Exco Resources – Filled to the Brim With Value Investor Insiders

• Weird stock sell-off has made Exco an attractive buy at ~50% discount to Wilbur Ross' buy price
• Board mostly comprised of value investor shareholders with excellent track records & hands-on approaches
• Value investors' concentrated stakes make up 49% of shares
• Close to no media or investor coverage – complex and uncertain stock
• An option on natural gas prices
• Stock market overvaluation is headwind though

Source: marcellus-shale.us

Since yesterday's large drop of Exco, I think it has become a good buy.

UPDATE Sep 24, 2pm: I was lucky enough to be delayed in buying shares, and will put at least a third of my portfolio in Exco tomorrow. UPDATE Sep 25, 11am: I just bought the shares at $3.85.

Exco Resources is a shale gas (and oil) exploration and drilling company, which got itself into some trouble in the last years by using too much debt to buy shale gas assets (though not on the scale of Chesapeake).

A cheap stock

I have been following Exco for the last 2 and a half years, watching Wilbur Ross talk about it on CNBC and then value friend Prem Watsa really following into it in Q4 of last year. Finally, I've come to the point where I want to buy a major stake in it.

Wilbur Ross is a distressed asset investor and his WL Ross & Co has had returns of about 44% since 1997. Ross' skill in executing overhauls and investors' aversiveness to bankruptcies and other failures, means I think a significant part of this return could persist.

Wilbur Ross built his position over the year from Q3 2010 and then added 60% in a share rights offering in January of this year. According to Gurufocus, his average price has been $15.85, but this is calculated using average share prices over quarters, so let's be conservative and make it $10. Plus, it ignored the mentioned rights offering in the calculation, which was done at $5, giving us an average buy price of ~$8.

This means today's price of ~$4 you can buy Exco at a ~50% discount of Wilbur Ross' buy price (intentionally rough estimate). It should be noted though that Wilbur Ross did admit twice in early 2012 to having started buying a bit too high/early. Nevertheless, you'd still be buying Exco at a big discount to what Ross believed to be a significant discount to intrinsic value (a double discount).

However, short interest is quite high at 23.8%, which is a negative.

UPDATE Oct 1: At yesterday's closing price of $3.34, you also get a dividend yield of 6%, assuming cash flows are sustainable.

Having said all this, I have had a hard time getting my head around actually valuing Exco's gas and oil reserves (which it comes down to). It's dependent on so many factors – whether reserve estimates are accurate, drilling taxes (severance & ad valorem) & lease contractual obligations to drill (which caused a lot of havoc when prices slumped), venture terms, management competency in acquisitions and sales, the time and costs to pump it up & transport it and future natural gas price movements & hedging on that. I'll be honest and say I just don't know, and am depending on the competency of the insiders who've bought the stock (traditional measures like a P/TBV of 4.5 or EV/EBIT of 68 would show an expensive stock). Exco's complexity may be one reason why media and investors stay away from it.

With hands-on insiders adding value

Exco's board is comprised of representatives of value investing firms (& one "independent" director with ties to the private equity group of Ares Management).

See below for the value investor stakes and their directors (up till Q2 13F):

”‹Note: Excludes Ares Management's Private Equity Group (with stake of 4.08% & "independent" director Jeffrey S. Serota) because I doubt that they actually predominantly have a value-investing approach

It should be mentioned that while Watsa & Ross have been steadily adding to their positions, T Boone Pickens & Ares have made large sales in March 2014 @ $5.14 and Aug 2013 @ $7.50 respectively. Pickens has been involved as a director since just before the IPO in beginning 2006 (as well as in 1998-2003) and as a shareholder before that. This does send a mixed message.

In the last 2 years, the directors have both removed a long-standing CEO (searching for a new one) and replaced the CFO. This both points to their readiness to act and previous managerial problems at Exco.

Wilbur Ross himself is known for actively restructuring assets of distressed businesses, leading them into profitability. He has often done this while combining businesses into new entities, calling them remarkably consistent names like International Steel Group, International Textile Group, International Coal Group and International Automotive Components.

