Description

Atlas America (ATLS) is a energy holding company originally spun out of Resource America (REXI).  It is extremely cheap for two reasons: 1)  it’s trading at a 20% discount to the sum of the parts, 2) the public parts ATLS owns are being undervalued by over 100%.  I believe ATLS is conservatively worth $55/share, ideally worth $70-80/share.

The Parts

Atlas Energy Resources LLP (ATN) is an E&P company structured as an MLP which ATLS owns a hair under 30m shares (48%) of.  There’s a couple of components to ATN.  First is the big upside – the Marcellus Shale.  ATN has 580k (280k core) acres that are prospective for the Marcellus Shale through what I suppose you could call dumb luck.  The shale is simply beneath much of their existing acreage.  I won’t get too into it here, there is more than enough information out there about the economics of the play.  ATN has so far quantified 4-6 Tcf, but this is only assuming vertical wells so the upside is much greater.  Range Resources (another cheap stock, btw) has had spectacular results so far and Chesapeake admits that Marcellus wells have the best IRR’s and shallowest 1^st year production decline of all their big shale plays.  I estimate breakeven gas price for horizontals is a mere $2.75/mcf.  ATN will have an inventory of about 3-5k wells.

Second is the root of the company, which is the partnership drilling in Appalachia.  ATN raises money from individuals through a broker network to drill shallow nat gas wells.  The idea of the business is typical of the Cohen family: invest as little equity as possible and charge a lot of fees.  ATN usually kicks in to be a 30% equity owner in these partnerships but they pay for their stake by simply reinvesting upfront fees paid by the LP’s.  Excluding the fees they are really only putting up 5-6% of their own capital to receive a 30% interest!  It reminds me of a great line from the movie Rounders: “I am paying you with your money.”  ATN receives fees for drilling, monthly maintenance fees, admin fees, and acreage fees.  There’s so many fees that I lose track...it’s sorta like a phone bill.  The assets are perfect for partnerships because the wells are extremely low risk (99% success), long lived (15 years), and there’s a gigantic inventory of them.  The main advantage for the LP’s is that they can deduct the drilling cost from their income taxes.  It has added benefit to ATN because as LP’s tax deferrals eventually catch up to them, they’re incentivized to invest in another fund.

The Marcellus Shale is also the big opportunity for ATN on the partnership management side.  ATN has new Marcellus participation funds that offer investors a little better return, but ATN charges upfront fees 4x higher than normal on the wells.  Also, because ATN charges a flat markup fee of 18% on drilling costs (recently raised from 15%), they are capturing more dollars because the Marcellus wells cost 4x more than shallow wells, while still only managing to put up 5-6% of their own capital.  None of these improved economics are in the stock yet.

How good is the partnership business?  Even after the Cohen fee-them-back-to-the-stone-age system, LP’s are still able to generate an 18-22% IRR at $8.00/mcf gas and 14% at $6.50/mcf gas.  And how do you think LP’s are feeling about their investment now?  The market has tanked but their checks are still coming in as usual – it might be their best performing investment.  Marcellus partnerships can generate much higher returns, closer to 25-30%.  How about the economics to ATN?  They’re so good that you wont see the company advertise them.  Management has previously stated that shallow drilling IRR’s are 70%, but since fees have been raised I think it’s closer to 200-250%...because ATN’s net investment is already very low, small changes cause large moves in the IRR.  My modeling suggests that Marcellus wells generate staggering 700-800% IRR’s at $8.00/mcf gas because of the leverage involved with drilling more expensive wells.  The whole key to this stuff is the upfront fees, I cannot stress that enough.  If you wanted to think about this business purely from an E&P standpoint, ATN has a $.34 f&d cost for their reserves!  Below is a rough estimate of how it looks.  My guess is that ATN eventually decides to participate with a 25% interest, which would make their net investment $0.  (Modeling out the LP and ATN IRR’s is pretty simple; I’ll walk through it more in the Q&A if anyone wants more info or arrives at substantially different returns)

Lastly is the 275k net acres in the Antrim Shale in Michigan.  Again, this is low risk drilling with unimpressive, yet steady results.  ATN drills these wells outside of the partnerships.  It’s a decent asset.  They also have 120k acres in TN that are prospective for the Chattanooga Shale.  Mostly undeveloped so far but it could be interesting one day.

ATN Class A Shares represent a 2% management fee from ATN.  ATLS owns all of the Class A shares and they are not required to contribute any additional capital to maintain the 2% fee.  ATLS simply takes 2% of all distributable income from ATN via this class of stock. 

