CURIOUS CASE OF MILLER ENERGY’S 10-K’s AND ITS HUGE BARGAIN PURCHASE

Multiple 10-K and related filings for a single reporting period can often signal tensions between a company and its auditor.  Such is the case with  Miller Energy Resources (MILL).  But, the business entity finally issued a 10-K with its auditor’s blessing, albeit several weeks late.

Miller Energy first supplied a late notification on July 15, 2011 (NT 10-K).  As we previously discussed, the firm then issued a 10-K on July 29 after the markets closed, but it reversed course in an 8-K on the following Monday August 1 in which it stated that the report should no longer be relied on because the auditor KPMG had to finish its work (“The 2011 10-K was filed … prior to KPMG LLP completing its review of the annual report and issuing their independent accountant’s report on the financial statements, as well as the consent to the use of their report…”).  You would have thought that the CEO and CFO would have been wise enough to wait on KPMG!  What were they thinking, or what were they up to?

Miller Energy Resources filed its first amended 10-K/A on  August 9^th   explaining:

“By this Amendment No. 1 we are amending our 2011 Form 10-K to include corrections to computational errors in our consolidated statement of cash flows which appeared in the 2011 Form 10-K filed on July 29, 2011. This Amendment No. 1 also includes corrections in text portions of the 2011 Form 10-K to conform the disclosure to the corrections in these computational errors, to correct computational errors in the Summary Compensation Table within Item 11. Executive Compensation, as well as to enhance and clarify disclosure appearing in the notes to the consolidated financial statements. We have also revised the disclosure in Item 9A. to reflect the additional weaknesses in disclosure controls and procedures from the filing of our 2011 10-K.”

We are always happy to see a firm correct its errors, but are astonished that they published these comments in a 10-K that still did not bear the auditor’s imprimatur.  Fortunately, KPMG finished its work and apparently was satisfied that the reports are in accordance with GAAP because Miller Energy submitted its second amended 10-K on August 29, with a “clean” auditor’s opinion intact.

While there are several reasons for these delays and the snafu of issuing a 10-K when you thought the auditor had finished its work, perhaps the item with the greatest impact on the delay was the incredible $461 million gain on several business combinations.  These gains arose when the company in fiscal 2010 purchased Ky-Tenn Oil ($0.9 million gain on acquisition), East Tennessee Consultants ($1.9 million gain), and Pacific Energy Resources ($458 million gain).  As the last transaction is the most material, we shall focus on it.

Note 14 in the annual report discloses these business purchase transactions.  It states that on December 10, 2009 the firm bought the Alaskan business of Pacific Energy Resources through a Chapter 11 proceeding.  The company paid approximately $4.3 million for the net assets, about half in equity and half in cash.  It received net assets with a fair value of $463 million, thus giving rise to this gain on acquisition of $458.7 (pretax).  We realize that this was a distressed sale, but we would have expected a bankruptcy trustee to have fought harder for the lenders if these values are accurate.

Within footnote 14 Miller Energy Resources shows its calculation of this gain on the bargain purchase, and the largest contributor to the gain is the oil and gas properties, which have a fair value of $476 million.  We wonder how the corporation obtained this fair value and how aggressive is the estimate of oil and gas reserves and what oil and gas prices it applied.

Since the entity has such a large gain on acquisition, it is not surprising that there is much controversy surrounding the estimate.  After all, the numbers do seem incredible.  Some in the investment community have taken a short position thinking the valuation is wildly overstated, such as The Street Sweeper.  Others have sued Miller Energy Resources and its top management, alleging securities fraud.

We do find it interesting that KPMG’s audit is for 2011 only, as KPMG demarcates its responsibility from that of the auditor of the 2010 financial statements, Sherb & Co.  But will this division of responsibility be sufficient protection for KPMG if matters turn bad or worse?  After all, the successor auditor is still on the hook for making sure the Company’s books reflect any impairment losses related to these acquired assets.  If, for example, the estimate of oil and gas reserves is overstated, Miller Energy is responsible for lowering the fair value of the oil and gas properties and recognizing the impairment loss on the income statement.  We presume that KPMG is well aware of their duty to verify that this valuation issue has been addressed, which might be the reason for the long delay in issuing audited financial statements.  Of course, Sherb & Co. is still on the hook for its blessing of the accounting for the initial transaction.

This essay reflects the opinion of the authors and not necessarily the opinions of The Pennsylvania State University, The American College, or Villanova University.