|Shares Out. (in M):||36||P/E||0||0|
|Market Cap (in $M):||230||P/FCF||0||0|
|Net Debt (in $M):||170||EBIT||0||0|
Thesis: The warrants of Rosehill Resources, a small cap, pure play Delaware Basin E&P that is currently trading at below 2.0x (on a fully diluted basis) 2019 EV/EBITDA (3.0x on 2018) vs the Delaware Basin comps/mid cap E&P 6.3x/4.9x 2019 EV/EBITDA medians, offer a 20-1 risk-reward opportunity with a potential 1000% upside in the next 12 to 24 months as the company continues to grow production and EBITDA and is able to refinance is complicated capital structure creating more liquidity for the stock.
Warrants: ROSEW (currently ~$1.00) are warrants on ROSE (currently at $7.50) with a strike price of $11.50 and a cap at $21.00 (if trades above $21 for 20 days company can reedem at $21). With $9.50 intrinsic value and about $1.50 in time value (4/27/2022 expiration) the max value for the warrants is about $11.00. With the stock so far below strike price, I believe if the thesis doesn't play out in next 2 years then you're facing a time decay loss to about $0.50 cents or 50%. You obviously may also invest in ROSE outright with a better margin of safety given the valuation. In the event of a take out below the exercise price the warrants have a make whole provision (see registration statement) which i believe at this price would entitle the holder to something like $2 or $3. Its an unlikely scenario at these prices so I won't go through the math of how I read this in the registration statement here.
So let me begin with that I use to be an energy analyst at a large cap value shop and the one thing I've learned is how worthless it is to invest in E&Ps (vs just an oil ETF if you want that exposure) and other commodities. I stay away from energy in general now a days and this caught my eye on a screen so I dug in out of boredom. So the fact that I am posting a long pitch on an E&P instrument, have it as a 3% position in my portfolio (plus some ROSEUs Ive been picking up whenever they become available) should tell you my convinction level on this is pretty high. However, I will certainly take all and any additional comments and bear thesis on this with an open mind.
So what is Rosehill? Its SPAC ... no no no ... stay with me. Don't leave yet! #notallSPACs or something. This is not a failed SPAC. Its just a new one with no liquidity. It's assets are located in the Delaware Basin and are in some of the most enviable land surrounded by the top players (APC, EOG, CXO, PDX etc). I believe the first thing that an investor needs to understand before even looking at the company is its VERY HAIRY capital structure which should at least begin to be resolved in the next year.
Currently there are ~36mm shares outstanding (note some databases only show 6mm). ONLY 6mm of those are tradeable (which is the main reason for the mispricing). The other 30mm are still owned by the Sponsor (K2/KLR/Rosemore) and 1/3 are available for sale as of April 2018 and the other 2/3 starting next April. This is one company that would actually benefit from a secondary offering (and its no surprise that there are 4 sell side shops covering it right now, including B Riley, looking for that future business).
Equity: 36mm at $7.50 = market cap of $270mm
Warrants: ~25.6mm warrants outstanding (!!!) at strike price of $11.50. For purposes of this analysis I'd like to do this on a fully diluted basis with the assumption that at $11.50 all warrants convert and cash is received. I just dont see this staying below $11.50 for long. At the bottom I'll include an ex warrant dilution EV as well. So at full conversion you'd receive $295 million cash.
Preferred Equity: Two traunches of PIK Preffered Equity. Traunch A is 8% Cumulative Perpetual Convertible Preferred that is currently convertible in ~8.5 mm shares at $11.50. Once again for purposes of this analysis I am assuming full conversion. If not converted, currently its value stands at $82mm.
Options/Restricted Stock: .7mm outstanding
So final fully diluted equity share count is ~71mm shares and at $7.50 is $530mm market value. This is offset by implied $295 cash inflow from warrant conversion. Since my price target is above $21.00 I will assume these numbers.
Other Preferred Equity:
Traunch B - $150mm, PIK option, 10%. They have the option to issue an additional $50mm.
Debt: $173mm. This is split up between $93mm 10% Second Lien Note and a $80mm revolving credit facility. In March 2018, ROSE entered into a new $500 million revolving credit facility maturing in 2022, with an initial borrowing base of $150 million. The facility was provided by a syndicate of five financial institutions led by a "small regional bank" JPMorgan Chase* which is a positive in that JPM likely provides them with cheaper hedging costs than most other small players. Next redetermination is scheduled for August 1st and solid credit ratios and active drilling program expected to result in continued increases in borrowing base. More on this below. The covenants are at 4.0x EBITDA and with the expected 2019 EBITDA of $280mm+ (more below) the company is close to its peers 1.3x and expects to be at around 1.5x at year end 2018 (at midpoint of $160mm to $180mm it would imply about $255mm at year end 2018.
