There’s only one thing when it comes to stock investing that scares me more than a company’s potential legal liabilities: accounting “issues.”
Investors rely on SEC filings and accounting reports to determine whether or not a stock is really worth their time and hard-earned money. These filings and reports need to be accurate, correct and timely in order to make a sound investing decision. When there’s issues with a firm’s accounting practices, it sends shivers down my spine.
Sometimes its turns out to be nothing, of course, as was the case with Linn Energy’s (NASDAQ:LINE) recent questions about its hedging practices. Others turn out to be more serious — Enron, anyone?
With that in mind, when small-cap Magnum Hunter Resources’ (NYSE:MHR) auditor had some questions about its accounting procedures, determining whether or not this is a temporary blip or something more sinister was paramount.
One of the big draws for investors to Magnum Hunter is the fact that the E&P firm has acreage in some of the nation’s biggest unconventional fields. The company owns land in fields such as the Marcellus, Eagle Ford, Utica and Bakken. That fact makes MHR potentially one of the best firms to take advantage of growing energy production and the hydraulic fracturing revolution sweeping North America.
If it is telling the truth, that is.
It seems that its independent auditor, PricewaterhouseCoopers has had some questions into just how it values its various properties and reserves. According to an official filing with the SEC, auditors at PwC had discovered information that “may have a material impact on the fairness or reliability of the company’s consolidated financial statements.”
The Big Five accounting firm also had questions about the energy company’s tax liabilities with respects to its ability to meet various debt covenants. Overall, the accounting firm believes that inadequate staffing and processes at MHR may have affected its financial controls and its statements.
To that end, PwC asked Magnum Hunter for more information. The E&P firm responded by giving PwC the middle finger and the boot.
Magnum Hunter believes its financial statements are accurate and the concerns mainly stemmed from the company’s rapid growth. Indeed, the firm has been adding acreage and production in America’s hottest shale regions like a madman.
MHR reported that it addressed PwC’s concerns by expanding and upgrading its accounting department and by hiring an outside accounting firm to help it complete its annual report for the year-ending in December 2012. The energy company also said it has adequate funding to meet its debt covenants and pay its bills.
Still, like I said, accounting problems are a huge red flag. Magnum Hunter shares had already fallen 17% this year before disclosing the accounting problems. Needless to say, investors weren’t so pleased with the company’s decision to drop PwC.
One April 17, when the filing was first announced, shares of MHR plunged almost 22% to reach $2.60. And today alone, the stock has shed another 9%, with the current price under $2.40 — the lowest price in three years.
Of course, that raises an obvious question: Is Magnum a value play now, or should investors steer clear?
As we said before, much of Magnum Hunter’s appeal is that the firm has operations in several of the country’s hottest shale and unconventional resource plays. However, some of that appeal could be dwindling without the recent accounting hassles. Like many of its successful competitors — such as EOG Resources (NYSE:EOG) and Cabot (NYSE:COG) — Magnum Hunter had been moving into more liquids-rich plays and relying less on dry gas production.
But the firm’s recent decision to sell its acreage in the liquids-rich Eagle Ford to Penn Virginia (NYSE:PVA) is a major step backwards on this strategy. Selling these assets will essentially, move MHR from a 60/40 oil and gas split to 40/60 production company. While that may bear fruit as natural gas prices rise, in today’s environment that’s not really cutting the mustard. At the same time, the company’s Utica acreage could be a problem as the region is quickly becoming a “hit or miss” for other producers.
All in all, the shift back to dry gas production could be occurring at just the wrong time — especially when there’s the account issues to contend with. Investing in independent oil and gas producers is hard enough without any accounting uncertainties.
For investors, the recent plunge in MHR’s share price may look appealing on the surface; who wouldn’t want to snatch up shares of growing E&P for 30% cheaper? Still, that appeal is only surface deep.
The potential accounting problems are a huge red flag and could continue to haunt the firm go sometime to come. After all, telling your auditor to go to heck because of concerns is not something most firms do. You have to really wonder what management is thinking. Add in the firm’s re-focusing and it’s all quite concerning.
In the end, MHR could be a decent short-term trade on any positive accounting news. However, given the recent sell-off across the board in the energy sector, investors are better suited looking for investments elsewhere.
As of this writing, Aaron Levitt did not own a position in any of the aforementioned securities.