BH - Biglari Holdings Inc. Secures Oil And Gas Development Deal

2023-12-12 16:56:37 ET

Summary

• Abraxas Petroleum has entered into a purchase/royalty-based arrangement with a third party company to conduct exploration and development activities on its Delaware Basin properties.
• Abraxas Petroleum’s proved developed non-producing and proved undeveloped reserves are currently carried at $0 on the balance sheet.
• Development activities will allow Abraxas to establish their proportional share of proved undeveloped reserves on the balance sheet over time as well as provide for ongoing royalty payments.
• Third quarter operating results were mixed with another solid quarter for insurance operations while Steak n Shake came in soft and production issues continue at Southern Oil.
• Valuation continues to imply significant upside.

Biglari Holdings Inc. (BH) reported third quarter results on November 3 ^rd and the headline news story was that its Abraxas Petroleum subsidiary had entered into a purchase/royalty deal with an un-named company for exploration of its Delaware Basin acreage. The new agreement provided for an upfront cash payment of $13.6 million which was recorded as a gain since the partner will be required to fund all expenses related to exploration, drilling and production for the new wells. The three-year agreement requires a minimum of eight new wells and Abraxas will receive an undisclosed royalty on all oil and gas produced from the new wells.

Readers of my Seeking Alpha article Biglari Holdings : Sum-Of-The-Parts Valuation published in July, will remember that Biglari’s oil and gas strategy has been to hold costs at a minimum and use capital expenditures only to maximize production from existing wells. Rather than investing capital in risky exploration and drilling operations to expand its reserve base, Biglari sought to partner with an experienced oil and gas development company to bear that risk.

Through a quirk of accounting, Abraxas Petroleum’s oil and gas reserves booked on the balance sheet include only Proved Developed Producing reserves. Because Abraxas was not actively engaged in the exploration and development of its oil and gas properties, accounting rules dictate that Proved Developed Non-Producing and Proved Undeveloped reserves cannot be booked as an asset (Proved Developed Non-Producing Reserves are those for which the well-bore exists and the reserves are identified but are not currently producing. Proved Undeveloped Reserves are on undrilled acreage offsetting producing wells that are reasonably certain of production when drilled).

The Securities and Exchange PV-10 Table for Biglari Holdings’ oil and gas operations as of 12/31/22 is detailed below.

The Proved Developed Non-Producing and Proved Undeveloped reserves detailed above only includes Southern Oil. While no current information is available on Abraxas Petroleum’s potential Proved Undeveloped reserves, we can gain some insight into the potential amount by reviewing Abraxas Petroleum’s 12/31/2020 10K filing .

The filing notes that the company converted 56 locations in the Delaware Basin with 19,901MBoe in Proved Undeveloped reserves to probable undeveloped reserves due to the lack of available capital to fund development of the wells. That does not mean these reserves somehow disappeared. The oil still lies buried underground, waiting to be extracted. As its new drilling partner conducts its development activities, Abraxas will receive royalties on the oil and gas produced, which will drop to the bottom line, largely as profit. In addition, the company will be able to reestablish its proportional share of Proved Undeveloped Reserves which has the potential to be a meaningful addition to its existing reserve base. All of this is currently reflected on the balance sheet at $0.

The Abraxas Petroleum Purchase Transaction Revisited

In light of the new royalty/development agreement, it’s worth revisiting Biglari’s original Abraxas purchase transaction. The company paid $80 million for 90% of the company in September 2022 and $5.4 million for the remaining 10% in June 2023. At the time of purchase, Abraxas had $25.1 million in cash on the balance sheet. Biglari subsequently sold the company's headquarters building ($4.7 million), reducing the purchase price to $55.6 million. Operating profits since acquisition ($8 million) and the recent upfront payment ($13.5 million) further reduces Biglari’s purchase price to $34.1 million. For that price, the company owns 66 producing oil and gas wells in the lucrative Permian and Delaware Basin with 7,948.5MBoe of Proved Developed Producing reserves and the potential of highly lucrative future royalty payments under the new development agreement on an estimated 19,901MBoe.

With the company’s restructuring and buyout of minority shareholders completed in the second quarter, Abraxas ramped up production in the third quarter of 2023 to an estimated 100,972 barrels of oil equivalents compared to an estimated 80,409 barrels in the second quarter.

Utilizing the Southern Oil operating model, Biglari implemented significant expense cuts at Abraxas over the last four quarters. General and Administration expenses peaked in the fourth quarter 2022 at $3.5 million, driven by one time severance and expense cuts. They have since steadily trended down to just $172,000 in the third quarter of 2023, with the company’s operations now rightsized.

Gross margin and pre-tax margin improved to 75.2% and 53.3%, respectively, during the third quarter 2023. Abraxas reported a net profit before taxes of $5.4 million in the third quarter 2023, not including the gain on sale. This is the first quarter representing 100% ownership and the full benefit of expense cuts, suggesting an annualized operating profit run rate of $21.6 million (assuming steady oil prices), or 63.3% of Biglari’s $34.1 million adjusted purchase price. Future royalties from the new development agreement will be icing on the cake for a deal that has quickly turned out to be an exceptional allocation of capital.

