Investing

I sold out the last of my EROC position in the last few days. I first wrote about EROC in mid July 2009 - Eagle Rock Energy Partners (EROC). I first pegged the value between $7.66 and $8.90 when EROC was trading around $3. In late July 2010 I posted an updated Valuation of Eagle Rock Energy (EROC) post transactions. This pegged a reasonable valuation, based on a weighted average of managements estimates contained in SEC filings, at $9. As EROC is now at around $9.40 I’ve closed all my positions in the stock and warrants.

When EROC was trading at $3 there was a forced seller and a belief that they could violate bank covenants. The forced sellers had purchased EROC for yield and the distribution had been cut to 2.5c per quarter. In reality the bank covenants could not be violated as the company had control over their hedges which provided a backdoor mechanism to remain in compliance. EROC subsequently announced a series of transactions to affect a recapitalization. There was a lot of controversy over the transactions. Kerrisdale Capital launched a site fair-eroc.com to vote down the proposal. Kerrisdale do good work and I bet they have a terrific run rate. However, this time they got it at least partially wrong. Kerrisdale outline their concerns at fair-eroc.com;

“So what remains? In our view, NGP is essentially canceling (sic) its subordinated units in exchange for $29mm (plus associated rights/warrants if they receive the fee in shares). These subordinated units are not worth $29mm+. With $1.65+ of arrearages ahead of them, the subordinated units will be underwater for 5+ years. We at Kerrisdale believe they are worth very little.”

In fact they were worth around $40M. I contacted Kerrisdale about their methodology for calculating the value. They had not calculated a value for those units but held a belief that the value was so far in the future that the uncertainty would wipe out all the value (sounds like an option doesn't it!). I calculated an undiscounted cashflow of nearly 400M and a discounted value of $40m. EROC was paying $35.5M for them. Kerrisdale did manage to bring about some minor changes in the plan and I appreciate their efforts to put management on notice.

As a result of the initial offer I valued EROC at $8.58 which was then updated by a few percent after the revised transaction was announced. 

In Kerrisdale’s 8/10/10 post on their activism efforts (login required) they note

“In the end, however, unitholders voted in favor of the plan. We’re not exactly sure why – the restructuring was clearly less than ideal, and we’re confident that NGP would have sweetened the offer if holders had rejected the initial proposal.”

The answer may lie in Behavioural finance. There is a famous experiment called the Ultimatum Game in which two volunteers participate. “The first player proposes how to divide the sum between the two players, and the second player can either accept or reject this proposal. If the second player rejects, neither player receives anything. If the second player accepts, the money is split according to the proposal. The game is played only once so that reciprocation is not an issue”. In many cultures a 50/50 split is offered and an offer below 20% is usually rejected. The most economically rational decision is to keep $19 and offer $1. The 2nd volunteer is still $1 better off but a 19/1 split is usually rejected. In this case NGP developed a proposal that offered value far from 50/50 but probably at around the 80/20 line (80 to NGP of course!). The reality was that EROC holders were offered incremental value, just substantially less than the value to NGP. Kerrisdale may well be right that NGP would have come back with a better offer but the offer on the table was accretive to shareholders.

At $9.39 there are a number of risks to EROC. Natural gas prices, interest rates, refinancing and capital investment risk. There are lots of ways EROC could be worth less than $9.40 and far fewer ways that it could be worth substantially more.

Finally, as this seems to have turned into the Seahawk (HAWK) blog it’s interesting to note the EROC timeline with a Seahawk overlay. The Seahawk closing prices are shifted to match my initial purchase of both HAWK and EROC.

If HAWK takes as long to play out as EROC then there are still 15 months to go. I have no particular insight that this is an appropriate timeline. However, if your timeline is substantially less than 1-3 years  then you are unlikely to see this play out before you (have to) close your position.

posted by Neil  # 10:12 PM