Company Overview Components - Oil & Gas

It's one of the first tasks you learn on the job, and even when your engaged on something live many analysts will roll out one or two snapshots a week. Although an actual template doesn't add much value, I think discussing what the most important topics in oil and gas does - and that's exactly what the overview is supposed to do.

The obvious
Parts of the overview are a no brainer. Usually the upper left quadrant discusses the basics of the company, like: name, ticker, headquarters, total enterprise value, average boe or cfe (barrels of oil equivalent for the more liquid [oil based] companies and cubic feet equivalent for the more gassy companies), net acreages (net as in net of working interest, oil and gas companies joint venture a lot of their land), and most recent guidance on the years capital budget and exit production.

The financials
Nearly every front page will have a "cap table" or a capitalization of the company. The flow of most capital tables goes something like: most recent stock price, fully diluted shares outstanding (getting this number right takes some carefully reading through the most recent Q and new releases since), market capitalization, net debt, and total enterprise value. Then come the optionals, if they pay a good dividend, include a dividend yield, if you want them to look cheap cherry pick the right multiples ($/acre if they have a lot of land but little resource, etc.) Credit stories need credit multiples, buyside stories need low metrics, sellside stories need high metrics, every company will have some of each depending on how you cut it. Rarely would you ever see a balance sheet, income statement or cash flow statement in any part of the presentation, although sometimes you see EBITDA and CFPS.

Resources
The resources are the meat of any natural resources company discussion. Oil and gas companies let these numbers slip in 3 main areas, the Annual Information Form that is disclosed every year end, the MD&A for each quarterly report, and the latest Investor Presentation. You can also add to the story through press release disclosure, quarterly transcripts and additional disclosure you can find in the annual report. Generally you want to find net acres by play and all the resource stats by play (Proved, Probable, Possible, Best Estimate Contingent). You also want % liquids, the average EUR (Estimated Ultimate Recovery) of the wells by formation, supply cost of the play (the break even gas price at 9% discount rate typically).

That's the first page usually, next you focus more on the story. You might profile each individual play they have, some merger metrics, etc.

Generally if you know how to talk to each of these points, you are ready to participate at some level in conversations with the client - and that's the first step to associate level banking.

Valuation practices in a Natural Resources Coverage Group

It has been interesting to see the similarities and differences between classroom methodology and industry practices when valuing oil and gas companies. Here are some key differences.

Discount Rates
CAPM is out, PV10 is in. On a cash flow basis there are two main techniques in valuing resource assets. One is a haircut technique where all Proven and Probable (2P) reserve cash flows (output * price - expenses) are discounted at 10%, and Contingent resources and Undiscovered resources (2C) (but owned acreage) cash flows are hair cut at 10 to 20%, and then they too are discounted at 10% - hence "PV10". The other methodology discounted 2P reserves at 10% and then contingent reserves at 12% or higher depending on the play.

Terminal Value
Mention a terminal value in an interview for a Natural Resource group and you've immediately put your landing possibilities in jeopardy. Gas wells produce at very predictable rates, which can be delineated into "type curves". For going forward assumptions you just have to know what type curve can be reasonably expected out of the play and package. After this you can model out production for the next 100 years if you want to; many of our models stretch beyond 2080.

Assumptions
Because PV10 is a fairly industry standard valuation method the real assumptions come into the model with prices, classifications between contingent, probable, and possible, and what Tcf values are given to land that haven't been risked (drilled with exploratory wells) yet.

Price decks generally come from 3 sources: brokerage consensus, engineer forecast, and forward contracts. To get the best value for their research everyone generally spends a lot of effort forecasting the major contracts (HHUB Gas, WTI Crude, Brent Crude), and then every other selling price is based off a differential to these contracts going forward. For instance a major Canadian gas selling price is at AECO, which generally trades at a C$0.50 discount to HHUB, thus if you have a decent idea of the expectations for HHUB, you also have a decent expectation for your local price point.

The engineers add a lot of value to the model. They provide you independent type curve estimates, price expectations, and reserve estimates that include 2P and 2C values.

Comparables
The comparable universe works much like it did in class, just the multiples are different. EV over reserves (1P, 2P, 2P + 2C),  acreage, and production are very common.

Wrinkles
An area of the model that are more complex than I had originally expected is the royalty calculation. Oil and gas firms are taxed twice, once on income after expenses, and once on production through complex royalty rate calculations. As an investment bank understanding and strategically advising our client through royalty rates is a big part of the business and after all the due diligence homework we often know more about the credit and rate reduction plans than major oil and gas companies who face these costs daily.

More to come.

What is Analyst Investment Banking Training Like?

