The Storm at Capricorn Energy Explained (UPDATED)

2023 has not started on a rosy note for all the oil and gas equities in the AlphaValue universe. For some, the beginning of the new year has been tainted by a gloomier story. Capricorn, the UK-based independent O&G producer, has been the worst-performing equity in our Oils coverage, down 7.64% ytd, although the stock is still up 26% over the past year. Over and above that, the downside risk seems to be tenacious. We are among the very few independent equity research firms who freely comment on the Capricorn story as it unfolds. Independence being at the core of our DNA, we believe that it is our duty to provide unbiased research on this subject. This equity story has strong implications in the Mediterranean zone and is quite dramatic, to say the least. 

The company is mired in a tug-of-war between shareholders and the management, thereby becoming the hottest potato among the European oil and gas equities over the past six months. Indeed, following Capricorn as an equity story has been as thrilling as watching the TV series Succession where the children of a media mogul break their necks to prevent a buyout but get played by their CEO father. 

The Vote on the Future 

Seriously disappointed and infuriated with the management’s merger recommendations, the latest being with Israeli gas producer NewMed (see our recent take on the merger), as well as the failure to provide a future strategy, Capricorn’s shareholders called for a general meeting in late December 2022 to vote on changes in the Board.  

The shareholders, led by activist investor Palliser owning 6.85%* of the voting rights, proposed 6 names to replace 7 Board members, including the CEO and CFO who have occupied these functions for at least a decade. Among the 6 names proffered by Palliser, Hesham Mekawi positively stands out. He is the former head of BP North Africa with extensive knowledge and experience in Egypt where Capricorn’s producing assets are located. Updating the production-sharing agreement with Egypt and creating more value from the relevant assets should be the top priority for the company. Mekawi could be the name to inject that much-needed dynamism. 

The management’s decision to hold the vote on the NewMed transaction and the Board change on the same day (1 February 2023)―the former in the morning and the latter in the afternoon―does however little to reassure the shareholders who will take the stage at a historic vote on the future of the company. 

Embroiled in governance problems, high costs, an inability to benefit from the high-price environment and the lack of a clear strategy, Capricorn desperately needs to refresh its board. It is quite difficult to guesstimate the outcome of the vote, nonetheless. Palliser is confident that shareholders holding 40% of the voting rights, including the ones listed below and undisclosed names, will vote for the Board change. 40% will be enough to secure the majority of the votes based on the historical turnout ratio (70%) at Capricorn’s general meetings. If the morning vote rejects the merger with NewMed, the odds for a Board change in the afternoon get higher and this will mark the dawn of a new era for Capricorn. On the contrary, if the morning session votes in favour of the NewMed merger, the possibility of winning the afternoon vote on the Board overhaul will get slimmer. Still, all bets are off. 

A Hard-to-Sell Historical Performance 

Capricorn’s recent history of financial performance reveals the company’s sensitivity to oil prices prior to the sale of Senegal and the UK North Sea assets, and the consolidation of the Egyptian operations in 2021. Although the gas-weighted hydrocarbon production is higher now at around 36,000 boe (23,739 boe in 2009), Capricorn is not able to benefit from this, even with higher prices, due to the fixed-price gas contracts with EGPC. Capricorn is bound by contracts wherein it sells the gas to EGPC at $2.9/mscf ($2.9/mmbtu and $0.49/boe) while the European benchmark averaged $31.5/mmbtu in Q2 2022.  

The net cash position has seen some improvement thanks to the proceeds from asset sales and the Indian tax refund of $1.07bn in 2022. Note however that the cash position has not been supported by any significant net cash flow from operations. 

‘We Want Returns,’ Cry Shareholders 

Given that the company is sitting on a cash pile, Capricorn shareholders naturally want a return on their investment. The balance sheet is as healthy as ever with $809m cash and cash equivalents as of the H1 FY2022 after $528.6m returned to shareholders in the same period.  The gross debt of the company is a mere $174m. 

The Israeli gas producer NewMed however has a net debt position of $2.14bn, with basically no cash at $53m. Capricorn shareholders are not entirely convinced by the future returns on the potential merged entity. Both Capricorn and NewMed however claim that they will return 30% of the $3bn-plus free cash flow to be generated during 2023-2027.  

Given the poor performance of the current management in terms of delivering good returns in the decade since they took over, shareholders have been voicing their demand for paybacks more strongly. In March 2022, the company announced a $200m share buyback program as part of its commitment to return $1bn in 2021 and 2022, of which only $25m has taken place. 

