Description

I am recommending a short position in Comstock Resources at the current price of $9.35 per share.  The borrow cost is currently very high (~80%) so I would suggest executing this via put options, or my security of choice, shorting in the money call options.

I personally am bullish on natural gas prices so I view this as an attractive pair trade against going long one of the Marcellus gas producers (my preference is AR).  If you are bearish on gas prices, I think CRK is the most attractive way to express this view. 

Recent Events

CRK stock is up 119% from its low of $4.34 on June 5^th.  Compare this to the Marcellus peer set which is down 30-40% over the same time period.  What has caused this tremendous outperformance?  The rally occurred due to Comstock’s acquisition of Covey Park from Denham Capital for $2.2 billion (mostly cash but with a little stock valued at $6.00 / share).  Denham Capital created Covey Park in 2014 and built the company through a few acquisitions and organic drilling.  The notable acquisitions were a $420mm acquisition of EP Energy’s Haynesville/Bossier assets which closed in 1Q 2016 (34k net acres and daily production of 113 mmcf/d) and a $465mm acquisition of Chesapeake’s Haynesville assets which closed in 1Q17 (41.5k net acres and daily production of 50 mmcf/d).   When Denham formed Covey Park, it provided a $300mm equity commitment and I have not read anything that would imply they increased their equity.  Covey Park had $1.1 billion of debt at the time Comstock acquired them.

With respect to the acquisition prices, I would again highlight what has happened to publicly traded natural gas producers since 2016 and 2017.  There is a laundry list of value destruction from the acquiror side in natural gas M&A but my favorite is EQT’s acquisition of Rice Energy in June 2017.  EQT had an EV of nearly $17 billion and bought RICE for $6.7 billion (in theory creating a nearly $24 billion enterprise value company).  The combined company EV today is less than $9 billion.  It used balance sheet cash and stock for $5.2 billion worth of the RICE transaction.  The combined company market cap today is now less than $3.2 billion (so the combined company market cap is only ~60% of what they paid for the RICE market cap).

The major point is that this sale to CRK was an incredible outcome for Denham Capital/Covey Park.  Denham capital received $700mm of cash, $210mm of preferred stock with a 10% coupon convertible at into common stock at $4.00/share, and 28.83mm shares of CRK common stock.  At the current stock price, this is an equity value of $1.5 billion.  They were able to earn 5x on their equity over a time period when public gas producers lost ~75%.  I give Denham Capital a lot of credit but one might want to consider that maybe CRK overpaid?

The other major reason for the explosive rally in CRK stock is due to the shares available for borrow being pulled shortly after Covey Park acquisition.  Previously borrow cost was anywhere from GC to about 5%, but borrow costs shot to over 100% in July.   

Jerry Jones

Adding fuel to the fire in the short squeeze is the fact that Dallas Cowboys owner Jerry Jones is the controlling shareholder of Comstock.  Jerry Jones first got involved with Comstock in May 2018 by contributing his oil producing properties in the Williston Basin for 88.6mm shares valued at $620mm ($7.00/share).  Comstock was a distressed gas producer at this point in time so the increase in assets without any assumption of debt was a much needed lifeline for the company (it also helped that the headline “value” Jerry Jones was receiving was stock at $7.00/share when the stock was trading below $5).  A similar short squeeze occurred after this transaction closed and its debt refinanced with the stock reaching $12 in the following months (it traded back down below $5 less than 6 months later).  This gave Jerry Jones an 84% ownership in the company at this time.

As part of the financing for the Covey Park acquisition Jerry Jones put up $475mm of cash, $175mm of it was in 10% cash pay convertible preferred stock (convertible at $4.00/share) and $300mm was in equity for 50mm shares (valued at $6.00/share).  With the Denham share issuance, this decreased Jerry’s ownership (on a non converted basis) to 75% of the company.

