If You Can't Make It To Vegas, Consider Lucas Energy

If You Can't Make it to Vegas, Consider Lucas Energy

Many investors use very specific screening criteria when selecting equities for greater scrutiny, valuation, and ultimately potential selection for an investment portfolio. The use of screens is helpful at times and incredibly boring most of the time. So it was through casual reading of various financial publications that Lucas Energy (LEI) piqued my interest. Ryan Morris, founder of Meson Capital Partners, was featured in a January 2013 Bloomberg Businessweek issue. In the article, there was one paragraph noting Morris's acquisition of 11% of LEI's shares and subsequent invitation to the company's board along with another seat on the board which went to Joshua Young, founder of Young Capital Management. Lucas Energy is a micro-cap oil and gas E&P company with a market cap of less than $50MM at the time of publication, minimal analyst coverage, institutional ownership of 5% according to Google Finance, net losses from '09-'12, and poor operating cash flow (OCF). As noted in the article, LEI has "rights to drill on oil-rich properties but not enough capital to get the crude out of the ground." In my opinion, LEI's future holds three outcomes: 1) Tremendous production growth from its oil-rich net proved undeveloped reserves, 2) acquisition via a larger buyer that wants LEI's assets and has the means to monetize its asset base and reduce much of its cost base by minimizing redundancies, or 3) fail and sell its assets at cheap valuations. I do not envision a long-term sideways market for this micro-cap. I also doubt Ryan Morris and Joshua Young invested heavily in LEI with option #3 as the desired outcome, but let's start with that possibility and work backwards to a probability-weighted valuation.
I don't mean to portend a failed future for LEI by addressing the worst-case scenario. Rather, I believe there is an inherent bias as an analyst to want to like a company when a significant amount of time is spent researching, analyzing, and modeling. "I did all of this work and I must have something to show for it!" It's important to be aware of that bias and to argue the long, short, and indifferent perspectives, step back, and assign the most weight to what truly seems most probable.
Beginning with the worst-case scenario, what are the chances LEI fails? Generally the question is whether or not a company will underperform, but for a micro-cap that in recent history has reported net losses and negative OCF, the possibility of a $0 value needs to be considered. So I dusted off my college textbook Financial Reporting and Statement Analysis - A Strategic Perspective and applied the Ohlson's Bankruptcy Prediction Model to LEI's financial statement (click on this link to download the Excel model I created). Using information from LEI's 10-K as of 3/31/12 (Lucas' FYE is 3/31) and 10-Q as of 9/30/12, the probability of bankruptcy according to my calculations is between 4% (using 9/30/12 data and assuming the Note Payable is classified as long-term debt) and 72% (using 3/31/12 data and assuming the note is classified as short-term debt), both ends of the range above the 3.8% necessary to minimize Type 1 and Type 2 errors according to Ohlson. The conclusion of the model is not a shocking revelation since LEI has reported four straight years of net losses and reports current liabilities that are 4 to 14 times greater than current assets, depending on how one views the $22MM Note Payable. LEI secured the note to acquire "interests in certain oil, gas and mineral leases, rights and assets located in Gonzales, Karnes and Wilson Counties, Texas." As noted in the most recent 10-Q, Lucas Energy is "in discussion with Nordic 1 [the seller of the assets and lender financing LEI's purchase of those sold assets] regarding making various modifications to the note, which include, among other items, an extension of the term and maturity date of the note." I consider it a short-term liability, but it can be paid off by using the underlying oil and gas properties as collateral should the lender express unwillingness to modify repayment terms. I'm not certain whether the loan, which was due on 11/17/12, was modified but I'm betting it was considering there was no sale transaction news near that date.
It's apparent the company is a risky bet based on operational performance. No company can report net losses in perpetuity without diminishing equity to $0. But the key is identifying if there are actions or events that would flip the switch on operational performance and unlock unrecognized shareholder value. There are a couple of opportunities to increase LEI shareholder value.

