Description

Stock Price: C$1.85

Market Cap: C$144mm

3 Month Average Trading Volume: 100,000 shares / day

Thesis

Canadian Spirit (SPI) provides a highly asymmetric risk-reward profile over the next 12-18 months, as successful development of its Montney acreage could lead to (at least) a 3-4x move in the stock, based on valuations implied by recent precedent deals.  This outcome is not highly dependent on improvement in near-term natural gas fundamentals.

Company Overview

SPI is a gas-levered E&P company with properties in British Columbia, Canada.  SPI controls much of its resource potential through a Montney shale joint venture with Canbriam (privately owned E&P backed by Warburg Pincus, ARC Financial, GE Asset Management and BlackRock) in the Farrell Creek regions.  Based on a third party evaluation, the company estimates total JV resource potential of 3.6-8.4 TCF of natural gas, and the company owns ~30% of this venture (so 1.1-2.5 TCF net).  The joint venture is in the process of developing the Montney project, and production is expected to begin early in 2011.  The company also has 100% ownership in 1.4-3.2 TCF of additional potential natural gas resource also in the Montney/Farrell Creek and 100% of 1.8 TCF of discovered and undiscovered natural gas resource in the Gething Formation.

SPI recently completed a 17.5mm share equity offering (priced at $1.50/share) that positions the company to fund its complete 2011 budget of $20-$25mm.  Pro forma for the net proceeds of the offering, the company has $37mm of cash and no debt.  The company has 77.7mm shares outstanding on a fully diluted basis.

According to management, the Montney play is economic at Henry Hub natural gas prices above ~$4.

Precedent Montney Transactions

Below is a summary of precedent deals in the Montney.

The most relevant is the transaction announced in December in which Sasol acquired a 50% stake in Talisman's Farrell Creek Montney properties.  Talisman's sections are adjacent to the sections held by SPI's JV with Canbriam.  The EV/M and EV/section analyses back out the valuation of current production (based on assumptions for EV/MMCF/d), midstream assets (in the case of Sasol/Talisman) and time value discount (in the case of Sasol/Talisman, in which the $1.05 billion consideration consisted of $260mm of cash and $790mm of development and drilling carry) to arrive at clean estimates of resource enterprise value.  The Talisman transaction implies the following values per share for SPI, as compared to the current market price of $1.85/share:  

• $2.08/share, assuming $0.15 per MCF and attributing no value to any of SPI's resources outside of the Canbriam JV.
• $4.78/share, assuming $0.15 per MCF and either (i) the high end of SPI's resource estimate for the Canbriam JV only or (ii) the low end of SPI's estimate for the Canbriam JV and other Montney.
• $3.93/share, assuming $18mm/section and SPI's net sections in the Canbriam JV only.
• $7.17/share, assuming $18mm/section and SPI's net sections in the Canbriam JV and other Montney.
• >$10/share, based on the high end of the SPI's total Montney net resource estimate.

None of these analyses attribute any value to the 1.8 TCF potential in the Gething formation or any cash, as I assume (conservatively) that SPI spends all of it in development.

SPI admittedly deserves to trade at a discount today to the valuations implied by the Talisman transaction, since Talisman is approximately 12 months ahead in terms of development and is currently producing.  These multiples are illustrative though of what SPI could be worth in 12-18 months in an M&A context.  In spite of the well-documented challenging near-term natural gas outlook, there remains a bid for acreage in the Montney and other high-quality North American shale gas plays from those with longer-term views (Montney deals above, CVX/ATLS, contemplated MBOs of KWK/XCO, Shell/East Resources, XOM/XTO, TOT/CHK JV, etc.).

Valuation Sensitivity 

Below are value per share sensitivities based on different assumptions for enterprise value per MCF and enterprise value per section, highlighting the asymmetry of the SPI opportunity.

Risks

• Execution risk in development and production
• Incremental weakness in natural gas prices

Catalyst