It has been fascinating watching Sound Energy (SOU) play out over the past few years, but probably less so if you’ve actually owned shares in it. This oil and gas company was one of the darlings of AIM until quite recently, and at its peak in early 2017 reached a market cap of close to £700 million, and a share price of over 90p. But since then reality has set in and the share price has collapsed. It has been a great example of just how high the market cap of some of these companies can be inflated to, providing there is a good story and you have the brokers and PR machine on your side. The speculation largely related to just how many billions its Tendrara licence in Morocco would ultimately be worth and how many tcf of gas would be proven to be present there, with CEO James Parsons giving investors all the encouragement that they needed to work themselves into a frenzy, with interview comments about each tcf of gas being worth £1 to the share price, amongst many other uber positive statements and talk of what size deal might be done if someone wanted to buy Tendrara. Well now that deal has actually landed – and I have to admit that I am surprised that it is as good as it appears to. But before people start getting excited...
I didn’t actually think it’d manage to find a buyer for its 47.5% in the field at all, given that the TE-5 Horst discovery, with 377bcf of 2C contingent resources, was a pre-existing discovery when Sound acquired the licence. Quite a few on social media seemed to think that it was a great deal - of course none of them would have been holding shares in Sound at the time though! - and the headline figure of $112.8 million for 51% of its Tendrara stake (24.2% of the field) actually looks pretty good compared to a market cap of circa £75 million (pre the news). Currently the deal - which is for the ‘Eastern Morocco Portfolio’, but basically means Tendrara - is only a non-binding heads of terms agreement and must be approved by shareholders, but given that originally Sound signed non-disclosure agreements with 23 companies, and by the looks of it this is the best offer, I’d be surprised if an alternative came along.
As for the offer itself, when you look into it in more details it is nowhere near as good as the headline figure would suggest, as $54.3 million of it is in cash, with the remainder being a free carry on any future capital expenditure - relating to its remaining 23.3% share of Tendrara - that it would have had to contribute towards reaching first gas. Of that $54.3 million cash component, only 55% will be received on completion of the deal, or just under $30 million; with a further 30% coming when a final investment decision is made in the future; and the remaining 15% being payable within 60 days of first gas production. At this stage the buyer is simply an unnamed UK registered private limited company, which I must admit always makes me wonder why it is still remaining anonymous even after an agreement has been signed, albeit non-binding. It also has the option to acquire a further 9% of Sound’s remaining interest on the same terms within a year of a deal being signed. It seems likely that plenty more drilling is going to be needed at Tendrara before it is anywhere near moving towards the production stage, which I’d expect to be at least a couple of years down the line, assuming it even happens, and it isn’t 100% clear from the RNS as to whether the free carry actually covers Sound for its share of any further exploration and appraisal drills across the block.
My reading of it is that it doesn’t cover any such drilling expenditure, as the RNS says that the free carry is for Sounds future CAPEX requirements to achieve first gas. So, it could well be on the hook to pay its share of future drilling costs. Even if we were to assume that the RNS is just badly worded and the deal covers any drilling costs, the company still isn’t exactly in a great position. It did have cash in the bank of £11 million as at the end of June 2019, and with the initial payment from this deal that would add somewhere around £24 million, depending on the exchange rate at the time of completion, so £35 million less any expenditure since then. But it also has £21.3 million to repay in June 2021 relating to the 5 year secured bonds, plus there are £6.2 million of trade payables that are listed as being due within 12 months (it is unclear from the account notes exactly what they relate to and whether some or all of it could be deferred). So that would leave at best around £14 million (ignoring the trade payables) and with annual admin running costs of circa £4 million per annum – allowing for the 50% reduction that has been implemented for those. It will be interesting, given the performance of the company, if any of those cost reductions include director remuneration, which stood at a total of £1.76 million for 2018, with £1.23 million of that being related to just the base salaries, and James Parsons earning roughly £1 million for his entire remuneration package!
So, the company doesn’t look in any danger of having to raise further funds in the near future, but I can’t see that money lasting through until Tendrara production, if and when that actually happens, and especially if it does have to pay its share of any drilling costs in the meantime. I know that some will be looking at this and seeing a potential bargain based on the fact that it has traded at much higher share prices in the past, but based on everything I’ve mentioned here, I would seriously question how it can justify the current market cap – given that there is no certainty of future cash flows from Tendrara – and definitely see it as a share to continue avoiding. This should also serve as a good case study as to why you shouldn’t pay too much attention to what the BOD of any company says and should always remember that part of their job is to promote their business to potential investors, so they will always paint a rosy picture. Even RNSs don’t always tell the full story and the best way to avoid being stung on a share like this one is to maintain a certain amount of scepticism about what is being claimed, and always question why, if the business is actually worth the amounts being claimed, the City professionals have managed to miss it, and have left private investors to pick up the shares at a huge discount to the claimed value!
Filed under: Sound Energy, Bearcast, Optibiotix, Rolls Royce, InnovaDerma, CAP-XX, Ed Croft
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