Magnum Hunter (MHR) short thesis

In the independent oil and gas space, I will happily bet against the high-cost operators.  I would argue that Magnum Hunter overpays insiders, wastes money on corporate aircraft, and has excessive G&A as a percentage of revenue.  This has contributed to Magnum Hunter’s track record of GAAP losses since current management took over in May 2009.

Market cap: $1.42B
% of float short: 18.2%
Cost of borrow: ~0.6%
The put options are somewhat liquid.

The Gary C Evans empire

Gary C Evans is Magnum Hunter’s CEO.  Evans is associated with the following companies:

  1. The “new” Magnum Hunter (ticker symbol MHR).  Current management took over in May 2009.  In July 2009 the predecessor company was renamed to Magnum Hunter.
  2. The “old” Magnum Hunter (ticker symbol MHRI).  Evans was the CEO though MHRI is unrelated to MHR except in name.  Old Magnum Hunter was merged with Cimarex (XEC) in 2005 in an all-stock deal worth around $2.1B.  Old Magnum Hunter shareholders actually did very, very well.
  3. TEL Offshore Trust (ticker symbol TELOZ).  Evans is a trustee.
  4. GreenHunter Resources (ticker symbol GRH).  Evans is the chairman and interim CEO.
  5. NovaVax (NVAX).  Evans is the chairman.  NovaVax is a development-stage pharma company.  The borrow is in the low single digits.

Old versus new Magnum Hunter

Shortly after Evans became the CEO of MHR, the company issued a press release stating the following:

We intend to bring similar disciplines that were utilized so successfully at [“old”] Magnum Hunter, including low finding and development costs, low operating costs and corporate overhead, in order to generate superior investment returns to our shareholders. We plan to significantly expand the Company’s asset base through the opportunistic acquisition and operation of producing properties with additional low risk drilling and development drilling opportunities. In the near term, we will focus on acquisitions and development of predominately oil-based properties as we believe the current fundamentals of oil are currently superior to natural gas.

In my opinion, old Magnum Hunter really did have low corporate overhead.  Take a look at G&A as a percentage of revenue at MHRI:

YE1996: 7.46%
YE1997: 4.83%
YE1998: 5.76%
YE1999: 4.19%
YE2000: 4.79%
YE2001: 4.51%
YE2002:  5.00%
YE2003: 4.72%
YE2004:  4.48%

The new Magnum Hunter has much higher overhead (figures from the YE2012 and YE2009 10-Ks unless stated otherwise):

YE2008: 24.96%*
YE2009: 82.66%* (*current management took over in May 2009)
YE2010: 84.41%
YE2011: 55.33%
YE2012: 23.76%
YE2013: 26.89% (YE2013 10-K)

While G&A as a percentage of revenue isn’t a perfect metric, there is clearly a night and day difference here.  The difference is partially explained by the use of corporate aircraft; the related party  disclosures section in the YE2012 10-K mentions that MHR is paying the CEO to rent a corporate jet:

During 2012, 2011 and 2010, we rented an airplane for business use at various times from Pilatus Hunter, LLC, an entity 100% owned by Gary C. Evans, our chairman and chief executive officer. Airplane rental expenses totaled $174,000, $463,000 and $450,000 for the years ended December 31, 2012, 2011 and 2010, respectively.

The true cost of corporate aircraft will be higher as there are other costs to operating the aircraft.  Another explanation for the high overhead is that insider salaries for officers and directors are much higher at the new Magnum Hunter versus the old Magnum Hunter.  (You can read the DEF 14A filings for yourself on SEC EDGAR.)  I have no idea where the rest of the G&A is going.

To me, it is pretty bizarre that the same CEO ran the old and the new Magnum Hunter so differently.  A potential explanation is that Evans got a free ride from those surrounding him.  For example, Richard R Frazier was the COO of Magnum Hunter and may very well be incredibly talented.  Evans liked him enough to name Frazier as the CEO of Magnum Hunter shortly prior to the merger with Cimarex.  After finalizing the sale/merger in June 2005, Frazier went on to start Keystone Petroleum in November 2005.  The Keystone website highlights the company’s performance [emphasis added]:

Keystone’s initial drilling project was the “Wolfberry” play in West Texas. After drilling 25 wells on Keystone’s acreage, the company sold those wells along with approximately 26,000 acres in two major sales and several minor ones. The Partnership’s business was essentially completed in November, 2011, resulting in a “return on investment” to the investors of 5.42 to 1 in less than 6 years.

Richard Frazier potentially explains why the old Magnum Hunter is so different compared to the new Magnum Hunter.  (Frazier has no position at the new Magnum Hunter.)  The old company had low corporate overhead and seems to have been very good at keeping their F&D costs down.

TELOZ

TELOZ owns a royalty on various offshore oil and gas wells.  Currently, the royalty is not distributing cash and therefore TELOZ is not distributing cash.  In 2011 the Trust sold 20% of its royalty, for $1.6M in gross proceeds and $1.486M net proceeds.  The gross proceeds imply a valuation of $8M for the royalty.

