|Shares Out. (in M):||103||P/E||0.0x||0.0x|
|Market Cap (in $M):||100||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||105||EBIT||-6||0|
AJ Lucas is an Australian-based drilling and construction services provider. The Australian operating assets, however, are more-or-less an unpleasant diversion from the real investment case surrounding AJ Lucas. That case centers around the free call option embedded in AJ Lucas’s common stock on an investment portfolio that provides ownership in Europe’s largest shale gas field, as well as several other large European shale gas and oil opportunities.
To understand the nature of the opportunity and how the equity has come to be priced so inefficiently, it is important to appreciate part of AJ Lucas’s history. The company was founded in the 1950’s as a building sub-contractor. Lucas developed expertise around horizontal directional drilling to lay pipeline infrastructure and became the leading player in this market. The company leveraged this expertise to develop a services business to help exploit coal, and coal seam gas resources in Australia. That business is now Lucas’s most important segment. AJ Lucas went public in 1999, bought several drilling services companies and grew from $24mn in annual revenues to $424mn in the span of nine years.
Along the way, AJ Lucas began investing excess cashflow directly into some of the resource plays they were helping to develop. They had some outstanding success and some outright failures, but on the whole they were earning returns such that they were able to continue the investment program while increasing the stakes each round.
The story began to unravel in 2008 when the company started to have difficulty integrating at least one of its large drilling services acquisitions. This led to poor safety and operating results just as the financial crisis began to impact the Australian economy. Unusually wet weather helped to further undermine results to the point that a once healthy and fairly dependable cash-flowing business began to hemorrhage cash.
The company’s liquidity difficulties were compounded by the fact that the investment portfolio demanded more capital than anticipated, while development work dragged on longer than expected. The leverage that the company accumulated during its growth years, and the large tax liability resulting from successful resource investing created a “hole” in AJ Lucas’s working capital balances of approximately $116mn by mid-year of 2011. AJ Lucas voluntarily suspended the trading of its shares on May 23, 2011 as it evaluated alternative financing proposals. The suspension was not lifted until late December 2011 when the firm was recapitalized.
AJ Lucas’s operating businesses have been woefully mismanaged for years. It is far from an ideal investment candidate in that sense. Underlining this point, the CEO has been embarrassingly well compensated while the company teetered on the edge of insolvency. Allan Campbell took home a $6.48mn cash bonus in 2009 related to the sale of an Australian gas asset that year. The distaste this mismanagement and shareholder unfriendly behavior has engendered in the market for AJ Lucas’s shares likely explains all or part of the inefficiency in valuing the firm’s European investment. AJ Lucas is seen as such a low quality story that the market simply ignores its European assets, believing that any investment in Lucas is not worth the risk.
Kerogen Capital is a Hong Kong-based private equity firm. The firm invests in upstream oil & gas assets that are leveraged to demand in Asia. The principals at Kerogen came out of JP Morgan where they served as investment bankers, mainly to the Chinese National Oil companies. Kerogen is reported to have a strategic partnership with China National Offshore Oil Corp (CNOOC) which includes a $500mn investment, and consulting services from CNOOC in return for a first look at exits on portfolio companies.
Late in 2011 AJ Lucas announced a recapitalization plan that included a Kerogen equity investment of $13.38mn (at $1.35/share), and a two-year $86.5mn mezzanine facility from Kerogen with options for up to 18.57mn shares. The plan also included a 1-for-2 rights offering to raise $51.3mn from existing shareholders at $1.35/share.
The rights offering was a fiasco, and the firm only placed $35.8mn worth of entitlement shares. The entitlement offering’s two sub-underwriters, Andial Holdings and Kerogen Capital, were obligated to make up the shortfall, however, Andial was unable to finance its share so the deal was scaled back to include only shares that had been subscribed.
Andial holds almost 12mn shares in AJ Lucas and is owned by AJ Lucas’s CEO, Allan Campbell. Andial appears to have been unable to finance both its share of rights and its sub-underwriter obligation. The fact that this deal’s primary underwriter needed 100% coverage by a group of sub-underwriters, which included the CEO’s company and private equity backer, speaks to the desperate nature of the situation.
Subsequent to the rights offering, AJ Lucas announced that it would raise between $30 and $35mn in equity at the same price as the rights offer ($1.35/share - a 35% premium to the current share price). In late June the company preannounced negatively (for the second time in six months), and announced that it would increase the raise to $40mn. The placement will be voted upon at a shareholder meeting in early September. The company stated that it has already identified investors willing to subscribe for shares at these levels. My educated guess is that a large part (if not all) of these monies will come from Kerogen.
