The Canadian oil patch continues to appear cheap with a number of companies trading well below their indicative fair value. One company that stands out is troubled intermediate E&P company Lightstream Resources (OTCPK:LSTMF). The market has taken a spectacular dislike to the company because of its high degree of leverage, seeing its share price plunge 52% over the last year.
This significant drop in its share price coupled with its high quality assets now sees a number of analysts claiming that it offers considerable upside potential and could triple in value. While I believe this to be overly optimistic, it is clear that the company is heavily undervalued by the market and on the basis of its existing assets offers investors potential upside in excess of 40%.
Investment case summary
Over the last year Lightstream's share price has plunged by over 50% with investors growing increasingly concerned by the company's high level of leverage. But the final nail in the coffin was the company's late November announcement that it would slash its dividend by 50%, cut capital expenditure and sell non-core assets as a means of reducing its debt.
There are a number of question marks surrounding this plan. But regardless of whether it can be successfully executed, Lightstream is undervalued with its net asset valuation (NAV), indicating that it is trading at a discount of 49% to its indicative fair value per share.
This disconnect between the value of its assets and its profitability highlights the upside potential that is available to investors. There are a range of catalysts that will allow Lightstream to realize this upside potential including:
- Successful assets sales allowing it to pay down a significant portion of its debt.
- Higher oil prices which will see Lightstream receive a higher realized price per BOE and generate higher revenues.
- Narrowing price differentials between Canadian crude and WTI further increasing Lightstream's average realized price per BOE.
- Ongoing cost controls and focused approach to capital expenditure thus reducing operational costs, improving cash flow and capital efficiencies.
- Slashing its dividend by 50% to Canadian 4 cents per share generating CAD $40 million in cash savings annually.
- High quality exploration and development assets with considerable potential. These assets are located in the relatively low risk jurisdiction of Canada reducing the political, economic and currency risk for investors.
When all of these factors are considered in conjunction with a NAV indicating Lightstream's indicative fair value per share is 49% higher than its current market price, it is clear there is considerable upside potential for investors.
Company profile and background
Lightstream Resources is a Canadian domiciled independent oil and gas exploration and production junior that has a more liquid listing on the Toronto Stock Exchange (LTS.TO). The company's key assets are its non conventional Cardium acreage in Alberta and its Bakken acreage in Saskatchewan along with conventional light oil opportunities in British Colombia as illustrated by the map below.
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Source: Lightstream Resources Corporate Presentation November 2013.
These assets offer considerable opportunity for Lightstream and have seen it build a solid portfolio of oil and gas reserves.
Holds significant oil and gas reserves
Lightstream is endowed with considerable oil and gas reserves for a small-cap junior E&P company, with proved reserves (1P) of 131 MMBOE and proved and probable reserves (2P) of 207 MMBOE. Even more importantly, over the last 4 years the company has been able to consistently grow its reserves, with 1P reserves having increased 47% and 2P reserves up by 44% as illustrated below.
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Source: Lightstream Resources Annual Financial Filings and Operational Updates.
This solid increase in reserves gives Lightstream an impressive reserve replacement rate of 229% for the full year 2012. This impressive growth in reserves was achieved through a combination of acquisition, development of probable reserves and significant exploration success. Boding well for the continued growth of Lightstream's reserves and its net asset value.
Investors should be aware that with Lightstream announcing at the end of November 2013 that 2014 capex is to be cut by 25% from 2013 levels, further reserve growth will remain flat over the short term. Although I don't believe that this will impact the solid reserve replacement rate with exploration and development funding being focused on drilling activities.
Lightstream's reserves also compare favorably to other independent E&P peers operating in North America including Whitecap Resources (OTC:SPGYF), Crescent Point Energy (OTCPK:CSCTF), Aurora Oil & Gas (OTC:AAGLF) and Whiting Petroleum (WLL) as the chart shows.
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Source data: Lightstream Resources, Whitecap Resources, Crescent Point Energy, Aurora Oil & Gas and Whiting Petroleum Reserves Reports, Operational Updates and Annual Financial Filings.
Even more importantly the majority of Lightstream's reserves are composed of light and medium oil, which is 76% of its total reserves as the chart below illustrates.
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Source data: Lightstream Resources, Whitecap Resources, Crescent Point Energy, Aurora Oil & Gas and Whiting Petroleum Reserves Reports, Operational Updates and Annual Financial Filings.
