Turnaround Letter Buy-rated Midstates Petroleum (MPO) is holding their annual meeting this Friday, August 2, when shareholders will vote on the pending merger with small-cap peer Amplify Energy. This combination was announced on May 6. We suggest that MPO shareholders vote for the merger: the post-merger company will likely be better-positioned than the current Midstates on its own, particularly given that the sharp decline in natural gas prices has weakened Midstates. We note that investor group Fir Tree sponsored the deal and holds large (23%+) stakes in both companies. The post-merger stock will be highly sensitive to natural gas prices.
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The steady 65% decline in Midstates share price from its May 3 pre-merger high of $12.81 has been frustrating. The fall-off started with the announcement of disappointing terms in the Amplify Energy merger. However, much of the decline has been driven by the sharp drop in natural gas prices combined with the dour outlook for future prices. The company’s 19% fall-off in first quarter 2019 production compared to the prior quarter has hurt Midstates’ stock as well, although this was not entirely unexpected as the company had planned on ceasing its drilling.
From here, the combined company valuation is low at about 3.1x pro forma estimated 2020 EBITDA of $160 million. This estimate is based on company disclosures, and includes a small decline in commodity prices and some decline in pro forma production. We note that the current spot natural gas price of about $2.20/MMBtu is 27% below the year-ago and year-end price of about $3.00/MMBtu, so without a commodity price recovery the pro forma EBITDA will be considerably lower than $160 million. The company estimates that it will achieve $20 million in cost savings, which would help offset weaker commodity prices. If a realistic estimate of pro forma 2020 EBITDA is $120 million, the firm would be valued at 4.2x EV/EBITDA.
The combined company will have $300 million in debt, or about 1.9x pro forma 2020 EBITDA. It is projecting $135 million in free cash flow in 2020 to help service this debt. However, we anticipate that this $135 million estimate could easily be lower due to the same issues noted above. This elevated debt will likely be an overhang so we expect management to whittle away at it until the debt reaches perhaps $200 million to $250 million.
Another key to the merger’s success will be management’s ability to stabilize and eventually reverse the production declines without overly stressing the balance sheet.
Overall, the post-merger stock will be highly sensitive to natural gas prices.
We continue to rate MPO shares a BUY. Our price target will be adjusted after the merger.
Disclosure Note: One or more employees of the Publisher own MPO shares.