Welcome to Episode 86 of Special Situation Investing.
Today’s situation is the breakup of a micro-cap oil and gas services company with operations in Canada and Papua New Guinea (PNG).
The company—High Arctic Energy Services—trades under the TSX ticker HWO and the OTC Pink Market ticker HGHAF.
Right at the start, to give credit where it’s due, we want to mention we first came across this situation through the work of another Substacker,. They wrote up the company back in April and May of this year. We highly recommend you check out their articles and consider subscribing to enjoy more of their work.
Because we’ll breakdown the details of the company later in this piece when we describe the spin-off components, let’s introduce the company by reading the succinct business description found on morningstar.com. It states:
High Arctic Energy Services Inc is engaged in providing contract drilling, well servicing, completion services, equipment rentals, and other oilfield services to the oil and natural gas industry in Papua New Guinea and Canada. The operating segments of the company are the Drilling Services segment which consists of drilling services; the Production Services segment which consists of well servicing and snubbing services; the Ancillary Services segment which provides rental equipment, nitrogen transport services, and engineering consulting to various companies within the oil and gas sector and Corporate segment. The Production Services segment generates the company's revenue.
As mentioned earlier, High Arctic Energy Services is a micro-cap. It has only 112 employees and a meager market cap of $60.36 million. Quick note: all dollar amounts in this piece are Canadian dollars (CAD) unless otherwise indicated.
Okay, let’s dive into the interesting bits.
On the 11th of May, in conjunction with company’s first quarter results, High Arctic reported its intention to return capital to shareholders and reorganize the company. The announcement had four main parts.
Spin-off the PNG, or “international operations,” as a private company.
Maintain the Canadian publicly listed company to allow it to focus on growing the Canadian business and utilizing the available $130 million non-capital tax loss carryforwards.
Return $38.2 million to shareholders in a tax-free manner.
Rightsize the G&A infrastructure.
The day after the announcement, the company held a conference call, and as you can imagine, management was asked lots of questions as investors sought details and clarification on the announcement. While management did its best to provide clarification, they made clear many details were yet to be hashed out and that investors could expect further details about the transaction in the paperwork that will be sent out prior to the vote. That vote is set to occur prior to the end of September 2023.
Now let’s dive deeper into each of these four parts. Perhaps the simplest way is to tackle them in reverse order to the list above, starting with the rightsizing of the G&A infrastructure.
The definition of rightsize is to reduce something to its optimal size. This is what management plans to do with general and administrative costs during the reorganization of the company. In their exact words, the plan is to “rightsize the general and administrative infrastructure to align with the new corporate structure.”
While management didn’t elaborate on what rightsizing will look like, they made a comment in the conference call about how G&A currently consumes over twenty percent of revenue and how they expect that percentage to decrease moving forward. Here’s what they said:
G&A costs were $2.1 million in Q1, lower than the $2.4 million experienced in the previous quarter. G&A is still relatively high in the quarter at 21.7% of revenue, which we expect will decrease and trend lower as we move throughout 2023 as higher revenues are realized from our operations in PNG.
Granted, these comments indicate management believes G&A’s percentage of revenue will decrease due to rising revenue, but, as the company’s structure is simplified and reorganized, G&A costs will likely fall on an absolute basis.
Expecting further details in the near future, our gut feeling is rightsizing could turn out to look like downsizing.
The second, and honestly, most eye-catching, part of the announcement is the planned capital return to shareholders. The proposed $38.2 million represents 61% of the company’s total market cap.
At the close of the first quarter in May, High Arctic sat on $46.7 million in cash. The majority, $38.2 million, of this stash came from the sale of the assets of its Canadian well servicing business which occurred in 2022.
In the May conference call, management claimed they pursued multiple avenues to deploy the cash in a manner to grow the business and increase returns to shareholders, but they weren’t able to close any deals. So instead of sitting on the cash, they intend to distribute it to shareholders.
In the press release containing the reorganization and return of capital announcement, the return was described as a “tax-free cash return of capital.” In the conference call the next day, management referred to it as a “tax-efficient return of cash to shareholders.” We’d be surprised if the distribution is 100% tax-free, but it does appear that it will be a cash distribution and not a return by some other method such as buybacks.
To put it in perspective, if one were to hypothetically buy the company outright, after the capital return has been distributed, they’d essentially pay a total of only $23.1 million for the operating business.
Maintain the Canadian public company
Through the spin-off, the operating business will split into two entities. The first of the two will remain publicly traded on the TSX and will likely keep the current company’s name and ticker symbol. This new public company itself will have two main components.
The first component will be a 42% stake in a private company called Team Snubbing Inc.
Back in 2022, around the same time High Arctic sold its well servicing business for $38.2 million, it also sold its snubbing fleet in exchange for a 42% stake in Team Snubbing. We’ll admit, when we began this research we had no clue what snubbing meant. Now we do. Snubbing is a process where pipe is entered into the wellbore with special equipment after the well is live, or pressurized. It’s a highly specialized aspect of oil and gas well services. High Arctic sold its fleet of 7 marketable packages and 32 inactive and out of service snubbing units, to Team Snubbing for the afore mentioned 42% stake, as well as the ability to appoint two out of Team Snubbing’s five directors.
The second component of the publicly traded remain company will be High Arctic’s ancillary services segment.
