Description

Third time is a charm. This is the third (and hopefully, last) time that there has been a VIC Abraxas writeup. The basis of this recommendation is that 1) natural gas prices are at a sustainable high level (>$5/Mcf) for the foreseeable future 2) Abraxas is and has always been a value play based on its reserves in the ground, and 3) there are some recent catalysts that have altered the timing from long term to short term realization. Abraxas is relatively well known in the market but has suffered from being long on promise and short on results – an indication that the Company’s inherent value is close to being recognized will reignite interest. The last three month’s trading volume of about 200,000 shares/day is a third of the level earlier this year.

I won’t rehash the previous analyses other than to summarize what is relevant today. Trace’s 6/2001 writeup reads like an insider’s evaluation of the Company’s reserve potential. He went wrong because gas prices went straight down in the second half of 2001, and in that environment, he underestimated the problems of Abraxas’ excessive leverage. Trace’s main points are still valid - Abraxas has valuable reserves waiting to be developed and has other unproved reserves that are extremely promising. To realize the value, large amounts of capital need to be expended, but the reserves are generally long lived (present reserve life index of more than 16 years in the U.S., 19 years in Canada) and would be attractive to any number of suitors whose cost of capital is much lower than Abraxas’. Similarly, I stand by my writeup of 3 years ago although I also failed to appreciate the leverage constraints. To deal with the excessive debt, management has arranged a number of refinancings (with substantial fees), has sold assets to pay down debt, has issued more shares and has finally negotiated financing agreements that allow them some freedom to spend excess cash flow to develop their properties. Offsetting those substantial negatives are high gas prices, generally brought about by factors that aren’t going to change anytime soon (this time it is different!). Dilution from additional shares has been reasonable given the Company’s financial situation and indicative of a board that is fully engaged in protecting the upside for existing shareholders.

Where are we today? Abraxas has $185 million of debt and 39 million fully diluted shares outstanding for a TEV of roughly $280 million. Based on annualized 3rd quarter results, the TEV/EBITDA is an unappealing 9x. The balance sheet shows a substantial negative net worth because reserve values had to be written down when gas prices cratered in 2001 and cannot be written back up as prices increase. The Company has had a restrictive covenant in its bond indenture limiting capex to $10 million/year, and was unsuccessful in removing that covenant this past summer. Without the ability to bring on additional production, Abraxas would not have been able to meet its eventual debt maturities. In October, however, management succeeded in arranging a new financing with few capex restrictions. As a result, the Company could double production over the next couple of years from the present 23 MMcf/d. All of the likely projects to increase production are from known reservoirs (150+ locations) and mostly constitute development wells (probable reserves) with a high potential of realization. Abraxas track record with this kind of project is excellent and supports the contention that the wells will be successfully drilled.

Six months ago, the Company made a presentation indicating that they had 128 Bcfe of such reserves which would take $91 million of capex to bring on stream. Valuing reserves at roughly $1.75/Mcf, management pegged the value of the Company at $5.21/share. The calculation was the net value of the development properties after additional capex plus the proved reserves (121 Bcfe), less total debt. Although today’s numbers are slightly different, it is fair to say that Abraxas has a net asset value of at least $5/share. That doesn’t take into account a $100 million NOL (maybe $60 million after Canadian asset sales, see below) and unproven reserves (which are likely to be substantial).

Now, to the catalysts that could drive the stock price in the near term:

- The Company filed a recent 8-K indicating that their poison pill (20% threshold) had lapsed after being in effect for 10 years. Coupled with some asset sales that should be very well received by the market, I believe that the board is now much more receptive to a sale of the Company or the participation of a large investor that could help fund reserve development.

