Description

AMPLIFY/MIDSTATES PRO FORMA CO

MPO agreed to buy AMPY in an all stock deal announced on May 5^th.  AMPY holders are set to receive 0.933 MPO shares for each AMPY share owned.  The deal is structured so MPO and AMPY holders will each own 50% of the PF company which will be renamed Amplify Energy and trade under ticker AMPY

The merger has turned out to be a poorly timed ahead of large decline in oil prices in May and June. Both companies have seen huge declines in their share prices since the deal was announced in early May.  The decline is in part the result of the unwind in takeover premium in MPO shares (MPO was exploring alternatives) as well as the more general 25-50% across the board collapse in energy shares.  MPO has fallen more than 65% since the deal was announced wiping out any premium AMPY holders were expecting in an all stock deal.  This write up will focus on the pro forma combined company despite my feeling as an AMPY holder that the current deal structure offers overall poor value for long term AMPY holders.  However, the deal is necessary in order to gain the critical mass and liquidity that will eventually give its largest holders, led by Fir Tree (largest holder of both companies) an exit strategy.  Standalone I believe AMPY shares are worth more than $30 in a $60 WTI environment but at this point I believe the chances of the deal falling apart are trivial.

AMPY was written up on VIC by DD12 who did a good job describing the company’s assets so I won’t repeat his fine work.  Essentially the company’s assets remained unchanged since that initial write up. Briefly, their two most valuable assets are conventional, low decline, relatively high LOE cost oily assets ($20-$25 per BOE).  The remainder of the assets are a small acreage position in Eagle Ford that could be monetized in the near future (MUR is the operator of the acreage) and a sizable acreage position in Cotton Valley/East Texas that is not being developed further and is currently in run off.  This asset is the least interesting and at some point, may be sold.  A brief description of MPO’s assets follows:

MPO Assets

MPO is a Mississippi Lime operator that has generally posted disappointing drilling results in what is a poor basin that does not merit any further drilling unless crude is $70+ and NGL’s are at least 35% of WTI (they are now 20% as a huge glut of NGLs has emerged). The current EV is less than $200M and over $1B in capital has been invested in these assets since inception. While the well declines in run off remains to be seen, it is likely that $700M has been incinerated in the shale fiasco.  What remains is a run off of existing production that I believe is worth north of $300M although nowhere near the $500M+ PV-10 in the 10-K IMO.  The AMPY rationale for merging with MPO was basically to add a cash cow asset that will be put in run off and bolt it on to AMPY platform generating $20M in SG&A savings.  All of MPO’s staff will be let go following the deal eliminating the aforementioned SG&A.  In addition, MPO has only $60M in debt and is expected to generate FCF at the May 5^th price strip according to the recently filed proxy as follows:

The financial projections for Midstates set forth above exclude any value ascribable to undeveloped reserves due to, among other reasons, (i) Midstates' stated intention to operate in a blowdown mode in the absence of the merger, (ii) Midstates’ objective of returning cash to stockholders, and (iii) current market conditions in which no value appears to be ascribed to undeveloped or unproven assets, particularly in out-of-favor basins.

Admittedly, production declines from MPO’s recent horizontal wells (they drilled 4 last year and worked over many more) may turn out to be worse than modeled although after speaking with AMPY CEO I felt comfortable that the assumptions here are conservative and there is some modest upside. AMPY’s CEO for instance said one modest cap ex expense will be to replace the old electric stability pumps in legacy wells with new rod pumps that will reduce downtime and perhaps add an immediate 5% to production. Aside from this investment any further investment in this field is unlikely as all assets in PF AMPY will compete for capital with other internal assets as well as any external opportunities.  AMPY intends to use the MPO FCF to return capital to holders likely through share repurchases and dividends.

AMPY

As of May 3, 2019, Amplify had total debt of $265M under its revolving credit facility, with a current borrowing base of $425M. Amplify's liquidity was $179M, consisting of $21 million of cash on hand and available borrowing capacity of $158M.

AMPY launched a significant cap ex project that is expected to be complete at a cost of $43M that will allow expansion in its Wyoming asset with estimates completion at end of Q3/early Q4. FCF will jump as this one time spend rolls off (the cap ex project is expected to allow the company to bring shut in wells back on line as it will have higher capacity for its CO2 EOR recovery wells in Wyoming). 

The projections for AMPY stand alone cash flows from the proxy at May 5^th strip pricing above is as follows:

The pro forma company is expected to generate $160MM in FCF in 2H of ’19 and ’20 combined ($50M in 2H ’19).  The MPO cash flows are not adjusted for the $20M SG&A savings AMPY expects to realize.  The pro forma company combined debt load at 3/31 was $325M and cash on hand was $22M. 

Game Changing Event

On June 27^th AMPY announced they had secured the release of $90M in cash they had posted in Bankruptcy for P&A liability for its offshore CA Assets.  The company is expected to set aside $3M per year going forward to fulfill the liability (NPV of less than $25MM).  The $90MM has completely changed the profile of standalone AMPY as it now has $115M in cash, $265M in debt, and FCF of $120M in the next 18 months.  Adding MPO brings an additional $50M in FCF (excluding $20M in synergies).