Kerogen’s interest in AJ Lucas is driven by AJ Lucas’s investment in a private UK company, Cuadrilla Resources. AJ Lucas and its partner private equity firm, Riverstone LLC, are majority shareholders in Cuadrilla, which was formed in 2007 to recover oil and gas through unconventional exploration in Europe. Riverstone and AJ Lucas each own 42% of Cuadrilla with the balance belonging to management and employees. Cuadrilla was early in identifying and acquiring exploration permits in prospective unconventional resources in Europe, just as the shale gas boom was beginning to take hold in the U.S.. Cuadrilla intends to prove the gas potential in these fields, and then sell them to large integrated oil & gas companies who can afford to develop them properly.
Cuadrilla holds exploration licenses for 1.2mn net acres in the UK, the Netherlands, Poland, and Hungary. The firm has applications pending for an additional 800k gross acres in the Netherlands, Poland, and the Czech Republic. AJ Lucas had invested $78.6mn in Cuadrilla as of February 2012, and is expected to invest an additional $20-$30mn over the next 12-18 months.
Cuadrilla’s drilling efforts are most advanced in the Bowland shale of the UK where it holds licenses for 293k gross acres. AJ Lucas has a 25% direct interest in this license in addition to its Cuadrilla stake, raising its ownership to 56.5% of the Bowland prospect.
After drilling three wells into the Bowland shale and fracking two of them (in vertical wells - horizontals have yet to be drilled), in September of 2011 Cuadrilla announced its internal estimate of gas in place within the Bowland shale of 200 trillion cubic feet. Subsequent investor presentations have presented 200 tcf as the minimum. I believe that ultimately this figure will rise to between 350-400 tcf based on information provided by management.
This is a very large-scale find. To put the 200 tcf figure into perspective, the press is fond of pointing out that it is more gas than Iraq has in its entire reserves. It is more than forty times the British Geological Survey’s estimate of shale gas recoverable from land drilling for the entire nation. Here in the U.S., the Marcellus shale is purported to have 141 tcf of “unproved reserves” according to the Energy Information Administration.
While it may be fun to marvel at the size of these figures, most industry experts will tell you that their value is marginal. This is because a gas in place or unproved resource estimate doesn’t tell us much about how much gas the shale will economically produce. This will be a function of the realized price of gas when it is sold, the costs involved in extracting it, and the amount of time it takes to extract it.
We don’t know for certain that the Bowland shale will produce commercially viable gas, however, we do know a number of factors that argue in its favor. Natural gas sells for $9 to $10/mcf in Europe - roughly 3-4x the price here in the States. Drillers pay no royalty in the UK as they do in the U.S. The Bowland shale is unusually thick, meaning that from one pad a driller could horizontally fracture multiple horizontal zones, accessing potentially large amounts of gas per well. Cuadrilla has estimated gas in place of 1.4 tcf/sq. mile. By comparison, one of the most prolific U.S. shales, the Barnett, holds 240 bcf/sq. mile. Technical measures such as vitrinite reflectance and total organic carbon also compare favorably with levels seen in the Barnett shale. The shale rock of the Bowland is easily fractured and produces good quality gas with minimal CO2. Importantly, the field is very close to major pipeline infrastructure.
There are also several factors that could make Bowland gas production uneconomic. First, the drilling will be expensive. In Poland it has cost as much as 3x what an equivalent well would cost in the U.S.. The UK infrastructure is better than in Poland, nonetheless Europe will likely always be a relatively high-cost geography in which to drill. Adding to the expense, the entire nation is watching Cuadrilla, making it very important that all precautions are taken as these wells are drilled, completed, and fracked such that there are no environmental issues.
There are several other challenges. The UK is more densely populated than the U.S. which may mean that certain parts of the shale are off-limits. The geology of the Bowland shale is not as straightforward as many of the U.S. shales which tend to be situated in a flat plane. The Bowland shale is characterized by multiple faults caused by rift tectonics which may require more complex multi-lateral wells. Yet because of the Bowland’s unusually thick pay-zones, its high pressures, its rich organic content, its initial test rates, as well as the relatively developed infrastructure in the UK, I have a fair degree of confidence that the play will ultimately prove viable. This takes into account the fact that well costs will decline over time as techniques are refined, and as a market for equipment is developed in Europe.
Even if well-economics are supportive of development, the direction of the environmental and political winds may have as much or more influence on the ultimate viability of the Bowland shale. In April and May of 2011, Cuadrilla’s hydraulic fracturing operations near Lancashire caused two minor tremors. One registered 2.3 on the Richter scale, the other 1.5. Of course these events added kerosene to the fire around the anti-fracking lobby in the UK, and set in motion a high-profile debate within the country regarding the merits of developing this resource.