- Abraxas has recently entered into a new financing that is structured in such a way as to lead me to conclude that there will be significant asset sales in Canada. The new debt financing is comprised of 4 parts: 1) a senior secured note, due 2009 at Libor + 7.5% (all-in = 9.72% until next summer), secured by all assets except the assets of the Canadian subsidiary, Grey Wolf, 2) an undrawn $15 million revolving credit, 3) a $25 million bridge loan (specifically labeled as such) at 12% secured by a 2nd lien on U.S. assets and all of the stock of Grey Wolf, and 4) a $35 million loan to Grey Wolf, proceeds of which were upstreamed to Abraxas, secured by Grey Wolf’s assets. Unlike Abraxas’ other subsidiaries, Grey Wolf does not guarantee loans 1, 2 & 3 nor are its assets pledged as collateral for those 3 loans, but as noted, its stock is the primary collateral for the $25 million bridge loan. The bridge loan allows for the release of the collateral if the stock of Grey Wolf is sold to a third party. Grey Wolf owns all of Abraxas’ assets in Canada including the Ladyfern holdings.
The present financing arrangement is very similar to the situation 2 years ago when Abraxas sold $138 million of properties and assets in the Caroline/Peace River Arch area to PrimeWest, a large Canadian royalty trust (EV = $2 billion). As part of the sale, Abraxas retained its interest in undeveloped Caroline lands and agreed to a farmout arrangement – PrimeWest earns 60% of future income from new wells in exchange for spending 100% of the capex and Abraxas earns a 40% carried interest with no cash out of pocket.
Prior to the farmout and similar to today, Abraxas and its Canadian subsidiaries had separate non recourse loans secured by separate asset pools in Canada and the U.S.; lenders in each situation had to give their assent for prospective individual asset sales. To get around those restrictions, Abraxas sold producing properties to PrimeWest for a large enough amount to pay off all Canadian loans, with the rest of the proceeds upstreamed to the parent to reduce its debt without touching the U.S. collateral pool. The asset sale was accomplished by the PrimeWest purchase of the stock of Abraxas’ Canadian subsidiaries with the retained Canadian assets contributed to a newly established Grey Wolf. I am proposing that the modus operandi is the same this time around, except that Grey Wolf has already upstreamed the proceeds of its loan ($35 million) to Abraxas. Canadian royalty trusts continue to be very aggressive bidders for reserves, and Abraxas’ prior and ongoing relationship with PrimeWest argues for another transaction between them, particularly for properties of mutual interest and in PrimeWest’s largest core area.
The new Grey Wolf loan documentation specifically provides for the disposition of properties as contemplated in the Grey Wolf/PrimeWest Farmout Agreement. The Farmout language includes a PrimeWest “Buy Back Option” using a PV-10 methodology at escalating prices allowing them to purchase Grey Wolf’s 40% carried interest in the proved and probable reserves developed under the Agreement. Although it doesn’t appear to me that the conditions have been met which would trigger the option, there could be a negotiated sale along the same lines.

- The $125 million floating notes were underwritten by an investment group, and as contemplated in the agreement, Abraxas has filed an S-4 which should become effective in early January to convert the securities into publicly traded debt. It wouldn’t be a stretch to state that an expectation of the underwriters was that there would be some positive news when it came time to market the notes. More to the point, the underwriters and advisors received 1.1 million shares as part of their compensation; they wouldn’t have accepted that arrangement unless they were sure that the equity had both minimal downside risk and the potential of a substantial upside.

Why do I think that both the bridge loan and the Canadian loan will be retired from one asset sale in the near future?

- Things start to happen if the bridge loan isn’t paid in 9 months; repayment of the bridge is the foremost priority;

- If there are U.S. asset sales, proceeds must be used to first pay down the $125 million note and the revolver. In other words, U.S. asset sales are unlikely to repay the bridge loan;

- Since Grey Wolf does not guarantee the bridge loan, it would be illegal for them to directly pay it off with partial asset sale proceeds. Upstreaming asset sale proceeds to Abraxas to have them retire the bridge wouldn’t work as per the previous paragraph. A partial asset sale could retire the Grey Wolf loan but wouldn’t address repayment of the bridge;

- Bridge loan repayment is predicated on the sale of Grey Wolf’s stock;

- Liquidation of Grey Wolf’s stock implies a $60+ million asset sale to repay its debt ($35 million) with at least $25 million leftover to retire the bridge loan;

- The $125 million loan has extremely onerous prepayment terms before 2007 (~10% penalty, only up to a third of the loan is allowed to be prepaid and only from an equity issuance). The Grey Wolf loan has no prepayment penalty (ditto the bridge loan). The Grey Wolf rate is Prime + 6.25%, increasing by 75bp every six months – extremely onerous if the debt is outstanding for any length of time.

