The current offer for this company seems to be substantially below its intrinsic value. At the same time there is a high probability that the deal will fall apart which is also reflected in the share price trading at a high discount to the purchase offer. Activist investors are currently working on other options to unlock shareholder value and it is also likely that other potential buyers might step in to acquire the company. Based on a scenario analysis I come up with a 25% upside potential for the company’s share price over the next twelve months.
Equal Energy is an oil and gas producer with operations in the U.S. (Oklahoma). In December 2013, management announced the execution of a definitive sales agreement with Petroflow to be taken over for USD 5.43 per share in cash.
Before you continue to read this write up, I highly recommend reading the “Background of the arrangement” section in Equal’s preliminary proxy statement. After that, it is also interesting to read this negative assessement of Equal’s management published by one of the former activist shareholders mentioned in the proxy statement. Equal took legal proceedings against this shareholder and entered into a settlement at the beginning of 2013.
There are different parties involved:
Based on the sales agreement the deal has to be completed until May 1st 2014. For Petroflow to get the deal done they need to obtain financing. This seems to be one of the major obstacles at the moment and the reason why the market is currently sceptical about a successful completion of the transaction. The stock price is currently trading at USD 4.68 or 14% below Petroflow’s offer. During Q4 2013, when the stock price was trading close to the offer price, merger arbitrage funds accumulated large positions in the company. As a successful acquisition became less likely at the beginning of 2014, these funds might have reduced their positions putting pressure on the share price.
The other major obstacle is that there are different shareholder groups who might not vote in favour of the deal as they do regard Petroflow’s offer as not adequate for Equal’s shareholders. To be completed the deal needs to be approved by two-thirds of shareholders. In addition, the transaction is subject to the condition that dissent rights will not have been exercised in respect of more than 5% of the Equal shares calculated on a fully-diluted basis.
Lawndale Capital Management, holding roughly 4.8% of EQU’s shares, has already indicated that they have concerns over the transaction. You can also find a letter as of April 2013 from Lawndale to Equal, where they request a change of the board of directors among other things.
Montclair actually started the bidding process for Equal, when they offered USD 4.0 per share in March 2013. After that, they increased their offer in two steps up to USD 4.85 per share. Based on Equal’s preliminary proxy statement they even made an unbinding offer of USD 5.40 per share briefly before Equal’s board decided that Petroflow’s offer would be superior to Montclair’s. Montclair is currently holding approx. 4.5% of Equal’s shares. Interestingly, Equal acquired their current operations in Oklahoma from nobody else than Montclair and Petroflow for approx. USD 246 m or USD 44,727 per flowing boe in 2006. Hence, both parties should have a good insight into the future operational potential of Equal’s assets. Obviously, Montclair is also questioning Petroflow’s bid and on April 11th 2014, Montclair proposed a leveraged share repurchase, which in their view will deliver superior value to Equal’s shareholders than a sale of the company to Petroflow. Based on a USD 6.0 per share tender offer for 48% of outstanding shares they estimate a minimum potential upside of 49% for shareholders assuming that the company will be valued at a peer group median price-earnings multiple after the repurchase. They argue that the Petroflow offer represents a high discount versus the peer group. In addition, they claim that Equal’s shareholders have borne the costs of the company’s drilling programme, but much of the resulting cash flow will only accrue to Petroflow’s benefit. Moreover, from their perspective the recent price increase in EQU’s three product streams is not adequatley reflected in the projections of Equal’s preliminary proxy statement. Apart from that, it is also noteworthy that based on the company’s latest 10-K for 2013 , proved reserves increased by 23% from the prior year.
In addition, Equal’s board and management are facing several class action lawsuits from different parties. The complaints, allege that in connection with the sales agreement, the members of the board and management breached their fiduciary duties to the Equal Shareholders. The complaints also allege that the agreement involves an unfair price, unfair sales process, self-dealing and unfairly preclusive deal protection devices.
Deal completion probability
Given the uncertainty about Petroflow’s ability to finance the deal and shareholders resistance, at the moment a completion of this deal seems to be rather unlikely. However, Equal’s management and board members have a lot of skin in the game. Though they hold only 1.9% of the outstanding shares, the execution of the deal would provide a large pay out for them. In total, Equal’s CEO alone will receive USD 3.4 m, if the deal is successful. So I believe that they will do everything they can to get the transaction done.
One can calculate the probability of a deal completion based on market prices. For example the price before Montclair offered USD 4.0 per share and put Equal in play as of March 25th 2013 was USD 3.5 per share. In addition, the share price before Montclair’s proposal of a share repurchase on April 11th 2014 was USD 4.37. So at that time the market implied a probability (Y) of 45% to a successful deal completion:
4.37 = 5.43 x (Y) + 3.50 x (1-Y) à Y= 45%
However, one can also use the price before the company announced that it has entered into exclusive negotiations for a proposed transaction on November 18, 2013 (USD 4.40 per share). Based on this share price the market implied a probability (Y) of 0% to a successful deal completion.
From my perspective a 25% probability that the transaction will be completed is a realistic estimate.
Broken deal scenarios and probabilities
Operating on a stand-alone basis
There is the possibility that Equal will continue its operations on a stand-alone basis. Based on a peer group analysis, the company is currently trading with a discount of roughly 50% to its peer group:
1) BOE: barrel of oil equivalent of natural gas and crude oil on the basis of 1 BOE for 6 Mcf of natural gas
From my perspective there are a couple of reasons why the company should trade with a discount to its peer group. Management has been criticised in the past for not being able to unlock shareholder value (as outlined above). The company has also some weaknesses with regard to their internal control mechanism as outlined by their auditors in the latest annual report. In addition, Equal’s profitability is below average as outlined by Montclair. Nevertheless, I believe that a 35% discount to the peer group would be more than sufficient to reflect these factors implying an intrinsic value of USD 6.10 per share. In a broken deal scenario I estimate a 25% probability for this outcome.
Operating on a stand-alone basis and implementation of share repurchase
Montclair estimates an intrinsic value of at least USD 7.01 per share, if Equal implements the leveraged share repurchase and improves its operational and financial efficiency. I think this outcome has a probability of 25%.
Equal will be acquired by another buyer
In the case of a broken deal, I believe it is highly likely that another buyer will step in. Provided that there will be no external shocks or unforeseen operational difficulties I think that the minimum offer will not be below Petroflow’s purchase price of USD 5.43 per share. I assume that the probability of this outcome is 50%.
From these scenarios I calculate an expected value of USD 5.85 per share implying a potential upside of 25% based on a current share price of USD 4.68 per share.
5.85 = 0.25x (5.43) + 0.75x (0.25x 6.10 +0.25x 7.01 +0.50x 5.43)
It is certainly questionable, whether Equal’s board and management act in the best interest of shareholders. However, in this case activist investors are involved and there is a good chance that they will influence the company’s representatives to move into the right direction. In addition, the current share price is trading substantially below Petroflow’s offer, though there are good reasons that this offer not only underestimates Equal’s private market value but also its public market value. So from my perspective the downside is limited.
Nevertheless, short term volatility has to be expected. If the deal breaks, the merger arbitrage funds might dump their remaining shares which could provide an attractive buying opportunity.
For the time being I will establish a 2% position for the portfolio with a share price limit of USD 4.70. Please click here for more information on WertArt Capital and the virtual portfolio.
Edit (4/14/2014): limit increase to USD 4.85.
The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!