A Matter of Appearances-September 2011
We can now add Northern Oil & Gas, Inc., of Wayzata (AMEX: NOG) to the long list of companies that have brought upon themselves the scourge of the short-sellers, those tenacious investors who profit when a stock’s price goes down.
Northern’s particular narrative has stoked the zeal of “the shorts” for many months, resulting at one point in one of the five largest short positions on all major exchanges, according to Motley Fool. In late June, nearly 60 percent of the company’s shares outstanding and tradable were still held by shorts.
But Northern also has distinguished itself as one of the largest companies specializing in “nonoperating interests” in the massive, oil-rich Williston Basin that lies beneath Saskatchewan, Montana, and the Dakotas. Advances in horizontal drilling have made the basin’s once-passed-over oil, which is trapped in layers of shale, easier to tap now.
Northern is in the oil and gas exploration business. Since its founding in 2006, the company’s “land men,” led by cofounder and CEO Michael Reger, have purchased leases to more than 150,000 acres of land, primarily in North Dakota’s Bakken Formation, and the Three Forks Formation just underneath it.
Once Northern secures the leases, it teams with independent operators who do the actual drilling and cede some of their production to Northern. Those arrangements generate the equivalent of 40 oil wells’ worth of revenues. That meant $44.6 million in revenues in 2010 (net of non-cash hedges against price volatility), up from $14.2 million in 2009, and $4.3 million in 2008. Earnings have followed a similar trajectory: $6.9 million in 2010, more than double the $2.8 million in 2009, and $2.4 million in 2008.
The “bull” version of the NOG story has helped fuel some vertiginous runs in the stock’s price, and has allowed the company to tap the capital markets five times for a total of $383 million, including two biggies: an $82.6 million offering in April 2010, and a $200.1 million offering the following November. Both were comfortably oversubscribed.
The company still has $100 million on its now nearly debt-free balance sheet, and though it’s still burning cash, Northern projects that its growing cash flow and available line of credit will keep it out of the equity markets and will soon make it self-funding.
So what’s not to like about this stock?
This, actually: Behind all the positive news is a company that appears to operate at the edge of the ethical envelope. A years-long pattern of management decision making and behavior—both professional and personal—calls into question Northern’s ability to act fully in the best interests of its shareholders.
Is the situation as bad as it appears? Maybe not. But the shorts have been able to bludgeon the company with it for months. In a three-hour interview, Reger, 35, acknowledged as much to me, referring to the past several months as “the PR mess.”
“We do really have a great company,” he says. “It’s really strong—the business model, our balance sheet. Optically, we need to be stronger, and we are going to work on that.”
Churning at the Top
There are plenty of “optics” to work on. A look at Securities and Exchange Commission (SEC) filings, court documents, news reports, and other records reveals a tangled web of overlapping family and business relationships; cross-hatched investments in companies that are competitors; massive insider selling; a vendor relationship that doesn’t pass the smell test; a questionable board appointment; and an executive team of four people that over the years have piled up a rather remarkable collection of more than 15 moving vehicle violations and other infractions.
It’s nothing less than Hot Stock meets Animal House.
It gives me indigestion to tell this story, because I own this stock (full disclosure) through an investment manager who looks after my vast fortune (so vast that I still work). A couple years ago, I traded in and out of NOG on an individual basis, with less than optimal results (hence, I now hire other people to do this for me). I don’t currently own shares directly, but Fidelity Investments and T. Rowe Price do: roughly 16.4 million shares, according to SEC filings as of March 31. Munder Capital Management owns 2.8 million shares, and Vanguard and State Street each own another 2.6 million shares. The list stretches on; high-powered institutional investors own roughly 80 percent of Northern Oil & Gas’s outstanding stock.
Meanwhile, Northern’s leaders have been churning their shares.
As of April 1, Reger owned just shy of 3 million shares of NOG, according to the company’s most recent proxy statement. Since the beginning of the year, he had sold nearly 908,000 shares, netting $25.8 million in proceeds. Ryan Gilbertson, also 35, cofounder of the company and its president, had sold 149,164 shares for a total of $4.1 million. All told, in the first four months of 2011, insiders—including board members—sold more than 1.2 million shares, reaping more than $35 million in proceeds, with the vast majority of those sales taking place as the stock ran toward a 52-week high of almost $34 a share.
One of those board members is Lisa Meier, who is head of the company’s audit committee and was recently named lead independent (that is, non-employee) director for Northern. Since December 2009, Meier, 38, has sold roughly $740,000 worth of stock granted to her at either no cost or as lower-cost options in Northern, including a sale of $340,000 during the insiders’ March 2011 selling spree.
