Trade Idea: GMX Resources (GMXR) Bonds

GMX Resources Inc. (GMXR) is an natural gas exploration & production company with operations in the Haynesville shale play in Texas/Louisiana. Recent weakness in natural gas prices has hurt natural gas E&P company valuations. Here's the company's most recent investor presentation [pdf].

GMXR's convertible notes trade at a higher yield than its straight-preferred stock, indicating at least a capital structure arbitrage opportunity and possibly some undervalued debt for us to buy.

The market capitalization is $120 million, plus $50 million in preferred stock and $219 million in debt (at face value). Earnings before interest, taxes, depreciation, amortization, and depletion (EBITDDA) for the twelve months ended June 30, 2010 was $61 million, giving an EV/EBITDDA ratio of about 6.3x.

The debt consists of a bank loan due August 2012 with $26 million drawn, plus two series of convertible notes. There are $117 million of the 5.00% converts due February 2013, which trade at 76 to yield 17.5%. Also, there are $74 million of the 4.50% converts due May 2015 that trade at 65 to yield 15%. Both converts are "busted": trading way below the conversion prices which for the 2013s is $32.50 and for the 2015s is $18.75. The total market value of the debt is $164 million, which is only 2.6x EBITDDA.

The company may extend the maturity date on the bank loan to July 8, 2013, if, on or prior to July 31, 2012, all of the the 5.00% convertible notes either have been fully converted to common stock or have been paid in full with the proceeds of an equity offering or new debt with a maturity date no earlier than 180 days after July 8, 2013.

Among other covenants on the bank loan, the company must maintain a current ratio greater than one, a ratio of debt to EBITDA less than 4x, and a EBITDA to interest coverage ratio of greater than 3x. Also, the company is prohibited from paying any dividends on or repurchasing any common stock, and from incurring any other debt.

One thing that's really odd is the company's 9.25% Series B Cumulative Preferred Stock [prospectus], which trades at 88 and yields about 10.5%. I can't understand how a straight preferred stock can trade at a yield 700 bps lower than the same company's convertible note. The preferred should be trading sharply lower just for yield parity with the debt!

GMXR has a rolling, three-year hedging program. They have hedged 7.2 Bcf (74%) of remaining estimated natural gas production for 2010. They also have 14.9 Bcf and 16.7 Bcf of natural gas hedged in 2011 and 2012, respectively, at average hedge prices of $6.14 and $6.08 per Mcf.

Besides the debt/EBITDA ratio calculated above, which seemed to suggest that the debt may be safe, some other valuation metrics to look at are: debt/proved reserves and debt/acreage. The ratio of the market value of GMXR's debt to its quantity of proved reserves is about $0.45/mcfe. For determining the safety of the bonds, I think it would be appropriate to compare this with other Haynesville E&P companies' EV/proved reserves ratios. For Comstock and Goodrich Petroleum, I come up with values above $1.75/mcfe. That suggests we'd be getting a good deal on reserves if GMXR defaulted on the bonds and they were converted to equity in a restructuring.

Risks: GMXR's acreage is mostly in Harrison County, which is said to be a less attractive part of the Haynesville play. They have also been spending massive amounts on drilling new wells, which creates a cash flow challenge.

Disclosure: Own GMXR bonds, short GMXR and GMXR preferred.