Description

Low-risk, catalyzed relative value arbitrage investment.

Long Petrobank Energy (TSX: PBG, PINK:PBEGF), Short 1.09 PetroBakken (TSX: PBN, PINK:PBKEF).  Please view the following pdf for better formatting and graphics: http://www.scribd.com/doc/111411441

Overview

PBG has three main assets:

1. 62.5% stake in PBN
2. $95mm of working capital
3. Heavy oil projects inAlbertaandSaskatchewan, namely Kerrobert andDawson(referred to as the Heavy oil Business Unit, or HBU)

PBN is a publicly traded E&P company with production from the Bakken and Cardium plays.  It was partially spun-out in 2009.  PBG also other minor assets, including a couple other oil sands leases and a patent-rich heavy oil technology business called Archon.

PBG trades at a substantial discount to the sum of its parts.  Management has telegraphed a complete spin-out of PBN shares to PBG shareholders, however they have not officially announced this.  I believe this spin-out will occur in the near term which will close the gap and create significant shareholder value.

What is it all worth?

PBG stock price closed at $12.01.  It is trading at a large discount to even its PBN holdings, currently worth $13.33 per PBG share (PBN closed at $12.45).  The stub is not quite yet break-even operationally, so I have adjusted its cash position by $21.5mm for G&A and capex, resulting in cash per share of $0.92.  The Kerrobert heavy oil project has 3.6mmbbl of probable reserves and an additional 4.9mmbbl of possible reserves.  I value these at $1.00/bbl of probable and $3.00/bbl of possible, resulting in $16mm for Kerrobert, or $0.16 per share.  I value the residual assets of the stub to be worth $0.05 per share. 

As for cash flow of the stub, management forecasts that the Kerrobert asset would put the company at break even if it could produce 1,000 bbl/d.  It is currently producing 350 bbl/d.  This has been a slightly problematic asset given that it is using a novel oil production technique called THAI, or Toe-Heel Air Injection (a type of fire flood technique).  The technology has been a disappointment so far, but has been building momentum over the past 8 months with increasing production results.

Net-net, I believe PBG is trading at a $2.45 discount (17%) to its intrinsic value under conservative estimates.  Some sell side analysts have pegged the stub’s value at $4.00 per share.  Management’s view of value, as shown in their recent investment presentation (p.24), is in-line with these estimates.

Why is it mispriced?

In our yield-starved world, people do weird things for dividends.  PBN pays a dividend, while PBG does not.  However irrational, fact of the matter is some people prefer to pay a premium to receive a dividend.  Also, PBG consolidates PBN in its financial statements, making it more difficult for investors to analyze.  Finally, the PBN spin-off has not officially announced.  Some investors may have gotten fatigue, as this inefficiency has lingered for a while.

Under my current value assumptions of the residual assets, PBG has traded from a high of a $3.00 premium to a low of a $3.50 discount. Once the spin-out occurs, I expect this discount to revert to zero. 

Management

Management’s 3-step strategy for value creation goes as such: acquire early stage assets, apply technology to create superior value, distribute business unit to shareholders to realize full value of each company.  They accomplished this with Colombian E&P Petrominerales (TSX: PMG), which was spun-out to investors in November 2010.

Management is well aware of the current market inefficiency reflected in the PBG share price and is using it to their advantage.  They are currently executing a share buyback program funded by sales of PBN shares on a one-for-one basis.  They can execute this up to 114k shares per day, with a limit of 7.8mm shares over the next year.  What makes this better is that PBG is enrolled under the PBN DRIP, enabling them to receive PBN shares instead of the monthly dividend at a 5% discount to the VWAP.  I calculated that this issuer bid creates roughly $0.18 cash per share in value annually, or 7.4% value accretion to the stub.

Spin-out rationale

1. Strategic – A spin-out of developed business units is in-line with management’s strategy and historical actions.
2. Value Creation – Management is aware of the value gap and has indicated their intent to eliminate it through a spin-out transaction.
3. Tax Considerations - According to Bloomberg, 31.3% of PBG holders reside in theUS.  One of the seven benefits of the November 2010 PMG spin-off was to “allow US Petrobank shareholders to benefit from a lower tax rate on the transaction as the receipt of the New Petrominerales shares are expected to be treated as “qualified dividends”, eligible for lower tax rates in 2010 compared to the ordinary income tax rates that are expected in 2011”, reflecting expectations for the expiry of the Bush tax cuts.  We are in the exact same position today relative to tax uncertainty and management is aware of this.

Timing considerations

One of the most important aspects of this trade is to get the timing right, as this significantly affects the IRR.  Management has telegraphed this spin-out, and has given themselves some wide goals posts with the “before year end 2013” target. 

Management has discussed timing considerations in past conference calls.  On the Q2 call in August, a few notable comments came out:

<A - Christopher John Charles Bloomer>: I think we've said that we expect [the spin-out] to happen before the end of 2013. There are structuring and tax considerations as well as whatever structure is put in place needs to be approved at the Board level by independent Board members. And that process is rolling through and certainly our hope will be that we'll be able to do it in a very tax efficient and value creation methodology that will allow us to have that happening fairly soon.

When pushed on the timing, CEO John Wright stated that the spin-out could happen quite soon:

<Q - Mark J. Friesen>: [Year end 2013] seems like a fairly generous timeframe. Is there a chance that it could happen much quicker than that?

<A - John David Wright>: Yeah. There is a chance that it can happen very quickly. But obviously, there are regulatory and structuring concerns around this that are not 100% in our control. And in no way do we want to hurry this process along and create unnecessary tax burdens for any of our shareholders or create a structure that isn't efficient for the standalone companies going forward. But it's absolutely in our – it's in the crosshairs, it's something we have a team focused on and we'll get there. Hopefully, we'll do it right and I think we've got a lot of experience in-house from the Petrominerales spin-out that we completed in 2010.

We believe that the PBN spin-out could be announced prior to year end 2012, with an effective date of December 31.  The PBN spin-out will most likely be a qualified dividend for US investors.  The dividend tax rate is set to go from 15% to ~39% once the Bush tax cuts expire at the end of this year, so a 2012 spin-out would be much more tax efficient from the perspective of US investors.  Also, a year-end transaction would give PBG clean financial statements beginning Q1 2013.  Finally, PBG has a large stack of cash and is no longer reliant on PBN’s dividend to fund its operations (that’s why it subscribed to the DRIP).  PBG has enough cash and its assets are far enough along that it can survive and thrive as an independent company.

As a reference, the PMG spin-out was announced November 2 2010 and was effective as at December 31 2010.

Return considerations

Catalyst