Penn West moves forward with release of audit
By all accounts, Penn West has delivered on what it committed to in July, when it delayed the release of second-quarter results pending the completion of an audit of its accounting practices.
It’s an important step forward for the company.
Chief executive David Roberts said in an interview that Penn West’s release of its restatements “put a bow on the ‘what happened to us’ and there will be things that will flow from that.”
“Management has responsibility for internal controls within the organization. The review uncovered areas that weren’t being addressed — or there was an override of those controls,” said Roberts. “Management override of controls is a material weakness that we identified. I am not proud of it, but I can tell you it is going to get fixed.”
That’s certainly what the market is expecting, even though the stock has recovered from the downdraft of July when it fell to $7.69. It rose almost 8 per cent when the audit was released, but has since fallen in concert with the current weakness in the equity markets. The stock closed Friday at $7.66.
The outcome of the audit — conducted by forensic accountants hired by Penn West’s audit committee, supported by independent legal counsel and examined by the company’s auditors — was revealed last week.
When Penn West announced the audit in August, it warned the result could be a restatement of operating costs for 2012 and 2013 because it had discovered $181 million during that period had been “reclassified to property, plant and equipment capital expenditures,” though there was no supporting documentation.
The audit showed cash flow falling by $145 million for the period under review — 2012, 2013 and the first quarter of 2014 — net income increasing by $12 million and operating costs jumping $367 million.
It also determined $137 million, not $180 million, was incorrectly capitalized as operating expenses in 2012 and 2013, which means the value of property, plant and equipment had been incorrectly stated.
What’s clear in reading the material released by Penn West is that the reclassification of expenses from operating to PP&E happened at the corporate level and that there were inconsistencies with respect to the supporting documentation.
What that says is the internal controls at Penn West were not what they needed to be.
For example, while Penn West would have had an auditor responsible for compliance with Sarbanes Oxley legislation in the United States, was its internal audit function robust enough to provide sufficient oversight?
The audit could not — and did not — uncover anything resembling a motive with respect to why the expenses were not properly recorded. You could surmise it was a mistake never brought to the attention of someone more senior, either because the corporate culture wasn’t conducive to this, or it was simply not recognized and continued uncorrected.
The ranks of senior management and board leadership at Penn West have since changed.
That said, it still raises the question as to why its auditors did not find the error. Presumably their fees cover the examination of accounting entries. At the very least, one would think the company’s auditors would look at the internal audit function and opine as to whether it was robust enough for a company the size of Penn West.
“We have material weaknesses and deficiencies in our internal controls,” David Dyck, chief financial officer of Penn West, said in a recent interview.
Like Roberts, he also emphasized the company is taking steps to put the right controls in place.
“The goal is to get back to zero, where you can have a clean set of financial statements and have zero deficiencies within your internal controls. We’ll get there, it’ll just take time,” said Dyck.
Roberts said KPMG will continue as Penn West’s auditors and that it will be up to the board, the audit committee and the company’s shareholders to decide at the next annual meeting as to whether they should retain that role.
The question now is what this all means for Penn West?
The company is onside with all of its debt covenants. Its borrowing base has not been affected, nor has the value of its reserves changed.
The company is maintaining its guidance for production, even though capital expenditures for 2014 will be $80 million lower than the $900 million originally budgeted.
Its second-quarter numbers — while overshadowed by the audit — showed an increase in earnings of seven per cent while cash flow beat the consensus by 15 per cent, coming in at 61 cents per share.
While the sky isn’t falling, Penn West is still carrying a debt load equivalent to 2.5 times cash flow, which is on the high side relative to the 1.5 times average of its peers.
There is no question Penn West is in the penalty box. When you look at past history, it’s been one of those companies in the oilpatch that has met its production forecasts twice in the last decade.
And, given that its shares are trading below net asset value and that it lacks a major shareholder, it’s not out of the question that an activist investor would become interested in either the turnaround potential or a sale premium.
There has been no shortage of that kind of interest in Canadian energy stocks — for better or worse — of late.
In other words, the new management at Penn West, while having good assets, needs to show it has what it takes to add value, further decrease operating costs and put the company back on a growth trajectory.
It’s a tall order, and the clock is definitely ticking.