Description

Long TMR – The Meridian Resources

Company description – from an online resource:

The Meridian Resource Corporation engages in the exploration for, acquisition, development, and production of oil and natural gas reserves. It principally operates on the onshore oil and gas regions in south Louisiana, the Texas Gulf Coast, and offshore in the Gulf of Mexico. As of December 31, 2003, the company’s proved reserves were approximately 146 billion cubic feet of natural gas equivalent. It had interests in leases and options to lease acreage in approximately 280,000 gross acres. The company also had interest in 31 oil wells and 60 natural gas wells, as of the same date. Meridian Resource was initially organized in 1985 as a master limited partnership and was converted into a Texas corporation in 1990. The company is headquartered in Houston, Texas.

Thesis

TMR was written up by otto695 last December. I suggest you go back and read about it there and compare it to our discussion. Today, TMR is an interesting opportunity in that it is “dog-ass” cheap – to quote a fellow manager. In the immediate future, however, I view it as an event-driven opportunity in that the company recently missed numbers due to poor drilling results and now has to come back to the street and announce some successful wells. When they do this and provide further guidance, the stock could move significantly. Right now, Wall Street analysts are using assumptions that have near zero reflection of what the company can earn should they drill according to plan.

The key driver of profits going forward will come from the Biloxi region, where the company is currently drilling with two rigs going to three rigs in January – up from the 1 to 2 rigs of the recent past. This is all shallow drilling for natural gas in an area that includes 450 square miles on which they have proprietary 3D seismic data. The primary drilling area within Biloxi is the Cris-I Sands region. Last quarter, they went outside of this area and drilled in some deep, lower probability areas and failed and thus blew the quarter. They made it very clear to the street that they had gone back to the Cris-I Sands area and that history has shown that drilling in that area had a high hit-rate and a high output per well. Further, they now have 2 rigs going in the area – up from 1 just a few months back. The company has every reason to make a positive announcement as soon as one or two wells are successful and flowing. Based on (1) reviewing their web site – which has up to date information on drilling, (2) discussions with an analyst as well as (3) recent talks with management, we think they will make a material announcement before the end of the year.

In the past year, the stock has moved between roughly $5 and $9. The fallout from the latest quarterly report sent many investors running for the exits. I think this has provided a great entry point with a decent margin of safety for new investors.


Management quality

Many investors have been burned by this company and current sentiment on the street is still negative. Management has promised certain things and under-delivered – thus the investor skepticism. We have repeatedly heard analysts at buy and sell-side firms refer to them as B or C management. However, their track record has been one where they have always met or exceeded production from previous years on a consistent basis. They have clearly made some mistakes in trying to manage street expectations, but that does not make them bad operators. The jury remains out. As the mere concept of drilling or mining at a natural resources company makes for inconsistent returns, we always cut some slack and require a big margin of before investing.

To investors’ advantage, management remains very accessible and open to talking. Their focus on relatively low-risk areas is not a bad one and they have been aggressive in buying up seemingly good assets – land, drilling rights, etc.. How shareholder friendly they are remains to be seen but they have reduced their debt levels from $239MM to $79MM in the past seven quarters. We think they have made some mistakes and are learning from them. I believe management is capable and fairly honest but want to note that there are concerns due to past inconsistent performance.


Asset and Production Discussion

Until the past few years, the company drilled primarily in Texas. Now, the primary drilling and revenue growth will come from Natural Gas drilling in the Biloxi region. Daily production is up to 105 mmcfe from 62.7 mmcfe at the beginning of 2003. The bulk of this growth has come from drilling in the Biloxi region.

In Biloxi (Louisiana), the company has about 540 square miles of 3D seismic data – of which 450 is proprietary. We endeavor below to show you what can be earned from that. What we do know about the Biloxi region prospects is the following:

- They have developed 90 solid leads – a number which should go up
- To date, they have found gas in 17 out of 24 drills – or a 70% success rate. This includes many lower probability / deeper wells. The Cris-I region has been closer to a 90% hit rate
- They have had 1 or 2 rigs going during this period. Now they have 2 rigs going and will have another one coming on in January
- Production was zero there in March of 2003 and is now 78.8mmcfe/day gross – 48.8 net (this is as per the presentation dated December 1, 2004 – management has told us that production in Biloxi is now about 50 net mmcfe/day – our model uses 43mmcfe which is about a month old and thus conservative)
- Current infrastructure can handle 180mmcfe per day – but will require more capex for additional pipelines as the company moves further outside of the current pipeline system

The company has now bought or has drilling rights to most of the land in which they will drill. This enables them to lower capex by about 30% and shift it to production vs. big up-front costs for land, seismic data, etc. Capex has kept free cash flow low – but I give companies credit for growth capex – if they have a good history of earning power from their investment decisions. Initial costs to date on the Biloxi region have been $124mm and total cash flow has already been $100mm on a net basis to the company. Evidently, there is a rapid payoff – estimated at around 3 to 6 months depending on the well.

