Description

GeoResources (GEOI) is a small-cap oil/gas E&P company run by a top-notch CEO named Frank Lodzinski who has a long history of making his investors rich. In his 20+ years in the industry, Lodzinski has started four oil/gas companies from scratch, and GEOI is his fifth entity. I have tracked the returns of his prior companies, and in the low case he returned 3x to his equity investors and in the high case 8x. Each entity had a lifespan of 4-7 years, whereupon Lodzinski would sell to a larger oil/gas concern and like clockwork start a new entity the following year. My reference checks show that this long-term record was not built by chance but by Lodzinski’s operational/deal-making skills, integrity, and a strong team that has stayed with him for decades. GEOI is currently trading at a 25% discount to my estimate of the hard value of their proved reserves (see below). If you invest behind a first-class CEO who previously returned 3-8x to his investors and you do so at a 25% discount to NAV, by pure arithmetic you make 4-11x multiples on money should history repeat itself. He is three years into GEOI and expects to sell GEOI in 2-4 years (which fits with the timing of his previous 4 entities).

However, there is more to the story than investing behind a great operator at a sizable discount. The market views GEOI as simply an operating oil/gas company – all street analysts following the company compare it to other small-cap E&Ps. However, as I will detail, GEOI should be viewed both an operating concern but also as a fledging asset mgmt business – Lodzinski has already structured two deals ($150M AUM currently) where GEOI is the GP and gets not only a 2% mgmt fee but a 35% incentive fee (after a 10% pref). I think this business has a reasonable chance to scale over the next several years if management shows good performance in the current deals and as the capital markets increasingly return to pre-crisis levels. At $1B in AUM, the potential pre-tax asset mgmt income could be in the $60M range vs. a market cap of roughly $150M today. Granted $1B AUM is a long way from $150M AUM, but Lodzinski has the track record to get there and you are paying nothing for this option anyway.

So with hard assets backing up your purchase price, you have two ways to win big: Lodzinski’s ability to create value in GEOI the operating concern and Lodzinski’s potential to scale GEOI the asset mgmt business. Lodzinski charges no fees beyond a reasonable salary and views GEOI as his entity – GEOI is the owner of the GPs of the asset mgmt partnerships he structured. Furthermore, it is at the GEOI entity level where Lodzinski owns 11% personally. His long-time backers, the Vlasic pickle family (they backed him on his previous entities as well) own another 19% at the GEOI entity level.

I can follow-up in the Q&A further about Lodzinski's track record in his prior entities, my thoughts on the upside with the asset management part of his operation, etc. The below shows my valuation of GEOI's hard assets which is obviously crucial to my thesis as it provides the downside protection to the investment.

• GEOI has 8.8M barrels of proved oil reserves and 34.8 bcf of proved natural gas reserves.
• 60% of reserves oil, 40% gas.
• Proved reserved further broken down into proved developed producing (PDP) reserves, proved developed non-producing (PDNP), and proved undeveloped (PUD). PDPs and PDNPs are the highest quality and are essentially hard assets – PUDs have risk. All three categories are proved reserves and are dramatically higher quality, lower risk than probable and possible reserves.
• GEOI’s reserves: 64% PDP, 16% PDNP, 20% PUD. Limited amount in PUD category.
• I give 0 credit to GEOI’s substantial probable/possible reserves.
• Focus on long-life, low-risk assets. Very little exploration, less than $800K a year.   
• Major states of operation: Texas, Louisiana, Oklahoma, and North Dakota.
• 100% on-shore.
• Exciting exploration play – Bakken Shale in North Dakota/Montana. GEOI was acquiring leases in early 2007, one year before the play became well-known.

• Variety of ways to value E&P companies – way that is most rational (in my opinion) is the PV-10 approach with a variety of manual adjustments.
• PV-10 is a projection of future cash flows arising from proved reserves discounted back at 10%, essentially DCF analysis with key inputs being quantity of reserves, commodity prices, and production costs. Quantity of reserves are set by an E&P’s third-party reserve engineer. Pricing is typically strip prices.
• 6/30/09 PV-10 value of $406M conservative starting point for market value given upward moves in commodity prices since then.

• However, critical to make adjustments for variety of flaws in PV-10 approach.
• First, PUDs are discounted back at 10% similar to PDPs/PDNPs despite PUDs having greater risk. I discount PUDs at 20%.
• PV-10 does not account for a company’s hedging program. GEOI CFO estimated $10M FMV of hedges based on current spot prices. I add to PV-10 value.
• PV-10 does not include corporate overhead. Due to mgmt fees from GEOI’s asset mgmt business, GEOI has low G&A for a company of its size: a few million dollars a year after tax. This should theoretically be capitalized and deducted from PV-10. I do not include it because it is this G&A that allows GEOI to create value above and beyond its proved reserve value - given Lodzinski’s past track record, I view these few million dollars a year of expense as a very high ROIC investment and the central reason to invest in GEOI in the first place.   
• PV-10 does not include income taxes. However, E&P companies in growth mode can often defer taxes for many years making the present value a fraction of face. For example, GEOI had $8M tax expense in 2008 but deferred $7M of it. This is why in private market transactions, the key metric used is usually pre-tax PV-10. Nonetheless, I present both pre and post tax PV-10.
• Making all these adjustments leads to $367M of pre-tax PV-10 and $279M of post-tax PV-10. Deducting the $90M of net debt results in $277M of net asset value in the pre-tax case and $189M in the post-tax case.
• With a current market cap of $169M, this leads to an approximately 11% discount to NAV in the post-tax case and a 39% discount in the pre-tax case.The average of these two is a 25% discount.
• The actual discounts to fair market value are greater because I have given zero credit to GEOI’s substantial probable/possible reserves. Because of GEOI’s early focus in the Bakken Shale which is now one of the hottest oil/gas plays, the company has 62 BCFs of probable natural gas reserves. If these become proved, GEOI’s proved reserves would double.  

Catalyst

No immediate catalyst, although at any time GEOI may announce a large deal with OPM and the market will recognize there is more to the GEOI story than just an operating E&P concern.

While there is no immediate catalyst, unlike many opportunities there is a clear medium term catalyst. Lodzinski has a clear history of selling entities after 5-7 years and he is three years into his latest entity. According to Lodzinski, there is nothing changed in the game plan for this entity as his previous four.