Edmond Jackson's Stockwatch: Salamander exposed as bid target

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Note how bids and deals have broken out in the oil & gas sector - involving as yet small to mid-cap shares fallen from favour.

Heritage Oil has agreed a 320p share offer from an investment company run by the former head of Qatar's sovereign wealth fund; FTSE Mid 250-listed Premier Oil has spurned approaches from Ophir Energy while it is said to be looking elsewhere; and FTSE SmallCap Salamander Energy has commenced a formal sale process after being approached for specific assets and "a small number of preliminary and conditional approaches for the entire share capital of the company".

It typifies financial cycles in this sector involving disconnect between industry and stockmarket perception of value. The market consensus has feared lower oil prices due to weak economic growth and shale development increasing supply; hence the sale of shares.

Last October, the World Bank predicted steadily declining oil prices, yet levels near $100 (£59) a barrel are still a bonanza compared with sub-$20 a decade or so ago. Civil war in Ukraine means prices are reacting on the upside and the conflict looks set to drag on. Possibly the effects of loose monetary policy has made acquirers feel gung-ho.

Establishing a new trend

Competition for Salamander's assets should help secure good prices and implies the industry sees it as cheaper to hunt for oil and gas on the stockmarket than in the ground - even when having to pay a premium for corporate control.

Possibly the new trend will establish a floor for share prices and other bids to follow. The likes of Afren and Eland Oil & Gas (ELA) in Nigeria; Faroe Petroleum, EnQuest and Ithaca in the North Sea. Bankers Petroleum, BowLeven, Circle Oil and Tullow Oil are all notable "potentials".

Salamander shares had dropped to about 100p, well below estimations of the value of 140p (on a 10% discount rate) for its producing assets alone.

The company floated in 2005 with a focus on Indonesia and Thailand and despite some good financial progress its exploration has generally disappointed - hence the shares recently reflecting a fear that exploration was cannibalising the business.

Pricing is pivotal

Shareholders have supported share issues at higher prices, the last two years ago: a 13 for 20 rights issue at 130p versus a share price of 256.1p implying an ex-rights price of 206p. To some extent therefore, the price at which this company could be bought will reflect institutional investors' feeling whether this is a useful chance to cut losses and move on, or management should be given more time.

Salamander fell almost continuously from near 220p a year ago despite good first-half 2013 results, with operating cash flow up 149% to $100.4 million as average production rose 39% to 14,900 barrels of oil equivalent per day (boepd). Pre-tax profit was flat at $15.9 million after expensing exploration costs otherwise it would have doubled to £124.6 million.

Last November's interim management statement was a mixed read with patchy exploration progress and flat 2014 production targeted.

The 2013 prelims showed net debt near $260 million (for gearing of about 65%) and net interest charges clipping over 30% of operating profit; so cash from divestments will be welcome.

A latest interim management statement re-iterates guidance for 2014 average production of 13-16,000 boepd and reads quite promisingly in terms of operations - although a long-term follower might wonder, where is the kicker to genuinely transform value? A recent gas discovery is good although substantial oil is really what investors seek.

The financial summary table shows no dividend (as typical from this kind of company, at this stage of development) and the consensus expects a slip in earnings. So Salamander is exposed as a bid target having made investments and some good progress, but without affirming the kind of story investors want.

Among brokers' analysts, First Energy Capital asserts a core net asset value (discovered resources) of 158p a share and entertains bids of 186p to 232p, while Cannacord values the core at 140p a share with a 10% discount rate - rising to 176p if a 7% rate is applied. "This might be a more reasonable estimate of potential upside for an acquirer with a lower cost of capital," the company say.

"Stop loss" and "saucer"

On an un-risked basis, i.e. respecting discoveries under appraisal, the target rises to 203p employing a 10% discount rate. This is quite a complex group to value though, and Deutsche Bank suggests a total risked value including exploration of 185p.

Selective disposals ought to enhance value if no bid for control materialises, so the shares are unlikely to fall right back. Possibly the near-term downside is 10p to 20p (i.e. roughly 10%) versus 30p or more upside (20%) in the event of a successful bid - so the risk/reward profile is interesting for speculators, also with the oil and gas sector now on the rebound.

The situation illustrates two examples of technical share analysis. Firstly a "stop loss" approach in oil & gas can be self-defeating: this sector is dynamic and a share that drops out of favour can easily become a bid target. Secondly the "saucer" pattern which according to chartist witchcraft is bullish (and I’ve seen verified on various occasions).

February to April 2014 exhibited a saucer in Salamander, then a spike. This could be rationalised by way of "get me out of here" desperation selling at chart lows, then information leaks about approaches. So look out for low-flying saucers in unloved shares.

For more information see salamander-energy.com.