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Quest Resources Seems Excessively Undervalued
by: Prudent Speculations May 28, 2008 | about stocks: QELP / QRCP
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Become a Contributor Submit an Article Font Size: PrintEmail TweetThis Quest Resource Corp (QRCP) is a fast growing natural gas driller. Quest Resources recently revamped its corporate structure with the packaging of its upstream and midstream operations into two MLPs, Quest Midstream Partners (which is not publicly traded) and Quest Energy Partners (QELP).
Quest Resources owns the general partners of its MLPs as well as significant limited partner interests. Quest Resource’s interests in these two MLPs provide the company with significant cash flow that has allowed Quest Resources to begin drilling on land that it owns in the fast growing Marcellus Shale area centered in western Pennsylvania.
I believe that the marketplace, due in part to the company’s complicated corporate structure and the recent concerns regarding its proposed merger with Pinnacle Gas Resources (PINN), has significantly undervalued the company. The merger, which was poorly thought out by Quest Resource’s management, has been called off. Significant value nonetheless remains in the stock, even after its recent move following the breakup of the merger.
Quest Resources owns 12.1 million units of Quest Energy Partners and 4.9 million units of Quest Midstream Partners. Based on the market value of the company’s stakes in Quest Energy Partners and the sale price of the Quest Midstream Partners units, Quest Resources appears to be undervalued. The company’s stake in Quest Energy Partners is worth about $194 million and the company’s stake in Quest Midstream Partners is worth somewhere around $91 million dollars. This gives a total value of $285 million to Quest Resource's holdings in its subsidiary companies.
Quest Resources also owns the general partners of Quest Energy Partners and Quest Midstream Partners. The general partnership of Quest Energy Partners has 25% of the incentive distribution rights (IDRs) for Quest Energy Partners. The company also owns the general partnership interest for Quest Midstream Partners; this general partnership has 50% of the incentive distribution rights for Quest Midstream Partners. A common rule of thumb that I used to value these general partnerships is to give them the theoretical value of their stake in the limited partnership if they were units instead of incentive distribution rights. For example, the general partnership of Quest Energy Partners should be valued at 25% of Quest Energy Partners' market capitalization. This is a common valuation in the industry as seen in the market caps given to other companies in the sector.
This puts the value of Quest Resource’s stake in Quest Energy’s general partnership at about $85 million and the company’s stake in Quest Midstream's general partnership at about $124 million. The company only owns 85% of Quest Midstream Partners' general partnership so that stake needs to be reduced by the appropriate amount, giving you a total value for the general partnership of about $105 million. Both general partnerships are still in their early IDR splits, so to be conservative, let's assume the general partnership interests to be worth 50% less than our estimate (although this will likely expand with time as the company grows to its potential). This would put the total value of Quest Resource’s general partnership interests at about $95 million.
If you combine the value of the general partnerships ($95 million) and the limited partnership units held by the company ($285 million), the company, on these attributes alone, should be worth $336 million (this takes into account the company’s $44 million in debt). Even though this figure ignores Quest Resource’s Marcellus Shale acreage, it still leaves the company significantly undervalued, given its current market capitalization of only $240 million. Quest Resources will receive $25 million in cash flow from its MLPs this year, giving the company the resources it needs to expand and develop its holdings in the Marcellus Shale.
Another point worth noting is that the value of Quest Resource’s general partnership interests are likely to grow at an incredible rate, as the value of the underlying limited partnership units increase in value. In most cases, the market capitalization of upstream limited partnerships has been known to rise significantly as a result of the limited partnerships frequently using their stock to finance acquisitions. While this may dilute Quest Resource’s holdings in their subsidiary companies, it should cause the general partnership interest, which holds the IDRs, to soar in value.
