Energy XXI Gulf Coast (EGC) – Merger Arbitrage – 16% Upside

Current Price – $7.81

Merger Consideration – $9.10

Upside – 16.5%

Expiration Date – 10th Oct, 2018

Merger Announcement

This deal was suggested by Dan.

 

EGC is an micro cap E&P company with assets in the GoM. Back in June it agreed to be acquired at $9.1/share by Cox Oil – private E&P also operating in the GoM. Till recently investors assigned almost zero risk to this deal and EGC shares traded at c. $9 leaving only minimal spread. However, everything changed on the 10th of September when it was announced that closing of the transaction has been extended till the 10th of Oct without any clarification for the delay. Investors were likely expecting prompt closure (as per merger agreement) after the shareholder approval (which happened on the 6th of Sep). This scared the market and ECG sold-off sharply with spread widening to 47% at one point and then normalizing to current 16% after another announcement that the merger is still on track.

The whole situation is a bit puzzling and has indications that market simply overreacted to the slight extension. This reminds me a bit of Lithium X Energy case from this spring but obviously might not play out as favorably.

 

Potential reasons for the spread and market sell-off

Although I am not really sure what has caused the widening of the spread, I am listing few points for consideration below.

-SEC investigation and settlement with previous management of EGC. As per press release this relates to pre-bankruptcy events and management of the company. News surfaced in mid July without having any effect on the spread at the time. So I do not think this is in any way related to current situation.

- Russell index removal. The company is part of Russell indices and was due to be removed from these upon merger. By my count index tracking funds own c. 15% of the stock. FTSE Russell announcements issued after the shareholder approval (herehere and here) suggested that removal was supposed to happen on 11th and 12th of Sep subject to merger actually closing. In this case there would not be any need for the index tracking funds to sell off the position as they would receive merger consideration instead. However, with the delay everything got trickier, as FTSE Russell ignoring the postponement ‘began the process to remove EGC’s common stock from the index’. This info was received on 19th of Sep and it is a bit unclear whether the removal actually happened on the 12th of Sep or is still in the process of happening. This Invesco ETF already excludes EGC, however BlackRock still seems to include it and Vanguard reports portfolio data only as of Aug 31st. Thus, it is uncertain if the sharp market sell-off might have been prompted by FTSE Russell screw-up

- Merger financing problems. Even though the deal was not conditioned on financing there might be some issues (even if temporary) in getting the required $320m+. This is the largest acquisition for Cox Oil so far and will almost double its production. No info Cox Oil financial standing is available and proxy notes that Cox did not obtain financing commitments before signing the agreement despite repeated insistence from EGC management. However, the company has done material acquisitions (amounts undisclosed) in both 2016 (from Chevron) and 2017 (from Freeport-McMoRan) should already have decent relations with financiers. Proxy also reiterates a number of times assurances from Cox about “robust financial strength” and that “financing would not be a hindrance”. With the merger doubling the company in size and no financing commitments agreed in advance a certain delay in finalizing financing could be expected.

- Cox Oil is reconsidering the acquisition. Geo location wise EGC seems to be a good fit for Cox operations as fields are located in virtually the same area. Price wise some investors with much more knowledge than me in the O&G industry would argue that Cox is getting a bargain (see section below). Also from the way the delay press release was worded (“The amendment also provides that Cox cannot refuse to consummate the merger because of any material adverse events occurring on or after September 10, 2018 until the closing date.”), it seems that ECG simply wanted to ensure that the deal is not cancelled due to subsequent unforeseen events suggesting that everything observed during due diligence up to 10th of Sep was satisfactory for Cox Oil. I also think that termination fee of $35m (>10% of the deal and probably similar amount of Cox valuation) is significant enough to ensure Cox Oil continues to put all efforts to close this.

 

Is Cox Oil getting a bargain?

For this part and also more detailed background on the company I would refer readers to recent EGC write-up on VIC, which was prepared by 8% investor in the company.

