On July 1st, 2019 I invested 13% of the After Dinner Investor portfolio into Gulfport Energy Corporation stock, ticker symbol GPOR. 5% of the fund is currently in cash, and I might use some or all of that cash to purchase more Gulfport stock. Or I may not, still undecided.
I am on the treasure hunt for no-brainer investments, as the site logo points out, and I believe I found one in Gulfport Energy. In this article I’ll explain why.
As Ben Graham teaches us in the Intelligent Investor, a stock is not solely a piece of paper; rather, it’s an ownership interest in a real business. So, let’s start by examining what Gulfport Energy does.
Gulfport Energy is an independent exploration and production company based in Oklahoma City, Oklahoma, and they have 350 employees. Gulfport was started in 1997 and went public in 1999. At this point in time, they’re focused on natural gas. They have some liquids production in one of their two major assets, but primarily they’re a natural gas company.
Their two major assets include about 210,000 acres in the Utica shale of eastern Ohio; and about 90,000 acres in the SCOOP play of southwestern Oklahoma, which was added at the end of 2017.
They lease land in these two areas, contract service companies to help them drill for natural gas, and develop producing wells. Then, they sell that natural gas to pipeline companies for cash. It’s a simple business.
Their Utica assets are well developed and in cash flow mode. Also, very heavy on gas production. Near 90% gas.
Their SCOOP assets are less developed, still in development mode. While still primarily natural gas assets, they have more of a liquids mix, with the breakdown being 70% natural gas, 20% natural gas liquids, and 10% oil.
They are now allocating 50% of their capital budget to the SCOOP assets, because at current prices, the margins are higher in the SCOOP than in the Utica. They have the ability to go back and forth between the two assets in terms of capital expenditure, so this allocation can change as natural gas, oil, and natural gas liquid prices change.
They have some additional non-core assets, including: producing wells in Louisiana, North Dakota, Colorado, and Thailand. But those assets are very small compared to their two core assets. They also have an above 20% ownership stake in a public oil and gas services company they spun-off in recent years, Mammoth Energy Services. And, they have an interest in an Alberta Oil Sands company, but I’m not sure how active that company is right now. There are also other non-core assets we don’t know much about, like a water treatment asset in Oklahoma we’ll discuss later on.
But bottom line, Gulfport Energy Corporation is a natural gas exploration and production company with two core assets, 210,000 acres in the Utica Shale in Ohio and 90,000 acres in the SCOOP in Oklahoma.
They have 4.7 trillion cubic feet of natural gas equivalent reserves. The SEC PV-10 value of those proved reserves is $3.4 billion. The PV-10 is a valuation method for oil and gas reserves that estimates future cash flows from those reserves, discounting them back to present value with a 10% discount rate. It’s a very rough valuation method, but it’s something. You can learn more about PV-10 here.
This June 2019 company presentation provides a detailed look at the company.
In the late fall of 2018, the long-time CEO at the time, Michael Moore resigned after an investigation into unauthorized credit card use and chartered aircraft usage issues. You can read about that in this Wall Street Journal article.
A few weeks later David Wood was announced as the new CEO. Wood spent 17 years at Murphy Oil Corporation, including time as the CEO. He’s an industry veteran.
How I Found Gulfport
Now that we know what Gulfport does and understand their business model and assets, we can move onto the investment decision. Before that, let’s briefly discuss how they showed up on my radar.
I’ve seen Warren Buffett say during old annual meetings that he doesn’t really know how companies end up on his radar as potential investments, as there’s no set process. And that’s what I experienced here with Gulfport Energy. I regularly scan The Wall Street Journal’s 52 week highs and lows, and I believe a few weeks ago I saw another Oklahoma City oil and gas company, Chaparral Energy, on there as a 52 week low. This kind of primed me to be thinking about the energy industry, even if subconsciously.
Then some time later, I was flipping through the companies in the current week’s Value Line, not liking what I was seeing. It was a lot of semiconductor companies and that is an industry I know nothing about and is not in my circle of competence.
Mohnish Pabrai’s voice then rang in my head: the thing is, you have to fish where the fish are.
