XTO Energy (OP/A): Continued confidence in organic growth potential
Goldman Sachs July 19, 2005
We continue to recommend shares of XTO Energy due to XTO?s leading combination of returns, free cash flow and production growth combined with the recent highly-accretive deal with Exxon Mobil in the Piceance Basin. We believe the rate of organic production growth for 2005 will accelerate to about 9% this year from 7% in 2004 and can increase further in 2006. While SG&A costs are partly rising due to seemingly more aggressive compensation practices, we believe XTO's overall increased costs are indicative of industry trends. Large-cap E&Ps have outperformed other energy stocks during the last quarter, but among them we still see upside for XTO and EnCana Corp. due to our confidence in these companies' strong asset bases. We rate XTO Outperform relative to an Attractive coverage view.
COSTS RISING - PART CONTROLLABLE, PART NOT
We attribute XTO's relatively weak share price performance on July 19 to concerns regarding higher SG&A and other cost line items in the 2Q 2005 results and in the company's guidance for the remainder of the year. Cash SG&A seems set to rise to about $1.50 per barrel of oil equivalent (BOE) in 2005, a 50% increase from 2004 levels. While there has certainly been wage inflation, we would expect that a 50% inflation rate per BOE will prove to be higher than industry peers. XTO is also seeing rising DD&A rates, which we believe is indicative of industry trends of rising finding and development (F&D) costs due in part to the impact of service cost inflation. On this point we do not believe that XTO's rate of increase will be greater than peers', and in fact we believe that XTO will continue to show lower drillbit F&D costs than other E&Ps.
KEY UPCOMING CATALYSTS
(1) Drilling in the Piceance Basin. We believe that XTO's deal with Exxon Mobil is worth $5 per XTO share in present value. XTO now has net ownership of about 35,000 undeveloped acres in what we believe to be high quality Piceance acreage with access to Exxon's ultra tight drilling technology. We believe that this small acreage position could become highly material to XTO's production growth and reserves (with an estimated 2.3 Tcfe of net recoverable resource), the bulk of which represents upside to our long-term estimates. XTO has not paid an up-front fee for the partnership, in sharp contrast to most unconventional gas transactions where large premiums are paid for acreage, let alone possible, probable or proved reserves. We believe that with greater developments in Piceance from a combination of XTO/Exxon, EnCana and Williams Corp., shares of Piceance producers can rise significantly. For more details please see our June 23 report, "Piceance Basin: Potential material upside for super- and small-caps," and our June 30 note on XTO.
(2) Permian Basin and Barnett Shale production growth. The Permian has been a key source of acquisitions for XTO over the last 18 months and most recently with the announced $200 million deal with Exxon. Given that the Permian is a relatively more mature source of conventional production for industry, we believe that there is some level of reasonable skepticism as to whether XTO can be as successful in growing Permian production as it has in East Texas and other areas. Because of this, if XTO can show continued growth from the Permian as it begins in more earnest to exploit recently-acquired properties, its assets there could be valued higher by the public market. On a conference call, management indicated its Goldsmith field (which represents about 10% of undrilled upside in the Permian prior to recent acquisitions) is seeing better-than-expected performance. The Barnett is being more closely watched and more fairly valued based on existing results in our view. However, XTO's quarterly well performance was quite good in our view, and further strong results from the Barnett could be a catalyst for the stock. We expect average Barnett production in 2005 and 2006 to be 85 MMcf/d and 141 MMcf/d, respectively.
(3) Share buybacks. CEO Bob Simpson gave the strongest indication yet that the company may use cash flow towards share buybacks (in the 1H 2006 time period). Management has hinted at share repurchase before but has never actually deployed a program. With XTO having done $3.5 billion in acquisitions since 2004, management indicated intent to slow down further large deals to focus on digesting recent ones. Last year's period of digestion lasted about a quarter, so it remains to be seen whether management will follow through with a repurchase program or find another large acquisition opportunity. We continue to expect further upside in commodity prices, and we believe that Street confidence in how companies will direct excess cash flows from super-spike commodity prices will be the key driver of share price upside.
VALUATION
XTO trades at 6.4x 2006 EV/debt-adjusted cash flow, at a premium to the 5.2x for other large-cap E&P companies. We believe this premium is deserved considering XTO's superior combination of growth, returns and expected free cash flow. We see 15% upside to a $41 traditional peak value (versus 9% for other E&Ps) and 68% upside to a $60 super-spike adjusted peak value. XTO's 2Q 2005 EPS of $0.60 was in-line with our $0.60 estimate and the First Call consensus of $0.61. Production was better than both our estimate and company guidance, and we believe that second half production guidance is conservative.
Each of the analysts named below hereby certifies that, with respect to each subject company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Brian Singer, Arjun Murti. |