When Northern Oil & Gas announced Meier’s appointment to the board in 2007, it noted that she had worked in the energy audit practice at PricewaterhouseCoopers, and “in accounting roles for three Fortune 500 companies.” It left out the fact that while she was at PWC, Meier served on the audit team charged with reviewing related-party deals at Enron, the transactions that ultimately destroyed the company.
“We knew we were progressive and pushing the envelope,” Meier told Businessweek in a “comeback” story on her post-Enron career. “Everyone was surprised by what was going on . . . . [But] you didn’t want to be the one saying, ‘I don’t get it.’”
Compensation Policies Shift
In advance of the insider selling this year, Northern’s management was richly fortified with new stock. Reger and Gilbertson were each awarded common and restricted stock grants as part of the company’s stock incentive plan: 293,326 shares, to be exact. Chief Financial Officer Chad Winter was granted 270,569 shares, and Chief Operating Officer James Sankovitz 280,854 shares.
Reger notes that the sales are all part of a systematic SEC–filed 10b5-1 shareholder divestiture plan, and that the timing of these and other sales is a function of the SEC-dictated window during which insiders are allowed to sell their stock.
Curiously, management noted in a 2008 news release that it was suspending its 10b5-1 program for both Reger and Gilbertson. In the same release, the company noted that Northern management would take no cash compensation, only stock, in all of 2009 and 2010.
Yet Northern’s 2011 proxy statement reports that in 2009, Reger and Gilbertson each received a cash salary of $285,000 and a bonus of $570,000, and in 2010 a salary of $330,000 with no cash bonus. CFO Winter and COO Sankovitz were each paid $155,000 in cash salary in 2009, and $235,000 in cash last year. Each of these four executives also received tens of thousands of dollars for their personal use of company-leased vehicles (reportedly Cadillac Escalades), 401(k) contributions, and reimbursement for personal travel and tax gross-ups.
In the 2008 news release, management explained that company officers had been selling stock to “diversify their holdings.” Reger defends the stock sales earlier this year on the same grounds. Roughly $21 million of his sales this spring were made in order to divest precisely 20 percent of his holdings for the sake of diversifying, he says, and the other sales were part of the company’s 10b5-1 program—which was reinstated by the board in November 2009. He also says that the board suspended the all-stock compensation program when the stock’s price went into a slump in 2008 and 2009, to avoid diluting shareholders. Asked why the company didn’t issue another news release to announce these changes, Reger says it “wasn’t required to.”
As for his overall compensation, Reger says: “I built a company that now has 150,000 acres of land under lease in the core of the Bakken play. We expect to do $180 million in cash flow this year, and I have created a lot of shareholder value based on the assets we have acquired. So from a compensation standpoint, I believe I am being fairly compensated.”
All in the Family: Northern Oil & Gas competitor Voyager Oil & Gas share key players.
Feeding a Competitor
All of the above aside, there’s the not-so-small matter of Voyager Oil & Gas (AMEX: VOG).
NOG and VOG are related not just in the quaint fact that their stock symbols mimic each other. Voyager is a company formed in 2008 by Reger’s brother, James Russell Reger, otherwise known as “JR,” or as “Mister Billings” on his Facebook page. Voyager is also connected to Northern in several other ways, even though it was dubbed a competitor in a federal shareholder lawsuit, which has since been dismissed on what can only be described as narrow legal grounds.
Northern and Voyager share parallel business plans. Like Northern, Voyager is dedicated to leasing land in the Bakken and Twin Forks formations of the Williston Basin, then partnering up with drilling companies to spud the land.
Voyager is headquartered in Billings, Montana, but has deep roots in Minnesota. The company evolved from a blind pool called Ante4, Inc. A blind pool is a form of limited partnership that raises money with no specific investment purpose identified in advance. The Ante blind pools were an investment vehicle favored by Lyle Berman and investment banker Larry Zipkin, respectively of Grand Casinos and Casino Magic Corporation fame.
In its first iteration in 2004, Ante4 begat Lyle Berman’s World Poker Tour, and later begat an oil and gas company called Plains Energy, which in 2008 begat Voyager Oil & Gas. Berman is Voyager’s board chairman. Also on the Voyager board are longtime Berman business associate Joe Lahti, former CEO of Shuffle Master, Inc., and Loren J. O’Toole, II, a lawyer from Plentywood, Montana.
