Irenic Sends Letter to the Board of Directors of Capricorn Energy

NEW YORK--(BUSINESS WIRE)--Irenic Capital Management, L.P. (together with its affiliates, “Irenic” or “we”) today announced that it has sent the below letter to the Board of Directors of Capricorn Energy plc (LSE: CNE.L).

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October 19, 2022

Capricorn Energy plc
50 Lothian Road
Edinburgh EH3 9BY
United Kingdom
Attn: The Board of Directors

Dear Members of the Board:

Re: Proposed All-Share Combination of Capricorn Energy plc with NewMed Energy Limited Partnership

Irenic Capital Management, L.P. (together with its affiliates, “Irenic” or “we”) is a meaningful shareholder of Capricorn Energy plc (the “Company” or “Capricorn”), with an approximately 1.5% stake in the Company. We write to you today to share our views on the Company’s recently announced merger (the “Proposed Merger”) with NewMed Energy Limited Partnership (“NewMed”). We welcome the Board’s decision to embrace the overwhelming logic of shareholder demands to withdraw from the previously considered combination with Tullow Oil plc (“Tullow”). However, its simultaneous pivot to pursue the Proposed Merger instead is equally unwise and disappointing.

We believe that the terms of the Proposed Merger remain profoundly unfavorable to Capricorn shareholders. Like the Tullow transaction, the Proposed Merger materially undervalues Capricorn’s collection of liquid or otherwise easily monetizable assets. Based on readily available markers of value for the majority of the Company’s assets—including its large net cash position, several near-term contractual earn-outs that will mostly turn to cash within the next year, and its sole production asset in Egypt—we believe the Company could realize almost 40% of incremental value through a straight liquidation relative to the Proposed Merger.

The plain numerical logic of the argument is clear: at current market prices, through the Proposed Merger, Capricorn shareholders are set to receive total consideration of GBp 254 in the form of (i) a pre-closing dividend of GBp 165 and (ii) a stake in the newly combined entity worth just GBp 88. By contrast, a straightforward liquidation would generate GBp 350 to Capricorn shareholders.

While the Proposed Merger represents a relative improvement to the terms contemplated in the now abandoned Tullow Scheme and the envisaged pre-close cash dividend is a step in the right direction, it will still result in Capricorn shareholders receiving grossly inadequate and riskier value for the assets they contribute. Moreover, the Company has yet to present shareholders with any proposal that represents superior value relative to the straightforward liquidation value we have assessed. This is despite months of efforts to effect one. For these reasons, we urge the Board to abandon the Proposed Merger and proceed with a liquidation of the Company’s assets in orderly fashion.

We have been involved in many similar situations across various industries and appreciate that an orderly wind-down must be done thoughtfully. Maximizing firm value against the backdrop of an imminent ceasing of operations requires considerable discipline. We are writing this letter in hopes of fostering a constructive dialogue with Capricorn’s management and Board where we can work together to adopt a thoughtful liquidation strategy.

About Irenic

Irenic is a research-intensive firm that engages in substantial due diligence. We make only a small number of investments such that when we do, we have high conviction in our conclusions. Our work on Capricorn has been extensive and exhaustive. In assessing the opportunities available to the Company, we utilized a full spectrum of internal resources and enlisted investment bankers, lawyers, and industry executives to further inform our views.

Irenic is named deliberately. The word irenic is an adjective that describes conduct “favoring, conducive to, or operating toward peace, moderation, or conciliation.” We will do our utmost to embody those tenets and be good partners to you as we work together to safeguard and realize value at Capricorn.

The Proposed Merger does not Maximize Value for Capricorn Shareholders

We estimate Capricorn’s Net Asset Value (NAV) to be GBp 350 per share. Most of this NAV is currently cash (roughly GBp 216—representing ~90% of the Company’s current share price) and is, therefore, subject to limited risk. Capricorn’s UK earn-out is deeply “in-the-money” and its Egyptian assets were acquired only recently in a competitive process at market-clearing prices. Moreover, Brent prices have climbed by close to 20% since the acquisition closed in September 2021 (and significantly more since the acquisition price was agreed in March 2021) implying material value should have accreted to the assets since the acquisition. These two components—earn-outs and Egypt—represent an incremental GBp 122 of per-share NAV in present value terms.¹

Capricorn’s NAV is not only well in excess of its current share price, but also highly certain and reasonably realizable—the cash is in the bank, the earn-outs are contractual, and its Egypt asset was only recently acquired. In contrast, the Proposed Merger effectively asks that Capricorn shareholders give up a meaningful chunk of its cash (~GBp 50—GBp 216 less the GBp 165 proposed dividend), ~75% of its earn-outs, and ~75% of the Egypt asset in exchange for just ~10% of the newly combined company. While we regard NewMed’s assets as more attractive than Tullow’s, their value remains highly uncertain and subject to a number of binary outcomes related to several key development stage expansions. Moreover, even after the combination, the combined equity will be significantly geared and investment research analysts believe NewMed to be currently trading at a significant premium to its NAV², underscoring the risk embedded in the share consideration of the offer—a risk that shareholders will not need to bear in a straightforward liquidation process.

