Dec 2011 with bank debt
-Bank Debt post-refinancing noted above = $131 mm + $43 mm in working capital deficiency; net result is ~$175 mm in bank debt against $275 mm of credit capacity

I believe the market is ignoring the relative value of Glacier within AAV's existing corporate structure which is illuminated below:

LNV mkt value:    $308 mm 

Liquidity Discount: 10%

Assumed Tax Rate: 27% (corporate tax rate at Sept 30 2012 and book basis as at LNV IPO)

LNV After-Tax Value net to AAV: ~$275 mm or $1.67 / share

Non-Core assets: 7,700 boe/d

Assumed multiple: $15,000 / flowing(1)

Non-Core asset value: $115.5 mm, round down to $100 mm

AAV Adjusted EV:

Current EV:                $930

Less: LNV stake:         $275

Less: Non-Core asset:  $100

AAV Glacier             $555 mm or $35k / flowing boe or 7.3x run rate well head cash flow @ $2.00 AECO*
*run rate assumes 140 mmcf/d plant expansion completed and estimated operating costs achieved.  "Well head cash flow" = revenue - operating, royalty and transportation expense at asset level, pre corporate and finance expenses.

(1) At the lower end of recent transactions given <65% WI in each asset and the presence of shallow gas resources; Ember Resources is a reasonably good comparable for the value of these assets though Ember was highly leveraged offset against a higher AECO strip at the time resulted in a transaction valued ~70% higher than the multiple I am using here

 
Additionally, it is important to note that the Company had total credit capacity of $575 mm prior to the spin out of LNV; subsequent to the spin out the Company reduced total credit availabilty to $475 mm ($275 mm for AAV, $200 mm for LNV) given limited use for the incremental availability and for avoidance of standby fees.  As such, even a 25% reduction in credit capacity relative to 2010 reserves, ignoring proved, developed producing reserves added, would be comfortably managed given AAV's low cost structure (see below) and LNV stake.

 Brief background on Industry Activity in "Resource Play" gas in NW AB and NE BC:

The looming investment decision regarding the Kitimat LNG Project (owned by Apache, Encana and EOG which has already received First Nations approval and substantively all Government approvals) has driven a flurry of activity into Northwest Alberta's and NE BC's shale gas resources.  There are a number of competing projects and consortiums (including those led by Shell, Talsiman, PETRONAS, etc) The main reason is the focus of senior and integrated E&Ps, NOC's and off-takers who are looking to acquire project level ownership in natural gas resources which will eventually be transported to the Kitimat area for conversion into LNG and shipped to the Far East where the product pricing is materially higher (~$14 - $16.00 mmbtu in Japan as an example as at Dec 31) than in North America.  Montney zone resources are ideal targets given their substantial scale, repeatability, low levels of geological variability which lends to manufacturing like repeatability in full develiopment.  Proximity to infrastructure which will ultimately connect to Kitimat is also seen as a key advantage; All of this has led to a substantial "land grab" by the aforementioned groups to partner with North American producers with large scale Montney and Horn River basin projects; recent transactions include (acquiror / target)(2):

-Mitsubishi / EnCana (Cutbank Ridge Montney, see below); $1.45 bn upfront, $1.45 bn carried capital
-PetroChina / Shell (Groundbirch Montney); $1 bn for 20% overall interest
-INPEX / Nexen (Horn River); $350 mm upfront, $350 mm carried capital
-KOGAS / EnCana (Horn River); $0 mm upfront, $185 mm carried capital
-PETRONAS / Progress Energy (North Montney) ; $268 mm upfront, $803 mm carried capital
-SASOL / Talisman (Farrell Creek Montney); $260 mm upfront, $790 mm carried capital
-Mitsubishi / Penn West (Horn River / Cordova); $250 mm upfront, $600 mm carried capital
-KOGAS / EnCana (Horn River / Montney); $0 mm upfront, $283 mm carried capital

(2) Source: Public filings and broker estimates 

What's clear from the above is the scale of the acquiror, the variable upfront "promotes" as well as the large amount of carried capital going into each respective project area.  In each of the above cases, the vendor is retaining a significant interest in the project as well as operatorship of the project.  The total amount of carried capital going into NE BC and NW AB (largely over 5 year periods) is >$4.5 bn excluding vendor working interest capex and upfront "promotes".  All this during a period of depressed natural gas assets which highlights the level of reserve capture desired and required to commit to various LNG projects and meet Far East customer demands in terms of capacity prior to contractual arrangements being finalized.  The estimated average transaction value per acre is ~$13k (after exclusion of anciliary assets) of the above transactions.

Previous corporate Montney transactions (Tourmaline / Cinch, ARC / Storm, Pengrowth / Monterey) have effectively priced 2P Montney reserves at $1 / mcf which has become an industry benchmark for resource gas in Western Canada (assumed 20 BCF of reserves per section generated by 5 BCF / well, 4 wells for section) with the resultant value being applied to other production and land value which somewhat triangulates to a Montney type well economics at 'normalized' gas prices.  Illustratively, if you assumed Montney prospectivity given nearby well control, low variability and large continguous shale resource, $13,000 / acre on a typical section would imply $8 mm in upfront capital, ~$5.5 mm in well costs (depending on operator scale, etc) to drive ~$5 mm of before tax NPV / well @ $4.00 gas  (10% discount rate)

 Brief note on Birchcliff Energy:

 In many ways, Birchcliff Energy ("BIR") is the closest comparable for AAV.  BIR has ~300 sections of Montney / Doig land, 21% of which has booked 2P reserves (company disclosure) or ~63 net sections.  Production of ~19,400 boe/d per most recent disclosure, 66% of which (~12,750/boe) is from the Montney / Doig play at BIR's Pouce Coupe asset. The Company expects to exit 2012 at 28,000 boe/d, the increase is largely attributable to Pouce Coupe where a gas plant expansion to 120 mmcf/d will increase production (98% gas) out of that asset to 20,000 boe/d; this compares to ~23,000 boe/d out of AAV's Glacier asset.  Based on BIR disclosure, post gas plant expansion, all-in operating costs would be ~$0.81 / mcf translating to $1.19 / mcf operating netbacks @ $2.00 AECO.