This is superior to many of its peers like Whitecap and Aurora which have a greater portion of their reserves composed of lower value non-gas liquids and natural gas. As such boding well for Lightstream's profitability with Canadian light crude trading at a far lower discount to WTI than NGLs and Canadian heavy crude.
Financial performance continues to improve
Despite being a small-cap E&P company Lightstream continues to deliver a solid financial performance. For the last 5 consecutive quarters the company's revenue has grown along with its gross profit and EBITDA as the chart below illustrates.
Source: Lightstream Resources Quarterly Financial Filings.
The company reported a healthy 5% QoQ and 39% YoY increase in revenue for the third quarter 2013 to $270 million. It also reported that net income had quadrupled QoQ and doubled YoY to $49 million. The key drivers of this solid financial performance were higher production and average realized oil prices during the period coupled with narrowing price differentials.
But while Lightstream continues to report a solid EBITDA margin, which for the third quarter 2013 was 74%, the impact of its high debt, capex and dividend payments is apparent. The company has consistently reported a negative operating profit margin for the last 5 quarters indicating Lightstream is struggling to pay for its fixed costs including its debt. This indicates that it is imperative for Lightstream to reduce its fixed costs and boost margins.
Lightstream has already announced significant changes in its capital plan that will see a reduction in fixed costs and a significant reduction in debt. As this plan gains traction its OPM will continue to improve. However, the turnaround strategy may also have a negative short-term impact on revenues and profitability, with less capex seeing lower production growth.
Lightstream's impressive third quarter 2013 EBITDA margin of 74% is superior to many of its North American peers as the chart below illustrates.
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Source data: Company 3Q12 to 3Q13 Financial Filings.
As such indicating that Lightstream's operational profitability is strong and it is the ongoing cash flow issues being created by its debt burden, capex and what was a high and unsustainable dividend payment that was affecting profitability. Again emphasizing as the turnaround strategy gains traction the company should be able to deliver improved value for share holders.
Balance sheet is heavily leveraged
The key driver of Lightstream's problems is its heavily levered balance sheet coupled with having negative free cash flow for the last 4 years. While its debt to equity ratio of 0.6 appears relatively low, Lightstream's debt totaling $2 billion is around 3.3 times its cash flow and almost 3 times its EBITDA.
Both of which indicate that Lightstream may have difficulty servicing its debt in an appropriate manner placing further pressure on its cash flow.
But these ratios are commensurate to its peers as the chart below shows, because oil exploration and production is a capital intensive activity that requires significant funding.
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It is clear that Lightstream needs to reduce its degree of leverage particularly as portion of cash flow and EBITDA. And with its recently introduced turnaround strategy this will occur.
Turnaround strategy set to restore the balance sheet
It could be argued that Lightstream's recently announced turnaround strategy is too little too late, but with the company clearly in possession of a solid portfolio of quality assets, it will have a positive impact as it gains traction.
The rapid growth of Lightstream's debt has placed considerable pressure on the company with interest expense alone having grown 11% YoY, to just under $36 million. This fixed expense along with others and an annual capex budget of $715 million and dividend payments of $188 million left Lightstream with a significant cash shortfall.
As such leaving Lightstream free cash flow negative for the past 4 consecutive years and bringing into question the sustainability of its current operations. This has spooked investors who have continued to drive down the company's share price. But in November 2013 management announced a comprehensive turnaround strategy aimed at reducing debt to more manageable levels.
The key plank of this strategy is to reduce debt to a manageable 2 times cash flow by 2015. Based on current cash flows this would require Lightstream to pay down around $700 million of its existing debt.
To achieve this management has flagged the completion of asset sales totaling $600 million by 2015 coupled with a significant reduction in capex in conjunction, as well as slashing the dividend payment by 50%. The capex reduction alone will save around 25% from projected 2013 levels, seeing Lightstream generate considerable cost savings of around $200 million. The dividend cut will also allow for around $40 million in annual cash savings.
Clearly with the completion of the asset sales and these measures in place management will comfortably meet the target of raising sufficient cash to pay down $700 million in debt. While I believe that the plan will be successful over the medium term, there are a number of risks associated with this plan.
Strategic plan risks
Investors should be aware that there are a number of risks associated with the company's strategic plan with a number of red flags regarding its implementation and success. Key among these red flags are:
- The current market for oil and gas assets is saturated with a range of assets for sale. This is because a number of companies have found themselves in similar positions to Lightstream and are seeking to divest themselves of poor quality and non-core assets. This has made it a buyers' market meaning that Lightstream may be unable to dispose of its non-core assets in an orderly manner and realize the full value of those assets.