After joining Exco's board of directors he said: "we do have a big position and will work more closely with them". Having him and Prem Watsa doing some constructive activism together, having worked earlier on both Bank of Ireland and Eurobank, is a big value-add to me.

Under this oversight, management has finally started to really reduce Exco's debt, by $630 million this year and $581 million in Q4 of last year (incl. through aforementioned share rights offering), and increasing liquidity, after 2013's $1 billion acquisition of Chesapeake assets. This gives them a bigger backstop to weather storms.

However, the balance sheet is still quite leveraged with a debt-to-equity ratio of 3.8 (removing goodwill, which has no value in of itself, makes it 8.2). The problem is, this ratio relies on the valuation of the reserves, through full-cost accounting, being accurate – which I doubt. This points again to Exco's complexity.

It's uncertain, but I think the true economic value has been understated.

With conservative accounting

Source: eia

"Companies like us, [a] gas company, who, 4 years ago, had thousands of proved undeveloped locations. Two things happened with SEC. As [natural gas] prices come down and they don't hit a certain hurdle rate, you got to write them off. That doesn't [mean] they're gone. They're just now in probable.

The second thing that happens is if – the new rule is if you don't have it on your schedule in the next 5 years, you have to take it off. That doesn't mean it's gone, that means it's in probable or possible...

But the bottom line is, and we've done a study on this, if prices, we say when, but if prices go up, we have potential for 5 to 6 Tcf in our asset base where it is now, if prices go up. And they kind of turn on – we run a model at $4, $5, $6, $7, each area brings on a lot of these things, and we're looking at wells that we would drill that have a 20% rate of return. So this asset base is still spectacular. It looks like it's going away, but it isn't going away. We're just writing it down."

- Former CEO Douglas Miller, conference call for 2012

There were $1,346,749 of impairmants of gas reserves in that year.

Currently, the volume of gas extractable from reported 'proved' reserves is stated at 1.1 TCF equivalant.

I've found that the full-cost accounting method tends to understate the value of reserves. Reserves are split into two categories – proved (chance to be economically producable >90%) and unproved (the rest, divided into probable >50% & possible >10%), both stated at cost. If the discounted cash flows valuation of proved reserves (based on natural gas / oil prices not including hedges here, the estimated volume left, and a 10% discount rate) is lower than the cost though, they are written down (but can not be written up). Likewise, unproved reserves are assessed periodically, and impaired when seen as less viable.

"The ceiling test involves comparing the net book value of the full cost pool, after taxes, to the full cost ceiling limitation defined below. In the event the full cost ceiling limitation is less than the full cost pool, a ceiling test write-down of oil and natural gas properties is required. The full cost ceiling limitation is computed as the sum of the present value of estimated future net revenues from our Proved Reserves by applying average prices.., less estimated future expenditures (based on current costs) to develop and produce the Proved Reserves, discounted at 10%, plus the cost of properties not being amortized and the lower of cost or estimated fair value of unproved properties included in the costs being amortized, net of income tax effects.

The ceiling test is computed using the simple average spot price for the trailing twelve month period using the first day of each month. For the twelve months ended December 31, 2012, the trailing 12 month reference prices were $94.71 per Bbl of oil for West Texas Intermediate at Cushing, Oklahoma and $2.76 per Mmbtu for natural gas at Henry Hub. and $46.57 per Bbl for NGLs...Under full cost accounting rules, any ceiling test write-downs of oil and natural gas properties may not be reversed in subsequent periods."

- 'Accounting for oil and natural gas properties' section, Annual Report 2012

The point is (if I interpret this correctly), that the low natural gas prices have pushed the stated value of Exco's properties down, even moving some to the 'probable' section of unproved reserves (0.41TCFE '09-'13), with corresponding write-downs. Also, if undeveloped proved reserves have not been developed for 5 years (per SEC's five year development rule), they are moved to to unproved reserves (0.18 TCFE for '11-'13). It also appears that write-downs on proved reserves in earlier periods cannot be reversed later on. This level of conservativeness is apt for the uncertainty that surrounds oil and gas exploration, but it has caused earnings, asset value and the extractable volume of 'proved' gas to be understated.