On October 3, 2011, BIR announced it was initiating a corporate sale process due to unsolicited expressisons of interest; BIR's Pouce Coupe Montney / Doig asset is directly north of AAV's Glacier asset and is very similar in terms of production, booked sections, overall booked reserves and plant capacity (120 mmcf/d vs. 140 mmcf/d for AAV).  At the time of the announcment BIR's EV was ~$1.7 bn or $88k / flowing boe and $7.45 / 2P boe (June 2011 update) on a 2P basis.  Currently, BIR's EV is ~$2.0 bn or ~20% higher since announcement notwithstanding spot AECO natural gas prices decreasing ~40% over the same 4.5 month time period.

 BIR has largely traded at a much higher relative valuation to AAV and other natural gas peers due to the support of Mr. Seymour Schulich who owns 26%.  Mr. Schulich is a well known and highly regarded investor whose support is often viewed as a "backstop" to BIR and as such, BIR has been a difficult name to short in the past.  The fact that there were unsolicited expressions of interest (can't confirm the "strength" of these approaches) at presumably ~$10.00 / share (date of announcement price) would imply there is a bid at some premium level to AAV's current valuation for these assets which would in effect monetize the relative valuation differential between the 2 companies ensuring this valuation differential could no longer be explained away so easily - the analogy would be the recent sale of several of your neighbours homes sitting on similar lot sizes (with similar homes) at prices materially higher than yours; you wouldn't list your house at a 50% discount to those transactions all else equal....I believe the same concept holds here.

 Without getting into too much detail regarding BIR, in order to effectively determine an appropriate benchmark for AAV's Glacier asset, excluding value for BIR's non-Montney / Doig asset is required (in mm's).

 

BIR Current EV:                     $2.0 bn

                                       High             Low
Less:
Worsley(3):                    $400           $700          

Other non-core(3):          $27             $45  

Undeveloped Land(3):    $150           $300 

 BIR Montney/Doig :       $1,423        $955

 

The midpoint of the above valuation implies $1,189 mm for BIR's Montney / Doig asset which includes 300 sections of land (21% or 63 equivalent sections booked); valuing the land is inherently difficult given comparable valuation metrics for other Montney transactions is greater than the current EV; that being said, one important caveat is assigning material value to BIR's land is in effect, double counting as in the JV deals listed above the carried capital is going directly into the ground to prove up reserves and incremental value whereas the incremental capital in a corporate transaction would go directly to BIR's shareholders which would increase the ultimate capital commitment / "liability" associated with drilling.  Booked FDC of $1,223 mm excludes any capital required to drill BIR's undeveloped land; if we assume 4 wells / section and 237 undrilled equivalent sections, the future capital required to fully develop these lands would equate to ~$5,200 mm or $34,000 / acre

 Using an implied BIR Montney / Doig EV of $1,189 mm equates to approximately:
-$59,000 / flowing boe/d vs. $35,000 / flowing boe/d for AAV
-$6.42 / 2P boe excl. FDC vs. $3.33 / 2P boe for AAV (4)
-$13.03 incl. FDC vs. $8.80 / 2P boe for AAV(4)
-22.0x run rate well head cash flow (pre G&A) @$2.00 AECO vs. 7.3x run rate well head cash flow @ $2.00 AECO for AAV (5); this is just illustrative but reflects differences in cost structure and valuation

 Its important to note that BIR's booked FDC reflects a multiple of 8.8x notional cash flow @ $4.00 AECO and 23.5x notional cash flow at $2.00 AECO vs. 5.0x and 12.0x for AAV respectively.

 The major differences between the companies, aside from the glaring differences in valuation, largely relate to the amount of undeveloped land.  In addition to the larger footprint (300 vs. ~80 sections) in the Montney, BIR claims substantial prospectivity in "hot" industry plays including the Duvernay (195 net sections) and the Nordegg (721 net sections).  The implied valuations above for undeveloped land have attempted to reflect the scarcity value of these sizeable positions but may understate the ultimate strategic value of this play.  If one were to "normalize" BIR's Montney / Doig valuation with AAV's on a 2P basis (use 2010 as the base year for illustrative purposes), an incremental $520 mm would be applied to BIR's undeveloped land value, which at the low case above would imply $2,650 / undeveloped acre or $1.7 mm / section.  In contrast, AAV has dislcosed a potential of 900 locations, including ~325 locations in the upper montney (its only booked zone to date).  If one were to include all of its potential drilling locations (900) and exclude the ~200 locations booked to date, AAV would provide for an incremental 3.5 TCF of gas and $3.8 bn of FDC which implies a substantial amount of development upside still associated with the asset.

(3) Worsley: High case assumes ~$85k / flowing boe/d and $13 / 2P boe; Low case assumes $150k / flowing and $23 / 2P boe; midpoint of the 2 most in line with precedent transactions given nature of asset
(3) Other non-core: High case assumes $15k / flowing boe/d; Low case assumes $25k / flowing boe/d
(3) Undevelped land: High case assumes $500 / acre; Low case assumes $1,000 / acre
(4) BIR based on June 30, 2011 disclosure vs. AAV as at Dec 31, 2010; important distinction as AAV has drilled >20 locations in 2011 (type curve is ~5 BCF / well)
(5) Run Rate well head cash flow assumes respective gas plants operating at full capacity, $2.00 AECO less stated projected operating costs and is prior to corporate and finance charges but includes operating, royalty and transportation expense

 What is Advantage worth:

 Given the strategic nature of Montney (and Horn River to a lesser extent) resource plays, a NAV or DCF based approach is not as meaningful in a distressed natural gas price environment in my opinion relative to value per mcf resource based metrics.  This is in contrast to conventional gas reserves / companies.  Based on conversations with CEOs, bankers and consultants, it appears foreign buyers (namely NOCs and off-takers) are utilizing pricing assumptions well in excess of current AECO and NYMEX strip pricing in basing their investment decisions.  I have also learned that while undeveloped acreage and scale are key determinants of strategic interest, off-takers in particular are focused on large scale, low variability and high deliverability resources (like the NOCs) that have large booked reserves (perhaps unlike the NOCs) today so that they can meet their commitments at both Kitimat based LNG projects as well as delivery commitments in their respective foreign markets; for these reasons, a NAV based approach materially understates the "terminal value" associated with these resource style assets. 

