With a sordid history and an uncertain future, it’s probably only appropriate that Quest Resources has 10-bagger potential. The near-term equity story here is a relatively simple NAV play that is being obscured by potential covenant defaults and some corporate fraud by the CEO. With the stock at $0.50 per share, I see a conservative current NAV as being over $7. Here is how I get there:

1)      The company owns mineral rights to 122k undeveloped acres in the Marcellus shale area. Most of these acres were purchased in the company’s acquisition of PetroEdge. The majority of the acreage is in West Virginia, which is a big advantage relative to the companies now drilling in New York and Pennsylvania. This is due to the more relaxed drilling laws in WV and the existing infrastructure. Recent transactions have taken place at well over $2,000 per acre for mineral rights (XTO, Dominion, etc), so I have tried to be conservative and use $1,000 per acre for a total value of $122 million

2)      The company owns 57% of the LP interest (3.2 million common units and 8.9 million subordinated units) in Quest Energy (ticker: QELP). The company collects about $21 million in annual dividends from its LP stake in QELP. Based on current market prices for QELP, this interest is worth about $70 million.

3)      The company owns 100% of the GP interest in Quest Energy. While the GP is not currently collecting override, the rapid production growth at QELP should enable this in the not too distant future. The GP of QELP gives the company about $1 million in annual dividends. It’s probably conservative to value this at 10% of the value of QELP or $12-million.

4)      The company owns 36% of the LP of Quest Midstream. The remainder is owned by private equity and the most recent transaction took place in November, 2007 at $20 per unit. The company collects about $8 million in annual dividends from its LP interest in Quest Midstream. I value the units at $10 (50% discount), for a total value to Quest Resources of $49 million.

5)      The company owns 85% of the GP interest in Quest Midstream. The company collects about $0.4 million in annual I value the GP interest here at 10% of the value of the LP or $11-million.

6)      There is $32.5 million of net debt at the Quest Resources level.

Taking the sum of #1-6 above gets you to $232 million or $7.19 per share. The market price is $0.50 ($16mm market cap, $38mm EV) yet the company collects nearly $30mm in annual dividends from its LP interests alone. Here is a spreadsheet of the NAV:

Quest Resources
NAV:
122k Acres Development Rights in Marcellus Shale					0.122
value per Acre					1000
Value of Development Rights					122
Net Debt					32.5
Quest Energy Partners, LP
Price per Share					5.82
Shares Outstanding					12.33
Market Cap					71.77
% Owned by Quest Resources					25.96%
Value of Quest Energy Partners Stake					18.63
Subordinated Units Outstanding					8.86
Value per Share					5.82
Market Cap of Subordinated Units					51.55
% Owned					100.00%
Value of Quest Energy Partners Stake					51.55
Total % Owned by Quest Resources					57%
Quest Energy Net Debt
Quest Midstream Partners last Transaction per Unit					$20.00
% Discount					50.0%
Value of Quest Midstream Unit					$10.00
Units Outstanding					13.50
Market Cap of Quest Midstream					$135.00
% Owned by Quest Resources					36%
value of Quest resources Stake					$48.60
Quest Midstream Net Debt					124
GP of QELP
Value of LP					123
% value of GP					10%
Value of GP					12.3
% Owned					100%
Value to QRCP					12.3
GP of Quest Midstream
Value of LP					135
% value of GP					10%
Value of GP					13.5
% Owned					85%
Value to QRCP					11.5
Total NAV					232.09
Shares Out					32.30
Value per Share					$7.19

While the NAV is relatively straight-forward, there are three potential problems here:

 

1)      Corporate fraud: The CEO stole $10 million from the company. This was announced on August 25^th and there has been little news since then. The company provided an operational update on October 10 and there was no new information regarding the malfeasance at the company.

2)      Covenant Problems: The company is now in violation of its covenants due to the fraud that took place. They will need to get a waiver from their banks.

3)      Capital Needs: The company is incurring unanticipated costs related to the investigation of the former CEO and the company must spend about $11-million on drilling in order to maintain the leases on about 15,000 acres of their land in the Marcellus shale area.

I think that all of these problems are solvable. The 1.5-month gap between the initial fraud reports and the last operational update strikes me as enough time for the company to identify whether or not there were a substantial number of other fraudulent activities at the company, even if they would have been unable to give a full accounting for them. I take the complete lack of any incremental information as positive. As regards the covenants, I think that the company should be able to get a waiver or, if not, there are substantial assets that could be sold, including the acreage and the controlling GP and LP interests. Lastly, as regards the company’s cash requirements, it appears that ongoing capex has been curtailed. The company should be able to farm out some of the drilling expenses in return for well interests and the dividend payment to come from the LP interests should be more than enough to fund the investigation.

 

Longer-term, I see substantial upside from even the $7 NAV based on a recovery in the price of QELP, an IPO of Quest Midstream at or above the last financing round price, and the well-level economics of the 122,000 acres of drilling land at Quest Resources.