TELOZ’s G&A is nearly a million dollars a year:

YE2012: $721,053
YE2011: $894,113
YE2010: $911,245

This overhead is a massive headwind for shareholders.  Almost a million dollars worth of overhead versus roughly $8M in assets is effectively a very high management fee.  In my opinion, the trustees should liquidate the trust and give the proceeds to shareholders.  I’m not sure why they have avoided this move.

Gary Evans is one of the three trustees of the trust.  In 2003, he was paid $41,366 to act as a trustee according to MHRI’s proxy.  His salary went up from 2001, when it was only $33,240.  Are the trustees avoiding a liquidation simply so they can collect a salary?  I don’t know.

GRH

Like MHR, GRH has a track record of GAAP losses year after year.  Its share price performance since its IPO has been poor:

green-hunter-performance

NVAZ

Gary Evans has been on NovaVax’s board since April 2005.  While one could criticize NovaVax’s corporate governance practices, they are not entirely unreasonable.  Evans’ share ownership relative to his director’s salary is very high.  He owns roughly 702,558 shares of NovaVax (current value $4,271K) versus his total compensation of ~$77k.  The ratio is 55:1.

Insider compensation for officers ($3,224k) and directors ($434k) combined is around $3,658k for YE2012.  It is a little on the high side at 4.6% of the company’s book value of $80.24M as of YE2012.  (Granted, key insider compensation relative to the company’s book value is not the best metric in the world.)

Mr. Evans sits on NovaVax’s audit committee.  I find this ironic because Magnum Hunter restated its financials in the past and had to deal with internal control problems.

Track Record

One way of looking at Evan’s skill in running Magnum Hunter is in terms of GAAP profitability.

At YE2009, the company had raised around $72.441M in equity and had an accumulated deficit of $33.136M.
At YE2012, the company had raised around $735.477M in equity and had an accumulated deficit of $586.365M.
In those three years, the company raised $663.036M in equity and generated GAAP losses of $553.229M.  Magnum Hunter has managed to lose almost everything that it has raised.

However, I would note a few things:

  1. Magnum Hunter was arguably unlucky.  They were heavily invested in shale gas.  Most unconventional shale companies have been losing their shirts due to an industry-wide oversupply of shale gas and low prices.  (I’d point out that most shale gas companies receive significantly lower prices than Henry Hub prices due to price differentials, so things are worse than what Henry Hub pricing suggests.)
  2. Compounding #1 was the fact that Magnum Hunter was leveraged to the hilt.  Like old Magnum Hunter, the company’s most expensive debt was in the ballpark of 10%.
  3. GAAP can sometimes cause distortions.  Many oil and gas companies have value that isn’t reflected on their balance sheets, especially if they use successful efforts accounting.

#2 is arguably a bad strategy.  I’m a fan of the late Ken Peak (of Contango Oil and Gas) and think that too much debt is dangerous.  As well, it is extremely difficult for Magnum Hunter to consistently beat its cost of capital on its most expensive debt (usually 8-10%+).

#1 doesn’t fully explain how Magnum Hunter racked up GAAP losses so quickly.  I would argue that Magnum Hunter is not good at finding gas cheaply.  It has taken many impairments on bad acreage where the company has let the lease expire.  And as mentioned previously, the excessive corporate overhead makes it difficult to earn profits.

As far as GAAP distortions go (#3), we could make an adjustment for the book value of the company’s oil and gas assets versus the standardized measure.  As of YE2013 (and before the sale of Eagle Ford assets):

Book value of oil and natural gas properties minus accumulated DD&A is $1,225M.
The standardized measure is $844.5M.
The difference is $380.5M (1225 – 844 = 380.5).

What’s happening here is that book value is actually greater than the standardized measure figure.  If we could assume that the standardized measure is accurate (unfortunately it never is), then the book value of Magnum Hunter’s equity of $450M as of YE2013 is overstated.  Adjusted book value would be $69.5M versus a market cap of roughly $1.41B.

EDIT (6/13/2015): At the end of 2013, the book value of unproved leasehold costs was $469M.  The first arbitrary assumption is that the fair value of the land rights is significantly lower than book value (i.e. some fraction of $469M).  The second assumption is that the standardized measure is overstated (as discussed below).  The third assumption is that (A) the fair value of the unproved leasehold costs and (B) the inflation of the standardized measure cancel each other out.  This shortcut may understate the value of Magnum Hunter’s assets.

Problems with the standardized measure

In theory, the standardized measure is supposed to be overly conservative.

  1. It does not include probable or possible reserves.  Only proved reserves.
  2. The discount rate of 10% is nearly always more conservative than what a buyer would pay for the assets.
  3. If the futures curve is in contango, then the standardized measure will be too conservative.
  4. In theory, the PV-10 estimate of a reserve is supposed to be on the conservative side 90% of the time and on the aggressive side 10% of the time.

