Kerr-McGee (IL/A): Updating estimates January 15, 2006 - Goldman Sachs
We are updating our 4Q and full-year 2005 EPS estimates for Kerr-McGee, which now stand at $1.70 ($2.25 before) and $9.40 ($9.87 before). Our updated EPS estimates reflect wider assumed natural gas price differentials, lower estimated production, and minor other adjustments. We have made no change to our 2006-2010 EPS estimates for Kerr-McGee. We maintain an In-Line rating on Kerr-McGee shares in the context of an Attractive coverage view.
I, Arjun Murti, hereby certify that all of the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report.
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Kerr-McGee (IL/A): Outlook improved, but long-term concerns remain January 12, 2006 Goldman Sachs
We believe Kerr-McGee's January 19 analyst meeting will showcase a company with a revamped and improved E&P strategy. We give management credit for the significant step changes it has taken to reduce capital intensity, raise reserve life, and improve profitability. However, we believe KMG still lacks the resource base to grow production beyond two to three years and, as such, continues to face acquisition risk and over-dependence on its exploration program over the long term. With KMG trading at only a slight valuation discount to its peers, we see a better combination of relative risk/reward and catalysts in other E&P stocks. We maintain an In-Line rating on KMG shares within the context of our Attractive coverage view. If KMG can outline a clear strategy that would deliver robust long-term growth and returns at its analyst meeting, we would have a more favorable view of its shares.
Please see our detailed report, "Kerr-McGee (IL/A): Outlook improved, but long-term concerns remain." If you a re on our e-mail distribution list, a .pdf will be sent today. All exhibit references in this note refer to the report.
KERR-MCGEE RESTRUCTURES, PREPARES FOR A NEW BEGINNING
Following investor concerns about the viability of Kerr-McGee's business model, the company announced in April 2005 a restructuring program that included share repurchases, separation of its chemicals business, E&P asset sales, and a hedging program. This contrasts to what we concluded in our analysis would maximize shareholder value-a full liquidation or "producing out" of reserves (for more details, please see our report published on March 7, 2005 on Kerr-McGee, "Time for a major revamp of KMG's E&P strategy"). Management instead opted to remain a going concern and restructure its E&P portfolio by shedding significant portions of its mature, fast-declining E&P asset base. It reallocated capital to longer-lived areas in the Rockies such as the Wattenberg and Greater Natural Buttes fields with the desire to lower capital intensity and dependency on its exploration program. It also separated its chemicals unit with the ultimate intent to fully exit the business.
We believe the restructuring program improves Kerr-McGee's E&P portfolio over the near term but falls short of addressing its lack of long-term growth prospects. In our view, exploitation from the Wattenberg and Greater Natural Buttes fields will not be sufficient to offset declines while incrementally growing production much beyond 2007. As such, we continue to see risk of an acquisition or over-dependence on exploration for Kerr-McGee especially over the medium-to-longer term.
In our view, if Kerr-McGee can convince investors at its January 19, 2006 analyst meeting that it can deliver competitive growth and returns in the 2008-2010 time-frame, the outlook for its shares could improve. Clearly, the analyst meeting will be an opportunity for management to showcase its accomplishments in restructuring the company. However, we believe further steps are necessary to truly distinguish Kerr-McGee over its domestic E&P peers. In our view, Kerr-McGee has yet to address its plans for sustaining its improved E&P performance beyond the next few years.
FROM THEN TO NOW: KERR-MCGEE'S RESTRUCTURING WAS VALUE-ENHANCING
We believe Kerr-McGee management has meaningfully improved its E&P portfolio via its asset divestiture program. As announced in April 2005, Kerr-McGee management began a restructuring program that included a modified "Dutch auction" tender offer, separation of its chemicals business, an oil and gas hedging program, and E&P asset sales. The restructuring program came on the heels of investor and Street concerns about Kerr-McGee's short-lived asset base, capital intensity, and below-average returns. Specific to its E&P portfolio, Kerr-McGee has since sold roughly 270 million BOE of reserves (230 million BOE in the North Sea and 40 million BOE in the US onshore) and is considering further bids in the Gulf of Mexico shelf. We estimate the asset sales increased Kerr-McGee's PD R/P (proved developed reserves to production) ratio to 7.5 years from 6.1. Relative ROCE is also expected to improve (see Exhibits 2 and 3).