According to the shareholder lawsuit against Northern’s officers, filed in August 2010 in U.S. District Court in Minneapolis, all four of Northern Oil & Gas’s top executives—Reger, Gilbertson, Sankovitz, and Winter—currently or at one time owned significant positions in Voyager Oil & Gas. Reger and his wife, Brittany, through a privately held company called Reger Gas Investments, were early investors in Plains Energy and eventually emerged with nearly 786,000 shares, or 1.73 percent of Voyager. Gilbertson, either personally or through investment companies he controlled, owned several hundred thousand shares of Plains (then Voyager), as did Sankovitz, who was a cofounder of Plains, and Winter, who as of last year owned 286,561 shares of Voyager common stock.
The lawsuit charges that Northern’s officers hurt their company by participating in the formation and funding of Voyager, and were guilty of a “breach of fiduciary duty” to Northern Oil & Gas shareholders because they essentially created a competitor that could capitalize on opportunities that Northern itself should have pursued.
It’s important to note again that the lawsuit in question has been dismissed; the judge ruled that the claim had no merit because none of Northern’s officers held a controlling share of Voyager. Legally, they are off the hook.
For his part, Reger says that he originally invested in Plains because it was targeting a different formation and looking for natural gas, not oil—an assertion that is not supported in any public statement from that company. He says he has gifted his stake in Voyager to a foundation.
If Voyager/Plains was going after only natural gas, that’s certainly not evident in its SEC filings or its financial results. In its business descriptions in those filings and in its press releases, Voyager, the result of a merger with Ante4 in April 2010, is clear from the beginning about its intention to target oil deposits, stating in its filing on April 16, 2010, that its “primary focus” is to acquire “high value leasehold interests specifically targeting the Bakken and Three Forks formations in the Williston Basin.” The filing goes on to describe them as rich oil-bearing formations.
And in its endeavor to find oil, Voyager has been succeeding: In its most recent quarter, Voyager generated oil production of more than 10,000 barrels, up more than 3,000 percent over the first quarter of 2010.
How Would It Look in the New York Times?
Then there’s the flap over an organization called Ashwood Resources, LLC, which, it turns out, was the recipient of roughly 90 fractional interests in Northern’s oil wells. Ashwood Resources’ primary contact, at least as of an August 7, 2009, incorporation filing with the Minnesota Secretary of State’s office, was Brittany Reger, Mike’s wife.
In recent SEC filings, Northern portrays the transfers to Ashwood—constituting 18 percent of one net well (Northern owns interests in wells, not wells outright, hence a “net well”)—as immaterial and legal. That disqualifies the transfers as a “related party transaction,” which would require a disclosure to investors. Reger says Northern made the transfers to cut down on the expense of administering those exceedingly small resource claims, and that any income from those transfers of assets did not amount to a sum of money to Ashwood that would require disclosure to shareholders.
Even so, the shorts have made a great deal out of Ashwood, so much so that Reger, at Northern’s recent annual meeting, apologized to those in attendance for the attention it has received.
Northern has been moving in recent months to address the issues the shorts have latched onto. Shareholders at the annual meeting approved the appointment of Deloitte & Touche, LLP, to replace Mantyla McReynolds, an accounting firm based in Salt Lake City. Mantyla is also the auditing firm for Voyager Oil & Gas.
But how did all of this come to pass—the ill-timed insider selling, the bountiful executive and board compensation, the intertwined companies? Northern’s actions haven’t been found to violate laws or regulations, at least not thus far, but by letting themselves fall prey to negative appearances and to the shorts, Northern’s executives have done the company some real damage. The stock has been cut in half and now, in fact, may actually be cheap, trading at roughly four times Northern’s projected 2012 operating earnings.
Northern is a young company, headed by relatively young executives, who may be vulnerable to a level of youthful exuberance (hence, their driving habits, for example). That exuberance may be tempered going forward if they ask themselves a simple question: “How would what we’re doing here look if it were printed on the front page of the New York Times?”
“This is how I look at everything now,” Reger says. “We have steadily built this company, quickly built this company. We are not perfect, but we did a really good job building it. We are more cognizant now of the optics, but nothing we have done is inappropriate.”
For a short taste of what short sellers are saying about Northern Oil & Gas, read blogger John Hempton, who goes after everything from the value assigned to Northern's acres to its growing share count to its transactions with Ashwood Resources. Search for “Northern” in his posts at brontecapital.blogspot.com. CNBC stock commentator Herb Greenberg offers another rundown of the shorts' rationale here.