On May 6th, Forest Oil announced that it was merging with privately-held Sabine Oil and Gas, a company roughly three times the size of Forest. The new company will be called Sabine Oil and Gas and trade under the ticker SABO once the merger closes in Q4. Because this deal was announced in the middle of a busy oil and gas earnings season and because there was no previous sell side coverage of Sabine, we believe most analysts and investors have completely missed the transformative nature of this deal and that Forest shares now have 76% upside to our "base case" fair value, with significant potential additional upside.
Prior to the announcement of this transaction, Forest shareholders had a claim on the equity of a poorly performing and over-levered microcap E&P company. As of May 5th (the day before the transaction was announced), Forest stock had declined 50% in 2014 and the company’s bonds traded in the $80s as investors rightfully questioned the entity’s ability to avoid bankruptcy.
As a result of this transaction, Forest shareholders will own shares in SABO, a company we believe will have a ~$4 billion enterprise value ($2.2 billion in pro forma debt). The new entity will have a manageable debt-load, substantial EBITDA, greater access to capital, a better growth profile, and a cheaper valuation. If this was not the middle of E&P earnings season, and if Sabine already had sell-side equity coverage, we believe that FST shares would already be trading near $3.50 per share, where it traded in January.
Forest shares have risen 20% since this deal was announced and volume in the last week was more than half of the outstanding shares. Despite this gain, we believe there is still 100%+ upside potential to the shares as investors and the analyst community digest this deal. We would note that Boaz Weinstein’s Saba Capital Management filed a 13G on Friday evening disclosing that they now own 10.7% of Forest’s outstanding shares. Based on prior filings it appears Weinstein's firm doubled their position in the two days following the transaction announcent.
KEY INVESTMENT STRENGTHS:
*Capable Management Team: Sabine’s management team will run the combined company, led by a C-Suite of executives with decades of experience in high level positions at top E&Ps like Petrohawk and Devon Energy.
*Above Peer Growth: On a pro forma basis, the combined company is projected to grow production by 20% YoY. This level of production grown will translate into even higher growth in EBITDA, primarily due to a shift towards liquids production. In 2015, the opportunity to reduce SG&A and other redundant expenses will be an extra boost to cash flow.
*Discounted Valuation to Peers: The most comparable company, based on size, production mix, asset and geographical mix, leverage and return opportunity is Exco Resources (XCO $5.47), a company that trades at a 2014 EV/EBITDA multiple of 6.9. If SABO trades at that multiple, despite growing faster than XCO, it would imply that Forest shares are worth $4.95 today – a 126% premium to the current share price.
*Under the Radar: We believe the undervaluation of FST/SABO is due to a lack of attention from a sell side analyst community that was previously negative on Forest and distracted by earnings from every other company in their coverage universe. We do not expect this inefficiency to last, given that the combined company is likely to have a multi-billion dollar market cap.