 On Friday, February 17, 2012, EnCana ("ECA") announced a JV on its Cutbank property whereby Mitsubishi will invest $2.9 bn in upfront and carried interest for a 40% stake in the JV.  Here's another way to think about the implied valuation as it relates to AAV:

None of ECA's production from Cutbank was included in the transaction, if you assume $1 / mcf for AAV's booked reserves (consistent with precedent transactions), thats ~$1.0 bn - based on AAV's December 31, 2010 reserves, 2011 should be reasonably higher.  Then based on the bookings and future dev't capital, assume AAV has booked ~200 locations (of 900 locations total), thats ~$900 mm of FDC and works out to ~2.5 wells/section, net that from 4 wells per section spacing and multiply by 80 sections, thats 10,950 'undeveloped equivalent acres' .  Assume that you would value that at ~$12,000 - $12,500 / acre consistent to the ECA / Mitsubishi transaction (ex value to 1C resources per another dealer's estimates), thats another ~$135 mm; you're now at:

 $1.135 bn for Glacier + $275 mm for LNV (tax adjusted and assuming liquidity discount) + $100 mm for non core assets - $260 mm in estimated net debt = ~$7.50 / share or 85% higher than AAV's current price of $4.04 / share.

 Go back to Glacier, there are total 51,200 acres vs. 409,000 in the ECA JV or 12.5%; the JV's implied total value (carried interest undiscounted) of $7.250 bn; as a sanity check, 12.5% of the JV's implied value = ~$910 mm, to AAV or reasonably close to the above =>that would take you to ~$6.00 / share. 

The EnCana / Mitsubishi deal was just another data pt, whether you look at AAV on a reserves or  DCF / NAV basis, precedent transactions, comparables, etc it all gets to the same answer => that the stock is materially undervalued in the context of current industry activity. A bad gas tape and misconceptions regarding leverage (ie higher than avg debt / cf multiple but the LNV stake would extinguish all of the debt in a secondary sale) and the fact that they are not in a process / doubt as to BIR transacting seem to be the reasons for the mispricing. Keep in mind BIR trades materially higher on most metrics when normalized for just its Montney / Doig asset (plant capacity expanding to 120 mmcf/d vs AAV @ 140 mmcf/d); even if BIR transacted sub-mkt the read through for AAV's booked and producing 'real estate' would be substantial.

 Through the non-core assets, @ $2.50 flat AECO you're buying Glacier at ~7.0x trough cash flow with a ~30 year RLI; these a ssets don't seem to be transacting on cash flow anyway (moreso land value and contingent / prospective resource) but using $4.00 normalized pricing environment, AAV is trading at ~3.6x cash flow or 6.5x free cash flow (assuming $100 mm to stay flat per company disclosure), reasonable downside protection given where the precedent transactions are occuring, the scale / scope of the projects and likely buyers

Unless managment and the board do something crazy (their own JV, a misguided acqusition of a liquids focused company to change production mix, etc) this looks very cheap with a number of distinct catalysts:

1) Successful conclusion of the BIR sales process at current market price; in the BIR Low case illustrated above a transaction would imply $6.44 / share or 60% above AAV's current stock price
=>If BIR does not transact, assume a 35% decrease to BIR's existing share price; the implied EV of BIR's Montney / Doig asset using the mid-point for the other assets would be ~$610 mm or $4.35 / share, 9% above AAV's current stock price
=>Asssume BIR transacted at $15 / share, or an implied Montney / Doig asset EV of $1.35 bn which would imply $8.74 / share or 116% above AAV's current stock price

2) The monetization of all or a portion of AAV's Longview stake; Longview appears to be trading at very reasonable multiples and metrics (and a 5.7% dividend yield) and more importantly, the sale of a portion of the stake could have some important benefits:
=>Materially reduce net debt outstanding which may lead to multiple expansion in line with comparable companies and relevant precedent transactions
=>Net debt could be reduced to say 1.0x trough cash flow (~$75 mm) with the residual proceeds being used to reduce basic shares outstanding by ~25% assuming a $5.00 modified reverse dutch auction price; this price is easily supportable based on the above

3) Sale of non-core assets to delever; the 3,500 boe/d (~15% of corporate production) is mainly shallow gas and likely very dilutive to operating netbacks and multiples.  There has been strategic interest in CBM assets that are close to AAV's existing assets per management comments; given the fact that the Company trades at a very material multiple discount to Montney peers, it is possible that the sale at metrics lower than its existing multiple may actually lead to multiple expansion by the perception that debt paydown further de-risks the Company and the improvement in blended netback

4) It is clear based on precedent transactions, normalized cash flow based valuation, NAV valuation based on engineering price decks and comparable company valuation that AAV through its non-core assets has terminal value that is well in excess of its current market valuation; to that end, it is possible there is active engagement by shareholders at the board level to effecuate some or all of the above value creating catalysts listed above.  It is important to note that AAV senior management created a "Technical Services Agreement" which provides for the management of Longview by AAV's senior executives.  Management and the board own very little stock and now, having set up their "next job" in in my view, in the event of a hostile or unsolicited approach there may be little resistance to ultimately putting the company into a strategic alternatives process if a large constiuent of shareholders expressed this view.

 5) A turn in North American gas markets.  AAV is a low cost supplier (forecasted operating costs of $0.50 / mcf, full supply cost of $1.50 / mcf) amongst its peer group and one of the lowest cost producers in Western Canada, given that, upside operating leverage to cash flow in a more robust pricing environment is very material; to illustrate, operating cash flow for Glacier at $4.00 AECO would be ~$184 mm vs. ~$76 mm at $2.00 AECO.  I wouldn't pay anything for this and as illustrated above, I don't believe you are today, increased gas price is a free option at this point.

