Seeking Alpha Article TodayLong Run Exploration: Cheap Canadian E&P With Huge 8.4% Yield https://seekingalpha.com/article/2483685-long-run-exploration-cheap-canadian-e-and-p-with-huge-8_4-percent-yield?ifp=0 Sep. 10, 2014 5:00 AM ET | 14 comments | About: Long Run Exploration Ltd. (WFREF) Subscribers to SA PRO had an early look at this article. Learn more about PRO » Disclosure: The author is long WFREF. (More...) Summary •Long Run Energy (LRE in Toronto) is an E&P company trading at a 15% FCF Yield and a huge 8.4% dividend yield. •Technical pressure has pushed the stock down 10% in the past month as shares issued to fund an acquisition recently hit the market. •Management grew production organically 5.5% in the last quarter, and at under 4x TEV/EBITDA, the stock is excessively cheap and misunderstood. (Editors' note: Long Run Exploration trades on the Toronto Stock Exchange under the ticker symbol LRE.TO, with ~$CAD 5M average daily volume) Long Run Exploration (OTCPK:WFREF) is an underfollowed small cap E&P company in Canada on the verge of re-rating as the market better grasps the implication of a recent acquisition and new guidance for 2014/2015. A monthly dividend implemented in January 2014 should also gradually attract an income seeking crowd, and the current yield is a healthy 8.4%. Acquisition wise, LRE recently closed two related deals to buy oil and gas assets in the Deep Basin area of Alberta (close to existing production) along with some needed infrastructure. Stock issued to fund these deals have flooded the market and pushed LRE down almost 10% in recent weeks, from $5.50 to just above $5 today. Overall on a proforma basis (using $90 oil and $3.75 gas in USD), LRE should produce 73c/share in free cash flow ex growth capex in 2015, easily covering their 42c dividend and implying a 15% FCF yield. At 3.7x proforma EBITDA (using my #s lower than guidance), LRE is priced cheaper than just about every comp on almost any metric: EV/EBITDA, EV/flowing BOE (41k), P/E (10x) or FCF (7x). Long Run could easily trade to a 5.0% - 6.0% dividend yield, which would imply $7.00 -8.40 per share. That is roughly a 50-75% return with dividends over the next 12 months. Using a 6.0x EV/EBITDA multiple on 2015 guidance, just below where peers trade on average, LRE would be worth $10.10, up 100%. This kind of multiple does not seem at all unreasonable given organic production growth of 5.5% in the most recent quarter. On the downside, the stock could sell down to $4.50 in the case where commodity prices continue to fall, or perhaps its private equity owners (Sprott Resources who hold 11% of the shares) become sellers. It is worth noting that insiders last November purchased almost 200,000 shares net just above $5, where the stock trades today. Finally, investors perhaps have not factored in a huge $1.5BB in operating loss carryforwards (NOLs), meaning LRE likely won't pay taxes until 2020 or later. Based on a 35% tax rate, I conservatively value the NOLs at $1 a share and the NAV of the existing reserves/infrastructure at $6.50/share. Why the Opportunity Exists Long Run just completed two related acquisitions, funded in large part with equity. Shares issued in the most recent Crocotta (OTCPK:CRCTF) deal hit investor accounts in mid-August, 44mm out of a base of 194mm. The selling has been heavy, pushing the stock down almost 10% despite solid earnings posted on Friday August 8th. Since then, over 30mm shares have changed hands, we think mostly clearing out former Crocotta shareholders who likely didn't know what they were selling. Worth noting, the two biggest shareholders of Crocotta (holding around 11mm shares in total) have opted not to sell, and in fact were keen to receive LRE shares in the deal in lieu of cash, as they viewed LRE equity as quite cheap. The former CEO of Crocotta also continues to hold 1.3mm shares according to the company. Business From the annual report: The business plan of Long Run is to create value on a production and reserve per share basis in the oil and gas industry in western Canada. To accomplish this, Long Run has pursued and will continue to pursue an integrated growth strategy including focused exploration, controlled exploitation and strategic acquisitions within its geographic project areas in the Peace River Arch region of the Western Canadian Sedimentary Basin. The company operates in the Alberta province of Canada. Peace River and Redwater Viking (Edmonton) are primarily oil producing plays, and the Northern Gas play (aka Boyer) is mostly liquids rich gas. Proforma for its recent acquisitions, LRE will produce roughly 50% gas, and 50% oil/liquids. The strategy in the past was growth, and fortunately the focus tended to be growth in production on a per share basis. While the company has grown primarily through acquisitions in the past 3 years, LRE has mixed issuing equity with utilizing inexpensive debt. Today, the goal is to slow down production growth to the 5-10% range, and provide income for shareholders. The company has an inventory of roughly 750 future drilling locations on top of its 1400 net producing wells today. Management made the strategic decision to slow growth with a goal of drilling 75 wells a year instead of former plans to drill 130 wells a year for 5 years (and then have to aggressively seek out new acreage or acquisitions). The latter would be a riskier prospect. The 42c dividend is fortunately set at a reasonable payout level so that there will be plenty of room to raise it over time. In my model, it appears that FCF/share after maintenance capex will be close to 73c next year. The company can delever at current dividend levels. (click to enlarge) Funds flow per share (cash flow from operations less working capital changes per share) has also been impressive: Source: Slide presentation Economics The well economics are quite good here, with