Pro forma the company will have the following capitalization:

$125M in cash ($115M AMPY + est MPO Q2 FCF)

$325M in Debt

42M fully diluted shares valuing PF equity at $250M.

Pro forma 2H ’19 FCF of $50MM is expected. 

The merger and cash release sets up an extremely unique short-term opportunity 

AMPY had an active $25M share buyback pre deal that has been put on hold.  It had been buying back stock at $7-$8 per share.  The pro forma company is committed to returning FCF to holders and was likely going to launch a $25M- $50M buyback post-merger closing BEFORE the $90M P&A windfall.  I have spoken to management arguing the $90M should be a windfall for AMPY holders and be issued as a special dividend pre closing but this is unlikely as MPO has indicated it will walk away from the deal if AMPY’s board pursues a pre closing dividend. 

I believe the company will immediately launch a $50M buyback after the deal closes and possibly initiate a modest dividend to partially return some of the expected 2H ’19 and ’20 FCF.  In addition to the company buyback, the combined company will see its weighting in the Russell 2K double as its shares outstanding will double post-merger.  This should create about 2-3M shares to buy from indexes when qtr end rebalances occur. 

The combined company has hedged more than 50% of its 2020 production and current 2020 and beyond strip is $2 below early May levels.  If the synergies are anywhere near the $20M promised, the savings will allow the PF company to meet projections at WTI prices modestly below current pricing. 

What does this mean for post-closing buying demand? 

At an average of $7 per MPO (current $5.80) share, the $50M can retire 7M shares.  Coupled with price agnostic index buying of 2-3M shares, we should see 9-10M shares to buy in 60 days following the deal closing on August 2^nd.  If the company finds willing sellers for its buyback up to $7 the 9/30 pro forma capitalization should be as follows:

Cash of $90M ($125M less $50M buyback + $15M FCF)

Debt of $325M

Shares Outstanding of 35M valuing equity at $7 per share at $245M. 

Looking forward to 2020 the company will have fully levered FCF of $105M or $3 per share if it completes the buyback.  At $7 per share we have 42% FCF yield.  If we assume company uses $35M per year to amortize debt, FCF falls to $70M or $2 per share for a 28.5% yield.

Pro Forma Float and Insider Holdings

Shareholders that are part of merger voting agreements will own the following pro forma amounts:

It is my assumption that none of the above insiders would be willing to sell stock below $10 (last level of MPO Dutch tender) as they are merging to use this platform to generate synergies, and more importantly to use the platform to bolt on other low risk PDP assets.  This platform can form a sizable yield-oriented company that will see further demand from both index funds if they issue more shares for private assets as well as income funds if they institute a modest 6% dividend. 

The stated goal for insider holders Fir Tree, Brigade, and Avenue is to use the company’s public currency and management expertise to roll up low risk PDP assets.  Given the current depression in energy sector valuations, management expects to find acquisitions at PDP 12-15 that it can bolt on.  The CEO indicated to me they had capacity to initially do deals up to $200M, utilizing $75M in cash on hand and $125M in debt on their revolver which will have availability of over $225M post-closing (MPO’s higher cost revolver will be rolled into AMPY’s for a yearly interest savings of ~$1M as well).

As such in the next two months we likely will see demand of 9-10MM shares with a total available float of about ~21.5M. The qtr end rebalance index buying should be completely price insensitive.  I believe this creates a unique opportunity to see at least 50% appreciation from current levels in the next two months with much higher potential going forward as the company executes on its strategy of aggregating low/no drilling risk PDP assets under a competent manager in CEO Mariani who has managed assets for PE firms in multiple basins.

Valuation

What is the stock worth next year if they pay a $2 dividend and have made a modest accretive acquisition?  I believe a 10-12% yield is likely suggesting a $16 - $20 target.  This level of dividend would also allow for an active buyback program, as well.  This is the appropriate method of valuation in my opinion as these assets are all PDP and in blow down requiring very little incremental cap ex. EBITDA multiple comparisons to shale players with little cash flow is not the correct valuation method here. AMPY reserve life is north of 12 years and MPO has a long tail of slow decline production. Given it is mature shale firm decline rates are uncertain IMO but it is a small part of the company’s longer term value as its assets are being valued at basically FCF for the next 5 years.

A successful acquisition program will likely create significant additional value if we ascribe any value to CEO Ken Mariani’s investing and operational acumen under the watchful eye of 3 large HF holders (admittedly Fir Tree’s record in energy has been abysmal but they seem to have refocused on low/no drilling risk properties and at current prices our/their margin safety is much greater). 

RISKS

1)      Material decline in energy prices to below $50 WTI and/2.50 nat gas(below $50 is arguably unsustainable IMO as a huge majority of shale production would rapidly tail off)

2)      MPO’s shale assets in the Mississippi Lime decline much faster than management projections

3)      Future asset purchases end up destroying capital as MPO drilling has in past 2 years

4)      Further drilling in Beta field yield poor results and destroys capital

Catalyst

1) Merger closing August 2nd.  COmpany announces a $50M buyback in conjuction with closing

2) Index buying following doubling of shares outstanding at qtr end index rebalance

3) Additional accretive acquisitions for low risk PDP assets at very depressed valuations