There are only a few projects of scale (PPY @ Cameron, Farrel Creek, and Town , CR's Septimus come to mind) without well capitalized players / JV's and AAV's Glacier remains the most developed along that path with an expanded 140 mmcf/d gas plant being constructed and 1 TCF of booked reserves so the thought is that management, given low ownership, has not been incented to transact (i.e. they have not shared the pain of shareholders) but ultimately there would be substantial interest from NOC's, Existing Montney JV's and offtakers who are looking for booked reserves and production to meet commitments for the various discussed LNG projects.  AAV is also not tied to any particular LNG project / consortium to my knowledge which is another major attraction given the 'land grab' taking place.  In addition to its existing December 2010 NI51-101 1 TCF of reserves, the Company has an incremental 600 BCF (at $1 / mcf this is ~$3.60 / share excluding the impact of associated FDC on related NAV) just to get to 4 wells / section in the upper Montney.  This still leaves a prospective >3 TCF of potential resource potential.

 Risks:

-BIR does not transact; as highlighted above, aside from a potential near term loss of 10-15% of market value, there is minor risk of permanent impairment of capital
-Gas prices decrease further; while this is a risk to near term equity value, the combination of strategic value of the asset, existing Longview stake which can be used to delever and low cost structure would enable the Company to manage through a further downturn while protecting optionality
-Acquisition; Conversations with management and other stakeholders would lead me to believe that this is well down the list of plausible options.  That being said, the "headline" multiple is still reasonable enough on a cash flow basis to drive a transaction

I believe the downside is muted while the presence of near term catalysts and market aversion to natural gas players as well as misperceptions regarding the Company's leverage and "true" valuation combine to create an attractive risk adjusted return opportunity.  Shorting a % of BIR against a long position in AAV could also be considered to hedge the downside of an event; as an example, given that I believe BIR will ultimately transact, I am long a multiple of capital of AAV relative to a small BIR short to remove some of the downside volatility

Catalyst

1) Successful conclusion of the BIR sales process at current market price; in the BIR Low case illustrated above a transaction would imply $6.44 / share or 60% above AAV's current stock price
=>If BIR does not transact, assume a 35% decrease to BIR's existing share price; the implied EV of BIR's Montney / Doig asset using the mid-point for the other assets would be ~$610 mm or $4.35 / share, 9% above AAV's current stock price
=>Asssume BIR transacted at $15 / share, or an implied Montney / Doig asset EV of $1.35 bn which would imply $8.74 / share or 116% above AAV's current stock price

2) The monetization of all or a portion of AAV's Longview stake; Longview appears to be trading at very reasonable multiples and metrics (and a 5.7% dividend yield) and more importantly, the sale of a portion of the stake could have some important benefits:
=>Materially reduce net debt outstanding which may lead to multiple expansion in line with comparable companies and relevant precedent transactions
=>Net debt could be reduced to say 1.0x trough cash flow (~$75 mm) with the residual proceeds being used to reduce basic shares outstanding by ~25% assuming a $5.00 modified reverse dutch auction price; this price is easily supportable based on the above

3) Sale of non-core assets to delever; the 3,500 boe/d (~15% of corporate production) is mainly shallow gas and likely very dilutive to operating netbacks and multiples.  There has been strategic interest in CBM assets that are close to AAV's existing assets per management comments; given the fact that the Company trades at a very material multiple discount to Montney peers, it is possible that the sale at metrics lower than its existing multiple may actually lead to multiple expansion by the perception that debt paydown further de-risks the Company and the improvement in blended netback

4) It is clear based on precedent transactions, normalized cash flow based valuation, NAV valuation based on engineering price decks and comparable company valuation that AAV through its non-core assets has terminal value that is well in excess of its current market valuation; to that end, it is possible there is active engagement by shareholders at the board level to effecuate some or all of the above value creating catalysts listed above.  It is important to note that AAV senior management created a "Technical Services Agreement" which provides for the management of Longview by AAV's senior executives.  Management and the board own very little stock and now, having set up their "next job" in in my view, in the event of a hostile or unsolicited approach there may be little resistance to ultimately putting the company into a strategic alternatives process if a large constiuent of shareholders expressed this view.

 5) A turn in North American gas markets.  AAV is a low cost supplier (forecasted operating costs of $0.50 / mcf, full supply cost of $1.50 / mcf) amongst its peer group and one of the lowest cost producers in Western Canada, given that, upside operating leverage to cash flow in a more robust pricing environment is very material; to illustrate, operating cash flow for Glacier at $4.00 AECO would be ~$184 mm vs. ~$76 mm at $2.00 AECO.  I wouldn't pay anything for this and as illustrated above, I don't believe you are today, increased gas price is a free option at this point.

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    Description

    Advantage Oil & Gas (TSX: AAV, "AAV" or "Advantage")

    Thesis:

    Macro headwinds and misperceptions regarding the Company's leverage and ability to weather a prolonged downturn in natural gas prices have led to AAV's Montney natural gas asset ("Glacier") being materially undervalued in the context of the Company's enterprise value, precedent transactions and comparable companies. Recent precedent transactions and corporate activity continue to highlight the significant strategic value of the Company's Glacier asset with numerous potential catalysts over the near and intermediate term which drive the potential for a material increase in the Company's equity value, current depressed natural gas prices notwithstanding. Given current valuation, there appears to be highly asymmetric return potential with minimal downside risks and a number of near and intermediate term catalysts to drive value creation. 