In our view, the scope of the completed E&P asset sales program was larger than originally expected, signaling perhaps management's willingness to truly revamp its E&P portfolio as opposed to simply "window dressing". In its April 2005 press release, management outlined its restructuring program which included an E&P asset divestiture program at $2.0-$2.5 billion. Although there was skepticism that the restructuring was motivated by shareholder activism from Carl C. Icahn and his affiliates and not by an intention to truly fix its E&P portfolio, management achieved nearly $3.5 billion in net after-tax proceeds to date following the release, with further likely sales of US Gulf of Mexico shelf assets. In our view, the fact that management sold more assets than originally planned could be a signal that it truly recognized the need for a dramatic change to its E&P portfolio.
At a minimum, the combination of Kerr-McGee's tender offer, hedging, and asset sales program allowed it to lock in an arbitrage between its equity valuation and high commodity strip prices (see Exhibit 4). In our view, the key to realizing the arbitrage is to simultaneously buy back stock at the time of hedging. Without the stock buybacks, we believe a hedging program is merely a price bet. The risk to this strategy, however, is that cost inflation could eat into profitability relative to now fixed revenues.
Aside from its E&P business, the intended full spin-off of its chemicals business, Tronox, was a slight disappointment. As part of its April restructuring plans Kerr-McGee's highlighted its intention to separate its chemicals business. Although this allows the company to focus its efforts solely on its E&P objectives, we have viewed the chemicals business as long-lived and one of the better performing assets in Kerr-McGee's portfolio over the long run. As such, we did not view the separation as enhancing shareholder value, especially given that we saw no arbitrage between Kerr-McGee's overall valuation and Tronox on a stand-alone basis. Expected total net proceeds from the transaction were also a disappointment at roughly $1.1 billion following an anticipated full spin-off of Tronox sometime in 2006 versus the Street and our expectations of $1.5-$1.7 billion (see Exhibit 5).
E&P OUTLOOK: IMPROVED NEAR-TERM, BUT LONGER-TERM PROSPECTS NOT COMPELLING
Adjusted for E&P asset sales, we see Kerr-McGee growing its E&P production at more than a 6% per annum rate through 2007, fueled by key projects in the Gulf of Mexico and China. This compares to management's current target of 5%-9% per annum through 2007. In the Gulf of Mexico, Constitution and Ticonderoga are expected to start-up later this year, while the Independence hub (Merganser, Vortex, and San Jacinto anchor fields) is expected to start-up in 2007. In China, first oil at several satellite fields in the Bohai Bay is expected in 2006. Finally, exploitation and development activities are also ongoing in the Rockies at the Wattenberg and Greater Natural Buttes fields. Near-term reserve replacement is also expected to be robust, with very little exploration success required.
Beyond 2007, however, we believe Kerr-McGee's production will struggle to grow. Even taking into account down-spacing towards 20-acre spacing at the Wattenberg field and exploitation projects at the Greater Natural Buttes field/Uinta Basin, we believe Kerr-McGee's production profile looks challenged over the long-run (see Exhibit 6). We assume 400-450 wells drilled and roughly 10,000 net BOE/d per annum production growth at the Wattenberg and the Greater Natural Buttes fields. In total, we estimate a 3% production CAGR for 2006-2010 and a 1% production CAGR for 2007-2010.