EGC went bankrupt in April 2016 and reemerged after restructuring in December. Management and board were changed, $3.6bn debt eliminated/converted to equity. Equity was almost fully owned by previous bondholders which not being natural owners of equity securities liquidated positions causing equity to drop from $30/share to the low of 3.5/share. Lack of operational improvements likely added to the share price decline. EGC has clean balance sheet (net cash position), but material asset retirement obligations ($700m).

Couple quotes on valuation:

EGC has arguably one of the best collection of producing assets in shallow waters in the GOM. If valued as peers (WTI as an example), EGC would be worth 5x it’s current price on proved reserves and 10x on proved and probable.

At current strip pricing, with no hedges going into 2019, EGC should generate around $280 million EBITDA next year, or around $100 million free cash flow. Which should by itself equate to a $30 dollar price per share vs it’s current price of below $6 per share.

Because of it’s ARO obligations and fixed cost basis, it is our belief that if oil prices (Brent) dip below $50 again, the equity is most likely to be worth zero. That is the bear case.

Even though these numbers might be over-optimistic if EGC continues as a standalone entity (after all no shareholders including the author of VIC article objected to Cox Oil offer) at the very least this suggests that there is significant value in the assets, that Cox Oil is not overpaying and that Cox should be quite eager to close the deal at the agreed price.

Also Cox Oil was not the only the party interested in EGC (although the only one willing to acquire the whole company outright). Before the Cox agreement was signed,  EGC announced intentions to dispose non-core assets together with asset retirement obligations to Orinoco Natural Resources (this was cancelled later in favor of Cox deal). Proxy also reveals a third party that was interested in EGC assets and actively pursued negotiations.

From VIC comments on Orinoco deal:

After going through the deal and speaking with management my thoughts are that the market is not pricing correctly what just happened today. Let me elaborate:

We were diluted by 35% but in exchange for what? Reduced ARO’s by $215m, $75m in G&A savings, which both add to $290m. Adjust for the $25m cash consideration the company is paying and that equals $265m. In exchange of 18m new shares. In other words the company just sold 35% of itself for $14.7 per share. Roughly double what the share price was yesterday.

 

Downside

With EGC already trading at pre-announcement levels I do not see material downside even if the current deal with Cox Oil breaks. If this happens, negotiations with the other two parties will likely restart or management will seek new ways to dispose non-core assets and reduced asset retirement obligations. On top of that EGC will get $35m termination fee, which is another $1/share.

If the share price drops significantly upon termination of the deal, it might provide a good entry opportunity for a fast rebound.

But also worth mentioning this note in the proxy “if EGC continues as a stand-alone company, it would need external financing in 2019 in order to finance its capital expenditures and cash shortfalls from operations”.

Published on: September 26, 2018  •  Published by:
Category: M&A
Tags:   •    •  

33 COMMENTS

  1. dt

    And forgot to mention that Oak Tree Capital with Howard Marks in the lead has 12% ownership of ECG. I understand the position relates to bankruptcy investments in debt that were later converted into equity.

  2. gheff912

    Regarding the language of Cox’s ability to refuse to consummate the deal: “Cannot refuse to consummate … until the closing date.” Does that imply they CAN refuse to consummate AFTER the closing date?

  3. Alex15

    Dt, am I correct in the assumption that all closing conditions have been met except for one (that is causing the delay)?!

    1. dt

      Reasons for the delay have not been stated and I am not sure whether it is one or more conditions. However it seems to be clear that the delay is on Cox side.

      1. Alex15

        Thank you, that helps. After researching I opened a small position today. I can’t remember a case where the expected closing date has been so precisely (usually it’s a lot vaguer) stated and then have one party come up and say that the merger failed. And the fact that we have’ t heard anything today also gives a bit more confidence.

  4. work 22

    These kinds of trades are sooooo tough. It could be the financing; it could be nothing. It could be a banker important to the deal has kids out with the flu; it could be the buyer got cold feet last minute. If the deal closes, we may never know what caused the delay (and not care!).
    Staying on the sidelines myself, just one opinion- I’m not as confident on the downside risk valuations considering this was a $5 stock 6 months ago. And there’s just so many unknowns. Imagine a person buying a house and backing out at the last minute but saying they needed one more month to decide- what would you think?