Who is there?
Many banks have stretched the net of who's included to global or nearly global. Having the Americas and APAC train in NYC and EMEA train in London is common but some bring everyone to the NYC headquarters. Analysts coming from APAC may have already worked several months because the school cycle is so different.

After spending some time with the analyst class there are some definite trends that become obvious. It is very rare to have analysts going to NYC who have not summered with the bank before, or at least with an IB of similar caliber. Most of the Ivy League school students end up going to NYC, which although geographically makes sense, is still interesting because many of these students exit with liberal art degrees. Many of the regional analysts would have summered before with the firm but that is not as strong a rule, most of these analysts come out of the less recruited schools, and many of them have econ or business backgrounds.

What is it like?
Training is generally a rehash of your average 4 year commerce program with a focus on applied skills (very little theory is taught), and familiarization of the tools needed to do the job. The NYC analysts may not be placed in their coverage groups yet, and so they are still networking for the job. Most of the regional analysts will have group placement and so training for them is less focused on performance, and more focused on getting the needed skills and having a good time in NYC and London.  Most firms in NYC will use one of two providers, wall street prep or AMT. The classes are very involved, you are constantly doing excel questions and creating output, which makes what is for many review a much less painful than it could be. The hours per day average between 8 and 12, with one or two all nighter's through the month.

Bottom Line
Analysts should take two things out of training: a network, and tool skills, in that order. Coverage groups will all treat projects fairly uniquely, so the modeling, valuation, and accounting fundamentals you have out of any business program are more than enough. You will however never have the chance to see the whole analyst class at the same time again, and you may need them in the future. Calling for information between groups happens and a friend is much more likely to carve out 15 minutes for your needs. Also when the analyst class looks to move on from the firm, the IB analyst pool can have great benefits when looking for exit ops.

After 4-6 weeks school is out, and the work begins. Enjoy your evenings while you have them!

A simple merger analysis and the MVBS method of discount rates

There is little less inspiring than studying foreign exchange finance that has managed to permeate the economics, derivatives, accounting, and equity sections of the CFA 2 exam, so a road map to M&A transactions and firm valuation with excess cash sounds like the perfect distraction.

What's in the title?
What is the difference between a merger, an acquisition, and a consolidation? Simply, a merger is a transaction where an acquirer buys the target and the target dissolves as a legal entity (A + B = A). An Acquisition is a transaction where the acquirer buys a majority stake in the target, but the target remains a legal entity (A + B = Ab). Lastly a consolidation is when two similar firms merge and form a new entity, (A + B = C). 

What's a firm worth?
In mergers the acquirer is buying the whole company, not just its equity. Thus when they make an offer for the firm they must take into account the equity holders and the premium they will require, in addition to buying out or assuming the target’s debt holders. This combination can be summed up with the term Enterprise Value (EV), where EV = Equity + Debt - Excess Cash. This is visually displayed in a market value balance sheet.

 

Liabilities are thought of as economic liabilities, or stakeholders of the company’s assets, not accounting liabilities which are by definition distinctly separate from equity.

There are some interesting identities that result from this economic model. One of the largest outside the M&A frame work is a surprising valuation result. The cost of capital of a firm is thought to be the weighted average of the cost of debt and the cost of equity. This "WACC" is a very well excepted method of discounting a firm’s cash flows to arrive at its total value, aka its enterprise value. This is true, however it is only true given a key assumption; the firm holds an immaterial amount of excess cash. Excess can loosely be determined as the cash balance that is above what would be needed for operations, or cash that is not called on through either the longer of a calendar year or a product cycle (make to sell). Most firms don't have this kind of cash, but some do, think Microsoft and Google. I'll do Google as an example below. 

 

Excess cash was assumed to be the balance in their marketable securities account (they have another $3 billion in their cash account) and equity was their May 15th share price close multiplied by the current shares outstanding. Look at that $24 billion in cash. Now look at what it implies about the firms Beta's. 

 

I grabbed the equity beta off of google finance, (ideally I would have taken the time to personally regress it because google finance is known to normalize it's beta using the 1/3 2/3 rule, but the point will still come across) and I assumed the debt beta to be 0.2 which is roughly what it could be. Note this is not the cost of debt, it’s a view of the value of debt in perspective of its credit rating and its relationship with the market. The beta of the firms liabilities corresponds to the risk that would be captured in a WACC discount rate (I do a clarifying example below). The punch line is this: cash has no beta. The beta of the enterprise (beta of the operation assets net of excess cash) can be backed into by the following identity. Beta of Liabilities = Beta of Total Assets. Beta of operation assets = Beta of Total Assets * Market Value of Assets / Enterprise Value. This is why the enterprise has a high beta; the excess cash is having a huge stabilization effect on the beta of debt and equity. Practitioners who simply use WACC to discount the firm’s cash flows grossly overestimate the firm’s value. The same example using discount rates is below. 

