Description

HK's 2025 notes are trading at ~65 (10.4% current return; 16.3% YTM; 55% return to change in control).  I wrote the equity up as a pair trade against JAG in September - that trade has been a disappointment so far (-28%). I continue to think the pair trade’s an attractive trade (especially so now given the strategic review discussed below) but think the bonds provide exposure to different risks and are attractive in their own right.  Please check the prior write-up on HK/JAG for a more detailed discussion of HK’s history and assets.

The notes cratered a few weeks back after HK's 4th quarter conference call where the company said they were going to explore strategic alternatives to include: M&A, asset sales, and/or a financing transaction.

At present, HK's capital structure is:

$47m of Cash

$0 Drawn on a $275m Bank Revolver

$625m of 2025 Notes ($406m at market).

HK had a PV-10 at YE 2018 of $860m ($65 Oil with a -$7 Differential; Diff is currently -$.90).  The PV-10 of the PDP assets was $550m using the same assumptions.

The bonds have a change of control provision at 101 (given the coupon and the cost of debt of most potential acquirers it might trade through 101 in an acquisition scenario) and HK is a clear acquisition target (they are actively seeking offers); given the shareholder list/activity and the fact that Floyd Wilson resigned (read: was fired) I suspect a sale of the company is the most likely outcome of the review though far from a certainty.

The concern for the selling bond holders appears to be a financing transaction to replace the bank line.  HK is nervous that if they outspend significantly in '19/'20, oil prices decline, and/or there are operational issues the banks might get nervous and leave them in a bind.  HK has the ability to issue $500m of secured debt ahead of the notes. While this would be bad for the notes to the extent that this issuance would prime them I'd point out that:

a) You're buying the company at an EV of ~$400m while the company would be highly accretive to acquirers at an EV of up to $1.4bln.  A lot of value would have to be destroyed before the bonds (which have equity like returns) were out of the money on an equity-like analysis (or even on a debt recovery analysis).  The company has told me they view it as extremely likely that they could quickly and without issue sell the company for an EV of ~$825-900m (I view this as important both in terms of triangulating fair value but, perhaps more importantly, as insight that there are no structural issues - like a fear that your shareholders are going to hate any deal - preventing peers from doing M&A).

b) $500m of secured notes issuance would come with $500m of cash on the balance sheet.  Duh but the important point here is that HK generates >10% corporate-level IRR's (notably excluding SG&A as an expense) down to ~$40 Oil (see below for an explanation).  Thus again, things would have to go very badly indeed for the secured notes not to pay for themselves.

I don’t think the analysis needs to be much more complicated than this but more than happy to answer any questions on cash-flow, operations etc. in the comments.

Tables below show what the ratio of the PV-10 is to the par value of the bonds at various benchmark (WTI/HH) Oil/Gas prices using the YE differentials (-$7 for Oil & -$1.50 Gas).  This excludes any value for the unproved acreage HK controls (>50,000 net acres in the Delaware with competitive EUR's/type-curves/economics).

PDP PV-10/Bonds at Par:

Total PV-10/Bonds at Par:

Note: In almost every cell in the tables above the Total PV-10 is larger than the PDP PV-10 implying PUD’s generate >10% IRR under almost all scenarios contemplated.  This excludes SG&A as an expense but is a conservative analysis as the best way I know how to adjust the PV-10 just lowers future revenue by the change in the assumed price * the # of units to be produced; this will leave the company producing some units at a cash loss (instead of shutting in production which is what they would do).

Risks:

Prolonged decline in oil prices to the $40's

Operational mis-steps (though these would presumably have to be quite large or coupled with decline in oil prices)

Typical E&P risks (geologic, macro, technological etc.)

Catalyst

Sale of the company or an asset

Execution

Possible exchange offer