So after hearing Mohnish remind me that I have to fish where the fish are and look for great investments in beaten up areas, I thought to myself, you know, Chaparral was at a 52 week low recently, I wonder how other oil and gas companies are doing?
Then I changed Value Line issue and went back a few weeks to the issue where lots of oil and gas companies were featured.
In that issue, I saw a company whose stock price had crashed, I saw a very low PE, and I saw a name I recognized, Gulfport Energy.
How Far We’ve Come
A few years ago, before I was a handsome, swashbuckling entrepreneur, I was a handsome, frustrated young accountant working in the oil and gas industry here in Oklahoma City. I would often learn about the oil and gas companies in town, and Gulfport was one of the companies I had studied. At the time, their stock price had done a huge run up from $3 to more than $60, and their success had caught my attention. I remember reading about the company, their founder, and getting familiar with them. Then I didn’t really think about them that much.
Occasionally, Gulfport would come top of mind and I’d look up their stock price or read an article about them, but for the most part, I didn’t think about them.
But then I saw them there in Value Line a few week ago and my longstanding familiarity with them caused me to dig deeper and see what was going on and figure out why their stock price had fallen from $74 to $5.
It’s weird how these things happen. If I hadn’t been a frustrated employee years ago, wasting time reading about local oil and gas companies, then I probably wouldn’t have been familiar with Gulfport and they wouldn’t have caught my eye.
Okay, so now that we’ve covered what Gulfport does, and how I found the investment, let’s talk about valuation and why I made the investment.
I think we have a hidden PE of 1. You’ll recall from Mohnish’s Ten Commandments, our job is to look for hidden PE of 1 stocks. A PE of 1 is so cheap, and it’s such a potential margin of safety producing scenario, that I take “PE of 1” to mean PE of 1-ish. So to me, PE of 1.5, PE of 2, and sometimes even PE of 3 can all be looked at as a near PE of 1 situation.
At the time I bought it, Gulfport was trading at a market cap of about $800 million (now it’s down to $670 million). Net income in 2018 was $430 million and adjusted net income was $321 million. Based on last year’s earnings of $430 million; when I bought them, they were just over a PE of 2, and adjusted it was a PE of 2.5, and now with the stock being down even more, based on last year, the adjusted PE is 2.
But it’s not about what happened, it’s about what’s going to happen.
In 2019, they’re planning for the same production levels as 2018. Value Line estimates they’ll earn $1.09. According to Seeking Alpha, 20 analysts come to an average of $1.24 a share in 2019. Let’s go with the lower estimate of $1.09.
They ended 2018 with 175 million shares outstanding, so $1.09 x 175 million shares = 2019 earnings of $190,750,000. That lines up with their adjusted net income in the first quarter of $53 million. $53 million x 4 quarters = About $200 million.
Value Line has them earning $1.32 a share in 2020 and the Seeking Alpha analyst average for 2020 is $1.42. We’ll go with the lower estimate.
2019 earnings = approximately $190 million
2020 earnings = approximately $231 million
Let’s take it one step further in terms of being conservative. In the first quarter of 2019 they bought back $30 million worth of shares and the share count at the end of Q1 was 163 million, down 7%. So let’s lower our earnings estimates by 7% since we were down per share times number of shares.
2019 earnings = approximately $178 million
2020 earnings = approximately $215 million
So over the next two years, we estimate Gulfport will earn $178 million and then $215 million.
So at a market cap of $800 million when I bought them at $5 a share, they’re trading at a current PE of 4.5.
Here is where things get interesting.
Gulfport’s stock price tanked after 2016 because of the energy prices crash that year. And in 2018 the company decided to buy back $200 million worth of shares.
And then as mentioned above, the former CEO resigned at the end of 2018, and the new CEO came onboard.
Around that time, a long time non-activist hedge fund shareholder, Firefly Value Partners, wrote the board a letter and said basically we don’t want to cause a distraction with a proxy fight, but this company is selling for way less than the assets are worth, buy back shares, get focused, and start running this company correctly. Read that letter here.