At 12/31/03 Grey Wolf had 21 Bcfe of proved reserves with a PV-10 of $55 million (at $5.05/Mcf) – I’m not aware of any substantial additions to proved reserves this year. Receiving $60 million for the reserves (to pay off both loans) would imply a price of around $3/Mcf – royalty trusts are paying high prices, but probably not that much – and I wouldn’t think that more than 10 Bcfe of proved reserves are attributable to the Caroline region. Furthermore, Abraxas is presently investing capex in a Canadian gas plant and the development of some other Canadian wells, so it’s unlikely that all of Grey Wolf’s assets will be sold. So, my guess is that a combination of proved and very probable reserves will be sold in the Caroline field, and that Abraxas will retain a couple of attractive Canadian properties for themselves (including Ladyfern). One of the reasons this would be an exciting transaction is that it gives substantial value to the probable reserves and in effect, validates the approach of assigning proved status to such reserves. Additionally, the amount of production sold will probably be less than 10% of Abraxas current output.

I think that there is a good possibility that Abraxas is worth a multiple many times today’s price based on its various untapped holdings. More conservatively, if we assume that proved and probable reserves are being sold to PrimeWest at $2.25/Mcf and the value of Abraxas’ remaining reserves (proved and probable) is $2/Mcf, the NAV would be more than $5/share as follows:

Volume (Bcfe) Value
$ millions
1/1/04 Proved Reserves 121
1/1/04 Probable Reserves 128
Less 2004 Production 9
Less sale to PrimeWest @$2.25/Mcf 27
___
Remaining Reserves @12/31/04 @$2 213 $426.67

Less: Development capex $91.00
Less: Remaining debt $125.00
Enterprise Value $210.67

Fully diluted shares 39 million

Net Asset Value $5.40/share

Additional considerations:
- The largest stockholder is Peter Lynch (3.3 million shares, 8.5% of the fully diluted total share count) who actually participated (made a couple of supportive comments) in the second quarter conference call. Lynch filed notices of an intention to sell shares in June, amended at the end of September to sell 105,000 shares, but has not taken such action (Yahoo and other websites incorrectly indicate that he has been a seller). Lynch first went over a 5% position 2 years ago, but has evidently owned some stock for a considerably longer period. A director of Abraxas for the last 5 years (Ralph Cox) owns 335,000 shares himself and as a trustee of the Fidelity Group of funds is the connection to Lynch. FMR established a new position in Abraxas in the second quarter of this year with 380,500 shares.

- A director of Abraxas since 1992 is the second largest shareholder with 2.4 million shares. He hasn’t sold shares for many years (if ever).

- Four years ago, EOG Resources (market cap = $8.5 billion) bought 709,400 Abraxas shares and entered into a farmout agreement with Abraxas to develop some of ABP’s Texas properties. Some of those same West Texas properties are now the focus of Abraxas’ development drilling efforts. Farmouts are again permitted under the new loan agreement within certain parameters. I assume, but have no way of verifying, that EOG still owns their Abraxas shares.

- As noted above, the new $125 million notes have onerous prepayment penalties, but a change of control (35% threshold) would trigger calling the notes at only a 1% fee.

Summary
Abraxas’ CEO gave an interview to The Wall Street Transcript in August 2001 when the stock price was in the $3.50 range in which he indicated that Abraxas was a likely target for a takeover and that a hostile bid at a low ball price was the only thing that kept him awake at night. With that mind set, I doubt that the poison pill would have been allowed to lapse without some confidence that the stock will be significantly higher in the near future. It is clear to me that a portion of the Canadian holdings will be sold, which I believe will be favorably viewed by investors. Even if my estimates are too rosy and all of the Canadian holdings are disposed, the sale would make Abraxas a more likely target at a premium to today’s price.

Catalyst

- Removal of the poison pill.

- Sale of Canadian properties - much more favorable debt profile, ability to finally develop underlying reserves, basis for valuing the rest of the Company.

- Additional information from management about remaining proved and probable reserves.

- Analyst coverage – none at present but Abraxas is a name well followed in the past.

- Proved reserves PV-10 value will be published with the 12/31/04 10-K. Given current gas prices, that value will likely be high and attract notice in March.