 

Excess Cash will not return 0%, it will return ~ 0.5% with today's rate, but this table doesn't concern itself with return, that is something to be modeled into the cash flows. This table concerns itself with the cost of capital and the appropriate discount rate for Google's projects. Practitioners not imbedding the leverage effect of cash, with incorrectly discount Google's project cash flows by a value 1.88% too low. In the terminal calculation, every dollar terminalized will result in a present value that is roughly $53 to high (1/1.88%).

Back to Mergers

I digress. Back to valuing a merger. Using the market value balance sheet discussed above, the acquirer has a pretty good idea of what they will have to pay. They can use the targets excess cash to help pay off the acquisition, (unlike patents and products, a target can't argue for a premium on its mountains of cash) and after a careful study of the bond covenants they will be able to determine what debt can be assumed, and what debt must be paid off with either its own cash or debt it issues itself.

I recently did a case competition that looked at the merger of Bank of New York, and Bank of Mellon. Here is how their MVBS's lined up. 

 

Again the equity is calculated stock price * shares outstanding. Debt is from the balance sheet, and both firms were assumed to have an immaterial amount of excess cash, so enterprise was the simple sum. When the merger took place BNY bought Mellon with an all stock offer, but the exchange ratio was a bit odd, BNY shares would be exchanged at 0.9434 (a large part of our case was arguing why this was too high and how they could bargain it down) and Mellon shares would convert at a 1:1 basis. Because of this quirk it is easier to think of Mellon buying BNY. 

Let’s assume both firms think synergies will be $7.5 billion present valued. Let's also assume synergies will be split in proportion to equity 'brought to the table.' What does the new firm look like? If the market values the synergies at the same value, what should the efficient share price be?

The easiest way to tackle this is to pretend the merger was an all cash offer. If Mellon bought BNY for all cash, they would need to pay $100 billion for the company plus $4.63 billion for their share of the synergies (7.5*26/(16+26)). This would produce a company looking something like this.

Woohoo $7 share price bump! The enterprise value is now the sum of the two companies plus the $7.5b in synergy and the debt is the debt of Mellon, the debt of BNY and $4.63b in BNY's synergy payout. Equity is simply Assets minus Debt, and then we call solve for share price by dividing by the number of shares outstanding. Obviously the firm is far to levered (7 times debt to equity, yikes!) so we need to look at the all stock merger. This is easy to do because we have not yet impounded the markets expected heavy discount on the stock due to our extreme leverage. Leaving this step out (we would need to do it if the merger was indeed all cash), we simply drop the cash payout from debt, and figure out how many shares need to be issued to solve for the same price per share. This is because, economically, the all stock and all cash deal involve the exact same payoffs, and so if we want to reward BNY with the same split of synergy, we simply just need to issue them enough stock to replicate the split they are getting under the current deal. This is how it looks. 

Now the debt equity ratio is a much more reasonable 2 (for a bank), and we have another 666 million shares outstanding that belong to BNY. It's that simple. From here you can play with any stock cash mix you want, and figure out all sorts of cool things like ownership stake, what stock payout is needed to keep within covenant restraints, and the sensitivity to each party in the event that synergy is less or more than expected. 

Oh and that exchange ratio, it’s 666/751.8=0.8858. BNY was arguing speculation had gotten out that the firms were going to merge and so they wanted to use the 6 month average stock prices. Unfortunately over the last 6 months Mellon had experienced a great rally where BNY had underperformed. The lower the equity value pre merger, the less stake you get in the synergies.

Accretion and Dilution

Will the EPS after the merger be higher or lower than it was before? Wither the merger is accretive or dilutive is a very common question from management, because they are used to thinking in terms of earnings per share, and have an expectation that their stock price will trade at a similar P/E multiple after the merger as it did before. The accretion dilution debate is basically economically irrelevant, but for the sake of the interview questions under the above assumptions plus the assumption that synergies are realized evenly, if the acquiring firms P/E multiple is higher than the (offer price)/E_target, the merger will be accretive. In reality it is not this simple; if there are high merger costs up front the merger will be dilutive at first and then can become accretive when synergies overwhelm integration costs later on. Also the reasoning behind the question is flawed, if a high P/E company buys a low P/E company of similar size, the market will adjust the price to a multiple that sits roughly between the two, unless there is good reason to believe that the high growth firm can make the low growth firms assets achieve high growth.