Evidently, the new CEO David Wood agreed with them. He and the board implemented another $400 million repurchase program to be carried out over 2019 and 2020. And they’re going to repurchases that $400 million worth of shares out of cash flow and non-core asset sales, which is great. And in the first quarter of 2019 they took action on this second repurchase program, buying back $30 million worth of shares.
When I bought the stock at the beginning of July, it was at $5, so let’s go off of that number (the numbers are even sweeter now that it’s down to $4.26).
Okay, let’s say they do buy back another $370 million worth of shares by the end of 2020. At $5 a share, that’s 74 million shares and the current share count is 163 million. What will the earnings per share then look like over the next two years.
163 million shares at the end of the first quarter minus the 74 million shares they’re going to buy back = 89 million shares
2019 earnings = approximately $178 million divided by 89 million shares = $2 per share
2020 earnings = approximately $215 million divided by 89 million shares = $2.41 per share
So if they do proceed with that buyback, at the end of 2020 they’ll be earning $2.41 a share, the price I bought them at was $5, and assuming no price movement up (which of course would be welcome once I owned the shares) they’d be sitting at a “PE of 2 on 2020 earnings,” and that’s cheap. That’s my hidden PE of near-1 scenario.
Now the stock price is $4.26. That’s a PE of 1.76 on 2020 earnings.
Mohnish’s Steel Company Example
Let’s look at it from another angle. First let’s watch Mohnish talk about a steel company investment he made. I set the video below to that section.
As you can see in the video, Mohnish bought a steel company selling at a hidden PE of 2, and his approach was to think about it as if he was buying the whole company. He said basically “I’ll buy the steel company for a PE of 2, get my purchase price back from those earnings over the next two years, and then I’ll basically have bought whatever assets are there are whatever earnings come later for free since I got my purchase price back within two years.”
And that’s my thinking here. The company is going to buy back $370 million more worth of shares by the end of 2020 out of cash flow and non-core asset sales, I’ll have bought the company for a hidden PE of 2, I’ll get my purchase price back via the earnings for the next two years, and when year three comes around I’ll own $3.4 billion of future cash flows (the PV-10) and $2 billion of debt. $3.4 billion of cash flow from producing the natural gas is more than $2 billion of debt, and it’s all good. Or another way to say it is I’ll get my purchase price back within two years and own a company with 4 trillion cubic feet of gas equivalent and $2 billion of debt. And again, this is the mindset as if I’d be buying the entire company.
But to me, this is cheap! A hidden PE of 2, now less than 2, and yes they have debt, but there’s also tons of reserves. PV-10 isn’t perfect, and these things are hard to estimate. But their balance sheet tells the same story, $6 billion of assets, $3 billion of liabilities, $3 billion of equity. If I’m buying the whole company I’m getting back my investment in 2 years and then I’ll own $3 billion of net assets.
The above story is nice, but it really depends on the quality and safety of these expected 2019 and 2020 earnings. If the company doesn’t earn what I expect it to earn, the hidden PE of less than 2 story won’t add up.
2019’s earnings are effectively locked in because of their hedging program. They’ve hedged most of their 2019 production and locked in a fixed price, and all they have to do is produce the gas and it’s very likely they’ll earn what we think they’ll earn.
What about 2020? They’ve started to lock in hedges for some of the production, and the plan is to continue to do that. We’ll know a lot more about the status of the hedge program and how much production they’ve locked down 2020 prices for when they report second quarter earnings soon. So we’ll know more as we go, but using hedges to lock in 2020 prices is the plan. And what they have to do then is continue to produce the natural gas; if they can do that, the expected earnings will come.
The main risk here seems to be natural gas prices. They’re down way, way lower than they have been recently, that’s a major reason the stock price crashed, and if they go a lot lower before they can lock in 2020 prices, then the PE of 2 story won’t work. It’s a risk, and I can live with it.