- The significant reduction in capex for exploration and development activities will affect the Lightstream's production and reserves growth rate. While this won't affect the value of the company's existing 1P and 2P reserves it will certainly affect operational cash flow.
Despite these red flags, Lightstream management have advised that production will remain relatively flat for the remainder of 2013 and into early 2014. As a result forecasting 2014 average daily production of 45,000 to 47,000 BOE.
While this may be the case, these risks will certainly have an impact on the company for the short term including:
- Flat production growth through 2014 and 2015, which will see operating cash flow remain flat.
- Declining reserve growth, which will more than likely see Lightstream's reserve replacement rate decline and flat reserve growth.
- The sale of non-core assets at fire sale or lower than expected prices.
However, I believe the likelihood and impact of these risks is minimal at this time.
Production is declining
Another worrying aspect is that Lightstream's production has declined for the last 4 consecutive quarters with it down by 2% QoQ 45 MBOE daily, as the chart below illustrates.
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Source data: Lightstream 3Q12 to 3Q13 Management Discussion and Analysis.
But this still represents a 15% YoY increase and the YoY increase can be attributed to significantly higher production from Lightstream's Cardium and Alberta/British Colombia business unit.
Cardium production grew by 40% YoY to 20.6 MBOE daily with Lightstream bringing 8 new wells online during the quarter. Whereas for its Alberta/British Colombia business unit production jumped 46% YoY to 2.6 MBOE daily with 4 new wells being brought online during the quarter.
Lightstream has worked hard to continue developing its asset base and boost the maturity of those assets so as to grow production. But with the forecast production in capex it is expected that production will remain flat, which is particularly poor timing with WTI now trading at well over $95 per barrel.
As such I would expect to see revenue and cash flow from production remain relatively flat. It is also likely that such a significant cut in capex will continue to affect production growth through 2015 and 2016.
Like its North American peers Lightstream saw the average realized price per barrel that it was able to obtain during the third quarter 2013 increase markedly because of higher oil prices. For that period its average realized price per barrel shot up 6% QoQ and 19% YoY to $79.36 as the chart below illustrates.
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Source data: Aurora Oil & Gas 3Q12 to 3Q13 Management Discussion and Analysis.
With WTI continuing to trade at over $90 a barrel and the price differential between Lightstream's light crude continuing to close against WTI I am expecting the company to maintain a high average realized price per barrel. The higher price can also be attributed to growing demand for Canadian crude as the Canadian dollar softens against the U.S. dollar. While increased takeaway capacity from Western Canada has also made Canadian light crude more attractive.
Lightstream's average realized price also compares favorably to its peers operating in North America - despite its light crude trading at a discount to WTI - as shown by the chart below.
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Source data: Lightstream Resources, Whitecap Resources, Crescent Point Energy, Aurora Oil & Gas and Whiting Petroleum 3Q12 to 3Q13 Financial Filings.
This can be principally attributed to the large portion of the company's production that is composed of higher value light oil particularly in comparison to companies like Aurora and Whitecap resources.
Consistently maintains a respectable netback
A pleasing aspect of Lightstream's performance is the company's ability to continue maintain a very respectable netback, which for the third quarter 2013 shot up by 9% QoQ and 21% YoY to $54.75, as the chart below illustrates.
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Source data: Lightstream Resources 3Q12 to 3Q13 Financial Filings.
The significant spike in Lightstream's netbacks for the third quarter of 2013 can be primarily attributed to a higher price per BOE for WTI and narrower differentials. Another factor was that despite overall transportation expenses increasing because of higher production, they fell by on a BOE basis by 11% YoY.
To a degree this was offset by higher royalties and increased production expenses. Royalties per BOE increased by 14% while production expenses per BOE jumped 7% YoY.
Lightstream's netback per barrel compares favorably with the industry average for North American oil explorers and producers, which is typically around $40 to $45 per barrel. It also compares favorably to a number of its peers as shown by the chart below.
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Source data: Lightstream Resources, Whitecap Resources, Crescent Point Energy, Aurora Oil & Gas and Whiting Petroleum 3Q12 to 3Q13 Financial Filings.
There are also signs that Lightstream's netback per BOE will remain high supported by high oil prices and narrower differentials.
Exploration and development program holds considerable potential
Lightstream's exploration and development program is focused on making initial capital investments in light oil resource plays that have the potential to generate rapid near-term production and cash flow growth. It then focuses on developing those assets and maturing the production base to generate growing free cash flow.
