Description

A formatted version with tables and pictures is available at https://dl.dropboxusercontent.com/u/36899760/Forest%20Oil%20%28FST%29%20VIC%20Writeup.pdf

Forest Oil (FST) is a misunderstood and underfollowed special situation that offers a highly asymmetric reward-to-risk opportunity at the current price. Having grossly underperformed on an absolute and relative basis over the last several years, FST has been all but abandoned by investors, which helps explain why the market has failed to fully recognize the value being created by a transformative merger. I have high conviction that the merger will close in the next few months and if so, I believe there is a very low probability of permanent capital impairment and a high probability of significant upside potential from the current price level. In addition, several identifiable catalysts exist to close the valuation gap between the current price and estimated intrinsic value.

Forest Oil announced a merger with the privately held Sabine Oil & Gas on May 6^th, 2014. This merger creates value for both parties. Forest improves their balance sheet, gets a proven management team and retains upside participation in the combined entity. Sabine gains a public stock listing, acquires additional scale in production and reserves at a discount to private market value and their management team remains in control of the combined entity. In addition, Sabine is backed by First Reserve, a notable private equity firm focused on the energy industry, which will ultimately be able to liquidate or distribute their holdings in a publicly traded security.

Legacy Forest Oil is an asset-rich domestic exploration and production company with a weak balance sheet. Over the last few years, it has been divesting assets to fund its drilling program while managing leverage. FST equity has dramatically underperformed on both an absolute and relative basis with the stock price falling 94% since the beginning of 2011. Forest’s production and reserves are heavily weighted towards natural gas (roughly 70%) with assets in Ark-La-Tex (gas), Eagle Ford (oil) and the Permian Basin (oil). Given capital constraints, management has focused on reducing the cost per well. Forest’s high indebtedness, large drilling program (capex) and recently weak drilling results prompted it to search for a partner.

First Reserve and a management team from Devon Energy founded Sabine Oil & Gas in 2007. Sabine’s production and reserves are also heavily weighted towards natural gas (roughly 70%) with assets in East Texas (gas), Eagle Ford (oil) and Granite Wash (oil). Sabine’s management has demonstrated very effective drilling and completion results which is partially reflected by its strong production growth of 38% from 2008-2014E. Sabine and First Reserve were looking to obtain a public listing for capital access for the operating business and sponsor liquidity.

There are three primary reasons why I believe that FST is being grossly undervalued by the market. The first bias is size. FST is a sub-$5 stock, trading at $2.20/share with a market capitalization of $262MM. This greatly limits institutional interest. In addition, there is no easy arbitrage opportunity to narrow the deal spread as Sabine is a private entity – eliminating another set of investors. The second bias is complexity. Because Sabine is private, investors cannot simply take a quoted price for Sabine to value the consideration being offered in the deal. Examining the fundamentals of privately-traded Sabine is a necessary condition to valuing the combined company – eliminating investors not willing to perform such a task. The final bias is disgust. FST has chronically disappointed investors over several years. Who is still watching and willing to invest?

The deal mechanics are straightforward and point to potential catalysts in shaping how the market will view the combined entity.

Immediately prior to the deal, Forest will reverse split 1:10, leaving roughly 12MM shares outstanding and a stock price of $22 (assuming current pricing of $2.20 pre-split). Sabine unitholders will be issued roughly 33MM shares in exchange for their interests, leaving total shares of 45MM, which at an implied current value of $22/share equates to a $1.0B market capitalization. Forest shareholders retain a 26.5% stake in the combined entity while Sabine unitholders will have a 73.5% interest. The $22 price and $1.0B market cap alone will greatly expand the pool of potential investors. In addition, the combined entity will be named Sabine Oil & Gas and trade under the ticker “SABO”. Investor disgust associated with the legacy Forest Oil brand will be disassociated from the going-forward entity. 

Net debt for the combined entity will be $2.2B, leaving an enterprise value of $3.2B. The deal is expected to close in late September/early October 2014. Financing commitments are already in place and regulatory approvals are not expected to be a barrier to closing. The deal will need approval from two-thirds of voting FST shareholders in a special election. I assign a high probability of success to this vote as FST was extensively shopped without receiving other offers, the stock is trading well above the $1.79 level it was at just prior to the deal announcement and the deal allows FST investors to participate in the upside of the combined entity.

One of the attractive features that led Sabine to acquire Forest is the complementary asset footprints of the two firms. The combined entity will have significant scale in East Texas shale gas plays in the Haynesville and Cotton Valley with 207K net acres of land and 178Mmcfe/d of production (81% gas) as well as increased scale in the Eagle Ford liquids play with 64.5K net acres of land and 74Mmcfe/d of production (31% gas). On a combined basis, the firm will have 1.5Tcfe of proved reserves (71% gas), 345 Mmcfe/d of 2014E production (65% gas) and 424K net acres of land.