It is frequently touted (by both Jerry and CRK) that Jerry has invested $1.1 billion into this company but I think that is a bit misleading.  To start with the first $620mm, this was an asset contribution, not new money.  It was also Williston Basin assets, which for anyone that follows oil rigs and production knows has been a horrible place to be.  Jerry’s assets were producing 10.5 mbbls/d of oil at the time they were contributed and the company is projecting 7.5-8.5 mbbls/d of total company oil production now.  The company will spend $34mm of D&C capex on their Eagle Ford properties this year (which have nothing to do with the Williston assets Jerry contributed) and only $4.2mm to Jerry’s contributed properties.  I would guess production from Jerry’s assets is close to half what they were when Jerry contributed them. I personally think it is safe to say those assets were not worth the $620mm which they were valued.

I would also highlight that Jerry’s $175mm investment in the convertible preferreds is very different from a straight stock investment.  The preferreds convert into common at $4/share and pay a 10% cash dividend so they get all the upside that common stock gets, a senior position in the capital structure, and an attractive carry.  The $300mm he invested for the 50mm shares is the only true “risk” investment he has made in this company in my opinion.  Considering he owned so much stock due to his asset contribution (which has been a home run for him after seeing the performance of the asset), I personally believe this additional investment was more for optics to secure the value he had created from the other transactions.

I believe creating a short squeeze in this stock has always been the end game.  I think CRK will do a large secondary at a big discount to the current inflated price which will further monetize (through dilution even though Jerry will need to participate to get it done) his prior transactions.

The most recent run up in CRK’s stock price was after Jerry appeared on CNBC highlighting the great prospects of Comstock.  He continues to compare it to his acquisition of the Cowboys (https://www.youtube.com/watch?v=W7bb1NQklck) which retail investors gobble up.

Valuation

Below is CRK’s debt stack:

As highlighted previously, the preferred is even worse than debt (for shareholders) because it is high cost and very dilutive.  The current market cap (not including the prefs) is $1.75 billion but when the prefs are included, it jumps to $2.67 billion. So the current EV is $5.4 billion.

Consensus 2020 EBITDA is $775mm so CRK is trading at 7.0x EV/EBITDA.  Interest/Pfd cost will be about $230mm and Capex will be about $600mm so CRK will burn about $50mm of cash next year. 

Pro Forma 2018 SEC PV10 is $4.1 billion.  So CRK currently trades with an EV/PV10 of 1.3x.  Reserves are 5.35 Tcfe so its an EV/mcfe of reserves of $1.00. 

Pick any gas producer you like and you will see that these multiples are generally ~2x its peer set.  Since I mentioned AR in the beginning, below is how AR compares (stripping out its AM stake and not counting its AM dividends):

EV/EBITDA ($3.6 bn / $1.0 bn): 3.6x

EV/PV10 ($3.6 bn / $12.6 bn): 0.3x

EV/mcfe of reserves ($3.6 bn / 18.0 Tcfe): $0.20

There are a lot of moving pieces to AR so just looking at these multiples is not the best way to compare them but you won’t find anything like CRK in a natural gas peer set. 

A few other things to highlight.  CRK only has 32% of its current daily production hedged for 2020 at ~$2.74/mmbtu  and less than 5% of its current daily production hedged in 2021.  Pro Forma Comstock has grown production 56% in the last 12 months (from 2Q18 to 2Q19).  Like all shale production, there are very high decline rates early in the well’s life, so extremely fast production growth means extremely fast natural decline rates.  For this reason, CRK is expecting to spend $357mm in D&C capex in the second half of this year (compared to $182mm in the first half) and is not forecasting any production growth. 

I have been following CRK for a long time now and it never ceases to amaze me how they continue to stay alive.  Out of a lot of borderline crooked E&P CEOs, I think Jay Allison is one of the most corrupt/deceptive.  I know most on this site do not buy into type curve/IRR slides in company presentations but I think CRK's are some of the most egregious.  

Catalyst

Borrow returning in the stock.  Rates are already beginning to drift lower again and once investor can short this stock again, I think it returns to the $4-$5 context.  

I also don't expect Denham to hold onto their 29mm shares of stock.  I think they will begin selling next year which will be tough for the market to absorb.

I could see a secondary issuance if the stock remains north of $8 which would also be a catalyst.