Currently the key assets Lightstream is focused on developing are its acreages in the Bakken and the Cardium, while seeking to bring new assets on line as capex and other resources allow. The company's asset development strategy is shown by the chart below.
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Source: Lightstream Resources Corporate Presentation November 2013.
Overall Lightstream has an outstanding drilling success rate which for the third quarter 2013 was 100% and 98% for the same period in 2012 as the chart below illustrates.
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Source: Lightstream Resources 3Q13 MD&A.
But with Lightstream curtailing its 2014 capex to be down by 25% in comparison to 2013, with the main focus on drillings and completions it will be unable to continue exploration and development at the same intensity.
Crude prices continue to strengthen
The outlook for crude continues to improve with WTI now trading at around $97 a barrel at the time of writing. I also expect higher crude prices to be sustained through 2014 boosting profitability for oil and gas E&P companies.
This is because the short-term outlook for crude prices is positive with WTI futures set for delivery in January 2014 priced at $97.90 per barrel and Brent futures deliverable in February 2014 at $110.24 per barrel. Indicating Lightstream will continue realizing a solid average price per barrel over the short term, particularly for the remainder of 2013 and into 2014.
The U.S. Energy Information Administration has forecast an average price per barrel for WTI in 2013 of $98 and $95 in 2014, while for Brent it is expected that it will average $108 per barrel in 2013 and $103 in 2014. This forecast also bodes well for Lightstream to continue realizing a high average price per barrel.
The longer-term outlook for crude among analysts is optimistic, with ongoing geopolitical tensions, labor disputes and conflict in the Middle-East expected to create further uncertainty and supply outages. This should set a floor under oil prices allowing E&P companies to operate with some certainty.
But recent developments in Mexico with the country ending a 75-year-old barrier to foreign investment in its oil fields has seen some analysts claims North America will be awash with crude. This is particularly the case with growing production from the U.S. and Canada.
Yet with greater demand for oil and natural gas is expected from emerging economies the International Energy Agency (IEA) projects that oil prices will rise to $145 per barrel by 2035. Boding well for the long-term performance of independent oil and gas E&P companies such as Lightstream.
Like many of its peers Lightstream manages its commodity risk or exposure to crude prices through a series of zero cost collars. As such allowing Lightstream create a greater degree of certainty with regard to earnings and cash flows. This provides greater cash flow stability in order to meet operational expenses and capital expenditure.
As the chart below illustrates these derivative contracts have set a minimum floor of just under $80 per barrel and a maximum cap of $112 per barrel and are referenced to the price of WTI.
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Source: Lightstream Resources 3Q13 MD&A.
This strategy allows Lightstream to manage commodity risk and smooth out its revenue and cash flows, allowing it to continue meeting dividend payments, capex requirements and fixed costs.
Dividend payments
As part of its strategic turnaround strategy Lightstream slashed its dividend by 50% to CAD 4 cents per share per month in late November 2013. This will allow the company to generate around $40 million in cash savings.
However, even after the dividend cut Lightstream still has an appealing dividend yield of almost 9% and based on third quarter 2013 net income would give Lightstream a dividend payout ratio of 46%. As a quick dirty measure of dividend sustainability this indicates that Lightstream's new dividend payment is sustainable.
The reduction in capex coupled with the savings generated by halving the dividend will also boost free cash flow also making the new dividend yield more sustainable. But I believe that the dividend is still vulnerable to being cut further if the company is unable to realize the desired prices for the non-core assets being sold as part of its divestment plan.
Foreign investors in Canadian companies need to be aware that withholding tax of 25% is payable on dividends paid. But this can be reduced depending on the nationality of the investor, and whether there is a tax treaty in place between Canada and the country in which the investor is domiciled.
For U.S. investors, the tax treaty between Canada and the U.S. reduces this withholding tax to 15%. In addition, there is no withholding tax payable for dividends paid to an approved pension or retirement plan, provided they are generally exempt from tax in the country of residence.
Finding Lightstream's indicative fair value per share
For the year to date Lightstream's share price has plunged 51% leaving it with some particularly attractive valuation ratios. These include having an enterprise value of a mere 4 times EBITDA and 25 times its 1P reserves as well as a price to operating cash flow of less than 2. All of which indicates that despite its debt problems the company is in oversold territory and that the market doesn't appreciate the quality of its core assets.
These ratios, also leave Lightstream appearing particularly cheap in comparison to its peers as the chart below illustrates.