    Brief Company Background:

    The Company is an intermediate exploration and production (E&P) company with operations throughout Alberta.  The Company had average production ~23,000 boe/d (92% gas) as at September 30, 2012 growing to a Company forecasted 29,000 boe/d in June 2012 owing to a gas plant expansion at its Glacier asset which represents ~68% of current production increasing to ~80% by June 2012.  The Company also maintains approximately 7,700 boe/d in non-core production, 55% of which is liquids rich natural gas, the balance of which is CBM production (shallow gas).  Additionally, the Company owns 63% (29.450 mm shares) of Longview Oil Corp (TSX: LNV, "LNV" "Longview") which was spun out of AAV in April 2011, on a pre-tax basis, the value of those shares is ~$308 mm or ~33% of AAV's current EV. 

    Basic capital structure summary below (in mm's except per share amounts unless otherwise noted):

    Current Price:     $4.04

    Basic S/O:           165.9

    Market Cap:       $670.4

    Net Debt (E):      $260.4

    EV:                   $930.8

    A couple key notes:

    -Net debt listed above includes ~$86 mm in a convertible debenture issue due Jan 2015 with conversion price of $8.60 / share. 
    -Net debt includes the refinancing of $63 mm of 2 seperate convertible debenture issues in Dec 2011 with bank debt
    -Bank Debt post-refinancing noted above = $131 mm + $43 mm in working capital deficiency; net result is ~$175 mm in bank debt against $275 mm of credit capacity

    I believe the market is ignoring the relative value of Glacier within AAV's existing corporate structure which is illuminated below:

    LNV mkt value:    $308 mm 

    Liquidity Discount: 10%

    Assumed Tax Rate: 27% (corporate tax rate at Sept 30 2012 and book basis as at LNV IPO)

    LNV After-Tax Value net to AAV: ~$275 mm or $1.67 / share

    Non-Core assets: 7,700 boe/d

    Assumed multiple: $15,000 / flowing(1)

    Non-Core asset value: $115.5 mm, round down to $100 mm

    AAV Adjusted EV:

    Current EV:                $930

    Less: LNV stake:         $275

    Less: Non-Core asset:  $100

    AAV Glacier             $555 mm or $35k / flowing boe or 7.3x run rate well head cash flow @ $2.00 AECO*
    *run rate assumes 140 mmcf/d plant expansion completed and estimated operating costs achieved.  "Well head cash flow" = revenue - operating, royalty and transportation expense at asset level, pre corporate and finance expenses.

    (1) At the lower end of recent transactions given <65% WI in each asset and the presence of shallow gas resources; Ember Resources is a reasonably good comparable for the value of these assets though Ember was highly leveraged offset against a higher AECO strip at the time resulted in a transaction valued ~70% higher than the multiple I am using here

     
    Additionally, it is important to note that the Company had total credit capacity of $575 mm prior to the spin out of LNV; subsequent to the spin out the Company reduced total credit availabilty to $475 mm ($275 mm for AAV, $200 mm for LNV) given limited use for the incremental availability and for avoidance of standby fees.  As such, even a 25% reduction in credit capacity relative to 2010 reserves, ignoring proved, developed producing reserves added, would be comfortably managed given AAV's low cost structure (see below) and LNV stake.

     Brief background on Industry Activity in "Resource Play" gas in NW AB and NE BC:

    The looming investment decision regarding the Kitimat LNG Project (owned by Apache, Encana and EOG which has already received First Nations approval and substantively all Government approvals) has driven a flurry of activity into Northwest Alberta's and NE BC's shale gas resources.  There are a number of competing projects and consortiums (including those led by Shell, Talsiman, PETRONAS, etc) The main reason is the focus of senior and integrated E&Ps, NOC's and off-takers who are looking to acquire project level ownership in natural gas resources which will eventually be transported to the Kitimat area for conversion into LNG and shipped to the Far East where the product pricing is materially higher (~$14 - $16.00 mmbtu in Japan as an example as at Dec 31) than in North America.  Montney zone resources are ideal targets given their substantial scale, repeatability, low levels of geological variability which lends to manufacturing like repeatability in full develiopment.  Proximity to infrastructure which will ultimately connect to Kitimat is also seen as a key advantage; All of this has led to a substantial "land grab" by the aforementioned groups to partner with North American producers with large scale Montney and Horn River basin projects; recent transactions include (acquiror / target)(2):

    -Mitsubishi / EnCana (Cutbank Ridge Montney, see below); $1.45 bn upfront, $1.45 bn carried capital
    -PetroChina / Shell (Groundbirch Montney); $1 bn for 20% overall interest
    -INPEX / Nexen (Horn River); $350 mm upfront, $350 mm carried capital
    -KOGAS / EnCana (Horn River); $0 mm upfront, $185 mm carried capital
    -PETRONAS / Progress Energy (North Montney) ; $268 mm upfront, $803 mm carried capital
    -SASOL / Talisman (Farrell Creek Montney); $260 mm upfront, $790 mm carried capital
    -Mitsubishi / Penn West (Horn River / Cordova); $250 mm upfront, $600 mm carried capital
    -KOGAS / EnCana (Horn River / Montney); $0 mm upfront, $283 mm carried capital

    (2) Source: Public filings and broker estimates 

    What's clear from the above is the scale of the acquiror, the variable upfront "promotes" as well as the large amount of carried capital going into each respective project area.  In each of the above cases, the vendor is retaining a significant interest in the project as well as operatorship of the project.  The total amount of carried capital going into NE BC and NW AB (largely over 5 year periods) is >$4.5 bn excluding vendor working interest capex and upfront "promotes".  All this during a period of depressed natural gas assets which highlights the level of reserve capture desired and required to commit to various LNG projects and meet Far East customer demands in terms of capacity prior to contractual arrangements being finalized.  The estimated average transaction value per acre is ~$13k (after exclusion of anciliary assets) of the above transactions.

