Fear of dilution has destroyed many good companies

Pengrowth Energy is a case in point

In a recent article, I suggested Precision Drilling (PD.TO) would benefit from an equity issue to resolve any risk from its $1.2 billion of debt which comprises half of its enterprise value. One prolific Twitter poster was sharply critical of that suggestion (WTIRealist @WTIBull) based on his personal belief that the dilution would harm investors and was unnecessary given that Precision is paying down its debt by about CAD$100 million or more a year. His criticism found support among other energy investors who follow him on Twitter.

My suggestion of an equity issue by Precision was simply to avoid needless risk. Dilution might limit share price gains but share price gains are only useful to investors who plan to sell their shares, pay the taxes on any gain, and try to find another equally good investment. I used to hold a large position in Pengrowth Energy (now gone from public markets after a near bankruptcy that cost me hundreds of thousands and likely cost Seymour Shulich hundreds of millions). In 2010 Pengrowth was a profitable company with about CAD$1 billion of debt, cash flow of over CAD$600 million a year and paid CAD$233 million in dividends that year. The strong performance repeated itself in 2011 when Pengrowth (led since 2009 by Derek Evans, now CEO of MEG Energy) debt stayed at CAD$1 billion after paying CAD$277 million in dividends from the CAD$693 million in cash flow that year. A nominal number of shares were issued in 2011 (34 million) some of them as management compensation.

In 2012, debt rose to CAD$1.5 billion after the acquisition of NAL Energy (a fine set of assets) and Pengrowth paid CAD$289 million in dividends from its CAD$554 million of cash flow and its share count rose to 511 million owing to the shares issued on the NAL acquisition. What could go wrong? Debt was less than three times cash flow, the asset base was larger, and oil prices remained constructive.

What went wrong is that Derek Evans did not take advantage of the markets enthusiasm for Pengrowth shares in 2010 to 2012 when the share price was north of $10 and Pengrowth had a market capitalization of over CAD$5 billion.

The rest of the story is a sad lesson in cyclical markets. The share count was kept at about 510 to 540 million shares, debt grew to the CAD$1.9 billion range, and Pengrowth faced a liquidity crisis and was taken private at $0.05 a share by CONA Resources (a unit of Waterous Energy Fund). Shulich held 28.5 percent of Pengrowth shares purchased at a cost in the billions and sold to CONA for about CAD$210 million.

Pengrowth was not alone in its foolish approach to balance sheet integrity. Lightstream Resources, Bonavista Energy and Bellatrix were all market darlings at one point, led by CEO’s who avoided dilution pretending energy prices would remain firm forever and leading their companies into insolvency proceedings with material losses to investors. I owned all of these and the resulting scar tissue is a strong reminder that future commodity prices are uncertain and a robust balance sheet is the best hedge.

I have avoided MEG Energy despite its excellent assets and burgeoning cash flow because I have no confidence in Derek Evans leadership. While MEG is paying down debt rapidly, Evans continues to promote stock buybacks (which may pay off handsomely if commodity prices remain firm) rather than getting rid of the debt in its entirety and beginning to pay dividends.

I like Precision Drilling and own a modest 1,000 shares purchased for less than CAD$100 a share and modestly hedged by selling March 2023 calls with a strike price of CAD$110 per share. I would add materially if the company issued shares either directly or through a rights offering which I would support.

Some risks are worth taking. Balance sheet risk in a commodity based company is not. WTIRealist may be a successful investor (I hope so) but he is definitely not a realist.