Note, even for Kerr-McGee to maintain production levels flat from 2008-2010, we estimate Kerr-McGee will require new production from currently undefined projects of nearly 45,000 net BOE/d by 2010. This is incremental to the already discovered resources and potential production from China, the Rockies, Gulf of Mexico, and Brazil. Assuming Kerr-McGee maintains a flat PD R/P of 7.5 years and an overall R/P ratio of 10 years, the company would have to add 560 million BOE of reserves through 2010, of which 380 million BOE can be accounted for by current discoveries and expected exploitation/development drilling (see Exhibit 7). This implies Kerr-McGee would have to find an incremental 180 million BOE of new reserves to keep production flat and nearly 250 million BOE to grow 2008-2010 production at a modest 3% CAGR.
Although finding 180-250 million BOE of new reserves is not an impossible task, it is not without risk either. Our estimates give credit for the entire probable and 50% of the possible resources management claims it has found in the Rockies (1.9 Tcfe in total). If down-spacing and other exploitation activities in the Rockies disappoint from currently high expectations, we believe Kerr-McGee would be increasingly more dependent on exploration activities (see Exhibit 8).
If decline rates are more benign than we estimate, the burden on Kerr-McGee to find new resources could lessen. In our analysis, we assume a 13% per annum decline rate (PD R/P ratio of 7.5 years). Assuming a 10% decline rate (PD R/P of 10) Kerr-McGee would need to find only 100 million BOE of unidentified new reserves each year. To Kerr-McGee management's credit, the magnitude of required new reserves has been significantly reduced from the roughly 490 million BOE we estimated before the restructuring.
KMG LIKELY NOT THE "NEXT AHC" UNTIL IT CAN FIND SUSTAINABLE AND PROFITABLE GROWTH
Despite an improved near-term outlook for Kerr-McGee, we believe risks remain to its turnaround strategy, most notably acquisition risk or over-dependence on its exploration program over the long-term. Although acquisitions are not inherently value-destructive, given currently high asset prices and the company's unfavorable track record, we believe it presents a risk to its turnaround strategy. Further, despite the significant improvement, we continue to see Kerr-McGee's E&P portfolio lagging its peer group in key E&P metrics such as F&D (finding and development) costs and reserve life (see Exhibit 9).
VALUATION: RELATIVE RISK/REWARD APPROPRIATE
We see 19% upside to a $116 traditional peak value for Kerr-McGee versus the peer group average showing 18% upside. We estimate downside risk to be 8% to a $90 traditional mid-cycle value and 57% upside to a $154 super-spike-adjusted peak value. This compares to the peer group average showing 12% downside risk and 52% upside to traditional mid-cycle and super-spike-adjusted valuations, respectively.
A net asset value (NAV) analysis yields consistent valuations with our traditional cash flow methodology. We estimate a $92 NAV assuming a $35/bbl long-term WTI oil price and $5/MMBtu long-term Henry Hub spot natural gas price. Assuming $45/bbl long-term oil and $6.50/MMBtu long-term natural gas price assumptions we estimate a $116 NAV (see Exhibit 10).
In our view, a slight valuation discount in Kerr-McGee shares relative to its peers is appropriate given that we believe Kerr-McGee has a less competitive E&P portfolio. Kerr-McGee shares currently trade at 5.8X 2006E EV/DACF (enterprise value to debt-adjusted cash flow) and 4.2X 2007E EV/DACF, which compares to the peer group average of 5.4X and 4.7X, respectively. Note, Kerr-McGee's 2006 oil and natural gas hedges are priced at roughly $50 per barrel for WTI oil and $7 per MMBtu for Henry Hub natural gas relative to our commodity price assumptions of $68 per barrel and $10 per MMBtu, respectively, for 2006. As such, Kerr-McGee may appear more fully valued on 2006E multiples than it otherwise would be without any hedges.
Exhibit 11 is a summary model of Kerr-McGee. Exhibit 12 shows comparative risk/reward for our coverage universe. Exhibit 13 shows comparative valuations for our coverage universe.
I, Arjun Murti, hereby certify that all of the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. |