Currently, this segment is comprised of High Arctic’s oilfield rental equipment in Canada and PNG as well as its Canadian Nitrogen and compliance services assets. Post spin-off, this part of the public company will only contain the rental equipment business in Canada. This is because the equipment rental in PNG will logically go with the PNG private company and because, as announced in June, High Arctic has entered into a deal to sell its Canadian nitrogen assets. Examples of the type of rentals High Arctic provides include cranes, trucks, forklifts, river pumps, generators, lighting towers and assorted other oilfield equipment.
So to recap, if the spin-off is completed, the remaining, publicly traded Canadian company will be comprise of two segments: a 42% stake in the private company Team Snubbing and the Canadian rental business.
Spin-off the PNG private company
Finally, we get to the spin-off itself.
High Arctic’s history in PNG began in early 2007, when it signed its first drilling services contract to operate a heli-portable rig for Oil Search Limited. In the years since, High Arctic grew its business to become an integral partner for the country’s major producers, TotalEnergies, Santos, and Exxon.
The company’s PNG business components include rigs, rentals, manpower, and camps. The rigs are heli-portable, meaning they can be disassembled and transported by helicopter, which is necessary due to the rugged terrain throughout PNG. High Arctic currently operates three of its own rigs and contracts others out to customers on multi-year contracts. The rental business in PNG is similar to the rental business in Canada, renting the same litany of products. Within the manpower section, High Arctic provides skilled and unskilled labor as well as training and competency testing for customer labor forces. Under Camps, High Arctic provides heli-portable, ready-made camp sites for deployment in the rugged PNG wilderness.
Two comments in the recent conference call give hints to the management’s rational for the spin-off.
First the CEO, Michael Maguire, said:
Our PNG business has been consistently undervalued by the public market, and we believe that the current market conditions make it appropriate to take steps to unlock value. We intend to put the recommendation to shareholder vote before the end of September. I believe our customers and employees in both PNG and Canada will appreciate and benefit from a locally managed business.
And secondly, he said:
The proposed spin-off of the Papua New Guinean business will allow senior management to concentrate where we have had the most success in the past.
So High Arctic’s management and board believe the PNG company is undervalued. To be honest, this was our first thought as well. Once we saw the breakdown of the capital return and the remaining Canadian company, we actually wondered if one would be getting the PNG spin-off for free.
As it turns out, our back-of-the-napkin-style calculation indicates, not free, but pretty close.
Here’s how we did it.
Starting with the market cap, current as of this writing, of $60.36 million, we subtracted out the $38.2 million capital return and $1.35 million for the Canadian nitrogen assets sale. This leaves us with $20.81 million. (A less conservative calculation would be to subtract High Arctic’s total cash position of $46.7 million.)
Next, we estimated a valuation of the Canadian remain company. In High Arctic’s filings, we found the valuation management put on the 42% stake in Team Snubbing at the time of the sale. This was $7.7 million.
The rental segment of the remain company required us to dig a bit deeper.
For the quarter ended 31 March 2023, the Canadian rental business brought in annualized revenue of $2.3 million. With an impressive operating margin of 58%, we get a net income of $1.33 million. Using the oil and gas equipment rental company, RPC Inc as a comparison, we applied its 5x market cap to net income ratio to High Arctic’s rental business net income and produced a hypothetical market cap of $6.7 million.
Thus, subtracting out the combined estimated valuation for the Canadian remain company of $14.4 million, leaves a value of $6.41 million for the spin-off PNG company.
High Arctic’s quarterly reports separate out revenue and operating margin for the PNG company. This tells us the annualized net income is about $13 million. Therefore, it appears the market is valuing the PNG spin-off at one half its current net income.
We agree with management, the PNG business does appear undervalued.
There’s so much more to consider in this situation. Unfortunately, we can’t possibly cover it all in under fifteen minutes. If the developing situation in High Arctic peaked your interest, here’s a few more things to consider:
The management owns a majority of the company shares. Yes, they have skin-in-the-game, but they can also make the vote in September go the way they want even with no other shareholder support. Something to watch.
Speaking of watching. It’ll be important to get the details on the reorganization that management will send out prior to the vote. For this reason, one of the cohosts of this shows does own a very small position in High Arctic.
One of the most glaring questions, and issues for investors, is the PNG spin-off is going to be spun-off as a private company. In the conference call, management stated that all investors will hold the same percentage of the private spin-off as they did in the company prior to the transaction. The illiquidity of private companies will make this situation a no-go for some investors.
Management seems to believe the operations in PNG are at a positive inflection point. This quarter that is about to close will be the first full quarter with a new rig under contract. They should report a large increase in quarter-over-quarter revenue. More contracts on other rigs are slatted to come online in 2024.
One reason management is so bullish on PNG is the progress their major customers in that country are making towards increasing LNG production. Both TotalEnergies and Exxon have recently announced major steps in plans to develop more of their assets in PNG.
With that, we’ll wrap it up there. All that’s left is to thank you all for your continued and increasing involvement and support. Thanks for sharing our content with other like-minded investors. Thank you for also commenting and telling us where we missed something or are totally off-base. This last week we had some very fruitful conversations with a few of you where we learned a lot of really useful information. So, thank you.
We’ll see you all next Saturday with another episode.
Thanks for supporting our work by sharing and subscribing!