Spartan Energy May Double: Stellar Management Track Record, Cheap Valuation, And Production Outperformance

Summary

• Among the best track records of any public company management team.
• Already outperforming in the third entity they are running, with more to come.
• Trading below analyst estimates despite beating guidance and projections - an unusual bargain!
• Recent set of 10 wells produced 3x as much as expected in their first 30 days of production.

(Editors' Note: Spartan Energy trades on the Toronto Stock Exchange under the ticker SPE.V, with ~$CAD 12.5M average daily volume).

Spartan Energy (OTC:PTORF) is a Canadian oil and gas E&P company trading below analyst estimates, despite management having generated a compounded 1,350% realized return over the course of 54 months in their prior two entities (and a total 6,750% compounded including performance so far in the third entity). Many companies where management has excellent track records trade with management premiums over the prevailing industry metrics. However, after a recent operations update, Spartan appears undervalued on its current assets and even more compelling when considering an appropriate "management premium" for the stock.

Opportunity Overview:

This presents an incredible return opportunity - in theory, a public company should price in a certain amount of future value creation. Considering the value created by management in their prior two entities, and considering the operational outperformance being achieved at Spartan Energy, the stock could trade at well over its current levels.

The reason the opportunity exists is simple - the company just did a large acquisition using stock, and the market is still "digesting" the acquisition and the large number of shares issued to finance the acquisition.

However, management has already shown tremendous operational results,beating production expectations on 10 wells by over 300% (produced over 190 boepd in the first 30 days on wells expected to produce 60 boepd). This is an indication they likely purchased assets for substantially below their potential value, and that they have the operational skills to likely dramatically increase the production and reserves from these assets.

It appears management is on track to create yet another highly lucrative entity (and exit) for investors. In the few months management has been in control of the entity (they recapitalized Alexander Energy, a micro cap E&P), they invested personal money in the company, raised capital, closed two acquisitions, and dramatically beat production expectations through drilling outperformance. This recipe is what earned their shareholders substantial returns in the prior two entities.

The opportunity set for the company is huge. Numerous public and private e&p companies in Canada have posted assets for sale, and capital markets remain closed to potential competing acquirers. The Canadian junior E&P space that traditionally acquired such assets is hurting after a market crash in 2011/2012, and subsequent to that crash, a number of Spartan's competitors have hobbled themselves by instituting dividends that consume a high percentage of operating cash flow.

Suggesting an investment in a company that intentionally does not pay a dividend may sound counter-intuitive, as investors in 2014 have been trained since the 2008 market crash to seek out companies with high, (hopefully) sustainable dividend yields. Particularly in Canada where non dividend paying E&P juniors substantially underperformed. However, oil and gas exploration and production is very capital intensive, and it is difficult for e&p companies to effectively exploit their assets if they have to distribute out a large portion of their cash flow to their shareholders.

Spartan management has demonstrated they can achieve substantially better returns for investors by redeploying capital than by paying out meager dividends. Spartan management earned 1,350% for investors over 54 months over the course of their prior two entities (a 500% ROI followed by a 269% ROI as seen on slides 29 and 30 in this presentation, which is a compounded 1,350%) - it would have taken ~28 years of compounded 10% dividends to achieve that return, or more than 6x as long. Factoring in the >5x move up in Spartan Energy stock so far since management took control in December 2013, Spartan management has returned over 6,750% to investors across 3 public Spartan entities so far.

So Spartan is at an advantage versus its dividend-paying peers, able to redeploy capital into high rate of return redevelopment projects, able to buy assets based on their intrinsic value and not just current cash flow, and able to focus on value creation rather than short-term return of capital.

Investment Bank Research Views: (in two words - "Buy More")

Two premier Canadian investment banks recently recommended buying Spartan stock, based on the combination of recent operational outperformance and management's track record.

GMP issued a $5 price target and warned investors that price target may rise as management continues to outperform. It said that the company has acquired a "quality starter pack of assets that can drive multi-year production and reserve growth" and that "we believe the company should warrant a premium valuation to its peers". As Spartan continues its acquire and exploit strategy, there could be substantial upside to the $5 price target.

GMP estimates Spartan is trading for ~7x EV/2015 EBITDA, which is a low multiple for a growing E&P company with stellar management, but a higher multiple than some of Spartan's peers. However, Spartan is already ahead of production rates projected by the bank and that were guided to by management, which implies actual 2015 EBITDA may be substantially higher than estimated by this bank, supporting a likely lower 2015 EV/EBITDA multiple (and a more attractive valuation). As Spartan outperforms operationally, analyst price targets may rise to support a forward 7x EV/EBITDA multiple, which may approach 2x the current stock price.

Another premier Canadian investment bank, Scotia, highlighted that Spartan is already beating consensus production expectations and that, more importantly, it is far exceeding its type curve in its new SE Saskatchewan drilling program. Scotia also suggested that Spartan may grow organically / within cash flow more than 25% this year. It is rare for companies to grow that rapidly within cash flow, particularly organically, which could drive a premium multiple going forward. In the bank's words, "too cheap, in our view, for a management team with a strong track record of building and selling companies, and a company where we see 25% growth with further consolidation upcoming. Buy more."

Background:

Spartan Energy is an oil and gas exploration and production company. It produces oil primarily in SE Saskatchewan. Spartan is focused on acquiring high quality assets that may not be optimally developed and redeveloping the assets to produce more effectively and economically.

Spartan trades primarily on the TSX V with the ticker SPE, and on the US OTC exchange with the ticker PTORF. There are 222 million shares outstanding (258 million fully diluted). It currently produces just under 7,000 boepd, and has guided production growth of over 25% per year while spending within cash flow (targeting production of 10-15,000 boepd within the next 18-24 months).

