Investing in the Undervalued

 | May 15, 2013 | 12:00 PM EDT
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We are always on the lookout for "special situations," here at Portfolio Guru, LLC; however, they have to be exceptional to outperform the currently frothy stock market. In reality, we are looking for companies that have been punished by the market and are offering value vs. the perceived worth of their assets.

On Monday, I wrote about Gastar Exploration (GST), whose shares -- common and preferred -- were weighed down by litigation with Chesapeake Utilities (CHK), which has since been settled. This is an example of the types of special situations my company looks for, and it proved to be an investable event. Another example in the oil patch is Magnum Hunter Resources (MHR). In this case, the investable event was the company's decision to fire PwC as its auditors. This came on the heels of massive delays in the company's filing of its 2012 10-K. (It was due March 1 under Securities and Exchange Commission (SEC) regulations but it still hasn't been filed.)

CEO Gary Evans has stated twice in the last week that the 10-K will be filed by mid-June with the first quarter's 10-Q likely to be filed by the end of June (it was due on May 10). Evans has also stated that MHR's accounting staff has been bolstered from 15 to 40 and that he is particularly pleased with the work of the new auditors, BDO.

It's a self-inflicted wound, but Magnum Hunter's special situation was its inability to file documents with the SEC. MHR shares plummeted as filing delays mounted and the market lost faith in this management team. Regaining credibility is key, and for analysts that's a matter of delivering on promises. In the past six weeks, Evans and MHR's Board have executed a divestiture (sold Eagle Ford shale assets to Penn Virginia raising $400 million), and announced the possibility of another (selling MHR's stake in its Eureka Hunter pipeline; MHR management values at $400 million to $500 million.)

MHR is reaping real cash from asset sales, which it is using to repay its debts. So management is doing what they said they would. Meanwhile, they are using cash flow from operations and proceeds from a 2012 debt offering to fund growth in their two core areas: Appalachia (MHR participates in the Marcellus shale and is beginning to drill in the Utica) and the Williston Basin in North Dakota, where MHR is pumping hydrocarbons from the Bakken shale. Again, doing what they said they would.

Valuing MHR is tricky because its last filed financial report covered the period ending Sept. 30. We'll use the numbers that exist and rely on management's recent analyst presentations. If we take MHR's reported reserves of 61.6 million barrels of oil equivalent and apply the same dollar value placed on the reserves of competitor Matador Resources--after stripping out assets held for sale and debt -- that leaves an equity value for "core MHR" of $9.11. The stock closed yesterday at $3.41. That's not to suggest MHR will hit $9 a share any time soon, but the recent high was $8.56 in April 2011. Regaining credibility and improving natural gas prices could go a long way toward restoring MHR's equity value.

In an undervalued company, our income-investing principles require us to seek a fixed-income option; Magnum Hunter has three preferred series outstanding. Due to covenants in its bond indenture, Magnum Hunter has to cease preferred dividend payments until the SEC documents are filed (the last monthly preferred dividend payment was made on April 1). It's important to note that these are cumulative preferreds, meaning those payments are accruing in arrears -- you will get paid.

The table below shows the details on MHR's three preferred stock series. If you are focused on return of capital, MHR.C is a sure bet in a zero-interest rate world. The company stated in an 8-K filing on May 9 that it will redeem the Series C as soon as the 10-K and 10-Q are filed. For longer-term investors, the other two (D and E) each offer yields in excess of 8.6%.

MHR's Preferred Stock Series

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