Description

Issuer: Long Run Exploration

Trade Idea: Event Driven / Clean Up Trade

Potential Return: 40 - 80%

Potential Downside: <10% (implies ~3.3x run-rate EBITDA; 75 - 100% discount to relevant peer group)

Catalysts: Clean up of overhang of major shareholder position and transition to a yield based valuation which will facilitate multiple re-rating

Situational Overview:

The Company was recapitalized by current management (including Bill Andrew, former PWT Vice Chair) in September 2011, subsequent to which the Company pursued a number of initiatives including a write down of reserves, acquisition of low decline gas assets, heavy oil assets and a transformative merger with Westfire Energy to gain entry into the Viking oil play.  Sprott Resource Corp. ("SRC") facilitated the merger of Long Run and Westfire through significant positions in both entities, which ultimately resulted in a current ~28% ownership in Long Run (18% basic ownership and 10% in convertible non-voting shares).  Due to liquidity / funding issues and poor investment performance at SRC, it appears increasingly likely that SRC is looking to monetize its common share position in LRE, which at current prices is valued at ~$190 mm. 

The Company, in part due to an overhang of the SRC block (which by nature is not long term or strategic to SRC but rather an consolidation of independent poor performing investments), trades at a significant discount to its relevant peers as listed below.  This is notwithstanding the stock being up ~20% over the past 3 months due to Company telegraphing its intent to convert to a yield driven model (announced November 7, 2013).  Notwithstanding this well telegraphed transition, the stock remains at a material discount to its relevant peers on every relevant metric, owing largely it would appear to the market at large choosing to not revalue the Company without a resolution to the SRC block and an initial dividend level set below expectations.  With that being said, the Company's assumptions appear to be highly conservative with the market ignoring the statistical undervaluation on a cash flow basis, the implied 'sandbagging' of its numbers (detail below) and the FFO growth resultant from a change in production mix during 2014.

Company Overview:

PF a recently announced disposition, the Company  maintains three core assets (1) Peace River Arch (primarily Montney Oil) (2) Edmonton (primarily Redwater Viking Oil) and (3) Northern AB Gas.

Production: ~25,000 boe/d (52% oil and liquids)

Reserves: ~83 mmboe (43% oil and liquids)

Run-Rate EBITDA: ~$270 mm ($30 pre-interest corporate netbacks)

The Company's PRA assets constitutes ~40% of corporate production.  The Company's reserve engineer completed a DPIIP study earlier this year for the PRA Montney Oil asset which demonstrates an ability to double oil reserves to a total of ~30 mmbls which would constitute unbooked value of >$150 mm or 15% of current EV.  The economics of the play are solid with forecasted 12 month payouts, relatively low capital requirements ($2 mm / well) and forecasted NPVs and IRRs of $3.5 mm and >100% at forecasted pricing.  The capital efficiency in the play ($16,000 / onstream bbl) is driven by the lower targeted depth which drives lower well costs.

Valuation:

Conservatively valuing the Company against a peer group that has a higher gas weighting and similar EV but that are non-dividend payers illustrates the valuation gap the Company currently experiences.  As the Company transitions to paying a dividend, I believe the valuation will normalize to trade on an EBITDA / DACF multiple basis, inline with how the sector generally trades for companies with >25,000 boe/d.

Sandbagging Guidance:

In transitioning to a yield based model away from a growth focused entity, the Company weighed its maximum capacity to fund a dividend under a total payout ratio of 100% (capex + dividend + interest / FFO) against the success of other entities (namely Surge Energy, TSE: SGY) that set initial dividends at a lower level than required to facilitate moderate increases to the target level, buttressed with accretive acquisitions that would further increase the dividend level.  Given that, the Company appears to have (and this has been confirmed through conversations with management) to have been more conservative in setting their initial guidance in terms of capital efficiencies, etc. under the premise that outperforming would lead to yield compression / higher multiple which would imply a higher dividend level and concurrently support completion of accretive acquisitions, etc.

While that model has worked for some, LRE has made a strategic mistake in that its cost of capital did not and does not support the ability to consummate meaningful transactions that would require equity financing - to that end, I would posit that setting the dividend at the appropriate level would have narrowed the cost of capital gap thereby creating a self-reinforcing cycle of acquisitions, dividend increases, cash flow accretion and shareholder value.  I believe the Company could currently support a dividend of ~$0.50/share or 25% above its initial annualized level.  At a 7% yield, the stock would be valued at $7.15 (33% above current) and still trade at a 1 - 2 turn discount on a EBITDA multiple basis to relevant peers

Assuming $25,000 boe/d capital efficiencies (~50% higher than those implied by its core projects in PRA and Edmonton areas and a 15% discount to their initial guidance) and an initial base decline of 28% consistent with the current business, a strategy geared towards paying out 85% of post maintenance capex cash flow (based on current netbacks) would imply the ability to pay out ~$0.55 / share in annualized dividends.  Similarly production weighted entities are currently yielding an average of 6.8%.  Assuming an 8% yield, the implied valuation would be $6.62 / share or ~30% above the current quote and would further imply 4.5x EBITDA, a meaningful discount to comparable companies.  Further, the Company currently is levered at 1.4x Debt / run rate EBITDA and analysts believe the Company would be able to grow production on a per share basis at 10%.  To the extent that drives a yield level in line with comparables above, that would imply $7.80 / share or 50% above the current quote or 4.9x, again a meaningful discount to its peers given its liquidity position (>$100 mm of available liquidity) a meaningful discount to its 2P NAV and a sustainable business.

Again, based on the pro-forma capital program (55% weighted to Montney Oil) it appears the Company is being highly conservative on their capital efficiency guidance to facilitate outperformance of market expectations.

Lastly, the Company's existing guidance implies 8% FFO growth in 2014 in addition to the yield, highly attractive on a relative basis.

Catalysts: 

While its clear the Company is cheap on a statistical basis, the key catalysts to unlock the value are more market related:

• The recirculation of a meaningful portion / all of the SRC block.  There is meaningful street conjecture that this block is available and being bid by multiple I-Banks
• Initial dividend payment has acted as a re-rating catalyst for other recent transitions (see: prior transitions including TOG, SGY, etc.)
• Q4 and Q1 2014 estimate outperformance leading to increased guidance for 2014

Catalyst

• The recirculation of a meaningful portion / all of the SRC block.  There is meaningful street conjecture that this block is available and being bid by multiple I-Banks
• Initial dividend payment has acted as a re-rating catalyst for other recent transitions (see: prior transitions including TOG, SGY, etc.)
• Q4 and Q1 2014 estimate outperformance leading to increased guidance for 2014