|Shares Out. (in M):||26||P/E||0.0x||0.0x|
|Market Cap (in $M):||119||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||135||EBIT||0||0|
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Compton Petroleum Corp (TSX: CMT), is an E&P company that produces natural gas and oil in Western Canada that is extremely undervalued on an asset value basis. We believe there is the opportunity to make over a 3x return from today by the company trading back in-line with its cheapest peers.
Compton’s operations extend from Northwest Alberta andBritish Columbiato theUnited Statesborder. The company pursues four deep basin natural gas plays: the Rock Creek sands at Niton in centralAlberta, the Basal Quartz sands atHighRiverin southernAlberta, the shallower Southern Plains sand play in southernAlberta, and an exploratory play at Callum/Cowley in the Foothills area of southernAlberta.
In 2008,Compton’s activities were directed towards the continued development of the corporation’s core natural gas resource plays in southern and centralAlberta. Comptonalso divested non-core asset areas with all proceeds from the divestments used to pay down bank debt. Comptonended the year with net debt to EBITDA of 2.9x.
With continued low natural gas prices throughout 2009 (the AECO spot price averaged $3.92 in 2009compared to $7.71 in 2008), management limited its capital program and reduced the corporation’s cost structure. Compton also reduced its net debt level from $885 mm in 2008 to $637 mm with the proceeds of an equity issue ($150 mm) and further asset sales, however the decline in natural gas prices combined with the decline in production from the reduction in capital expenditure caused EBITDA to fall from $307.6 mm to $106.6mm in 2009 and the company ended the year with net debt to EBITDA of 5.9x.
In 2010, management continued to maintain a prudent approach in its capital investment decisions and focused its development strategy to optimize asset value, emphasize cost reduction, and carefully manage its capital structure. In addition, the corporation began development of its emerging oil properties with drilling in the Southern Plains area.Comptonalso completed the sale of a portion of its natural gas assets located in the Niton and Gilby areas inCentral Albertafor gross proceeds of $150.2 million (or $2.66 per Proved Mcfe). Gas prices remained stagnant, but production continued to decline from underinvestment in the assets.
In October 2010,Comptoncompleted a recapitalization of its capital structure by exchanging all of its US$450.0 million 7 5/8% Notes due 2013 for a combination of US$193.5 million 10% notes due 2017, US$45.0 million 10% Mandatory Convertible Notes due September 2011 and US$184.5 million of cash. This resulted in an overall reduction of the Corporation’s total debt amount outstanding by approximately 33% to $382.8 million at December 31, 2010 from $568.9 million, repositioning its capital structure and providing improved debt levels going forward. The company continued to evaluate various asset sales as a means to reduce leverage.
In 2010 it was determined that the most prospective buyers forCompton’s assets were Canadian and preferred to rely on the report of a recognized Canadian reserves evaluator as opposed to Netherland, Sewell & Associates (one of the topU.S.reserve engineering firms). As such the company changed its independent reserve evaluator to GLJ Petroleum Consultants (one of the top Canadian reserve engineering firms). GLJ’s technical interpretation of the data caused the company to take a write-down on its reserves. Proved reserves had a negative revision of 19.9 on an initial reserve base of 95.8 MMBOE. 2P reserves had a negative revision of 51 MMBOE on an initial reserve base of 161.5 MMBOE. We have heard current reserves are conservative and may be found to be understated when re-evaluated at year-end.
The continued low level of natural gas prices in 2011 has limitedCompton’s internally generated cash flow available to invest in drilling activities. As a result, capital spending, before acquisitions, divestments and corporate expenses decreased by 44% in the second quarter and 41% on a year-to-date basis through June 2011 compared to the first half of 2010. Average daily production declined from 19,446 boepd for the first six months of 2010 to 13,622 boepd in 2011. By comparison, production averaged close to 30,000 boepd during 2008.
Reason for Mispricing
On June 6, 2011, in an effort to reduce leverage on the company’s balance sheet and thus position the company to invest in its asset base to grow production again, the company announced a highly dilutive recapitalization involving a debt-for-equity swap that would hand creditors over 90% of the equity. The reorg included: a reverse-split of the existing common shares at 1 for 200; giving the existing equity holders cashless warrants with a 3-year life that convert into common shares at specific trigger prices; and a $50 million rights offering with transferable rights and oversubscription privileges.
The following highlights the main terms of the reorg:
- Investors of the old equity would receive 1 new share, 2 cashless warrants and 1 right to buy 0.48515 additional shares at $7.82 per share
- The life of the warrants is three years, with one warrant converting into one common share if the VWAP of the stock over any 20-day period is greater than or equal to $11.92 in year 1, $12.52 in year 2, or $13.14 in year 3
- Holders of the 10% Senior Notes and 10% Mandatory Convertible Notes would receive common shares and rights in exchange for their Notes. A certain percentage of the Note holders (the Backstop Group) agreed to backstop the rights offering. In addition to the common shares and rights, upon conversion of their debt to equity, the Backstop Group would receive as compensation for agreeing to backstop the rights offering additional common shares, rights and warrants. From the public filings that have come out following the restructuring, we know that Davidson Kempner, Texas Pacific Group and Monarch Alternative Capital were 3 members of the Backstop Group, with 45% pro forma ownership.