*side note: as a result the company got invited to the JPM energy conference next week which is a pretty nice deal for a sub-$300mm small cap SPAC
Current implied EV: $530mm equity - $295mm implied cash inflow (or $220mm at current prices) + $150mm preferred equity + $170mm net debt = fully diluted EV at $550mm to $650mm. At my target price of $21.00 the EV is $1,500mm. On an uncoverted basis its $690mm.
4,645 acres in Northern Delaware Basin with 10 stacked plays/250 gross locations in Loving County, TX and Lea County, NM. This is one of the most enviable land positions in the basin and is surrounded by other major players (EOG, Anadarko, Chevron, and Apache). The company should drill 26 to 28 wells in 2018. The negative here is that they are not all connected and in some ways they are limited in drilling horizontally vs their competitors ("I drank your milkshake" scenario). The PV-10 NAV at $53 oil is $600mm with 60% oil and 60%/40% split between Proved/Unproved.
6,505 acress in Southern Delaware Basin in Paco County, TX. These were acquired in late 2017/early 2018 for a $117mm or $18,000 per acre. Wolfcamp A and B reservoirs at White Wolf are in a localized depositional “Sweet Spot” between the Coyanosa Waha Ridge and the Central Basin Platform. No drilling yet but will start in 2018, excellent land, may pursue bolt on land acquisition opportunities. This is a new play for 2018 and is not booked for the PV-10 2017 reserves. I would imagine booking those reserves for 2018 10-k filing 9-10 months from now should show significant reserve growth for the screening databases and should attract more eye balls on the stock.
Obvious note that needs to be included: Delaware Basin has some of the lowest break even costs at close to $30/bbl which is one of the main reasons i gave this a second look when it popped up on a screen and most of the companies concentrated in this area tend to command higher valuation premiums (see Valuation below)
Personal note: On things I am not a huge expert on, ie nuances of small land plays in TX, I tend to lean on my network of buy side energy analysts that I've learned to trust over the years to double check my work. I've spoken to 5 pure play PE/HF energy guys who eat/sleep/breathe small cap and all cap E&Ps and they all agreed that the locations are excellent. Two ended up buying the warrants as far as I know as a result of me asking them to do this. Counterpoint from one was that ROSE has a lot less future development land CURRENTLY vs other small cap E&Ps which will have to potentially be grown by future bolt on acqusitions to be comparable to its peers.
Production: While 2017 was a "get started year" with barely any drilling (~7,000 BOEPD in 4Q17), the company is well on its way with 12,256 BOEPD (77% oil) in Q118 and ahead of guidance/schedule to 18,000 BOEPD in April 2018. The company's guidance for 2018 is 15,000 to 17,000 BOEPD so it is already ahead of that. For 2019 the company is guiding to 23,000 to 25,000 BOEPD which I believe given the current results to be conservative.
Guidance: For 2018 the company expects to earn between $170mm to $190mm in EBITDAX and for 2019 the company expects to have an EBITDAX of $260mm to $280mm. Approximately 50% of expected production for both years is hedged at $53 to $56 oil and $2.90 to $3.00 natural gas. For 1Q18 the company earned $35mm in EBITDAX for its 12,256 BOEPD equaivalent production or about $31/EBITDA per barrell. The guidance assumes $55 oil/$3.00 natural gas for both 2018 and 2019. Capital guidance reflects having two rigs drilling and a dedicated frac crew for 2018 and adding a third rig in the fourth quarter of 2018 to drill between 50 and 54 wells and complete between 42 and 46 wells in 2018. This is all pretty standard, and I would say even conservative but oil is a fickle price commodity and who knows what will happen between now and 12/31/2019 so $55 oil is a pretty good baseline. The capital spend guidance for next two years of which 83% is expected to go toward drilling, completition and recompletion activitivities should be about $200mm above EBITDA levels each which should be covered by operating cash flow and increased but cautious borrowing.
Bottom line: This is not a complicated story on the production/resources side and for pure play E&Ps it shouldn't be.