A Look at the Post-Merger Capricorn Energy

One major issue for the current Capricorn shareholders is the prospective share they will hold in the combined entity if the merger proceeds. Capricorn will issue 2.3373 shares for each NewMed unit and, in the end, the number of outstanding shares in the new entity will be 3.015bn. Accordingly, Capricorn shareholders will own 10.3% of the combined group and the rest (89.7%) will be held by NewMed shareholders. 

Moreover, Itshak Sharon Tshuva, who is the ultimate controlling shareholder of Delek Group, holds 50.18% of the voting rights in Delek Group. He will have almost de facto control over the Delek Group’s direct and indirect shareholding in the merged entity, giving him the majority of the voting rights. This would result in a complete remodelling of Capricorn's shareholder structure and governance. His thirst for success could be the driving force Capricorn needs. 

The merger could give Capricorn the required scale and stability of cash flows, and long-term exposure to higher gas prices. In addition to the near-term committed cash returns, the merger promises longer-term value creation for shareholders thanks to high-quality assets. 

An Adventurous Road to the Future 

In our view, there is a clear urgency to update the agreements in Egypt and grow the production base in addition to executing the commitments on shareholder returns. After years of unsuccessful exploration that cost $2.4bn from 2007 to 2021, a merger with NewMed may have its operational pluses as a way to increase production. If the terms are right for Capricorn shareholders, it could be an elegant exit. NewMed effectively offers great potential given the company’s giant Leviathan field that we value at $4.8bn (NPV10). For such an ambitious venture, Capricorn is the perfect listed shell company with cash attached to get a listing in London on the cheap. 
For now, Capricorn is hard to rely on for investors, except for those who are looking for the Ark of Covenant in Egypt. 

Valuations available on request  

UPDATES 20/1/2023

nstitutional Shareholder Services (ISS), a shareholder proxy adviser, recommended Capricorn shareholders vote against the NewMed merger and vote in favour of the board overhaul.
Shareholders will vote on the merger proposal on 1 February 2023 in the morning and on the board change in the afternoon.

In its recommendation, ISS notes the lack of compelling strategic rationale, low valuation and substandard sale process, which provide the ground to vote against the NewMed merger.
The advisor even provides a critical approach to Leviathan, a giant gas field in which Capricorn will hold a stake after the merger, on the grounds that it will not contribute to the decoupling from fossil fuels.

In our view, ISS’s approach underestimates the value Leviathan could bring to Capricorn. A high-quality asset like Leviathan will boost Capricorn’s production by 75,000 – 80,000 barrels of oil equivalent per day natural gas while giving the company exposure to higher contractual prices in markets with increasing gas demand.

If the merger fails, we could see a brief appreciation of Capricorn’s price as the odds for board change will increase and shareholders will definitely welcome such a victory. But in the long run, it will be difficult for the company to finance growth operations.
If the merger follows through, shareholders could protest the company and dump the shares after receiving the pre-completion special dividend ($620m and $1.92/sh), putting downside pressure on the stock.

24/1/2023

Capricorn shareholders have been pushing the general meeting to vote on the NewMed merger after a GM for a board overhaul. After a massive campaign, they have succeeded to adjourn the meeting for the vote on the NewMed merger to 22 February 2023. The GM for board change will go ahead on 1 February 2023 as planned. Even before the meeting, all parties agreed on the board change. Accordingly:
- Nicoletta Giadrossi will step down as chair following the NewMed vote on 22 February 2023 and will relinquish her role as the board member effective immediately,
- Simon Thomson, the CEO, will step down as board director with immediate effect
- James Smith remains on the board as CFO will remain on the board until 1 February 2023
- 3 board members will step down as board members effective immediately and one member will stay until 1 February 2023 to ensure ongoing oversight of reporting obligations and other corporate governance requirements
All in all, we have a new board at Capricorn Energy after a long period of poor governance that has frustrated the shareholders with minimal returns in the last decade and failed to give a clear strategy.
Shareholders will likely receive at least $500m as planned after the Indian tax refund in 2021.
In our view, the terms of the agreement should be discussed to decrease the massive dilution for shareholders, but the merger will also bring good prospects for production growth to Capricorn. However, there are higher chances of the merger not going through.

Contact analyst - Elif BINICI - e.binici@alphavalue.eu