around $50/BOE in revenue against $25/BOE in operating cash costs (Lifting/SG&A/royalties). Capex (F&D Costs) runs around mid teens ($14-18/BOE) and should be close to 15-17 going forward. That leaves $8-10/BOE in economic profit post tax/interest. The company has $1.5BB in NOLs, meaning it won't have to pay cash taxes until 2020 or later. Slide to illustrate the netback number below (NI + D&A in fact), but excludes F&D costs: (click to enlarge) Regarding F&D, drilling costs are lower than shale oil plays in the US Bakken or Eagle Ford, primarily as drilling depths tend to be much shallower in the Peace River and Redwater Viking. Whereas Eagle Ford wells range from 4,000 - 14,000 feet, wells in LRE's regions range from 2700 - 3000 feet. Instead of spending $4mm on a well, LRE will spend under $1mm. Acreage here is best characterized as tight sands/conventional wells, although LRE does drill horizontally. Hedges/ Prices Edmonton Light Sweet oil trades pretty close to WTI today at around $93/barrel. Natural gas prices in Alberta at AECO tend to trade around Henry Hub or at some discount, with current prices in USD at $3.58/mcf vs Henry Hub in the $3.88/mcf range. (as an aside often gas in Canada is quote in C$/gigajoule - a gigajoule is .95MMBtu's) The risk to pricing is that differentials are high in Edmonton given lack of pipeline capacity, and AECO natgas prices are the furthest from markets in the US and Toronto. AECO prices have in fact suffered for years. As for hedging, the company has sold forward 65% of 2014 oil production and 20% for 2015. Gas is 70% hedged for 2014 and 30% for 2015. The good news lately is that AECO/Henry Hub prices have rebounded dramatically from the 2011 lows and gas storage remains at 7 year lows. At least until next winter, demand should remain relatively strong to refill depleted gas storage. So far too, it doesn't appear that the gas rig count has shifted at all to drilling more natural gas. Below is a good chart indicating how low storage is today in Canada, with the green line well below even the 5 year low range: In the US, gas storage appears similarly low, with stocks 15% below the 5 year average. Capitalization The company aims to keep leverage below 1.5x, though it is now at just under 2x with the recent acquisition pro forma. Their bank facility matures May 2016, and covenants cap senior leverage at 3.0x, and total leverage at 3.5x (measured as Debt/EBITDA). They shouldn't have a problem with these. The company's credit facility was also upsized from $575mm to $695mm with the closing of the Crocotta deal. Projections Management has guided to 2014 pro forma Funds Flow of $320mm (CF from ops less WC changes). Adding back interest of $35mm implies EBITDA of $355mm (pf 2014, and taxes will be zero). With capex of $250, FCF pre dividends appears quite healthy at $70mm or $0.47/share this year. Now with the recent sell off in oil and gas prices, I have modeled 2015 using $90 oil and $3.75 gas in USD, coming up with slightly lower and more conservative figures. (click to enlarge) There seems considerable upside if management hits their 2015 targets, and limited downside in a miss. Upside case: with a commodity price rebound, at $1.00 in FCF/share next year, LRE could be a double with dividends. A conservative upside case of $8 would still imply a 5.25% dividend yield, and almost 60% upside. Technicals Private Equity firm Sprott Resources (OTCPK:SCPZF) holds 23mm shares (11%). Rumors are that this block has been shopped for sale to various Canadian I-banks. This overhang has kept a lid on LRE this year generally, and with more shares issued to fund two deals, the technical picture has been terrible. Sprott will likely look to sell their block in the next year, and generally have a minimum price of $5.50 that they are looking for (or so I'm told). Sprott did unload 12.6mm shares at $5.35 in May. Generally, though the worst of the selling from Crocotta shareholders appears over. On the flip side, management has made no secret of the fact that they are looking to sell certain production and some raw land, and sales proceeds could be funneled toward a share buy back in the next few months. Conclusion Against peers like Torc Oil & Gas (OTCPK:VREYF) (4% yield, 7.2x TEV/EBITDA) and Surge Energy (OTCPK:ZPTAF) (6.5% yield and 6.7x TEV/EBITDA), Long Run appears 30-40% undervalued at a minimum. With such a large NOL and shareholder friendly management, LRE should trade at an EBITDA premium to its peers. With their two acquisitions now closed, LRE will begin to report clean financials highlighting its current earnings potential, providing a bit of a catalyst for the stock. Most investors probably haven't looked carefully at their pro forma financials (published last month here), but they are an important read and give a sense for the company's pro forma income statement and balance sheet. Finally, I'd only point out that it's rare for a growing E&P company to trade below 4.0x EBITDA (particularly ones based in politically friendly environments with decent well economics). One could argue that there is acquisition risk, but management has vowed to focus on integrating their current asset base, and improving the efficiency of their production as opposed to doing any more deals. I do not believe they are empire builders, as production on a per share basis has grown 17% over the past couple of years. Worst case, I will be happy to clip a hefty 8.4% coupon waiting for the stock to come back. Risks •Commodity Prices/Differentials •Acquisition Risk, although management seems to be embarking on a path of steady slower growth as the existing acreage has matured. •Technical pressure on stock •Missed Production Figures •Recession Editor's Note: This article discusses one or more securities that do not trade on a major exchange. Please be aware of the risks associated with these stocks.