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Jim Doak says when a stock is a good short, you can smell it. The co-founder of Sui Generis Investment Partners is getting a whiff of trouble from Seven Generations Energy Ltd. and advises taking a short position in the Calgary-based oil and gas outfit before the market catches wind.
Seven Generations (VII.TO) pushed ahead with a $932-million initial public offering last October amid collapsing energy markets at a per share price of $18 - well below their original target. The stock has pushed as high as $24 and as low as $14 over the last 52 weeks. Eleven out of fourteen analysts covering Seven Generations have a 'buy' rating on the stock according to Bloomberg.
Doak laid out a three-pronged case for betting against Seven Generations on BNN Tuesday.
OVERSPENDING TO MEET CONTRACTS
Seven Generations’ CEO said he’s going to continue spending to meet production targets in the face of low commodity prices, moving in the opposite direction of its peers to gain market share. That has Doak worried.
“This is a company that knows how to spend money, which I don’t think is a great virtue for an oil and gas company in 2015,” he said.
Seven Generations is running 10 rigs in its main Montney play in North Western Alberta, with plans to add another three in the summer, and two more before year’s end.
Doak says the company is contracted to the hilt and spending at 3.5 times its cash flow in 2015 to keep up with its natural gas commitments. The company is committed to delivering 500 million cubic feet per day of liquids-rich gas on the Alliance Pipeline to the U.S. Midwest by 2018.
“They have very substantial commitments to take or pay contracts. So they need to drill. They are drilling in the Monteny section of North West Alberta, a very expensive place to drill. We’re talking about his company having to raise primary equity to keep this tremendous spending pattern going,” said Doak.
OVERVALUED SHARES ARE AT RISK OF BEING DILUTED
Seven Generations shares are down 7.66 percent year-to-date at Tuesday’s close, but Doak says he finds it’s hard to imagine why anyone would pay a cent above the company’s net asset value of $10.70.
More importantly, he worries about the impact of 82 percent of the company’s equity hitting the market when a lock up releases on May 6. When that stock hits the bid, Doak is betting the flood will lead to a sell off.
And the news for shareholders could get worse; he says Seven Generations will be forced to issue more primary equity – diluting the value of existing shares – in order to keep up its spending at the current pace.
“We are talking about [secondary stock offerings] coming out, existing shareholders selling as soon as they can in the month of May. Then we’re talking about this company having to raise more primary equity to keep this tremendous spending pattern going,” he said.
PROMOTION COUPLED WITH CORPORATE EXODUS
The company’s latest investor presentation projects a 52-percent internal rate of return (IRR) on wells pumping $45 barrels of WTI, a figure Doak says is aggressive and largely out of step with peers in the Monteny.
“Most companies in Canada would feel great about having a 15 percent IRR. And at $45 WTI, are they going to get a 52 percent IRR on those wells? That’s very aggressive,” he said.
The corporate shake in recent weeks at Seven Generations is unnerving given the combined influence both positions have on the company’s fundamentals according to Doak.
“Their auditor quit or was let go or decided not to audit them anymore last week. Then their CFO resigned. They need to lock up their people and make sure they don’t leave. Who’s on first? Who’s on second? That’s part of the smell that makes this a really good short,” he said.
BONUS: EVEN THE COMPANY’S SIGNAGE IS A BAD SIGN
Remember when U.S. auto industry executives arrived in Washington D.C. in private jets before extending their hands for government bailout money? It came off as excessive and out of touch with tough times.
Canada’s energy sector isn’t exactly riding high these days, so a story related to Doak about Seven Generations’ special signage struck a chord with him.
“We were talking with a fellow that had been up in the Montney area. This is rugged country. He said the Seven Generations sign that’s outside their wells is big, custom, put on two posts, like the entrance to a ranch. But when you got down the street to Canadian Natural Resources’ (CNQ.TO) wells, and CNQ is one of the best run corporations in Canada, they have a piece of paper stapled to a post,” he said.