In practice, the standardized measure is almost always inflated.  There are a number of ways to inflate the numbers.  The real problem is that there are virtually no consequences for inflating reserves.  The reserve engineer won’t get kicked out of their professional organization or be barred from doing future reserve estimates.  I’m not aware of anybody being fined or jailed for inflated reserves.  There’s practically zero downside.  Because the current situation is a magnet for fraud, I am extremely skeptical about estimated reserves.  I would argue that reserve estimations tend to be more aggressive when it comes to promotional CEOs who fly around on corporate jets and are constantly selling shares.

Are Magnum Hunter’s reserves being inflated?  It’s hard to say.  Like most independent oil and gas companies, MHR releases very little technical data so there’s really no way for me to perform a high level of due diligence.  One issue I see is that $96M out of the $708M in proved developed reserves are PDNPs.  In my opinion, this practice of recording PDNPs for unconventional shale assets is dubious (my CHK post has a slightly longer explanation).  Ultimately, I have no idea if Magnum Hunter’s reserve engineering will turn out to be overly conservative or aggressive.

Capital structure

Historically, Magnum Hunter has constantly been selling shares and issuing debt.  Generally speaking, I am extremely skeptical about companies that do this.

Here’s how Magnum Hunter’s capital structure stands as of YE2013:

$876M: Long term debt.  The most expensive debt here is a second lien term loan for Eureka Hunter Pipeline with an interest rate of 12.5%.
$136M: Series A Convertible Preferred Units of Eureka Hunter Holdings.  Cumulative distribution rate 8.0%.
$100M: Series C Cumulative Perpetual Preferred Stock.  Cumulative dividend rate 10.25%.
$221M: Series D Cumulative Preferred Stock.  Cumulative dividend rate 8.0%.
$95M: Series E Cumulative Convertible Preferred Stock.  Cumulative dividend rate 8.0%.
$1408M: Common stock.  170.687M shares outstanding.
Warrants:  There are ~17M warrants outstanding with a strike price of $8.50/warrant.  As well, there is a much smaller number of other warrants and options.

There are no significant debt maturities in 2014 and 2015.  In 2016, there is $224M in debt due.

The warrants

In 2011 and 2013, the company issued 1 warrant for every 10 common shares.  The stated reason was to ‘congratulate’ shareholders (press release).

“Our Board of Directors has granted this dividend to our shareholders of record as a form of appreciation to both old and new shareholders alike.  We are appreciative of the confidence reflected by these shareholders in supporting our Company as we embark on a new era of growth in the unconventional shale plays where we are actively developing this resource.”

In my opinion, the warrants don’t really make sense from a business perspective.  Size is an anchor on performance.  If the company is good and genuinely investing capital at 20-50% IRRs (as suggested in company presentations), then dilution is a bad idea for shareholders.  If the company isn’t that good, then raising capital will only help to pay Magnum Hunter’s massive G&A costs.

The company’s stated explanation doesn’t make sense.

The debt

I’m surprised that the company’s subsidiary Eureka Hunter is borrowing at 12.5% (on a non-recourse basis).  This suggests to me that Eureka Hunter may be distressed.  It is also extremely unusual to borrow at such a high interest rate to build a midstream asset; midstream assets are generally seen as lower risk and lower reward than upstream assets.

Magnum Hunter itself has a high cost of capital and strikes me as distressed.  Companies that borrow at extremely high interest rates tend to be on their way towards bankruptcy.  (I suppose that Sirius XM is an exception.)

How much is the equity worth? / Valuation

Earlier, I stated that “adjusted book value would be $69.5M versus a market cap of roughly $1.41B”.  The Series D and E preferred stock are lumped into shareholders’ equity.  These series of preferred are not convertible into common stock and have a liquidation preference ahead of the common shareholders.  I subtract the preferred stock out of shareholders’ equity.

$69.5M – $221M – $95M = -$246.5M

By this calculation, the common shareholders’ equity is underwater.  Obviously the equity cannot be worth less than 0.  There is some option value to the equity at the very least.

However, it seems to me that Hunter Magnum common shares are slightly overvalued.

*Disclosure:  Short MHR (common shares and puts) and NVAX.  No position in TELOZ or GRH.

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4 thoughts on “Magnum Hunter (MHR) short thesis

  1. Any thoughts on how much a private market buyer or industry buyer would pay to acquire MHR (and then presumably cut away the G&A line)?

    • It would likely be based on a NPV calculation similar to standardized measure. So probably a NPV of the future cash flows, 6-8% discount rate, no BS reserve engineering, etc. The reserve engineering is extremely tricky.

      The SEC PV-10 value likely does not include most of the corporate G&A. One of the ways you inflate PV-10 is to exclude corporate G&A and to understate the G&A needed to operate the assets.

  2. Pingback: My approach to shorting oil and gas | Glenn Chan's Random Notes on Investing

  3. Pingback: Energy stock rankings (Oct 2014) | Glenn Chan's Random Notes on Investing

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