    Previous corporate Montney transactions (Tourmaline / Cinch, ARC / Storm, Pengrowth / Monterey) have effectively priced 2P Montney reserves at $1 / mcf which has become an industry benchmark for resource gas in Western Canada (assumed 20 BCF of reserves per section generated by 5 BCF / well, 4 wells for section) with the resultant value being applied to other production and land value which somewhat triangulates to a Montney type well economics at 'normalized' gas prices.  Illustratively, if you assumed Montney prospectivity given nearby well control, low variability and large continguous shale resource, $13,000 / acre on a typical section would imply $8 mm in upfront capital, ~$5.5 mm in well costs (depending on operator scale, etc) to drive ~$5 mm of before tax NPV / well @ $4.00 gas  (10% discount rate)

     Brief note on Birchcliff Energy:

     In many ways, Birchcliff Energy ("BIR") is the closest comparable for AAV.  BIR has ~300 sections of Montney / Doig land, 21% of which has booked 2P reserves (company disclosure) or ~63 net sections.  Production of ~19,400 boe/d per most recent disclosure, 66% of which (~12,750/boe) is from the Montney / Doig play at BIR's Pouce Coupe asset. The Company expects to exit 2012 at 28,000 boe/d, the increase is largely attributable to Pouce Coupe where a gas plant expansion to 120 mmcf/d will increase production (98% gas) out of that asset to 20,000 boe/d; this compares to ~23,000 boe/d out of AAV's Glacier asset.  Based on BIR disclosure, post gas plant expansion, all-in operating costs would be ~$0.81 / mcf translating to $1.19 / mcf operating netbacks @ $2.00 AECO.

    On October 3, 2011, BIR announced it was initiating a corporate sale process due to unsolicited expressisons of interest; BIR's Pouce Coupe Montney / Doig asset is directly north of AAV's Glacier asset and is very similar in terms of production, booked sections, overall booked reserves and plant capacity (120 mmcf/d vs. 140 mmcf/d for AAV).  At the time of the announcment BIR's EV was ~$1.7 bn or $88k / flowing boe and $7.45 / 2P boe (June 2011 update) on a 2P basis.  Currently, BIR's EV is ~$2.0 bn or ~20% higher since announcement notwithstanding spot AECO natural gas prices decreasing ~40% over the same 4.5 month time period.

     BIR has largely traded at a much higher relative valuation to AAV and other natural gas peers due to the support of Mr. Seymour Schulich who owns 26%.  Mr. Schulich is a well known and highly regarded investor whose support is often viewed as a "backstop" to BIR and as such, BIR has been a difficult name to short in the past.  The fact that there were unsolicited expressions of interest (can't confirm the "strength" of these approaches) at presumably ~$10.00 / share (date of announcement price) would imply there is a bid at some premium level to AAV's current valuation for these assets which would in effect monetize the relative valuation differential between the 2 companies ensuring this valuation differential could no longer be explained away so easily - the analogy would be the recent sale of several of your neighbours homes sitting on similar lot sizes (with similar homes) at prices materially higher than yours; you wouldn't list your house at a 50% discount to those transactions all else equal....I believe the same concept holds here.

     Without getting into too much detail regarding BIR, in order to effectively determine an appropriate benchmark for AAV's Glacier asset, excluding value for BIR's non-Montney / Doig asset is required (in mm's).

     

    BIR Current EV:                     $2.0 bn

                                           High             Low
    Less:
    Worsley(3):                    $400           $700          

    Other non-core(3):          $27             $45  

    Undeveloped Land(3):    $150           $300 

     BIR Montney/Doig :       $1,423        $955

     

    The midpoint of the above valuation implies $1,189 mm for BIR's Montney / Doig asset which includes 300 sections of land (21% or 63 equivalent sections booked); valuing the land is inherently difficult given comparable valuation metrics for other Montney transactions is greater than the current EV; that being said, one important caveat is assigning material value to BIR's land is in effect, double counting as in the JV deals listed above the carried capital is going directly into the ground to prove up reserves and incremental value whereas the incremental capital in a corporate transaction would go directly to BIR's shareholders which would increase the ultimate capital commitment / "liability" associated with drilling.  Booked FDC of $1,223 mm excludes any capital required to drill BIR's undeveloped land; if we assume 4 wells / section and 237 undrilled equivalent sections, the future capital required to fully develop these lands would equate to ~$5,200 mm or $34,000 / acre

     Using an implied BIR Montney / Doig EV of $1,189 mm equates to approximately:
    -$59,000 / flowing boe/d vs. $35,000 / flowing boe/d for AAV
    -$6.42 / 2P boe excl. FDC vs. $3.33 / 2P boe for AAV (4)
    -$13.03 incl. FDC vs. $8.80 / 2P boe for AAV(4)
    -22.0x run rate well head cash flow (pre G&A) @$2.00 AECO vs. 7.3x run rate well head cash flow @ $2.00 AECO for AAV (5); this is just illustrative but reflects differences in cost structure and valuation

     Its important to note that BIR's booked FDC reflects a multiple of 8.8x notional cash flow @ $4.00 AECO and 23.5x notional cash flow at $2.00 AECO vs. 5.0x and 12.0x for AAV respectively.

     The major differences between the companies, aside from the glaring differences in valuation, largely relate to the amount of undeveloped land.  In addition to the larger footprint (300 vs. ~80 sections) in the Montney, BIR claims substantial prospectivity in "hot" industry plays including the Duvernay (195 net sections) and the Nordegg (721 net sections).  The implied valuations above for undeveloped land have attempted to reflect the scarcity value of these sizeable positions but may understate the ultimate strategic value of this play.  If one were to "normalize" BIR's Montney / Doig valuation with AAV's on a 2P basis (use 2010 as the base year for illustrative purposes), an incremental $520 mm would be applied to BIR's undeveloped land value, which at the low case above would imply $2,650 / undeveloped acre or $1.7 mm / section.  In contrast, AAV has dislcosed a potential of 900 locations, including ~325 locations in the upper montney (its only booked zone to date).  If one were to include all of its potential drilling locations (900) and exclude the ~200 locations booked to date, AAV would provide for an incremental 3.5 TCF of gas and $3.8 bn of FDC which implies a substantial amount of development upside still associated with the asset.