Cuadrilla voluntarily called a fracking moratorium while it commissioned a study to review the seismic events. The UK’s Department of Energy and Climate Change also commissioned at least one study to examine the situation. That study, which was released in April of 2012, recommended that fracking be allowed to resume with the introduction of multiple controls to insure environmental safety. Cuadrilla appears to be pleased with the outcome and may have in fact played a role in the formation of these controls. We await a decision from the UK Parliament with respect to fracking, but it is very likely to be a favorable ruling for gas drillers.
Politics are impossible to forecast accurately, but understanding the potential strategic value of gas reserves in the United Kingdom puts perspective around the government’s seemingly positive disposition toward gas exploration. The UK is dependent on foreign sources for roughly half its natural gas, and natural gas accounts for one-third of the UK’s energy needs. Russia’s Gazprom is said to supply over a quarter of Europe’s gas – an uncomfortable situation as Russian supply has been used as a political tool in recent history. Almost as troubling is the fact that production from the UK’s major source of natural gas, the North Sea, has been dropping precipitously of late. One would guess that an inexpensive new source of domestic fuel that is secure, relatively clean, and that creates jobs, would win support from most constituents in the UK. It has so far, however, anti-fracking emotion sometimes trumps empirical data, and the results can be unpredictable.
What’s it all worth?
At a high level, the valuation case is simple. AJ Lucas’s operating companies are valued fairly by the public market, however, the market is assigning zero value to AJ Lucas’s share of Cuadrilla and its direct ownership in the UK prospects (Bowland and Weald). Thus a share of AJ Lucas stock gives the owner a free call option on any success of Cuadrilla. Free is almost always a good deal, but in this case it has special appeal since Cuadrilla may be worth multiple times the value of AJ Lucas’s operating businesses.
Valuing the Operating Businesses
A balance sheet analysis shows AJ Lucas progressing from a working capital deficit of $66.5mn at calendar year-end 2011 to a $23.5mn positive balance after completing several milestones including the $40 million AUD equity offering mentioned previously, a sale of the BC&I business, and the completion of the rights offering earlier this year. This is a rough estimate and is based on a number of assumptions that may or may not hold true. It also omits the positive impact of operating performance during the period as well as the movement of any non-current liabilities to the current portion of the balance sheet.
One assumption I’m making is that the company is able to sell a majority (70%) stake of its Building Construction and Infrastructure (BC&I) business. Lucas reported that it was in discussions with an international specialist construction group to dispose of the business in its last update.
To value the BC&I business I’m using a 4x ebitda multiple on a run-rate number from the first half of the fiscal year. Historical valuations in the construction industry support a 7x multiple (based on a Deloitte Construction M&A survey in Europe from 2011) but this is a rushed sale of a business that is deteriorating. The BC&I business involves large contracts and potentially large liabilities when things go wrong. BC&I customers demand contractors with big, healthy balance sheets so Lucas’s order book has been declining quickly. Needless to say, Lucas is not in a position of strength as far as negotiating terms of this transaction. A 4x multiple yields around $60mn enterprise value, and would net the company somewhere in the $21mn range of cash assuming 25% debt, $6mn contribution to working capital, and $4mn in taxes.
The Drilling division is a fairly healthy business and is not currently for sale. There are a number of tailwinds for this business with exploration for coal and coal seam gas enjoying a surge in Australia. Asian growth has been a big source of demand for Australian energy resources. Japan’s need to replace nuclear energy has further strengthened the development of natural gas in Australia. With over $180bn in LNG facilities currently being built, the natural gas supply chain must be ramped to fill this capacity. While larger multinationals have aggressively bid for much of this gas exploration and development work, Lucas is seeing signs that pricing is becoming more rational and it is likely to benefit. At the end of 2011 Lucas had over two years of work in Drilling Services backlog.
According to management the Drilling Services business should generate ebitda margins of at least twenty percent. Though they’ve been below this mark recently, they have been making steady progress toward it, and management claims that they will come very close to it this quarter due to cost-cutting initiatives and a renewed focus on the business. If we take them at their word, the business can produce approximately $40mn in ebitda. In the name of conservatism, for valuation purposes I have haircut them a bit and assumed 17.5 percent margins on flat revenue which gets us to $35mn ebitda. At a five multiple, the business is valued at $175mn. The ebitda multiple is based on a Deloitte North American energy equipment and services report from 2011. That report showed that ev/ebitda multiples in transactions have ranged from 4.8x to 12.1x on a quarterly basis over the last three years.
Netting out the remaining debt of $84mn against the $175mn drilling business, the working capital surplus of $23.5mn, as well as the $18mn of stub value for the 30% ownership in the BC&I business, we come to an equity value for the operating businesses in the neighborhood of $132mn. Reuters shows the current market capitalization at approximately $100mn, however, this doesn’t account for the 29mn in share dilution from the new equity (I counted the cash from the deal in my valuation work so we need to account for the new shares). Once the new shares are factored in, the stock appears to be fairly valued at $1.10 versus the current price of $1.00.