While we’re talking risk, another risk is that the non-core assets don’t sell for the amount they’re expecting. It’s a risk. But we had good, unexpected news when the CEO reported on the Q1 earnings call that one of the non-core assets they’re selling is expected to bring in at least $50 million, a water treatment asset, and they’re going to use the first $50 million of that sale price to pay down debt, so they’re confident enough about earnings and asset sales that for this additional non-core asset they’re selling they don’t even need to use the first $50 million from it to fund buybacks.
What about the debt?
Gulfport has over $2 billion of debt so it is important to have a clear idea of the debt situation, when that debt is due, and if it threatens our equity investment.
The first thing that makes me feel okay about the amount of debt, is the amount of assets. The balance sheet net property and equipment of $5.6 billion, they have 4.7 trillion cubic feet of natural gas equivalent reserves, and PV-10 of $3.2 billion. I think the amount of natural gas reserves they have makes the debt less threatening.
Another reason why I’m okay with the debt is the debt schedule. The debt principal due within 3 years is just over $300 million. In 2018 their income from operations was just under $400 million and in the first quarter of 2019 their income from operation was a little bit over $90 million. Let’s take that $90 million and assume that’s what they’re going to make each quarter for the next few years, $360 million per year. $360 million in income from operations, per year, covers the total debt principal of $300 million. $360 million x 3 years = Over a $1 billion and that’s much more than the $300 million in principal they owe over these three years.
And further out there’s more debt due 3 to 5 years down the line and more than 5 years down the line, but the strategy of this investment is to hold for the two years while we earn back our PE of 2 and then see where the price of the stock is at. But even then, 5 years down the line, in 2024 to 2026 we’re talking about $1.9 billion. And if income from operations is $360 million x 7 years = $2.5 billion… that’s more than the debt due. It’s hard to predict where natural gas prices will be then. And they could refinance the debt further out as it comes due. Basically I’m concerned about the next two to three years and in terms of covering the principal due during those three years with income from producing natural gas, I think we’re covered.
And in terms of the interest expense each year and being able to pay that, it appears there’s about $35 million of interest expense per quarter, and that’s covered by the $90 million of income from operations per quarter.
And finally, it’s worth noting that under their contractual obligations section, where this debt is located, there’s also a large dollar amount of “firm transportation contracts.” I take this to mean the fulfillment contracts they sign with pipeline companies. This shows up in the income statement as part of income from operation as an expense called “Midstream gathering and processing expenses.” It’s a big number, but I guess we just have to assume they’re running their business correctly in that regard and wouldn’t sign those fulfillment contracts unless they were very confident about the ability for the wells to keep pumping that amount of natural gas.
It’s a lot of debt, but they also have a lot of assets. And at current natural gas prices, I’m confident in their ability to pay off the interest expense each year and pay off the debt payments over the next few years. If there is a historic crash in the price of natural gas and it goes a lot lower, this situation might change. But a historic crash seems unlikely. But again, risk is risk and that is a possibility. But given the opportunity, I’m okay with that level of low risk. And barring that kind of low probability event, I think they’re going to be okay to pay off the interest and the debt due over the next few years while I’m potentially still owning the business.
Why does Mr. Market not like Gulfport?
Now let’s check in with our one and only business partner, our indefatigable hero, Mr. Market.
Why is Mr. Market depressed about Gulfport Energy and their prospects? I think it comes down to two things.
The first is the price of natural gas. The fracking revolution has increased the supply of recoverable gas and the price is way down from the early and mid 2000s. But it’s also down since a few years ago where it more traded near $4 instead of the $2.40 where it is now. So the drop in natural gas prices has hurt the stock price.
There’s also a lot of uncertainty around Gulfport. The management issues, the management changes, the change in strategies, etc. Right now they’re in “stay focused and focus on cash flow” mode as opposed to “grow” mode. And from reading the last few years of earnings transcripts, the analysts seem to always be pushing for growth with questions like “what price is it going to take for you all to commit to more drilling and grow production?” I think Mr. Market sees a company with some uncertainty in a beat-up industry, and to make matters worse to Mr. Market, now the company is going into “stay stable, don’t grow, focus on cash flow” mode and isn’t interested in growing production. And Mr. Market wants companies with growth that can be sold to investors.