    (3) Worsley: High case assumes ~$85k / flowing boe/d and $13 / 2P boe; Low case assumes $150k / flowing and $23 / 2P boe; midpoint of the 2 most in line with precedent transactions given nature of asset
    (3) Other non-core: High case assumes $15k / flowing boe/d; Low case assumes $25k / flowing boe/d
    (3) Undevelped land: High case assumes $500 / acre; Low case assumes $1,000 / acre
    (4) BIR based on June 30, 2011 disclosure vs. AAV as at Dec 31, 2010; important distinction as AAV has drilled >20 locations in 2011 (type curve is ~5 BCF / well)
    (5) Run Rate well head cash flow assumes respective gas plants operating at full capacity, $2.00 AECO less stated projected operating costs and is prior to corporate and finance charges but includes operating, royalty and transportation expense

     What is Advantage worth:

     Given the strategic nature of Montney (and Horn River to a lesser extent) resource plays, a NAV or DCF based approach is not as meaningful in a distressed natural gas price environment in my opinion relative to value per mcf resource based metrics.  This is in contrast to conventional gas reserves / companies.  Based on conversations with CEOs, bankers and consultants, it appears foreign buyers (namely NOCs and off-takers) are utilizing pricing assumptions well in excess of current AECO and NYMEX strip pricing in basing their investment decisions.  I have also learned that while undeveloped acreage and scale are key determinants of strategic interest, off-takers in particular are focused on large scale, low variability and high deliverability resources (like the NOCs) that have large booked reserves (perhaps unlike the NOCs) today so that they can meet their commitments at both Kitimat based LNG projects as well as delivery commitments in their respective foreign markets; for these reasons, a NAV based approach materially understates the "terminal value" associated with these resource style assets. 

     On Friday, February 17, 2012, EnCana ("ECA") announced a JV on its Cutbank property whereby Mitsubishi will invest $2.9 bn in upfront and carried interest for a 40% stake in the JV.  Here's another way to think about the implied valuation as it relates to AAV:

    None of ECA's production from Cutbank was included in the transaction, if you assume $1 / mcf for AAV's booked reserves (consistent with precedent transactions), thats ~$1.0 bn - based on AAV's December 31, 2010 reserves, 2011 should be reasonably higher.  Then based on the bookings and future dev't capital, assume AAV has booked ~200 locations (of 900 locations total), thats ~$900 mm of FDC and works out to ~2.5 wells/section, net that from 4 wells per section spacing and multiply by 80 sections, thats 10,950 'undeveloped equivalent acres' .  Assume that you would value that at ~$12,000 - $12,500 / acre consistent to the ECA / Mitsubishi transaction (ex value to 1C resources per another dealer's estimates), thats another ~$135 mm; you're now at:

     $1.135 bn for Glacier + $275 mm for LNV (tax adjusted and assuming liquidity discount) + $100 mm for non core assets - $260 mm in estimated net debt = ~$7.50 / share or 85% higher than AAV's current price of $4.04 / share.

     Go back to Glacier, there are total 51,200 acres vs. 409,000 in the ECA JV or 12.5%; the JV's implied total value (carried interest undiscounted) of $7.250 bn; as a sanity check, 12.5% of the JV's implied value = ~$910 mm, to AAV or reasonably close to the above =>that would take you to ~$6.00 / share. 

    The EnCana / Mitsubishi deal was just another data pt, whether you look at AAV on a reserves or  DCF / NAV basis, precedent transactions, comparables, etc it all gets to the same answer => that the stock is materially undervalued in the context of current industry activity. A bad gas tape and misconceptions regarding leverage (ie higher than avg debt / cf multiple but the LNV stake would extinguish all of the debt in a secondary sale) and the fact that they are not in a process / doubt as to BIR transacting seem to be the reasons for the mispricing. Keep in mind BIR trades materially higher on most metrics when normalized for just its Montney / Doig asset (plant capacity expanding to 120 mmcf/d vs AAV @ 140 mmcf/d); even if BIR transacted sub-mkt the read through for AAV's booked and producing 'real estate' would be substantial.

     Through the non-core assets, @ $2.50 flat AECO you're buying Glacier at ~7.0x trough cash flow with a ~30 year RLI; these a ssets don't seem to be transacting on cash flow anyway (moreso land value and contingent / prospective resource) but using $4.00 normalized pricing environment, AAV is trading at ~3.6x cash flow or 6.5x free cash flow (assuming $100 mm to stay flat per company disclosure), reasonable downside protection given where the precedent transactions are occuring, the scale / scope of the projects and likely buyers

    Unless managment and the board do something crazy (their own JV, a misguided acqusition of a liquids focused company to change production mix, etc) this looks very cheap with a number of distinct catalysts:

    1) Successful conclusion of the BIR sales process at current market price; in the BIR Low case illustrated above a transaction would imply $6.44 / share or 60% above AAV's current stock price
    =>If BIR does not transact, assume a 35% decrease to BIR's existing share price; the implied EV of BIR's Montney / Doig asset using the mid-point for the other assets would be ~$610 mm or $4.35 / share, 9% above AAV's current stock price
    =>Asssume BIR transacted at $15 / share, or an implied Montney / Doig asset EV of $1.35 bn which would imply $8.74 / share or 116% above AAV's current stock price

    2) The monetization of all or a portion of AAV's Longview stake; Longview appears to be trading at very reasonable multiples and metrics (and a 5.7% dividend yield) and more importantly, the sale of a portion of the stake could have some important benefits:
    =>Materially reduce net debt outstanding which may lead to multiple expansion in line with comparable companies and relevant precedent transactions
    =>Net debt could be reduced to say 1.0x trough cash flow (~$75 mm) with the residual proceeds being used to reduce basic shares outstanding by ~25% assuming a $5.00 modified reverse dutch auction price; this price is easily supportable based on the above

    3) Sale of non-core assets to delever; the 3,500 boe/d (~15% of corporate production) is mainly shallow gas and likely very dilutive to operating netbacks and multiples.  There has been strategic interest in CBM assets that are close to AAV's existing assets per management comments; given the fact that the Company trades at a very material multiple discount to Montney peers, it is possible that the sale at metrics lower than its existing multiple may actually lead to multiple expansion by the perception that debt paydown further de-risks the Company and the improvement in blended netback

    4) It is clear based on precedent transactions, normalized cash flow based valuation, NAV valuation based on engineering price decks and comparable company valuation that AAV through its non-core assets has terminal value that is well in excess of its current market valuation; to that end, it is possible there is active engagement by shareholders at the board level to effecuate some or all of the above value creating catalysts listed above.  It is important to note that AAV senior management created a "Technical Services Agreement" which provides for the management of Longview by AAV's senior executives.  Management and the board own very little stock and now, having set up their "next job" in in my view, in the event of a hostile or unsolicited approach there may be little resistance to ultimately putting the company into a strategic alternatives process if a large constiuent of shareholders expressed this view.