ATN Incentive Distribution Rights (IDR’s) represent the incentive fee ATLS is paid on ATN’s distributions.  If ATN’s distribution is > $.59/unit, ATLS gets a 25% incentive fee.  Second quarter distribution was $.61.  In light of the Marcellus opportunity, the IDR’s are worth a lot of money.  Think of the IDR’s as getting almost 25% of the Marcellus reserves for free.  Structurally, this is no different than the hedge fund management business, only most of the future returns are reasonably certain.

Atlas Pipeline LP (APL) is a pipeline MLP with assets in the same Appalachia region as well as OK/AR; ATLS owns 1.1m shares (2%) of APL.  Virtually all of the volume through the PA pipeline is from ATN, in fact APL is required to build the infrastructure for ATN.  This is the weak link in the fence right now as it’s overleveraged and lost a lot of money earlier this year on bad hedges.  I think the key to APL, besides execution, is just the continued activity in Appalachia from ATN.  As long as ATN keeps drilling and producing gas/liquids, and commodity prices don’t get destroyed, APL distribution growth in the 2-5% seems achievable.  Investor presentation here: http://library.corporate-ir.net/library/11/113/113240/items/308916/APL_September2008InvestorPresentation.pdf

Atlas Pipeline Holdings LP (AHD) is a holding company that owns the GP interest and 5.7m shares (12.5%) of APL; ATLS owns 17.8m shares (64%) of AHD.  Again, just more leverage here.  I will tip my cap to Omega Advisors for proposing that APL could significantly lower their cost of capital by acquiring AHD and internalizing the GP.  It’s a good idea and would keep more of the capital in-house.

Cash at the holding company is $72m and no debt.

Cash Flows from ATN, AHD and APL, based on annualized Q2 distributions, would amount to $108m.  These distributions are likely to be raised as total production and volumes grow.  You could argue that valuing the PV of these cash flows would be double-counting, so I will exclude this from the valuation.  But understand that cash will be building at ATLS and at current prices it will mostly be used to repurchase shares.  There’s also a gathering fee that ATLS has to pay to APL.

Lightfoot Capital is an investment partnership formed between ATLS, Magnetar Capital, and Lehman Brothers.  It was formed in Feb 2007 as investment vehicle to invest in MLP’s.  ATLS kicked in $20m to the fund and has an 18% interest in the GP.  I’ll be honest here, I have absolutely no idea what this fund has done since it was funded.

Sum Of The Parts

Valuing ATN is somewhat more difficult than a traditional E&P.  If you just looked at ATN like any old E&P it would be trading at 5x cash flow, $2.40/proven reserve, and a 44% premium to 2007 PV10 (regrettably, the price has moved up a lot since I started writing this earlier in the week).  I think the Marcellus acreage alone is right now worth about $550m if you assume $1,300/acre (this is what Range is currently paying) for their 280k southwestern PA acres and $650/acre for the remaining 300k acres.  I expect this value to increase significantly as the play gets proved up, and though this might be premature, acreage values in southwest PA of $15-30k wouldn’t be a stretch in a few years.  The partnership business is currently generating about $125m in cash flow, but this is going to ramp up with as the Marcellus wells become a bigger portion of the business.  Other NAV’s are based on normalized 2009 yields.  ATLS has 40.3m shares out.

ATLS looks better than the subs because it’s not being given credit for the private assets, so you get double-bubble.  Plus it’s not an MLP so you don’t have the hassle of dealing with K1’s, and there’s just more leverage inherent to it.

Potential Problems

One of the fears is that market anarchy could halt ATN’s ability to raise capital through their partnerships.  A lot of the retail LP investors are no doubt poorer now than before.  This could be a problem in the short-term because about 30% of distributable cash flow comes from fee income associated with new drilling.  Fortunately, the other 70% of cash flow comes from ongoing fees and nat gas production with very long life and shallow decline, so there is a medium-term floor to how low the distribution could go.  I don’t think gas prices are big problem since most of their production through 2011 is hedged at prices between $7-9/mcf.

Other concerns have to do with the Cohen’s…let’s just lay all these cards on the table now (the REXI Q&A can give you some flavor).  There are many investors who have low opinions of the family.  This is not without merit and frankly, I share many of the complaints: The Cohen’s engage in nepotism in a way that would make third-world government officials blush.  You have to set aside a couple hours to make sense of the related party section of the proxies.  Compensation is excessive for family members (Ed’s son, Jonathon, who I actually think is a good guy, made ~$13m combined from the Atlas companies last year as a non-executive director.  How do I say this delicately…WTF?!?!).  They jump on fads and bandwagons.  And they make no apologies for any of it.  REXI, RSO and TBBK have been slightly better than horrible throughout the financial meltdown.  RAS, AFN, and TRMM have been undeniable failures.  I’m a former long-time shareholder of REXI and I can’t see myself ever investing in another Cohen company other than ATLS.  Despite all the turmoil, the Atlas companies have all been cranking along, sticking to their strategies, and producing nice returns. 

Catalyst