Assumptions for reserve estimates – as per the company
o 5.97 gas
o $32.23 oil

Reserves – 2003 Year End Reserves:
- Proved developed and producing are 69 bcfe with a net present value of $284mm and represent 47% of reserves.
- Proved developed and non-producing are 44 bcfe with a NPV of $123mm and represent 30% of reserves
- Proved undeveloped are 33 bcfe with an NPV of $100mm and represent 23% of the reserves

New Biloxi conservative drilling assumptions are as follows:

- # of wells drilled per month = 2 (despite there being 3 rigs going)
- Success rate = 70%
- # of successful wells/month = 1.4 (vs. the 2+ that would come online if they have 3 rigs going)
- Average mmcfe / day per well = 7,000 (vs. company range of 8-10). We modeled with 7,000
- Decline per well per month for first year = 2% - very conservative
- Decline per well per month for second year = 8% - extremely conservative
- Revenue interest per well = 65%
- Total new wells drilled by end of 2 years = 33.6 = 24 times 1.4 wells per month
- Net daily production to the company per day by end of 2006 will be greater than 100 mmcfe

Production across the company: So far, we have ignored production of oil as well as current production outside of the Biloxi region. Currently, that (outside) production is at 47 mmcfe per day and holding steady. It has ranged as high as 60mmcfe. We assume a 15% depletion rate per year – as per the company’s guidance. Current production in Biloxi will materially fall off starting in the second half of 2005 – falling off from the current 43 mmcfe down to roughly 15 mmcfe/day of that by the end of 2006.

New production in Biloxi will be materially higher than what every analyst is putting out – reaching as high as 106mmcfe by the end of 2006 – and that assumes a reasonable falloff in production.


What it can earn:

In the past 7 quarters, discretionary cash flow has grown from $20.6mm to $43.7mm, while total debt has gone down from $235mm to $79mm. Current debt to book is now 19% - down from 56%.

Our model shows that with $6 gas and $32 oil (very low) over the next two years, the company will have:

($ in 000)
2005 revenues: $267,259
2005 expenses: $174,001
2005 after tax NI: $55,278 or $0.61 per share
2005 EBITDA: $213,396
2005 DD&A: $130,138
2005 Capex: $120,000
2005 Deferred Taxes $23,566
2005 total free cash flow: $89,030
2005 FCF per share: $0.96

2006 revenues: $326,219
2006 expenses: $207,365
2006 after tax NI: $74,023 or $0.80 per share
2006 EBITDA: $267,737
2006 DD&A: $158,883
2006 Capex: $100,000
2006 Deferred Taxes $30,451
2006 total free cash flow: $163,405
2006 FCF per share: $1.76 per share

We have been extremely conservative in these numbers. To reiterate: We have given them credit for:
- drilling two wells per month in Biloxi, not three – despite three rigs going
- having 7mmcfe per well vs. the 8-10 range
- depleting the wells much faster than historical performance has been
- depleting the current Biloxi wells much faster than current company forecasts

At yesterday’s closing price of $6.06, the company is trading at 6.3X 2005 and 3.5X 2006 FCF, respectively.


Current Capital Structure, Valuation, etc. – Trailing Twelve Months or Current:
Total Revenues 188.6
Shares Outstanding: 79.2 mm
Market Capitalization 484.0 mm
TEV/Total Revenue 3.0x
EBITDA 155.5 mm
Total Enterprise Value 567.7 mm
TEV/EBITDA 3.7x
EBIT 53.1 mm
Cash & ST Invst. 28.4 mm
P/Diluted EPS before Extra 21.0x
Net Income 26.3 mm
Total Debt 80.6
Price/Tang BV 1.6x
Capital Expenditure (116.3)
Total Assets 488.1
Total Debt/EBITDA 0.5x

Risks

The key risks to this story are the following
- Drilling in the Biloxi region could have low yields – both in finding working wells as well as the capacity that each one yields
- Drilling in other areas could fail
- Price of natural gas could come in from its current high figures
- Current focus on Biloxi may be to the detriment of production outside of it – thus that stable production figure may decrease.
- Bad weather- hurricanes, etc.
- Water flooding of wells – slows production dramatically
- Permitting – if the state cracks down, they will have a slower drilling pace

Catalyst

- New drilling success in the Biloxi region. We view this as quite high. They are near completion on three wells – which can be seen on their web site
- Investors wake up to the fact that the company went after deep wells outside their sweet spot in the Cris-I Sands region.
- The company must also show “religion” in sticking to drilling in the higher output areas such as the Cris-I Sands region. After a period of 3 to 6 months of success with new wells, credit for their reserves and cash flow should increase.