Description

Meridian Resource Corp -- TMR ($5.41)

Description:

TMR is an exploration and production company with assets and ongoing exploration and development primarily in Texas and Louisiana.

TMR is a bit of a turnaround story. The company had a history (in the 1990s) of drilling large deep gas prospects and coming up with a lower-than- hoped-for hit rate. Moreover, their strategy in the late 90s was to take large net interests in the wells rather than sharing the costs with partners. Given the poor hit rate, increased debt load, as well as weaker natural gas prices toward the end of the decade, the stock fell from around $15 to the low single digits between 1997-2000.

Over the last 1-2 years, the company has shifted its strategy to shallow gas prospecting and has, I believe, stumbled on a significant discovery that is only now beginning to come to light. The find is called Biloxi Marshlands and, to be fair, was uncovered by a separate company called Manti (which is private). TMR, however, was able to move quickly to secure a significant acreage position interlacing that of Manti’s.

The success rate on the wells drilled so far has been phenomenal and the bonus has been that the wells have all been much larger than expected so far. Manti has drilled approximately 28 wells so far over the past year or so and has been successful on 22 of them. The average initial production has been 11.5mmcfe/d. These are very sizable wells. Moreover, the decline rates have not been bad. TMR estimates a decline rate of 20-30% over the first two years (though the actual rate of decline is not certain given that their have not been any wells on-line for 2 years to-date since it is a new find). TMR itself has now drilled 5 wells in the play (all successful) and the initial production results have been terrific:

Biloxi marshlands #6-1: 11.7mmcfe/d
Biloxi marshlands #6-2: 30.0mmcfe/d
Biloxi marshlands #7-1: 13.5 mmcfe/d
Biloxi marshlands #1-2: 16.1mmcfe/d
Biloxi marshlands #18-1: 10.0 mmcfe/d

Keep in mind, TMR has varying net interests in all of these wells and they have not all been put on-line at their initial test rates (for example, the #6-2 has come on-line in the 27mmcfe/d range).

TMR’s total production is the latest quarter was about 90mmcfe/d and its’ current production is about 100mmcfe/d, so with further success in this field (and as long as the decline rates do not accelerate) this will be a rapidly growing gas producer for several years to come.

The company already has identified an additional 5-7 drilling prospects on its initial seismic encompassing 43 square miles. A second seismic shot covering 187 square miles is being processed with 20 or more prospects identified. A third shot, on acreage already under company control, is planned on 270 square miles. With a minimum of 25 prospects already identified, and the possibility of at least another 25 on the final seismic shot, the potential for a substantial increase in the company’s production and cash flow exists over the next several years. Even assuming that the wells come in at an average of one-half what the initial wells have delivered to Manti and TMR, the company could easily double or triple its production over the next two years.

TMR is planning 12-14 wells in 2004. Assuming they have 10 successful wells at just 6mmcfe/d, their production would increase by about 50% in 2004. I am assuming about a 10% decline rate in the overall current production from 100mmcfe/d to 90mmcfe/d and then adding 60mmcfe/d from the new finds. TMR could continue this growth for 2005-7 as well, all the while, reducing debt and leveraging fixed costs. And, keep in mind, this analysis assumes the wells produce at about 6mmcfe/d while initial results across 27 wells (22 at Manti and 5 at TMR) suggest the potential for much higher average production rates.


What’s it worth? Third Quarter run-rate discretionary cash flow (EBITDA) is about $122M. (As an aside, the gas-equivalent price in 3Q was $4.71). Below is the enterprise value:

Enterprise Value:
LTD 143M
Convert 20M
Pref 73M
Eq Value: 322M
Cash: 17M
Total: $541M

So, on run-rate, the stock is trading at approximately 4.4x EV/EBITDA. The beauty of a fast-growing E&P company is what happens when production ramps, as I expect with TMR. Holding commodity prices stable with 3Q levels of $4.71/mmcfe, the production increase I have outlined above would yield run-rate EBITDA of about $180M exiting 2004 and about $150M in EBITDA for 2004. Moreover, the company would be able to pay down roughly $60m in debt during 2004 as well:

2004 EBITDA $150M
Capex Plan: $65M
Interest Costs $8M
Prefered div: $7M
Cash taxes $10M
Net available for debt reduction: $60M

Under this scenario, the stock is priced at just 2.7x run-rate EBITDA one year forward and 3.2x 2004 EBITDA. Again, this assumes commodity prices of $4.71/mmcfe which is well below current and forward pricing and assumes success in the Biloxi marshlands play which is well below to-date average results.

Many small and mid-cap E&P companies trade at about 5-6x forward EBITDA. Were TMR to reach just 5x EBITDA on 2004 EBITDA under what I believe is a conservative forecast for the Biloxi program, the stock would reach about $10.



Here’s the analysis:

150m*5=$750M TEV
year-end debt=$83M
covert= $20M
pref=73M
cash= $17M
equity value=$591M
implied price per share= $9.85


In short, one can come up with a number of different scenarios involving success rates and the size of each well, but given that this is a relatively shallow gas play with already demonstrated high success rates across 30+ wells, the upside far outweighs the downside here. Moreover, given that this is a multi-year play and there is a good chance that the wells come in even larger than is posited in this case, there is a strong possibility for an above-average multiple on the stock (due to its higher than average growth rates) and higher EBITDA than I have outlined. Under this optimistic case, the stock would trade well into double digits over the next 1-2 years.


I am not suggesting this stock has no downside and for that reason it may not be for everyone, but I do believe that the reward far outweighs the risk and, more importantly, that a probability weighting on the possible outcomes suggests: a very low probability of significant downside, a low/very low probability of small downside, a very good chance for modest/moderate/good upside and good chance for very significant upside.


Risks/negatives:

The main risk is poor drilling results
Other risks:
Commodity prices

Catalyst

Catalyst:
The main catalyst will be the forthcoming drilling results especially the 2004 gas drilling program at Biloxi Marshlands.

Other catalysts:
1) Commodity prices (though, obviously, this could cut either way)
2) Increased institutional interest now that the stock has crossed $5/share
3) Additional research coverage. TMR has only one or two third tier analysts covering the company now. Given the Biloxi Marshland find, along with good liquidity in the stock, I would expect additional coverage over the next year or so.