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It is clear that on the basis of these ratios Lightstream has been oversold by the market and appears particularly cheap, when the volume of its reserves and the strength of its core profitability is considered. But these ratios by their backward looking nature do not tell investors the full story.
To obtain a clearer view of Lightstream's indicative fair value per share I have utilized a net asset value (NAV) methodology. To do this, I have calculated the present value of the after-tax asset value of Lightstream's proved and probable reserves. I have then divided this value by the number of common shares outstanding in order to so as to give an indicative fair value per share.
When using this methodology and calculating Lightstream's indicative fair value per share the following assumptions have been used:
- I have taken Lightstream's 2P reserves of 207 MMBOE and discounted the difference between its 1P reserves of 131 MMBOE by 50%. This represents the average accepted likelihood of probable reserves becoming proven reserves.
- I have not taken into account any growth or decline in reserves as the existing reserves used in the calculation are Lightstream's recognized current 1P and 2P reserves. The cut in capex will not affect existing reported 1P and 2P reserves.
- I have discounted the future value of the company's cash flows derived from those reserves by 10%, to determine their present value in accordance with accepted industry methodology. This discounts future values back to their present value given the time cost of money.
- I have assumed an average basket price per barrel of oil of $85, representing both the outlook for the price of crude and Lightstream's ability to continue generating a solid average realized price per barrel. This is significantly lower than the spot price for WTI of over $97 per barrel.
- I have factored in a minimum royalty rate of 12% reflecting Lightstream's average royalty rate.
- I have conducted the valuation over a 10-year period.
- I have calculated the present value of debt and asset retirement obligations using a 3% growth rate (representing the long-term GDP growth rate) over the valuation period. This factors in the likelihood that both debt and asset retirement obligations will continue to grow as the company expands.
- Despite the positive exploration and development outlook I have not factored in any increase in reserves from those operations or future discoveries. Primarily because of the uncertainty that surrounds oil exploration, the long lead-times to bring new discoveries online and the impact of asset sales.
After applying these assumptions and factoring in each of the catalysts discussed I have determined an indicative fair value of $7.72 per share for Lightstream as set out in the chart below.
With Lightstream currently trading at $5.17 per share at the time of writing, this represents potential upside of just over 49% making Lightstream a deep-value investment opportunity. This becomes even more apparent when the conservative valuation methodology, high asset quality and substantial margin of safety is considered.
Risks
With Lightstream currently battling to reduce its level of leverage by cutting capex and making non-core assets sales there are a range of risks investors may face. If it is unable to raise the required funds to reduce debt to 2 times cash flow Lightstream will need to consider more aggressive turnaround options including:
- Cutting its remaining monthly dividend of CAD 4 cents all together. This would generate approximately an additional $40 million in annual cash savings. I believe this to be a logical step to make up any shortfall and while making the company less appealing to investors would allow it to unlock further long-term value.
- The potential sale of further assets to make up the shortfall in funds generated by the sale of non-core assets. This has the potential to impact Lightstream's existing reserves. Although the net impact on its NAV would be non-existent with the reduction in debt offsetting the reduction in 1P and 2P reserves.
- An additional equity raising, which would have a significant dilutive impact on existing investors with the company trading at close to its 52 week low. But I also believe this to be highly unlikely because there are a number of other options to be executed first.
- The breakup or significant restructuring of the company, allowing it to be sold in part or as whole to another suitor. This would certainly unlock value for shareholders who have invested at recent lows with any sale being made at a premium to its existing NAV. But I believe this to be unlikely at this time because Lightstream's high level of debt makes it an unattractive acquisition target. In addition to which, Lightstream as it is currently structured would be a sizeable acquisition that would be difficult for many likely suitors to digest. This may become more likely though if Lightstream reduces debt and divests itself of non-core assets.
Clearly there are a range of risks that will impact on Lightstream's ability to effectively execute its turnaround strategy and unlock value for shareholders. But I believe that in the worst case the strategy will be partially successful and an additional dividend cut may be the likely outcome.
Bottom line
It is clear that management have over leveraged Lightstream which in turn has seen the company's share price punished by the market with management failing to act in a timely fashion to address the issue. This coupled with the significant dividend cut has seen the company fall into disrepute with investors.
But it now appears that the company has been significantly oversold with it trading at a significant discount to the indicative fair value of its existing assets. As such it now offers investors significant potential upside of just over 49% making a deep-value investment opportunity. While it's strategic restructuring program will go a considerable way to addressing the debt concerns and reducing leverage to a sustainable level.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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