January 04, 2010 - 11:26pm EST by
2010 2011
Price: 1.50 EPS - -
Shares Out. (in M): 80 P/E - -
Market Cap (in $M): 120 P/FCF - -
Net Debt (in $M): 25 EBIT 0 0
TEV ($): 145 TEV/EBIT - -
Borrow Cost: NA

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Note: the following idea was my submission for entry into the VIC and the stock has since declined by ~25 cents.  I mention this only to point out that I realize this is a volatile, small-cap stock and would therefore encourage patience/preparedness for this stock to rally again should the company announce a recent well result and generate enthusiasm with retail investors.  However, regardless of short-term movement, I think the long-term thesis still holds and is warranted to share with the VIC.

Cubic Energy (QBC) is a compelling short opportunity as a result of poor underlying valuation support, relatively deceptive management, and future share price pressure which should follow from a recently completed PIPE transaction.

Cubic's fundamental asset is a passive/non-operated working interest in deep mineral rights on ~5,000 acres in Desoto County, Louisiana (Western Desoto, just on the border with Texas) which is prospective for the renowned Haynesville Shale.  Cubic's acreage is surrounded by Chesapeake Energy and Goodrich Petroleum acreage and Cubic recently farmed-out its section to Exco Resources (to be operator).  (Note: While NE Desoto is the most attractive part of the Haynesville (30k+/acre), Cubic's area is less pressured and therefore valuations reflect the more moderate economics of the area.)

The actual amount of acreage is the first source of deception by management - if you examine the lone presentation on Cubic's website, the only acreage figure you will find is 13,000, which is the total number of gross acres which Cubic has an interest in.  In reality, per QBCs recently filed 10K, their total net acreage is 6,000 acres and upon examination of the last 5 years of 10Ks, at least 1,000 acres can be traced back to legacy, conventional wells (which have trivial production/value relative to QBCs Haynesville acreage).  I conservatively assume QBC has 5,000 net Haynesville acres, however it is possible that the true number is actually less than this (absolutely no disclosure by management).

With regards to valuation of these 5,000 acres, I use assumptions based on examination of 30+ wells surrounding Cubic's acreage.  My per acre valuation for Cubic's mineral rights is ~$12-18,000 per acre using the following assumptions:
Well cost: $8.5mm
30-Day Avg. Initial production: 10,000 Mmcf/day (consistent with all wells drilled to date)
b-factor (curvature of initial decline): 1.2
EUR: 5-6Bcf
Net Revenue Interest: 77%
Gas Price: $6-7/mcf
Operating Expenses: $3000/month + $.50/mcf (exclude severance tax to be conservative)
Pre-tax Discount Factor: 20%
Spacing (per well): 80 acres
Pre-Tax Cash Flow NPV/well (20%): ~$1.3-1.8mm

Using $12-18,000 per acre, I assign $60-90mm of value for this acreage.  While I think these assumptions are all quite conservative (from a short's perspective), one definitive (and less technical) valuation point is described below.

Cubic's partner in its Haynesville acreage is a company controlled by Cubic's CEO.  Cubic and this company split the acreage approximately in half (with a small portion controlled by other operators).  Recently, the CEO's company sold its portion of the acreage to Exco Resources for an undisclosed amount and for consideration which included $31mm of Drilling Credits.  These credits were subsequently sold to QBC in exchange for QBC common and convertible preferred shares.  These drilling credits can be used by QBC towards its share of the capital costs it is required to contribute towards new wells ($8.5mm/well) and therefore can be valued like cash on QBCs balance sheet. 

Importantly, Exco has indicated it paid less than $15,000 per acre for this package from QBCs partner - this is an important benchmark when thinking about the total value of the acreage attributable to QBC because the partners acreage was identical to Cubic's position and Exco was the high bidder in a semi-private auction for the acreage position.  I think it is highly unlikely any company would pay more than $15,000 per acre for Cubic's position, as it would make drilling wells marginally economic at $6-7/mcf gas.

The next valuation point is with regards to the fully diluted share count.  This is another area where I think management is less than forthcoming with facts.  The reality is that management (particularly CEO Calvin Wallen) are serial share issuers to the detriment of shareholders and I have no reason to believe this trend will stop (particularly at current share prices).

My analysis indicates that the actual fully-diluted sharecount is ~100mm based on:
9/04/09 Disclosed Sharecount: 64.7mm
Add: 2.1mm (Private Placement on 08/18/09 - includes 1.5mm warrants @ $.85)
Add: 5mm (Wells Fargo Convertible Term Loan - strike = $1.00)
Add: 2.5mm (Wells Fargo Warrants - from March 5, 2007 - strike = $1.00)
Add: 20.7mm (Compensation for Drilling Credits - includes prefs convertible  into 10.5mm @ $1.20)
Add: 5mm (Additional warrants issued to Wells Fargo on 12/18/09 - strike = $1.00)
= Fully Diluted Sharecount = 100mm

Note: If all warrants were exercised, the cash inflow to the company would be ~$8.8mm.

The company recently increased the Authorized Share count to 120mm from 100mm which indicates management intends to continue diluting existing shareholders (typically through issuance to insiders for which the company gets low/no consideration in return).

Including the fully diluted sharecount and assuming all warrants are exercised (adding both to the sharecount and the cash balances), the current Enterprise Value in the market is ~156mm.
My calculations are:
100mm shares x $1.40/share = 140mm market-cap.
Add: 25mm Debt
Less: 9mm of Warrant Exercise Cash Inflow
= Total EV of $156mm
(note: there was <$.5mm cash balance as of 9/30/09)

Based on my valuation analysis of the acreage and drilling credits, I think it would be far too aggressive to assign any more than $120mm of value ($90m for acreage and $30mm of drilling credits) to the entire company and I assign this as the worst case for shorts in QBC.  In reality, QBCs valuation is more likely closer to $80mm and importantly, the company will most likely continue their serial dilution exercise to the benefit of short sellers.  In addition, my valuation analysis does not include the perpetual stream of cash that insiders take out of the company in the form of bloated cash compensation and suspect, above-market loan/preferred stock issuance to insiders.  As a result, I think QBCs market value will ultimately reach $60-80mm or $.60-.80 per share as compared to the current price of $1.40.

Finally, if looking for a near-term catalyst, the shares from the PIPE done in August were registered in late December (meaning they can now be sold) and should provide somewhat of an overhang on the share price as PIPE participants look for liquidity (up 100% on their investment) - UPDATE: this is likely part of the 25 cent decline over the last week.

For these reasons, I think short-sellers will be rewarded as the market refocuses from the current enthusiasm surrounding a renegotiated credit facility to the lack of underlying valuation support in the assets QBC owns.  I realize this analysis depends heavily on the assumptions and valuation I place on the acreage, but I believe that my valuation is consistent with and conservative relative to current market valuations (ie: I don't think any 3rd company would pay $20,000/acre for mineral rights near QBC's acreage) - clearly views on long-term natural gas prices will drive per-acre valuations somewhat but my analysis of supply-demand and marginal cost studies indicates that $6-7/mcf is a reasonable estimate of the long-term price.  Importantly this is also the range generally priced into the the majority of E&P stocks and the forward curve at this point and therefore the risk of higher gas prices could be reasonably hedged through a long-short framework or potentially with options.


PIPE participant selling

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