The Path To Closing The Valuation Gap
Currently, as shown above, the company has a highly dilutive and expensive capital structure and low liquidity for the stock both of which need to be addressed. There are many scenarios, but the most likely one is growing its EBITDAX in 2018-2019 to above $200mm-$300mm as planned, tapping the high yield markets or continuing to expand its borrowing base to the additional $420mm potentially available and taking out the expensive prefferred equity/buying back some warrants. An additional/complimentary solution would be to do a secondary, raising $50mm to $100mm, and additionally allowing for the sponsors to get rid of at least 1/3 of their holdings (available to do so now and 2/3 next April 2019) to create more liqudity for the stock and getting it added to small cap indexes. I believe Rosemore intends to stick it out for the long term, per conversation with another shareholder, and are unlikely to participate. They are unlikely to do this below their $10 cost basis but i believe another solid Q or two should raise the profile of the stock and get it to north of $10.00 where this should be a possibility if not for them but other sponsors. The buying back of the warrants may be tricky but its been done by SPACs before. Borrowing a $100mm to buy back all the warrants (unlikely) at $4.00 (a signficant 300% premium) would increase the price of the equity in the $1500mm EV/5.3x EBITDA scenario from $21.00 to $24.00 (as a pure speculative example!). Since the warrant holders are mostly the current shareholders i would imagine there would be a warrant price for them to entice them to increase the value of their overall holding with a warrant buyback. Most recently, I remember seeing the Del Taco SPAC (TACO/TACOW) taking out a big chunk of their warrants outstanding at about 20% premium to warrant trading price. Another opportunity that I see as a likelyhood is convincing the warrant holders to accept better terms in return for converting warrants to equity which would decrease dilution, increase cash inflows and liquidity for the stock. Management commented on a recent sell side call that they intend to address balance sheet issues in the coming year with some of the scenarious I mentioned.
Sponsors: ROSE was formed on April 27th, 2017 through a merger of Tema Oil and Gas Company into a Special Purpose Acquisition Company (“SPAC”) called KLR Energy Acquisition Corp. Tema had historically been owned by the Rosenberg family, traces its origins to the American Oil Co. (Amoco), and has operated in West Texas for more than 50 years. In the recent early 2016 oil downturn, Tema was capital-constrained and began looking for a partner to help the company develop and operate its acreage. Around that same time is when former EPL CEO and industry veteran Gary Hanna (see bio in appendix) completed the $80 million SPAC IPO. Energy-focused investment bank KLR Group partnered with Gary, as both believed there was an opportunity to create a best-in-class E&P focused on growth. After speaking with over 50 targets and performing diligence on many of those, the team agreed that Tema was the best fit.
Overall, more than 70% of the shares and warrants are held by the SPAC sponsors, the Board, and Rosenberg family organizations. Most notably, K2 Principal Fund and Geode Fund have been a consistent and fairly indiscriminate seller of stock at prices from $10.40 to $7.70 sold in April 2017 through May 2018. K2 was an original SPAC investor and helped provide the backstop with the PIPE that got the deal done. In April 2018 K2 sold over a 100,000 shares and as of May 2018 it has 322,000 shares left to sell. Geode is done and I believe only has the convertible preferred left. I believe once the forced selling by them stops the stock should rebound strongly in 2H2018.
Side Letter by Rosemore and KLR to back stop the price: "On December 20, 2016, KLR Sponsor and Rosemore entered into a Side Letter, pursuant to which the parties agreed to backstop redemptions by the Company’s public stockholders in excess of 30% of the outstanding shares of Class A Common Stock by purchasing shares of Class A Common Stock or Series A Preferred Stock in an amount up to $20 million. Pursuant to the Side Letter, KLR Sponsor agreed to transfer to Rosemore 750,000 warrants. In addition, under the terms of the Side Letter, certain shares of Class A Common Stock held by KLR Sponsor may be reallocated to Rosemore on the second anniversary of the closing date of the Transaction as a result of (i) certain acquisition activities undertaken by the Company as of certain times of determination and (ii) the volume weighted average trading price of the Class A Common Stock as of certain times of determination."
Finally, while i am sure it doesn't put a dent in Cliff's overall net worth, AQR is listed as owning almost 500,000 warrants.
Management: First note: The CEO Alan Townsend is retiring upon finding a replacement. This isn't a red flag or anything. He's 68. He was pretty clear he wanted to retire and enjoy life. But he is solid and its a loss. Fortunately Gary Hanna is still the Chairman of the Board. He is very well respected in the industry and I have little doubt they will find a suitable replacement. From speaking with other shareholders, everyone thinks very highly of Gary and his industry experience.
Craig Owen is the former CFO, CAO and Controller at Southwestern Energy and Controller at Anadarko and has significant energy and public company experience. Seems well respected but Southwestern's stock didn't exactly perform well from 2008 to 2017 so we'll see.
Brian Ayers, the chief geology officer, has been with Tema (aka Rosemore) for more than 6 years and has over 38 years experience and he knows the land well. He is also the former CEO of Centurion Exploration and VP of Domestic Exploration at Coastal Oil & Gas.
I think for reasons that the Southern Delaware Basin is not yet developed or booked in reserves it does not make sense to value ROSE on NAV/PV-10 etc basis. So i am choosing to value this on EV/EBITDA reasons, as well as its also the acqusition currency in this space and this company is likely a long term take out.