Beyond the uneconomical exchange ratio implied by the reverse merger and risky nature of NewMed’s assets, the Proposed Merger appears to have limited strategic rationale; except, of course, to effectively provide NewMed—a tightly-held, Israel-listed partnership—with a premium listing on the LSE. The combination is set to produce minimal financial synergies of which Capricorn shareholders would only receive a diminished pro-rata share of ~10%. In fact, the companies did not once include reference to any synergies in their recommendation document published on September 28, 2022. While the Proposed Merger is touted as “creating a MENA Gas and Energy Champion,” we do not see strategic merit in combining gas-rich onshore assets in Egypt with offshore gas assets in Israel. These are different production technologies, regulatory regimes, and geopolitical risk profiles; and unlike the prior transaction, there are no meaningful financial synergies from G&A savings. By contrast, the liquidation process we propose effectively creates full G&A reduction (“synergies”) which fully accretes to Capricorn shareholders and provides meaningful upside.

Below we outline our more detailed considerations on Capricorn’s value buckets:

1. Cash—As of June 30, 2022, the Company had $809 million in gross cash on its balance sheet representing GBp 216 at the current exchange rate.³
2. Earn Outs—Resulting from various historical asset transactions, Capricorn currently has three contractual earn-outs in-place. Its UK earn-out (related to the previously sold North Sea assets) represents ~$197 million of present value to be earned over the next four years at the current Brent forward curve. Capricorn is further set to receive a lump-sum payment upon achievement of first oil from its former Senegal asset (disposed to Woodside in December 2020). Woodside has recently been upbeat to the market about their expectation for first oil in 2023 and we believe this to be a reasonable base case. This results in a present value of ~$89 million. Finally, Capricorn is set to make earn-out payments to Shell related to its Egypt asset which, based on current Brent strip pricing, represent ~$65 million of value leakage. All told, Capricorn’s contractual arrangements have a net present value of ~$221 million (or GBp 59).
3. Egypt Assets—As laid out above, Capricorn acquired the asset just one year ago, paying $323 million upfront for its share (with its JV partner Cheiron acquiring the remaining 50%) from Shell in Egypt’s Western Desert (the “Egypt Assets”). It is our understanding that Capricorn was one of many bidders for these assets and that interest in the assets from other auction participants remains substantial. Moreover, the price of Brent is greater today by ~20%, and a good part of this incremental value (net of earn-out) will accrue to Capricorn as owner of the Egypt Assets. For reference, the Egypt Assets generated gross profits of $105 million in 1H22 alone and are tracking to generate FY22 gross profits of >$150 million. A sale process today would be stronger because potential bidders are financially healthier. Much of the prior sales process took place during the depths of COVID and the period thereafter (it was launched in November of 2019 and a deal was announced in March 2021) when many E&P companies otherwise potentially interested in acquiring the Egypt Assets were focused on fortifying their balance sheets rather than making acquisitions. Today, many E&Ps are flush with cash with many in the process of turning debt-free over the coming quarters. Third, since Capricorn completed the acquisition, a neighboring concession has renegotiated a better economic arrangement with the Egyptian government and there is higher potential that Capricorn (or a future alternative owner of these assets) can achieve the same. As you are doubtlessly aware, the Egyptian government recently ratified a new modernized production sharing contract (“PSC”) with APA Corporation (“Apache”), which operates substantial energy assets in the country. The agreement “create[s] a single cost recovery pool, facilitate[s] increased recovery of prior investment, adjust[s] cost recovery and production sharing percentages, and refresh[es] the term length of both exploration and development leases.”⁴ In short, the new PSC represents substantial economic benefit to Apache and reflects the Egyptian government’s desire to facilitate increased investment in the face of declining domestic production. While no two PSCs are alike, our work suggests that the asset owner should be able to negotiate a similarly PSC modernization, which would meaningfully enhance value.⁵ We ascribe a total value of $425 million to the Egypt Assets based on current Brent strip pricing and the contracted natural gas offtake and net the existing non-recourse debt balance of $178 million, representing GBp 63 (inclusive of 2H22 cash flows).
4. Exploration Assets—We attribute GBp 10 to these assets at present. While value for the Company’s exploration assets is difficult to ascertain, we deem an aggregate value of GBp 10 per share (or $25 million) conservative, especially as netted with the full capex guidance for the assets (see below). There are some recent disappointments amongst Capricorn’s exploration assets (incl. its own offshore Israel and UK licenses) but likely some non-trivial value in its Suriname, Mauritania, and Mexico assets with drilling to commence in 4Q22.
5. Capex—Management guidance for FY22 is for $175-$195 million in total capex of which Capricorn has spent ~$85 million in 1H22 already. We net out the full remaining ~$100 million to the mid-point of this guidance for the remainder of FY22, representing value leakage of GBp 27 (represented in both Egypt and exploration asset values above).
6. Net Working Capital—As of 1H22, Capricorn had a net working capital balance of $74 million, including significant accounts receivables related to its Egypt Assets of $114 million that have been building for the last six months. As many operators have done for decades, we expect the Company to receive these payments implying the full benefit of this net working capital should accrue to shareholders over time, representing GBp 20 in total.
7. Other Leakage—While we regard the timeline for an orderly liquidation of Capricorn’s assets as a rather straightforward endeavor given a set of highly liquid assets, we embed a $50 million G&A budget as leakage to achieve this process as well as ~$20 million of costs and fees to liquidate all assets (assuming ~4% of gross proceeds). This represents total additional value leakage of GBp 18.

