Harvest Oil & Gas (HRST) – Liquidation – 39%+ Upside

Current Price: $19.75

Liquidation Value: $27.36+

Upside: 39%+

Expiration date: TBD

This idea was shared by Brian.

 

Harvest Oil & Gas is a $20m market cap, failed E&P play which is in liquidation. All of its assets have already been sold and the remaining book value ($33.76/share) is comprised mostly of cash ($13/share) and sellers’ note ($22/share). The sellers’ note was received as a payment for the sale of the latest major asset in the Appalachian basin ($22m) and is structured in two tranches, which mature in 2025 and 2027. However, note’s agreement also includes 11%/14% interest rate (tranch 1), with 1% monthly amortization and 90% cash sweep provisions and as both gas and oil prices have increased substantially since mid’20 when the sale occurred, the buyer should be highly incentivized to repay/refinance the notes as soon as possible. At the time of the sale, the management has also clearly communicated that they expect it to be repaid prior to the maturities. We spoke briefly with Mike Caldwell, an affiliate of the Appalachian assets’ buyer, but haven’t gotten a call back. I have a call in with the company and will update as I receive additional clarification.

HRST trades thinly, has a float of only 316k shares or $5.9m. Nearly 70% of the shares are held by three large funds (two hedge funds and CEF), which seem to be in control of the board and should be incentivized to push for maximum recovery in a timely manner. Moreover, there have been several board changes recently, which resulted in the chairman (who is likely an affiliate of the major shareholders) taking over 5 different roles (including CEO, president, secretary and general counsel). This is undoubtedly positive and speaks in favor of a highly optimized liquidation process going forward. Worth noting that since mid’20 the company has already returned $23/share to shareholders.

I assume $2 mil in liquidation costs, which is pretty standard and makes sense to me in light of their current setup. I also model $4.5m of total further cash burn, which is somewhat arbitrary and I think conservative. Moreover, the 11%/ 14% interest rate on tranch 1 ($18m) will offset some part (or all) of the ongoing costs. Overall, this results in a final liquidation value of $27.36/share, providing 39% upside to current prices.

The risks are:

• The sellers’ note repayment could take longer than expected or default (unlikely as explained below).
• Taxes. Apparently, the two previous distributions (both $10/share, here and here) were not taxed while the last one ($3/share) was treated as a taxable liquidating distribution per their PR. Liquidating distributions typically reduce an investor’s basis and I’m not totally sure why they termed this a “taxable liquidating distribution” except that they may be making reference to it being taxable once an investor’s basis is exhausted. For the avoidance of doubt, HRST can be purchased through an IRA.
• There is also one remaining unknown regarding $5.7m in uncollected accounts receivable from 8 years ago that the former manager EnerVest Ltd asserts Harvest may be responsible for. In Oct’19 EnerVest Group informed HRST that there are $4.1m of uncollectible accounts receivable from third party working interest owners in O&G properties where Harvest owns a significant working interest. The amount was recently increased to $5.7m. 2020 annual report states that these costs were primarily incurred over the last 8 years and were paid by the EnerVest Group as the contract operator for such properties. HRST performed a preliminary assessment of its obligations and communicated to EnerVest that it believes it is not responsible for these amounts and is not currently accruing anything (see quote below). Some of these A/R go back to before Harvest’s predecessor filed for bankruptcy in 2018. Any further details on this claim are limited. Overall, it is probably unlikely, but if Harvest had to cover the entire amount, we’d be down to around $21/share in net liquidation value, 6% upside from the current price.

Harvest has performed a preliminary assessment of its obligations with respect to these amounts and has communicated to the EnerVest Group that it believes that the amounts are not currently owed by Harvest to the EnerVest Group

 

Appalachian basin asset sale and seller’s note

Initially, the assets were agreed to be sold for $14.5m cash and $6m seller’s note, while the transaction was estimated to close in August’20. However, the process took longer than expected and the sale closed in October’20 for slightly higher consideration ($21.8m) but fully paid in seller’s note.

The note was structured in two tranches:

• Tranch 1 – $17.8m with 11% annual interest rate payable in cash or 14% if paid-in-kind (added to the principal balance). Tranche 1 also includes monthly scheduled amortization payments of 1% (from the outstanding principal) beginning February 2021, and an additional monthly amortization payment based on a 90% excess cash flow sweep (payment of the excess cash generated by the assets), with the first payment scheduled for the end of February 2021. Final maturity is Oct’2025.
• Tranche 2 – $4.1m with 3% interest rate through April’24, 7.5% from May 1, 2024 through October 31, 2025 and 11% thereafter. Interests are payable in kind. Tranche 2 also includes monthly amortization based on a 90% excess cash flow sweep that begins after Tranche One is fully repaid.  Final maturity is Oct’2027.