"While companies are eager to enter shale plays and sometimes are willing to pay a premium to do so, the market price of natural gas is at a five-year low with new production coming online regularly. This gap may lead to a substantial difference in the actual valuation of the deal for financial reporting purposes. Another factor that can lead to value adjustments is the timing of cash flows and the inability to obtain capital to fund production due to lower gas prices."

- Valuing the Great Shale Play, PwC, 2011

Ignored by media and investors alike

There has been little meaningful news or investor blog coverage in the last half a year. Wilbur Ross has not been mentioning Exco in interviews. This lack of media attention is a positive. Analysts have been negative, with 4 holds, 4 underperforms and 1 sell.

With some economic tailwinds

Since the start of 2012, natural gas prices have risen from unsustainable (because of excess supply, many gas drillers breaking-even or losing money & long-term arbitrage with coal and oil) lows.

It's possible, but not forecastable (at least for me), that gas prices will rise further in next few years. The main reason I can think of is further arbitrage with oil as well as international coal, for example via conversion of vehicle fleets to gas or LNG shipping (other minor reasons, such as no toxic by-products in burning & natural gas' supposed lower CO2 emmissions can be thought of).

A barrel of crude oil has ~5.85 mmBTU (million British Thermal Units) of energy content and the spot price of oil (expressed in barrels), should therefore theoretically (assuming utility is determined by energy content alone) trade at the same price as ~5.85 times the spot price of natural gas (expressed in mmBTU). In practice, however, the oil spot price has historically traded at 9.1 times that of natural gas. Reasons include oil's much wider use in motor vehicles, easier transportation due to its liquid form and the extra gas often pumped up during oil production. Currently though, it trades at a ratio of 24, 2.6 times the historical ratio, which can be mainly attributed to the supply glut created by the shale gas revolution. Through arbitrage, this ratio is likely to mean-revert in the long run.

Therefore, if the oil price mythically remains constant in today's dollars, the gas price could touch $10 again, but this is not at all a realistic scenario in, say, the next two years. Much more reasonable would be an increase to $5.

You could say with Exco's still leveraged balance sheet and untouched reserves that are only profitable at higher prices, it is like a call option on natural gas (Henry Hub spot price graph pictured below).

Source: Nasdaq

Also, current subdued well profits multiply with a small increase in the natural gas price (as would losses if it ever reverses). Below is a graph on the DeSoto Haynesville gas wells' estimated internal rate of return, depending on the spot price.

Source: Exco June Investor Presentation

A question would be why Exco's revenues have not already increased massively since 2012's ~$2 / mmBTU low of natural gas. I have a feeling that it could have to do with many of Exco's gas reserves only becoming profitable at prices higher than today and management's long-term focus on gathering and exploiting profitable assets instead of short-term profits. But I'm really not that sure, and might revisit this section later. Anyone experienced in this willing to lend his/her insights would be much appreciated.

UPDATE Oct 2: LwC noticed something which I should have: production declined by 30% from Q2 2012 to Q2 2014.

A negative though, is that the US stock market appears overvalued, as mentioned in a previous article of mine, with negative to 4% expected returns in the next 10 years. Importantly, there is little value spread (valuations are quite uniform), as opposed to the Dotcom bubble, where Nasdaq stocks were trading at average P/E ratios of 115 alongside cheap, neglected old economy stocks. This both means that there is a risk of correlation in a market crash and that it is less likely that Exco is the neglected, undervalued stock that it appears to be.

With a buyout possibility

Though I think it's unlikely (given the current level of control enjoyed by insiders, why acquire?), there are a couple of reasons why a buyout could occur:

1. The size of the stakes held together by the aforementioned investors (with directors in direct contact with each other & connections between them incl. Watsa & Ross and Ross & Pickens).
2. Exco's debt reductions and goal to reduce it further. This makes a leveraged buyout more doable.
3. The precedent of the 2010 buyout offer, which had Oaktree, then-CEO Douglas Miller, Ares & T Boone Pickens (the latter three now having reduced stakes) as interested parties.
4. The buyout experience of the parties:

• Ross & Pickens are veterans in the buyout space.
• Prem Watsa regularly acquires companies through his holding & tried this recently with RIM.
• Ares' private equity group speaks for itself.
• Oaktree has also had plenty of experience.