1. Cost Reduction (specifically G&A): LEI's cost per unit produced is a tad above normal. In a JPMorgan Oil & Gas Primer report dated 11/18/05 (the report is only $5 online - worth the cash for any oil and gas investor and still relevant eight years later), it was noted that E&P costs per Mcfe were $3.69 in 2004, projected to be $4.25 in '05 at the time. During my analysis, LEI was compared to several peers as provided by Finance Google. Cost per Mcfe for CRZO, CXPO, SARA, and EPM were $3.64, $5.86, $3.72, and $7.31, respectively. Any guesses for LEI's cost per Mcfe? For the FYE 3/31/12, LEI's cost per Mcfe was calculated at about $37 and only a couple dollars less when excluding severance and property taxes (refer to the Comparable Company Ratio Analysis here). The company's average cost per Mcfe from '09 to '11 was about $27 and I forecast it to be about $31 for the FYE13. Part of the reason LEI's cost per unit is so high is because the company has spent much of its capital acquiring oil-rich assets and now needs additional capital to extract the assets. Taking a look at the company's reserve to production ratio (R/P) of 155 years will also demonstrate the need to increase production. The R/P average for LEI's four peers was 26 years.
2. Development of the Undeveloped: LEI's cost per unit, as mentioned above, is in large part high as a result of low production. Of the 8.8MMboe LEI has booked as proved developed (PD) reserves, 8.4MMboe is proved undeveloped (PUD) while only 0.4MMboe is proved developed producing (PDP). Per Wikipedia, "PD reserves are reserves that can be produced with the existing wells and perforations, or from additional reservoirs where minimal additional investment (operating expense) is required. PUD reserves require additional capital investment (e.g. drilling new wells) to bring oil to the surface." The problem LEI must solve is how to get the necessary capital to turn its non-producing assets into revenue, but it is a good problem to have. I recently reviewed a company that had the same issues LEI had from an operational perspective but with a much less valuable asset base. Given LEI's size, the company has limited company presentations (one from 6/12 on its website), no earnings call transcripts, and no significant public 3rd party commentary, it's difficult to get a feel for the overall company strategy, including its plan for raising capital. It's a leap of faith for an investor to trust the company will come up with the capital through equity issues, raising debt, or entering into joint ventures, but then again, this is a high risk proposition and by nature, much harder to predict future operations than, say, Exxon Mobil (XOM). LEI has quality assets, it just needs to figure out a way to obtain capital necessary to produce them.

Asset Base
LEI primarily operates in the Austin Chalk, Eagle Ford, and Buda formations in Gonzales, Wilson, Karnes, and Atascosa Counties in Texas, southeast of San Antonio. Refer to the images below for the geography of operations and the formation cross-sectional illustration. As of 9/30/12, about 22,000 of the company's almost 28,000 gross acres were in the Austin Chalk formation. LEI had 67 active well bores, with 10 wells providing about 85% of total production equal to 220 net Boe/d.
LEI noted it sought to acquire over 15,000 acres in Gonzales and Wilson Counties prior to the heightened attention the investment community provided the Eagle Ford area. As noted in the first image below, LEI is in the sweet spot of the Eagle Ford Shale where other successful E&P companies operate like EOG.
Geographic Location of LEI's primary asset base:
(click to enlarge)
Cross-sectional view of LEI's primary asset base:
(click to enlarge)
Valuation
There is no doubt Lucas Energy is a high-growth company. Oil PD and PUD reserves have grown at a three-year CAGR of more than 45%, while natural gas reserves have grown by more than 1,000% from FY11 to FY12. It should be noted oil comprises 80% of the company's proved reserves and LEI is considered an oil company that produces gas associated with the oil production. If the projected revenue in my model for '13 seems aggressive at first glance (see below), LEI generated $4.5MM through the first six months of its FY2013.
(click to enlarge)
Using what I consider to be aggressive but reasonable assumptions regarding revenue growth and margin improvement, free cash flow (FCF) will first be generated in LEI's FY2015. That projection is quite sensitive to capital expenditure assumptions, which I hope to better understand as I continue to follow the company.
I recently read an article on the CFA Institute website about how small-cap investing is more of an art than a science, and I understand Preston Athey's point of view completely. It's a challenge to properly value much bigger and more mature companies with somewhat predictable cash flows so there is even more ambiguity surrounding key assumptions in the forecasting of a micro-cap business that is still very young (incorporated in Nevada in 2003 under the name Panorama Investments Corp.) with much more unpredictable cash flows. The question about how Lucas Energy is going to extract its assets will determine whether or not the security will deliver healthy returns over the next few years. Based on what I know now, I calculate a fair value for LEI of about $2.50 per share so I think anything in the $1.50/share is reasonable. Meson Capital Partners just bought more than 310,000 shares of LEI for a weighted average price of $1.48/share as noted in Form 4 filings with the SEC on 1/2/13 and 1/8/13. So the question is, do you believe in the predictive power of a bankruptcy model or do you believe management and the board can steer LEI in the right direction. This is a story to watch and I'm excited to see what takes place over the next few years as LEI aims to grow its production.
By Rob Wilson
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.