The following table shows the change in the company’s capital structure as a result of the reorg:
Pro forma for the restructuring the company is levered at 1.6x net debt to LTM EBITDA. Following the restructuring, the company’s Board consisted of the CEO Tim Granger, 4 new independent directors that were put forward by the Backstop Group and two incumbent independent directors.
The following table shows the computation of the pro forma share count:
A considerable percentage of the new equity is currently held by former bondholders (that were not associated with the Backstop Group), which has resulted in a post-reorg dynamic with the former bondholders exiting their position and putting selling pressure on the stock.
Following the recapitalization, the company reported its third quarter results. During Q3 production averaged 13,429 boepd, despite limited capital spending. With the company’s leverage dramatically reduced, the company’s stated plan was to live within its operating cash flow in the depressed commodity environment and spend cash flow from operations on development and exploration capital expenditure in order to increase production, which has dropped off considerably due to recent underinvestment in the assets as a result of being capital structure constrained.
On November 28, 2011, the company announced that the President and CEO Tim Granger would be resigning from the company and the Board of Directors. In addition, the VP of Business Development and Land, the COO and the CFO would also all be resigning fromComptonto pursue other interests, although have agreed to stay during a transition period while the company seeks replacements. The two incumbent directors on the Board would also be resigning, leaving the Board consisting solely of the four newly appointed directors. Following this announcement, the stock fell an additional 20%. The uncertainty surrounding the management team’s surprising departure from the company coupled with the post-reorg dynamic is causing the stock to trade at an extremely depressed level.
Attached is a table showingCompton’s trading multiples on an asset basis relative to comparables with a similar asset mix.
Reserve equivalent multiples have been converted assuming 1 Bbl of oil is equivalent to 6,000 cfe of natural gas.
From our checks it is our understanding that the incumbent management team’s departure from the company was due to a disagreement between the management team and the newly appointed Board of Directors on two main issues: i) the compensation package that the newly appointed Board of Directors were prepared to give them and ii) the new Board’s aversion to having an aggressive capital expenditure budget in today’s low price gas environment, which would almost certainly have required another equity raise, which the Board felt was not in the best interest of shareholders given the current valuation of the stock. Given the significant difference in opinion between the incumbent management team and the newly appointed Board of Directors, the management team decided it was best that they part ways.
New Management and Board of Directors
Following the restructuring and the recent management team resignations, the company has four directors. All of them are new and nominated to the Board on behalf of the Backstop Group.
Adrian Loader, 63 - Chairman of the Board, former President and CEO of Shell Canada
Dr. Edward Bogle, 59 – Executive in Residence at the Alberta Department of Energy
George Hickox, Jr., 49 – Principal of Energy Investment Partnership Heller Hickox & Company
Michael Leffell, 52 - Former Deputy Executive Managing Member at Davidson Kempner and founder of Portage Advisors
On December 9, 2011, the company announced that its former CFO Leigh Cassidy, who resigned from his position in early 2011, has rejoined the company as its CFO. It is our understanding that he left for cost cutting reasons. His return was welcomed by some of the larger shareholders. The company has a search in place to replace the rest of the management team as well as to look for two new independent directors. For the time being Dr. Edward Bogle is serving as interim CEO, while the rest of the old management team (aside from Granger) have committed to staying with the company through March until their replacements can be found.
After a new management team is put in place and the post-reorg dynamic dissipates, we expect the company to trade back towards the low end of its peer group of those producers with a similar mix of assets. Looking at this on an asset value basis would give a target price that is over 200% higher than today’s price of $4.90:
The warrants (which are also owned by the Backstop Group) also trade on the Toronto Stock Exchange. The warrants could also be a very interesting speculative buy. Currently trading at $2, they present the opportunity to make over a 6x return if the valuation gap between the company and the low end of its peer group (~$2 per Mcfe) closes in the next three years, and over 12x should the company trade in line with its peers at $3.15 per Mcfe.
- The primary risk is that over 80% of the company’s production is natural gas; should gas prices fall further from already depressed levels it could impact the company’s ability to generate cash flow. According to the company, a $1.00 change in natural gas prices would change cash flow by $21 million. The company generates $35 million of operating cash flow on an annual basis today. From the Q3 result, operating and transportation costs were at a run-rate of $1.87 per Mcfe, administrative expenses were $0.30 per Mcfe and royalties are ~17% of sales, which should provide a better understanding of how low gas prices can go on the company’s current cost structure before the company stops generating cash flow from operations. While gas prices are generally viewed as depressed today, one could always hedge the position by shorting a basket of more expensive comparables with a similar exposure to natural gas or by buying puts on the commodity.
The following table shows purchase price multiples paid on comparable companies with similar assets during 1998-1999 when gas prices were as low as $1.03 per Mcfe compared to $3.10 per Mcfe today:
Comptoncurrently trades below the minimum purchase price multiple paid, implying the private market value under an extremely depressed commodity environment still provides good downside protection.
- USD/CAD exposure. We have no view – fairly straightforward to hedge.
- Appointment of new management team
- Post-reorg dynamic dissipating
- Outright sale of the company
- Appointment of new management team
- Post-reorg dynamic dissipating
- Outright sale of the company
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