On a pure play Permian comp basis which includes (XEC, CXO, FANG, EGN, PXD, RSPP) this set is trading at 2018 EV/EBITDA median of 8.4X and 2019 of 6.3X, with the lowest is Cimarex at 5.2X and the highest obvious Pioneer Resources at 7.9X (which I don't really consider a real comp to ROSE due to its size but its a comp due to its similar asset locations).
On the comps used by the company in their presentation (CDEV, CLR, CPE, CXO, FANG, EGN, JAG, LPI, NFX, OAS, PDCE, PE, PXD, QEP, RSPP, SM, SRCI, WLL, WPX, XEC, XOG) this set is trading at 2018 EV/EBITDA median of 6.9X and 2019 of 5.3X, with the lowest is XOG at 3.5x and the highest is still Pioneer Resources at 7.9X.
Using the same set of comps for companies under $5b of capitalization the 2018 median drops to 6.0x and 2019 to 4.9x.
So this is obviously a theoretical art exercise. As I said, at 5.3X 2019 medians the stock is a $21 stock at current valuation. From $7.50 and a $550mm EV, every one multiple turn on 2019 EV/EBITDA equals about $4.00 per share. At the lowest multiple out there, XOG, at 3.5X, the implied value would still be $13.50 or an 80% return on the stock and 200% return on the warrants. At the industry medians of 5.3X its a $21 stock or a 180% return and 1000% return for the warrants. I think i described the catalysts (balance sheet refinance, 2018 NAV publishing, continuing to deliver on guidance results, creating stock liqudity) that could get us there but its obviously up to the analyst to determine the appropriate multiple and probabilities of these events happening. I find the assymetrical optionality of the warrants to be really nice and while I don't have control over everything and do not like some things, like retirement of CEO, I believe the correct ingredients are there for this to potentially be a homerun.
- The company is a JOBS Act SPAC with material control weaknesses. They are working to remediate these, as they were understaffed and given that its a newly formed public entity with a new CFO this is an area of concern. I would imagine fixing this would go someways to unlocking the valuation gap and hopefully Craig Owen with his public company experience can overcome this issue quickly.
- Oil is a very volatile commodity and as I mentioned most E&Ps over the medium term tend to trade with the oil price. Likely for this thesis to play out the prices have to stay in the at least $55 range and thats not given. In general long term E&P investing is not an advisable industry as i believe we may be closer to it becoming coal than most think (thats an opinion not a fact). So invest at your risk.
- Energy infrastructure investment has been weak. ROSE has most of the pieces in place and an excellent supply team to carry it through mid 2019 but should bottle neck or lack of investment continue to rear their heads this can certainly impact the industry and ROSE.
Appendix: Gary Hanna bio
Gary C. Hanna, has served as our Chairman since September 2015. Mr. Hanna has over 30 years of executive experience in the energy exploration and production and service sectors, with a primary focus in the mid-continent U.S. and Gulf of Mexico regions. Between September 2015 and April 2017, Mr. Hanna also served as our Chief Executive Officer. Between June 2015 and September 2015, Mr. Hanna evaluated various investment and employment opportunities. Mr. Hanna was a consultant for Energy XXI Gulf Coast, Inc. from June 2014 to June 2015. From 2009 until June 2014, Mr. Hanna served as the Chief Executive Officer of EPL Oil & Gas, Inc., or EPL, a publicly-traded company that was acquired by Energy XXI in June 2014 for $2.3 billion, and was elected as a director of EPL in June 2010 and Chairman in 2013. From 2008 to 2009, Mr. Hanna served as President and Chief Executive Officer of Admiral Energy Services, a start-up company focused on the development of offshore energy services. From 1999 to 2007, Mr. Hanna served in various capacities at Tetra Technologies, Inc., an international oil and gas services production company, including serving as Senior Vice President from 2002 to 2007. Mr. Hanna also served as President and Chief Executive Officer of Tetra’s affiliate, Maritech Resources, Inc., and as President of Tetra Applied Technologies, Inc., another Tetra affiliate. From 1996 to 1998, Mr. Hanna served as the President and Chief Executive Officer of Gulfport Energy Corporation, a public oil and gas exploration company. From 1995 to 1998, he also served as the Chief Operations Officer for DLB Oil& Gas, Inc., a mid-continent exploration public company. From 1982 to 1995, Mr. Hanna served as President and Chief Executive Officer of Hanna Oil Properties, Inc., a company engaged in oil services and the development of mid-continent oil and gas prospects. Since November 2015, Mr. Hanna has served as a member of the boards of directors of Hercules Offshore, Inc. and Aspire Holdings Corp. Mr. Hanna holds a B.B.A. in Economics from the University of Oklahoma. Mr. Hanna is well-qualified to serve as director due to his extensive operational, financial and management background.
- Balance sheet refinance
- Growth in EBITDA/reserves at high double digits
- Long term sale
- Warrant buyback offers