Take Linn Energy (LINE) as an example; Linn Energy’s market capitalization has risen from $583 million at its IPO in January of 2006 to roughly $2.6 billion today. If Quest Energy Partners is able to sustain a similar growth rate to Linn Energy, Quest Energy Partners' market cap could be at $1.5 billion by 2011, making Quest Energy Partners' general partnership (held by Quest Resources) worth somewhere around $400 million by 2011. If the success of other publicly traded companies that hold general partnerships and MLPs can be used as an example, there is clearly significant growth potential in Quest Resource’s general partnerships.
As I briefly mention above, Quest Resources is using its significant cash flow from its MLPs to drill in the Marcellus Shale play, which is rapidly gaining fame for its productivity. There are many companies with significant acreage in the play. Atlas Energy Resources (ATN), (I have talked about its parent company here, which is at worst a larger Quest), probably has the most exposure to the Marcellus of any large companies. Atlas Energy Resources' market cap is $2.6 billion and Atlas Energy Resources has 551,000 Marcellus acres with about half of them in SW Pennsylvania. Quest Resources has a market cap of $238 million and Quest Resources has 52,100 acres with all of the acres in SW Pennsylvania. It would appear that Quest Resource’s acres are just as valuable as Atlas Energy Resources', but they maybe even more valuable as all of Quest Resources' acres lie in SW Pennsylvania.
Figuring out how much the acres are worth is difficult, yet in doing so the true value of Quest Resources becomes apparent. Wachovia has estimated the NPV of Atlas Energy Resources' Marcellus acres to be at least $6000 per acre; if one were to value Quest Resources' acreage at $6000 an acre, one would arrive at a value of $313 million. There is likely to be upside to the $6000 per acre number, as the Marcellus play is further proved through drilling.
Acreage in the well proven Barnett Shale is typically valued at between $20,000 to $30,000 per acre, so that should give you an idea of the upside potential of the Marcellus area, should the deposits pan out in a manner similar to the Barnett Shale. Atlas Energy Resources' drilling results appear to be fairly comparable to the types of results achieved in the core area of the Barnett, so it seems likely that acreage values will rise from current levels. Nevertheless, it is important to remember that the value of any company’s land will depend on exactly where it is located in the area. To be conservative, let's assume Quest Resource’s acreage is only worth $3000 per acre, half of Atlas Energy Resources' valuation according to Wachovia; if the $3000 dollars per acre figure is used, Quest Resources is sitting on $156 million of land.
In recent months, an impending merger with Pinnacle Gas Resources has negatively impacted Quest Resource’s stock price. Since management announced the deal, the company’s stock dropped from $11 to below $7 a share. The Pinnacle Gas Resources transaction would have diluted Quest Resource’s valuable assets and cash flow by issuing the company’s shares to purchase a large amount of undeveloped land in the Powder River Basin. Fortunately, management recently saw the error of the deal, or perhaps feared that it would not get shareholder approval, and scuttled the merger.
Even after Quest Resource’s recent run up, the company has still lagged the natural gas index substantially over the period since the merger was announced. Quest Resources seems to be very undervalued but the Pinnacle Gas Resources transaction has to make a person question the wisdom of the company’s management and probably justifies the current discount to its fair value seen in the stock price.
Today, Quest Resources appears to own assets that should make its equity worth $491 million or $21 per share. These assets, as mentioned above, include the company’s holdings of its limited partnership units, it stake in the limited partnerships general partner and $156 million in Marcellus Shale acreage, with debt of course being subtracted out. A slight discount to this estimate is probably reasonable, considering management nearly made a terrible blunder in regards to the Pinnacle Gas Resources acquisition. The current stock price of $10 seems excessively low to me and reflects far too great a disconnect from the stock's true value. I think a price in the high teens for QRCP would be justified based on the current holdings and numbers being put out by the company.
Going forward, there appears to be significant growth potential from both the company’s Marcellus acreage and its general partnership interests. In the hands of competent management, Quest Resources could easily be worth two to three times the $21 it appears to be worth now, once the value of the company’s Marcellus Shale acreage and future growth in the area and general partnership interests has been fully realized.
For Further Review:
Termination of Merger Agreement
10-Q
10-K
Disclosure: Long QRCP
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