Turning to Third Quarter 2023 Earnings

Biglari Holdings reported a pre-tax loss of $74.0 million in the third quarter of 2023 as a result of mark to market accounting losses of $89.6 million in the investment partnership. Some quarters this will be a sizable gain when the market is up and a sizable loss when the market is down. From an analytical perspective you should view these gains and losses as generally meaningless in evaluating the operating performance of the company but rather focus on the operating results of the individual businesses (detailed below).

Restaurant Operations

Steak ‘n Shake and Western Sizzlin reported pre-tax profits of $16.8 million through the first nine months of 2023 (adjusted to eliminate gains on sale of restaurants and impairments) compared to $12.8 million for the same period, one year ago. Adjusted pre-tax earnings in the third quarter 2023 fell $1.8 million, or 41%, to $2.6 million compared to the third quarter 2022. General and administrative expenses increased $1.2 million during the period as a result of increased support staff. Franchise fees from traditional franchisees fell $1.0 million, or 20%, to $4.1 million as a result of 25 fewer franchisees in the system. Traditional Steak ‘n Shake franchisees were particularly hard hit during the pandemic and the restaurant count has steadily trended down over the last four years.

Partially offsetting the increased costs and declining traditional franchise fees is the continued growth in the Franchise Partner program. During the third quarter 2023, franchise partners paid $17.6 million in fees, or $97,359 per store versus $15.9 million, or $92,865 per store for the same period, one year ago. It was good news to see the addition of four new partners to the program during the third quarter after the moratorium imposed earlier in the year.

The 2022 Franchise Disclosure document for the Franchise Partner program was filed in July of this year. Good progress was made across the board with increases in average Franchise Partner earnings, median earnings and second, third and fourth quartile results.

In an effort to enhance Steak ‘n Shake’s pre-tax return on capital, Sardar Biglari’s 2022 annual letter to shareholders indicated his intention to reduce the company’s book net worth by $44 million, largely through the sale of closed restaurant real estate. Progress on this initiative has been slow. I estimate that five locations have been sold year to date for total proceeds of approximately $10 million. Three properties are currently under contract with 16 other locations list for sale.

Stemming the decline in the traditional franchise restaurant base while successfully executing on the real estate sales strategy will be critical in achieving Biglari’s long term goal of a 20% pre-tax return on capital.

Insurance Operations

Year to date pre-tax earnings increased $3.2 million, or 46.7%, to $10.1 million driven by outstanding underwriting results at First Guard and increased investment income as a result of higher interest rates. Southern Pioneer continued to show an underwriting loss as a result of weather-related losses and increased costs related to technology projects.

Oil and Gas Operations

It was not all good news on the oil and gas front. Southern Oil reported a significant drop in revenues and pre-tax earnings. Sardar Biglari indicated at this year’s annual meeting that two wells were taken out of production due to pressure issues. Production was an estimated 100,537 barrels of oil equivalents in the fourth quarter 2022. After the pressure issues, estimated production was 65,000 barrels of oil equivalents in the first and second quarters of 2023 before falling to an estimated 48,768 in the third quarter. No other information is available to explain the significant decline other than to assume the pressure issues have continued.

Year to date, revenues declined $23.3 million, or 63%, to $13.6 million as a result of lower oil and gas prices and the production issues. Pre-tax profits fell $16.2 million, or 85% to $2.9 million. Gross margin and earnings before tax margin have fallen significantly as a result.

While the production issues have been disappointing, they are not unexpected in the oil patch. The company has worked through previous declines in the past and ultimate resolution represents upside potential for earnings in my view.

Corporate and Other Expenses

It is anticipated that Sardar Biglari will be eligible for an incentive compensation payment from Biglari Holdings in 2023 and the company is currently accruing for the payment. Year to date, Corporate and Other expenses have increased $5.3 million which is largely believed to be for the incentive payment. The last time Biglari received an incentive compensation payment from Biglari Holdings was 2017.

Valuation Remains Compelling

I will use the same market capitalization calculation method from my Seeking Alpha article Biglari Holdings: Sum-Of-The-Parts Valuation which was published in July.

In calculating the current market capitalization for Biglari Holdings, it is important to remember the shares it holds in its own company stock. This value is treated much like treasury stock, where the amount is subtracted from the investment company assets and basically disappears from the balance sheet. In order to calculate the appropriate number of shares to be used in the market capitalization calculation, the equivalent Class A shares held by the investment partnership must then be deducted from the total outstanding equivalent class A shares. The calculation is detailed below:

Remember, most financial websites report Biglari Holdings’ market capitalization using the total Class A shares of 620,592, amounting to $468.1 million (Class A market price as of 12/8/23 of $754.23). This is incorrect and significantly overstates the actual market value. It is essential to exclude the 331,585 shares Biglari owns in itself. Using the net 289,007 shares outstanding times the current share price yields the correct market capitalization of $217.9 million. Add outstanding debt ($19 million) to this amount and total enterprise valuation is $236.9 million. Net out marketable securities held in the investment partnerships totaling $151.8 million (net of deferred tax liabilities) as well as $34.0 million in cash at the operating companies, yields an adjusted enterprise valuation of just $51.1 million. The valuation remains compelling considering that the various operating entities reported trailing 12-month pre-tax profits of $30.0 million (not including the gain on sale at Abraxas) resulting in a 1.7x multiple.

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