In probably the strongest statement in ages I’ve seen on debt, KKR backed Crescent Energy (NYSE: CRGY) has a low-leverage strategy that should slowly catch the market’s attention. So many investors believe that leverage is the way to big gains. Yet here is one of the largest companies in the world (KKR) known to use leverage, and it is very clear that they do not use leverage in order to make big profits. This should be a strong signal to investors that financial leverage has little chance of success in this very low profile industry.
Management makes it very clear that this business will be financially sound from the start. This contrasts with KKR’s usual reputation of leveraged buyouts followed by rapid deleveraging. Obviously, industry volatility would destroy such a short-term strategy. It is almost impossible to say when a sustained period of high commodity prices will last long enough for such a strategy to succeed. On the other hand, the current financial strategy is likely to succeed even under the worst possible conditions in the industry.
This means that an investment in this company is a bet on the management to find very advantageous offers which are immediately accretive and have more advantages by improving the management of the acquired properties. KKR usually doesn’t get involved to make a 10% or 20% return. Instead, backers would be more likely to get involved if they could triple the value of the investment in 5 years.
The risks of buying heavily discounted properties would be that they are discounted for a reason and that reason cannot be overcome. However, this branch has a long history of turning around troubled subsidiaries as well as getting involved in the industry. This should alleviate potential issues.
The other risk is that management wants to make bigger deals. But larger transactions often present logistical challenges simply because of their size. However, KKR has long been doing these types of transactions (large and small) for a long time. Therefore, management has considerable experience with large and small transactions.
One thing that reduces risk here is low leverage. Companies with low leverage often get as many tries as they need to succeed. On the other hand, indebted companies must pay and service debt even in times of industry weakness. This has often proved fatal for heavily indebted companies in the sector.
For shareholders, quarterly reports might not make sense “forever.” The reason for this is that “big” deals tend to significantly alter the future prospects of the business. In the meantime, past transactions often take a year (of reporting) to optimize operations for the future. A steady stream of acquisitions cloud quarterly reports just about every time. This could make it nearly impossible for the market to gauge the company’s prospects. This could lead to below average stock market performance.
So there would have to be considerable confidence in the management boards. Normally, the market wants a track record before Mr. Market offers a proper valuation for the stock. Here, it may take some time before this record becomes apparent in the market.
A typical example would probably be the company’s Eagle Ford operations. The management is clearly priced above at least several competitors. But operating expenses would be what the market relies on, as higher prices may not be sustainable unless management can explain a permanent advantage to the market.
These above-average operating expenses could easily be due to much older production as leases were not developed during the sales process or an operator who used less than operational best practices. Still, older production will be produced as long as there is positive cash flow, regardless of the consequences of the statement. It will likely take some time for the cost savings to become meaningful to the market through quarterly reports.
Differences in production costs may also be related to the composition of sales. The Eagle Ford has high oil leases which of course have the highest margin. But there’s also the liquid-rich gas window which has a different cost structure (not to mention the Eagle Ford’s dry gas zones). Thus, a comparison with other operators is not as convincing as it could be in other industries.
This is probably a good example of what Crescent Energy management needs to present to the market for earnings to be properly priced. In addition to this, an allocation of key properties, as noted above, relative to industry standards or competitors with a similar product sales mix, also seems warranted. Chart Industries (GTLS) is another company that regularly makes acquisitions that cloud earnings. Without some dissection, it’s nearly impossible for the market to tell what’s going on.
Now Chart also does this for cash flow and other metrics because fast-growing companies often have negative cash flow and write-offs that need to be explained. But if management can determine what’s recurring and normal versus what’s “once,” then the market can begin to price common stock correctly.
Meanwhile, sooner or later, the company will become large enough that regular operations predominate in reporting. But it might take some time. Shareholders must therefore be patient. This management has a very good track record of shareholder profits.
Management purchased the Uinta basin for approximately 2x adjusted EBITDAX. Compare that to Shell (SHEL), which sold some Permian properties to ConocoPhillips (COP) for around 3.7x adjusted EBITDAX. Shell is a known decent operator and certainly not in distress. Therefore, the upside potential of this purchase will be significantly lower than that of the Uinta Basin purchase (or those the company has made in bankruptcy court).
Typically, a bargain buy strategy by management that is used to doing just that has a lot of upside potential. So many times the cost of purchased issues is significantly higher than the cost of turning the operation around just in case there are unforeseen issues. Therefore, if the worst happens, it is already in the purchase price. But if things go better than expected (which they often do), shareholders benefit.
This management has a lot of shares in the company. Therefore, if the company is doing well, so is management.
There were concerns about general and administrative costs. Still, the forecasts presented above are reasonable, and they are decreasing (at least so far) with each acquisition. This decline should reflect very tight cost control. Clearly, management intends to take maintaining a low leverage ratio seriously, as indicated in the guidance above.
Probably the biggest concern in this industry is free cash flow. This should be of considerable benefit at various oil and gas price levels as management optimizes the operations of each acquisition. It may have even more benefits as new wells are drilled with the latest technology and completion techniques to replace older (more expensive) declining production.
There is clearly a lot for an investor to take in. But it is very sound management that is likely to produce excellent long-term results from the current share price. The unusual trading strategy is quite normal for KKR. Meanwhile, the stock price appears to have very little chance of managing successfully.