It should also be mentioned that Exco could eventually become an attractive bite-sized acquisition for multinationals, like ExxonMobil, or merge with a similiarly-sized player based in the same area, like SandRidge Energy.

But is not a sure thing

Honestly, I don't know why the stock price dropped so much in one day. There may be insiders acting on negative data that I'm not aware of. And given the size of the sell-down, with no meaningful news appearing to be connected with it, it's possible that a big insider is quickly unloading shares. I don't understand though why anyone would dump their shares to push down prices like that (excl. short-sellers), so it's more likely that multiple sellers were involved. Nothing significant is happening in terms of insider transactions or Form 4 filings of the big three investors.

UPDATE Oct 1 (added data Oct 3): With the further sell-off, below some data-crunching:

Ross & Oaktree are very unlikely to be sellers, as they haven't filed mandatory (for >10% stake) Form 4s. Watsa is also unlikely, because of his director & that his stake is close to the 5% mark (requiring 13G filing if crossed). As is Cyrus, with its director having access to insider information. Pickens is a director and also hasn't filed a Form 4.

Some evidence that the price changes are caused by increased selling volume:

The average daily volume of 6,5 million was definitely higher than the average of 3.4 million for the almost news-absent period since the Q2 filing.

Assuming that supply of other uninformed investors stays constant (no increased selling because of price drop or less selling because of value for price), we can do a very rough estimation of what the informed (or distressed) sellers(s) have dumped on the market. This is a big if, partly because the NYSE ARCA Natural Gas Index also dropped 6.0% in this period, as well as the typical variation in trading volume over small-periods of time.

Below I calculate the excess shares traded compared to the 5-year average:

*adjusted for share rights offering in Jan 14

UPDATE Oct 3: it's no longer possible for Ares to be an only seller and I think it could be a combination of informed / distressed big sellers like Ares, with panicked retail investors / mutual funds and perhaps some more short-selling.

It's interesting that the biggest volume comes on the day that the Q3 report date was announced and that Exco has bought hedges that limits its upside for 2015 to $4.45/MmBTU. People seem to be afraid that Exco would lose its upside for 2015, which I think is a fair point. On the other hand, there are indications supply is higher than expected and the coming winter milder.

Richard Zeits, who has a substantiated analysis that is negative on the stock, thinks that the drops are caused by forced selling, similar to those in '08/'09.

Which individual shareholder owned this number of shares? Ares Management.

(as does Vanguard Group, which seems like an unlikely big seller unless Exco gets dropped from the Russell 2000). As their appointed director officially no longer works for Ares since Mar 2014, they are free to sell as they wish, I think.

Alternatively, it is a combination of smaller sellers and/or short-sales, which have been on the rise.

I should also note that a holding like Exco that has a complicated business structure, has a lot of debt, relies on a lot of drilling unknowns and is affected directly by volatile commodity prices, comes with a lot of uncertainty and a much higher chance of unexpected high losses than your average blue-chip.

I appreciate feedback, including reasoned criticism. :-)

Note:

For full transparancy, I originally posted a short note here on Sep 22 (which got accepted by Gurufocus on Sep 23) with the sentence "With this morning's drop of Exco Resources to $4.20, I'm going to start off by suggesting a buy (I'm not in it yet because I have to get out of some other positions). I will add more information in the next few hours."

On the afternoon of Sep 22 and Sep 23 & 24 I expanded and pretty much completed the article. I added the full-cost accounting section on 26 Sep. I added the short interest sentence & "up til Q2 13F" in 'A cheap stock' section and the stylised reserves graphic on Oct 1. Added amount of TCFE moved to unproved reserves & '5 year development rule' sentence on Oct 2. See comment section below for later discussion.