Dynamic Stories at Two Small-Cap Drillers

 | Nov 11, 2013 | 6:00 PM EST  | Comments
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It's earnings season in the small-cap unconventional drilling sector. I've been bullish on the following three names: GreenHunter Resources (GRH), Evolution Petroleum (EPM) and Magnum Hunter Resources (MHR). Because of space limitations, I will discuss GreenHunter and Evolution today and Magnum Hunter on Tuesday.

GreenHunter Resources will report earnings before the market opens tomorrow and conduct a conference call at 11:30 a.m. EST. This is news, because GreenHunter has not hosted an earnings conference call since April 2012. I believe that the company's hire of CFO Ronald McClung has changed its approach toward financial reporting, accounting and communication. A cynic might note that GreenHunter's re-initiation of conference calls indicates that the company's financial difficulties are subsiding and that the true cash-flow potential of this business is now worth displaying to the investing public.

That's an oversimplification, but I am long the preferreds for all my clients, and I have GreenHunter common exposure as well, so if good news is the motivation for renewed communication, then so be it.

As I have noted in previous columns, GreenHunter's management, led by interim CEO Jonathan Hoopes and chairman and largest shareholder Gary Evans, are aggressively seeking capital. So tomorrow's announcement should be value added for public and for potential private investors in GreenHunter.

Here's what to watch for on GreenHunter:

GreenHunter's most recent operating update indicated an 18% sequential increase in the third quarter in volume of fluids handled in Appalachia. Outlook always trumps results, though, so I'll be listening intently for guidance on that rate into 2014.

GreenHunter's South Texas salt water disposal (SWD) wells have performed well, but the company is clearly focused on Appalachia, so any update on divestiture progress in Texas will be welcome. This would also affect the company's ability to enter into the Bakken market in the Dakotas, a market which it has targeted for growth, in which it does not currently operate and in which it needs SWD capacity.

We'll be listening for any guidance on capital expenditure budget for 2013 and 2014. Not only will this drive my forecast for GreenHunter's top-line growth, this also helps connect the dots on how much capital it will raise.

Evolution Petroleum announced this morning the initiation of a quarterly dividend payout at a rate of $0.10 per share. It's payable to shareholders of record on Dec. 6, so the "buy date" for the dividend is Tuesday, Dec. 3. Evolution shares have risen 55% this year, I believe largely in anticipation of the capital return strategy. But initiating a dividend is a first step, not an endgame.

I believe that Evolution would still consider selling either the entire company or its interest in the Delhi Field alone if a suitable buyer offered a.) the right price and b.) a tax-efficient strategy, which is especially relevant here, since Evolution's tax basis on its Delhi asset is near zero. Delhi has been a challenge, as operating partner Denbury had a significant drilling accident there in the summer. This has delayed the date at which Evolution's royalty interest would revert to a working interest (it's based on cumulative cash flow from Delhi), giving Evolution 23.9% of the field's cash flow but also necessitating a high level of capital expenditures from Evolution,

Evolution currently has no debt, and while management noted on last week's earnings conference call that Evolution is working on adding flexibility to its revolving credit facility, the company's private-equity sponsors did not intend for Evolution to be an operator. It's possible to envision a scenario in which Evolution as we know it is gone and investors are left with a.) an amount in cash close to Evolution's current value and b.) a holding in NGS Technologies, which is Evolution's "start-up" company that markets its gas-assisted rod pump technology (GARP) to oil producers.

So the story is not over yet, but the initiation of a common dividend and the entry into a revolving credit facility makes it, at the margin, less likely that the company will call its Series A preferreds. The Series A preferreds are callable beginning July 1, 2014, and while it's a small issue -- $10 million overall -- any funds used to pay common dividends -- $2.9 million per quarter at the announced rate -- are funds that can't be used to call the preferreds.

Owing to the long-lived nature of production at Delhi and Evolution's debt-free balance sheet, the preferreds are the perfect Portfolio Guru investment. I have told CEO Bob Herlin and CFO Sterling McDonald that my preference would be to collect the 8.5% coupon on EPM-A (it's trading at a premium to par, so the current yield is 8.1%) for the entire productive life of their Delhi assets, which is currently estimated at 43 years! OK, that's not going to happen, but in a sector beset with volatility, Evolution is a welcome safe haven.  

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