2020 annual report shows that so far interests on both tranches were paid-in-kind, with the total principal of the note increasing to $22.4m:

Appalachian basin assets was a network of oil and natural gas production/gathering/transportation systems, which produced 440MBbls of oil, 7.8MMcf of natural gas and 33 MBbls of natural gas liquids in 2019 and also had 99.6 Bcfe oil reserves remaining as of Dec’19. At the time of the initial sale agreement (Jul’20), natural gas price fluctuated around $1.80/MMBTU and oil was around $40. When the deal was finalized in Oct’20, natural gas traded at $3.30 and oil was mostly unchanged. At the time of the sale  management commented:

Based on recent commodity strip prices, Harvest currently expects both tranches to be repaid prior to their final maturities.

Since then oil prices have increased to $63 while natural gas remained stable at $3.20.

Overall, the buyer likely got a great deal, buying 99 Bcfe of reserves at a relative trough in energy prices from a forced seller. It’s likely the notes are paid off relatively rapidly based on the contractual amortization requirements, and the buyer is incentivized to pay off the first tranche, at a current 11%/14% accruing interest rate, sooner rather than later.

The company also had some remaining wells left in the Appalachian basin. A handful of them were sold for $100k in early 2021, and the remaining uneconomic wells will be capped and abandoned (asset retirement obligations of $234k are included within paybales)

The buyer Oilwell Shares. It was formed in 2017 and the entity which purchased these assets was formed shortly before the deal was announced. The management team claims to have substantial experience within the Appalachian region:

We have had a local presence in the Appalachian for over a 100 years that has enabled us to cultivate countless invaluable local relationships with landowners, communities, and other energy companies.

Oilwell is concentrated in this one basin and claims 99% drilling success, but the available information is limited.

 

Harvest Oil & Gas

Company’s balance sheet looks like this (based on Dec’20 figures adjusted for recent distribution).

Assets:

• Cash – $12.98/share. $13.2m net of $3.1m distribution (June’21).
• Accounts receivable – $4.23/share. $4.3m, mostly from oil & gas sale revenues, which have likely converted to cash by now.
• Seller’s note – $22.02/share. $22.4m  in total.
• Other assets – $2.75/share. $2.8m in total (current and long term other assets) – aside from a small lease asset of $39k, I’ve not been able to figure out the remaining part of this bucket. So not sure whether these can be converted to cash.

Less Liabilities:

• Accounts payable and accrued liabilities – $7.67/share. $7.8m in total.
• Other long-term liabilities – $0.54/share. $0.55m in total.

Also as of Dec’20, the company also had $1m assets and around $1m liabilities attributed for certain unsold O&G propertes in Michigan (assets held for sale). The company states that these assets were sold in January’21 for “a de minimis amount of consideration”. There should be no further obligation thus these items were excluded from the calculations above.

This results in $34.3m in BV or around $33.76/share. Deducting a further $6.5m for further admin costs and liquidation expenses (probably overly conservative) leaves us with $27.8m or $27.36/share in expected liquidating distributions.

Excluding ‘Other assets’ – as it is not clear if these can be converted to cash – the expected liquidation value would be reduced by a further $2.75/share.

HRST burned/lost $1.5m in Q4’20, which was highly elevated as Harvest was still operating for part of the quarter and incurred various transaction and legal costs. Estimating the remaining ongoing cashburn at $4.5m for the rest of the year should be conservative enough with the cleaned board and the current setup. Keep in mind that the interest rate from tranche 1 interest rate would result in $2m-$2.5m or $1.97-$2.45/share BV increase annually, which should offset most of the cash burn from ongoing costs.

One more thing – given the outstanding cash, the recent (June’21) $3.1m distribution could be considered conservative (i.e. why retain the other $13m on the balance?), however, HRST had $8m in payables and the $5.7m in disputed A/R, so they likely needed to keep $13m in liquidity as an extra precaution.

3 largest shareholders are:

• Finepoint Capital funds (hedge fund with around $4bn AUM) – 32.2%;
• CQS funds – credit-focused hedge fund with $19bn AUM – 24.1%
• FS Energy And Power Fund – invesment management firm with $2.2bn AUM – 13.3%;

All 3 shareholders use to be pre-bankruptcy (2017, at the time HRST used to be called EV Energy) noteholders. The company emerged from bankruptcy in June 2018. At the same time, Steven J. Pully (the current chairman, CEO, etc.) was added to the board, so it is highly likely that he is an affiliate of the major shareholders.