And all this negativity has caused Mr. Market to miss that the company has brought in a solid CEO who’s focused on implementing a cash-flow focused business plan and focused on buying back $370 million more shares.
That’s Mr. Market’s view.
My view is that the company is already cheap, they’re going to get even cheaper when they buy back $370 million more shares out of cash flow and non-core asset sales, I really like the new CEO and the way he’s communicating and executing on his plans, and I think Mr. Market is giving us a bargain letting us buy Gulfport Energy for $670 million as I write this.
What is the game plan?
The overall plan here is to buy this profit-producing natural gas company for a hidden PE of less than 2, hold it for two years, earn back my investment in the form of earnings, and then at that point whatever net assets and future earnings are they will be mine for free since I’ll have already earned back my investment.
I don’t expect this company to trade at a PE of less than 2 for very long after the PE of less than 2 is unhidden. I expect the valuation will rise. But I’m not sure to what extent the valuation will rise. Will it be a PE of 4, 6, or 10? I’m not sure. I just expect it would be higher than 2. A PE of 2 for a profitable and focused natural gas company with plenty of net assets doesn’t seem rational.
So buy, hold for two years, possibly buy more if the price goes down, monitor the situation throughout, earn back my investment over two years in the form of earnings, and see where we’re at in two years, with the expectation that at some point the valuation will be higher than 2.
I also think there’s a decent chance someone is going to come along and purchase Gulfport at some point during this process. It’s just priced so cheap, especially if they buy back the $370 million of additional shares they’re planning to, that I think there’s a good chance someone comes along and buys their assets. We’ll see.
I’m not a macro investor. I focus like Arjuna on the business. I have no clue where the price of natural gas will go. Since 1997 it’s rarely been lower than it is today.
If the price of natural gas halves it doesn’t seem like producers could make money at that level. But if the price of natural gas does tank, then this investment will be rough for awhile. The stock price will likely go down further, the assets will be written down, and losses will show up. But it’s already so cheap that if they buy back those additional shares, at that point I’ll reevaluate and see if they can outlast the downturn and survive, and possibly buy more.
If natural gas happens to rise, that will just be luck and a cherry on top. I’m not buying Gulfport because of the price of natural gas and any movement from here. I’m buying Gulfport because they’re planning to buy back another $370 million of shares using cashflow and the sale of non-core assets by 2020, that’ll push them to a PE of below 2 in 2020, and my job is to find PE’s of 1 or close to that, as profitable companies with assets don’t stay valued for PE’s of 1, and I expect the valuation to go up and to make money when Mr. Market starts valuing Gulfport’s earnings higher than a PE of less than 2.
The rub here is whether or not Gulfport produces that cash, sells those non-core assets, and buys back another $370 million worth of shares. Will they produce the cash? Will they be able to sell the non-core assets for the prices they expect? Will they take action and buy back that amount of shares while the price is so depressed? And will they stay focused and execute this plan? Those are the questions we will eagerly be getting answers to over the next 18 months.
I believe my margin of safety is in the already-depressed price. If for some reason they fail to repurchase the $370 million of shares, then instead of a PE of less than 2 we’ll be at a PE of 3 to 4 and have much more assets than debt and they’ll continue to produce natural gas, pay their interest and debt, and continue to have earnings. I think the margin of safety is in the already-depressed price level.
The major wipe out risk here is a prolonged crash in the price of natural gas where Gulfport can’t earn enough to pay its debts. It’s a possibility, but it does not seem likely enough to scare me away from the opportunity here. There’s an inherit, continual demand for natural gas in this country, our LNG exports are projected to continue to grow, and when the price drops too low, people stop drilling, supply goes down, and the prices come back up. A prolonged crash is a risk, but I’m okay with it.
So that’s the story of what Gulfport Energy does, how I found it, why I invested, why Mr. Market is wrong, and the game plan on how we expect things to go.
If you’re interested in learning more about Gulfport I recommend reading their recent quarterly reports, annual reports, and earnings call transcripts.
What do you think of the investment? Let me know with a message on the contact page and be sure to tune into the podcast episode about this Gulfport investment.