Asset Background:

One way to look at the potential value of the assets, and perhaps a relevant perspective before delving into specifics, is to look at how the market valued the previous owner of the majority of the current assets, Renegade Petroleum, before operational missteps and concern around dividend sustainability crashed the stock. At one point, Renegade traded for almost $5 per share, and Spartan was ultimately able to buy out the company for ~$1.50 per share.

Considering Spartan has apparently corrected the asset performance issues, as evidenced by the recent operational update and outperformance, the appropriate value for the Renegade assets might ultimately be the ~$1.2 billion implied by the $5 per share price Renegade shares once achieved (or higher as the assets are further optimized), implying a potential $5+ per share value to Spartan just for those assets.

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Spartan acquired Renegade in a stock for stock deal, issuing 117 million Spartan shares. Obviously, when shares of Renegade traded to almost $5 per share, buyers and management of Renegade saw further upside, implying potential for an uplift to Spartan well beyond 1.5x, assuming continued outperformance. To further quantify it, at $5 per share, Renegade shareholders were valuing Renegade equity at $1.2 billion, more than Spartan's current market cap, despite lower production, lack of operational outperformance, and without a management with a track record like Spartan's.

Asset Overview:

Spartan's primary focus at the moment is in SE Saskatchewan. Here is a map of their assets in the area (these maps are from Spartan's recent presentation, slides 10-16):

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And here are the well economics that Spartan Management is underwriting (keep in mind they are achieving 3x the production shown in these economics, implying IRRs that are "off the charts"):

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Spartan also has exposure to the Viking resource play, where results have been in line with the type curve - good but not exceptional.

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It appears management has been more focused on the Frobisher for now, but as they focus on their Viking asset, the results there may outperform too.

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Management Historical Returns:

Here is an overview of the background of the management team (most of the team has been together for all 3 of the Spartan entities):

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And here is an overview by Spartan management of the returns from their prior two Spartan entities (perhaps more articulate in their words than mine):

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Beyond the obvious massive return on investment to shareholders, it is interesting to note that both entities saw impressive production per share and cash flow per share growth. Spartan Energy seems to be on track to follow the patterns of the prior two entities, growing production per share, cash flow per share, and ultimately perhaps generating a similar substantial ROI for investors.

Valuation:

Obviously valuation is an important component in any investment consideration. GMP has a $5 price target, based on a forward 7.5x EV/Ebitda metric, although as discussed above, Spartan's actual likely EBITDA in 2015 is probably a lot higher, driven by operational outperformance. Scotia didn't quantify value but pounded the table, arguing investors should "buy more."

7x forward EBITDA seems very reasonable for a rapidly growing E&P company with an exceptional track record. If one more Renegade sized deal is completed in the next year on similar terms, Spartan may be on track to achieve 2x its projected 2015 EBITDA on a debt and share adjusted basis, which would imply at least a double from current levels.

Another way to look at valuation: Spartan Management compounded investors money at a ~180% rate of return over the 4.5 years they managed the prior 2 Spartan entities. It is difficult to value that return stream when evaluating a particular equity which has specific assets, cash flow, reserves, etc. However, that track record is clearly valuable, and I think that as investors realize that and as management continues to outperform, SPE may be bid up to 2x+ NAV.

Either way, it appears that Spartan stock may be likely to double in the next year. Below are some of the catalysts that may unlock that value.

Catalysts:

1) Continued production growth and operational outperformance. Success speaks for itself, the recent operations update was outstanding, and more of the same seems likely to drive the stock up materially.

2) Spartan is still not well known in Canada and almost totally unknown in the US. As the company continues its operational excellence, this will change, which could re-rate the stock. Investors want to own stocks run by management teams that outperform.

3) Investment banks in Canada and elsewhere will pick up coverage. Some banks don't yet officially cover Spartan but have started to mention the company in their sales notes. As Spartan grows, these banks will initiate research. Certain banks have cross border exposure, such as Canaccord or Scotia (through Howard Weil), which may get Spartan on the radar of fund managers in the US looking for investments like Spartan.

4) Additional acquisitions will likely take place and will likely be accretive. Beyond value accretion, getting bigger will make the stock more "investable" by larger fund managers more willing to "pay up" for strong management with a great track record.

Risks:

No discussion of a potential investment would be complete without a discussion of the various potential risks. Obviously, as an oil and gas producer, Spartan is exposed to oil price volatility, regulations, transportation issues, and other concerns associated with the business. Spartan is also a Canadian-listed stock, so there are risks associated with being listed on the TSX Venture exchange. And of course, individual wells or even whole development programs could underperform (even though so far, Spartan management has outperformed in each of their three public entities, including SPE). If the market or oil prices were to crash, Spartan could be disproportionately affected, considering its small size, growth orientation, and exposure to oil prices.

Summary:

It is rare to have this type of opportunity: to invest with stellar management into a reasonably valued entity with organic and inorganic growth potential. Spartan management have demonstrated their capabilities multiple times, and already appear on track to achieve another remarkable success with their 3rd Spartan entity. They bought a high potential asset base, have already dramatically improved well results, and have stated their intent to acquire additional assets. The opportunity set is there, with numerous assets available on the market at attractive multiples that would be accretive to Spartan Energy. And management has proven their ability to improve results and create value from acquired assets. In short, Spartan is an exceptional opportunity for a multiple times return in a medium-term time frame. I am long Spartan Energy.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment adviser capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment adviser. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

By Josh Young

Source:http://seekingalpha.com/article/2185813-spartan-energy-may-double-stellar-management-track-record-cheap-valuation-and-production-outperformance