    1. dt

      6 months ago oil traded significantly lower, so EGC only became more attractive since the initial negotiations with all the involved parties started. So in my view the unaffected price (before Cox announcement) of $7.5/share is a reasonable estimate of the downside. In the short term might trade lower if the deal drops, but will likely recover quite fast, potentially with announcement of transactions with other parties.

      So for my perspective this seems like good risk/reward.

      1. work 22

        Fair enough- i forgot to add that quite often with these ‘last minute’ delay situations the price is negotiated down. That’s a distinct possibility as well. Hopefully not for everyone long!

        1. dt

          Agreed, risk of deal cancellation is high, but downside in case that happens should be limited. Today/tomorrow we should hear something.

        2. Alex15

          Work22, can a bidder lower the bid after shareholders have approved the merger? Do you know a case where this happened?

          1. work 22

            It happens more than you’d think, check out AVOL in September 2015. Price lowered from $32 to $31.
            Verizon also paid $350 million less for Yahoo after a deal was signed (because of data breaches on Yahoo’s servers).
            The “can” part might not be what the sellers had intended when they signed the agreement, but sometimes a lower price is better than no deal at all!!

    1. work 22

      that does sound like a positive quote on “financing documents, are nearly complete.” I wonder if Cox overestimated their ability to waltz into a deal with no financing contingency? Maybe the banks needed more time to sign off on Cox as a buyer? That would make sense. I like how EGC reminded Cox that they are not off the hook in anyway lol: “This extension is not a waiver of obligations under the merger agreement. The closing of the transaction is not subject to a financing condition.” Translation; we can wait a little longer, but you still gotta pay guys!

      I’m still sitting on the headlines, though i am rooting for you longs. Good luck.

  5. dnitka

    Looks like trading was halted today. Possibly the deal is closed/closing. Will look for news after the bell.

    1. dnitka

      Can’t tell. My broker had trading halted but yahoo finance was still showing updated prices.

  6. dt

    With the deadline having passed, I am guessing another extension will be announced in the coming hours.

    1. Alex15

      That seems like the most likely outcome. The communication of both companies is so confusing…

  7. Terence

    Premarket trading while awaiting news: so far at 8:29am, 35k shares traded, all in the $7′s,

    except the first trade of 100 shares at $9.06 and another 100 shares later at $8.90 (apparently representing optimistic investors).

  8. Terence

    Good news – “… expect to complete the merger within the next few hours”!

  9. Neo

    HOUSTON, Oct. 18, 2018 (GLOBE NEWSWIRE) — Energy XXI Gulf Coast, Inc. (“EGC” or the “Company”) (NASDAQ: EGC) today provided an update regarding the closing of the merger with affiliates of Cox Oil LLC (“Cox”).

    EGC previously announced on October 10, 2018 that EGC and Cox jointly agreed to extend the closing date of the merger to October 17, 2018.

    EGC and Cox began the closing process at 7:15 a.m. Central Time this morning and expect to complete the merger within the next few hours.

  10. dt

    EGC should get some kind of award for the strangest investor communication: press release on upcoming closure without 8K, same happened with extension when 8K was few hours late. Also both press releases came way after the deadlines have already expired.

    Anyways, happy to see this saga seemingly ending favorably.

    1. Dan Silverstein

      Glad this worked out. This morning, even after the announcement by EGC that the merger was going to close in a few hours, I found sellers willing to trade their shares for about $9/share. I doubled my position which was already substantial. A nearly risk-free 1% in one day seemed worthwhile. The EGC deal almost kept me in the green on an otherwise pretty ugly day for the market.

      Glad I could contribute something to the board.

      Dan S

  11. work 22

    What a saga! Certainly tested some stomach linings. Nice trade.
    Will be interesting if the story ever comes out why and how close it really was. Sometimes its good to analyze past trades and see what the odds really were- like watching the Texas Hold ‘Em poker matches where they show the odds for each player in the lower left corner. It might have been just paperwork, or Cox being overconfident as oil sold off. Anyway, nice trade!

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