     5) A turn in North American gas markets.  AAV is a low cost supplier (forecasted operating costs of $0.50 / mcf, full supply cost of $1.50 / mcf) amongst its peer group and one of the lowest cost producers in Western Canada, given that, upside operating leverage to cash flow in a more robust pricing environment is very material; to illustrate, operating cash flow for Glacier at $4.00 AECO would be ~$184 mm vs. ~$76 mm at $2.00 AECO.  I wouldn't pay anything for this and as illustrated above, I don't believe you are today, increased gas price is a free option at this point.

    There are only a few projects of scale (PPY @ Cameron, Farrel Creek, and Town , CR's Septimus come to mind) without well capitalized players / JV's and AAV's Glacier remains the most developed along that path with an expanded 140 mmcf/d gas plant being constructed and 1 TCF of booked reserves so the thought is that management, given low ownership, has not been incented to transact (i.e. they have not shared the pain of shareholders) but ultimately there would be substantial interest from NOC's, Existing Montney JV's and offtakers who are looking for booked reserves and production to meet commitments for the various discussed LNG projects.  AAV is also not tied to any particular LNG project / consortium to my knowledge which is another major attraction given the 'land grab' taking place.  In addition to its existing December 2010 NI51-101 1 TCF of reserves, the Company has an incremental 600 BCF (at $1 / mcf this is ~$3.60 / share excluding the impact of associated FDC on related NAV) just to get to 4 wells / section in the upper Montney.  This still leaves a prospective >3 TCF of potential resource potential.

     Risks:

    -BIR does not transact; as highlighted above, aside from a potential near term loss of 10-15% of market value, there is minor risk of permanent impairment of capital
    -Gas prices decrease further; while this is a risk to near term equity value, the combination of strategic value of the asset, existing Longview stake which can be used to delever and low cost structure would enable the Company to manage through a further downturn while protecting optionality
    -Acquisition; Conversations with management and other stakeholders would lead me to believe that this is well down the list of plausible options.  That being said, the "headline" multiple is still reasonable enough on a cash flow basis to drive a transaction

    I believe the downside is muted while the presence of near term catalysts and market aversion to natural gas players as well as misperceptions regarding the Company's leverage and "true" valuation combine to create an attractive risk adjusted return opportunity.  Shorting a % of BIR against a long position in AAV could also be considered to hedge the downside of an event; as an example, given that I believe BIR will ultimately transact, I am long a multiple of capital of AAV relative to a small BIR short to remove some of the downside volatility

    Catalyst

    1) Successful conclusion of the BIR sales process at current market price; in the BIR Low case illustrated above a transaction would imply $6.44 / share or 60% above AAV's current stock price
    =>If BIR does not transact, assume a 35% decrease to BIR's existing share price; the implied EV of BIR's Montney / Doig asset using the mid-point for the other assets would be ~$610 mm or $4.35 / share, 9% above AAV's current stock price
    =>Asssume BIR transacted at $15 / share, or an implied Montney / Doig asset EV of $1.35 bn which would imply $8.74 / share or 116% above AAV's current stock price

    2) The monetization of all or a portion of AAV's Longview stake; Longview appears to be trading at very reasonable multiples and metrics (and a 5.7% dividend yield) and more importantly, the sale of a portion of the stake could have some important benefits:
    =>Materially reduce net debt outstanding which may lead to multiple expansion in line with comparable companies and relevant precedent transactions
    =>Net debt could be reduced to say 1.0x trough cash flow (~$75 mm) with the residual proceeds being used to reduce basic shares outstanding by ~25% assuming a $5.00 modified reverse dutch auction price; this price is easily supportable based on the above

    3) Sale of non-core assets to delever; the 3,500 boe/d (~15% of corporate production) is mainly shallow gas and likely very dilutive to operating netbacks and multiples.  There has been strategic interest in CBM assets that are close to AAV's existing assets per management comments; given the fact that the Company trades at a very material multiple discount to Montney peers, it is possible that the sale at metrics lower than its existing multiple may actually lead to multiple expansion by the perception that debt paydown further de-risks the Company and the improvement in blended netback

    4) It is clear based on precedent transactions, normalized cash flow based valuation, NAV valuation based on engineering price decks and comparable company valuation that AAV through its non-core assets has terminal value that is well in excess of its current market valuation; to that end, it is possible there is active engagement by shareholders at the board level to effecuate some or all of the above value creating catalysts listed above.  It is important to note that AAV senior management created a "Technical Services Agreement" which provides for the management of Longview by AAV's senior executives.  Management and the board own very little stock and now, having set up their "next job" in in my view, in the event of a hostile or unsolicited approach there may be little resistance to ultimately putting the company into a strategic alternatives process if a large constiuent of shareholders expressed this view.

     5) A turn in North American gas markets.  AAV is a low cost supplier (forecasted operating costs of $0.50 / mcf, full supply cost of $1.50 / mcf) amongst its peer group and one of the lowest cost producers in Western Canada, given that, upside operating leverage to cash flow in a more robust pricing environment is very material; to illustrate, operating cash flow for Glacier at $4.00 AECO would be ~$184 mm vs. ~$76 mm at $2.00 AECO.  I wouldn't pay anything for this and as illustrated above, I don't believe you are today, increased gas price is a free option at this point.

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