Conclusion

The Proposed Merger—much like the previously contemplated Scheme—seeks to compel Capricorn shareholders to contribute their high-quality assets at a bargain valuation to a combined company, this time using an upfront cash payment as a carrot and a lower acceptance threshold as a stick. The alternative is handing to shareholders the straightforward value of the assets they are due.

We are yet to find a single shareholder that believes Capricorn has a mandate to grow. What shareholders seek is a course of action that maximizes value—whether that course entails growth or entails shrinking is of no consequence. Given shareholders’ reaction to the Tullow deal, the Board should know this. While the Proposed Merger looks improved relative to the Tullow transaction, it is still not the value maximizing path and we have little doubt Capricorn shareholders remain opposed.

At this point further efforts to identify yet another proposed merger do not make sense. The fact that no superior proposal beyond the Proposed Merger has emerged after months of searching speaks a plain and simple language: the Board must act in the fiduciary duty of its shareholders and liquidate the assets.

We appreciate your consideration and look forward to engaging with the Board on our proposal over the coming weeks.

Sincerely,

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About Irenic

Irenic Capital Management, L.P. is an investment management firm founded by Adam Katz and Andy Dodge. Based in New York City, Irenic works collaboratively with publicly traded companies to ensure operating activities, capital deployment and management incentives are all aligned to create value for the company and its owners. For more information about Irenic, please visit www.irenicmgmt.com.

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¹ In addition, Irenic is of the view that there is material incremental upside potential in the Egypt asset based on the ability to renegotiate cost-sharing terms with the Egyptian government. The local authorities have recently improved several operators’ terms to incent incremental capital investment into the country’s hydrocarbon production. If Capricorn were to realize similar improvements, it could result in GBp 100 of upside. However, given uncertainty around such renegotiations we do not ascribe any immediate value to a renegotiation now. It is likely that a different owner—one with experience in operating Egypt and other assets on the ground—would be willing to ascribe some value to this renegotiation when looking at a potential purchase of the Egypt assets.
² Barclays, the sole NewMed broker, most recently attributed ILs 770 of NAV per share to NewMed’s assets versus its current share price of ILs 825.
³ We commend the company’s decision to already return a significant portion of its $1,056 million Indian tax refund to shareholders by means of its April 2022 tender offer representing more than $500 million.
⁴ APA Corporation Announces Egyptian Parliament’s Approval of Modernized Production Sharing Contract, November 30, 2021, https://www.globenewswire.com/en/news-release/2021/11/30/2343505/0/en/APA-Corporation-Announces-Egyptian-Parliament-s-Approval-of-Modernized-Production-Sharing-Contract.html.
⁵ In addition to our asset-level NAV that is based on the value at year-end 2022, we believe Capricorn will generate well-level free cash flow of at least $160 million in 2022. From this well-level free cash flow, we deduct $130 million for management’s guided capital expenditures in 2022.