Sabine has stated that they have sufficient liquidity through 2015 and have committed to not issue equity until 2016 at the earliest, reducing dilution risk. In addition, they are committed to deleveraging the balance sheet from 4.6x pro forma Net Debt/EBITDA to 3.3x through divestitures and production growth. The combined entity has several assets including Forest’s Permian acreage (which is non-producing) and Sabine’s Granite Wash acreage (which is producing oil at high IRRs, but may be more attractive to sell rather than to invest in the drilling program necessary to fully exploit the play over time). Asset sales such as these could delever the balance sheet and reduce future capital expenditures with little impact to production and operating cash flow.

Following the close of the transaction, Sabine will likely take advantage of its increased scale and credit profile to refinance its existing debt at more favorable rates. In addition, starting in 2015, the combined company should be able to discharge 2/3 of Forest’s SG&A expenses ($29MM of savings). There is high optionality starting in 2015 if the combined company is able to combine Sabine’s high returns on drilling and completion activities with Forest’s focus on D&C cost containment to drive expanded returns across the entire asset portfolio – particularly if they can improve returns on legacy Forest reserves.

Valuation 

To establish a base intrinsic value, let’s first examine the net asset value (NAV) of the asset portfolio as if no future investments will be made. We consider three primary assets: flowing production on proved developed reserves, proved undeveloped reserves and unproved undeveloped acreage. Using Q113 production, we get a NAV range of $3.01 - $7.36 with a midpoint of $5.19 (all prices shown are pre-split to compare with the current price of FST). If we use 2014E production, the NAV range rises to $3.50 - $8.09 with a midpoint of $5.80. Notably, the low end of the NAV range which views the company in runoff of the current portfolio rather than as a going concern is 37% - 59% above the current quote of $2.20 – illustrating the limited downside exposure that gives me high conviction in the asymmetric reward-to-risk profile of this security.

Viewed against comparable companies such as Comstock Resources (CRK) and Exco Resources (XCO) – which are both gas-concentrated firms operating in the same areas in East Texas (gas) and the Eagle Ford (oil) – the combined company looks significantly undervalued at the current price. Examining trading multiples for EV/Proved Reserves, EV/Proved Developed Reserves and EV/PV-10, reveal potential upside to $4.39 - $5.90 or 100% - 168% above the current quote. Note that this does not take into account production growth or any expectations for increasing returns on the asset portfolio.

2014 Estimated production growth should drive EBITDA growth which supports a re-rating of the equity of the combined entity. 2014E production of 345 Mmcfe/d should drive revenues of $795MM (at $4 gas/$90 oil) to $899MM at current energy strip prices, which will drive EBITDA to $556MM - $660MM, respectively. Applying a conservative 6.5x EV/EBITDA multiple yields equity prices of $4.08 - $5.58 – 86% - 154% above the current quote.

I am not establishing 2015 estimates at this time, but the combined drivers of continued production growth, reduced interest and SG&A expenses, reduced leverage through divestitures and a rationalization of which will be a combined $800MM - $825MM 2014 capex budget should combine to provide strong EBITDA growth in 2015. Increased EBITDA paired with an improving balance sheet should allow for continued upside. Additional upside could be driven by improved results on well performance and cost.

The primary risks relate to the deal closing and energy prices. On June 16^th, a financing rumor roiled FST stock taking it from $2.47 to $1.97. On June 17^th Sabine issued a statement that all financing commitments are in place and the stock has partially rebounded. This further illustrates the inefficiency and biases that surround this unloved and overlooked stock. I believe that this deal is firmly in both parties’ best interests and that it will close on time. Energy prices are a longer term risk. Both Sabine and Forest have hedged some portion of their production, but a significant decline in energy prices – particularly natural gas would adversely impact results. Of course, energy price risk can be hedged through a variety of means.

The potential for capital impairment exists in the unlikely event that the deal does not close. FST traded for $1.79 prior to announcement and had traded as low as $1.55 following disappointing Q1 results. I would expect the shares to trade in roughly this range if the deal fell apart, representing a -19% to -30% downside, but with an estimated probability of only 5%.

If the deal closes, the NAV values support a rerating to at least $3.00/share – representing 36% upside, with 20% estimated probability. Comparable trading valuations support a re-rating to $4.00 - $5.00 by year-end 2014/early 2015 – representing 82% - 127% upside with an estimated probability of 50%. Long term catalysts could result in substantial cash flow growth in 2015, which combined with an improving balance sheet, could deliver prices beyond $6.00, representing 173%+ upside with a probability of 25%.

This highly asymmetric reward-to-risk profile of potential outcomes combined with an understanding of the identifiable structural reasons likely responsible for the current mispricing and the numerous catalysts that should result in the re-rating of the equity in both the near and longer term combine to make Forest Oil a high conviction purchase at current prices.

Catalyst