I can provide more detailed back-up on these numbers as needed.
An early-stage shale resource story, Cuadrilla is a challenge to value. The major focus rests on the Bowland shale at this point, and that resource’s value could be close to zero or it could be multiple billions of dollars. I’ll walk you through my assumptions and talk about the probabilities and you can adjust these to fit your view.
Management has stated publicly that gas in place is at least 200 tcf. In my analysis I assumed that it was 250 tcf even though it sounds like the number may be revised toward 350-400 tcf. The recovery factor tells us how much gas can be viably produced from the shale. An average recovery factor here in the U.S. is 25 percent. That rate is usually associated with geologies that are of moderate complexity and average reservoir pressures and properties. A low case of 15 percent is applied in rare circumstances (see reference here page 28) I’ve used a ten percent recovery factor for the Bowland because of the complex geology, the scarcity of announced results, and the risk that some areas will be too politically sensitive to allow fracking. This produces a recoverable figure of 25 tcf of gas.
Buyers have paid $1.50 to $2.50/mcf for proved gas reserves in North American markets recently. Cuadrilla is far from having verified, proved reserves and will likely only have a few producing wells when it sells or partners the Bowland license. Since it is very early stage, we ought to discount its economics in a sale relative to “proved” reserve transactions. There are multiple confounding variables that could be employed to argue for a higher or lower price, but we’ll keep this simple and as conservative as possible because there are so many unknowns. A rate of $0.05/mcf equates to a value of approximately $1.25bn for the Bowland license, of which $706mn would go to AJ Lucas. This would yield approximately $371mn after a 30% corporate tax. Adding an $80mn valuation for Cuadrilla’s remaining six shale basins (a conservative guess based on roughly $40mn in equipment and $40mn in value for remaining licenses) translates to a total value for Cuadrilla in the range of $450mn or $4.52/share to AJL. That’s $4.50/share of value in addition to AJL’s current $1 share price.
While fitting numbers around the Bowland shale prospect can help give it context, it also highlights the fact that there are significant unknowns. As a check against our valuation methodology we can look at Lucas’s investment in Cuadrilla and the return that the above Bowland sale would imply. At the end of this year AJ Lucas will have invested approximately $100mn in Cuadrilla over six years, so we’re talking about a 7-8x return. The firm has returned between 10x and 20x on past natural gas investments (it has also lost everything on some) so this Bowland appraisal is not without precedent.
It’s also worth reiterating that because of CNOOC’s involvement with Kerogen, the Chinese oil company will likely take a look at the Bowland property. In multiple past deals, CNOOC has shown it is willing to “pay up” to acquire strategic resources. AJ Lucas’s CEO, Allan Campbell, was quoted in the press as saying “We’re not looking to double or treble our money, let’s put it this way.” Based on what we know, an 8x return seems reasonable.
We can debate the probabilities around the outcome that I’ve argued above. I think I’ve presented a solid “base case” that has a fairly high likelihood of occurrence, however, you find my analysis too optimistic or pessimistic. Regardless, the probabilities may not matter all the much because you will likely agree that the value of Cuadrilla is greater than zero. Yet zero is approximately what you are paying for this asset when you buy AJ Lucas’s stock.
A free option on Europe’s largest shale field presents a compelling value proposition. The value of that proposition is underlined when a large private equity investor, who specializes in unconventional upstream oil & gas assets, steps up to the plate and buys the equity at a 35 percent premium to market prices. Notably that private equity investor would have conducted extensive due diligence on Cuadrilla (a private company), gaining access to data that you and I cannot.
Perhaps the market is imputing some value for Cuadrilla while undervaluing Lucas’s operating businesses? I don’t think this is the case. AJ Lucas’s share price doesn’t respond to Cuadrilla-related news. For instance this Spring when the DECC announced the recommendation that fracking be allowed to restart with controls, AJ Lucas’s stock didn’t move an inch. Two other UK gas firms with shale properties surged on the news. Igas was up 16 percent that day, and is now up more than 34 percent from levels before the report. Lucas’s stock continues to tread water, yet it does respond to announcements about the operating businesses.
Short term: completing announced stock deal at $1.35; selling majority of BC&I business; reporting fiscal year with improved margins in the drilling services business; restarting fracking/drilling program in Bowland this fall; 3D seismic data in second half of 2012.
Longer term: the fracking program on the initial three wells will finish around March 2013 and we should get some data along the way; sale/partnership of Bowland license will likely come in 12-18 months.