Apache (IL/A): Growth expected to accelerate in 2H, but greater long-term visibility key to regaining bellwether valuation
Goldman Sachs July 28, 2005
We believe the potential for accelerating volume growth in 2H 2005 and Apache's ability to improve long-term volume growth visibility are the key catalysts for its stock price performance relative to the E&P sector. On an absolute basis and relative to the S&P 500, we expect both Apache and the broader sector to perform well owing to our bullish commodity macro outlook and Attractive coverage view. With Apache having lost its bellwether valuation status over the last 12-18 months, we find its shares at an intriguing valuation relative to its peers. However, we believe the market will continue to favor the companies with multi-year, visible organic production growth, which favors the trio of EnCana (OP/A), EOG Resources (IL/A), and XTO Energy (OP/A) among the large-cap E&Ps at this time. Hence there is no change to our In-Line rating on Apache.
KEY COMPANY-SPECIFIC CATALYSTS
(1) Volume growth acceleration in 2H 2005. We continue to believe Apache will experience accelerating year-over-year volume growth in the second-half of 2005. Specifically, we are forecasting an 8% increase in 3Q and a 9% rise in 4Q. Driving the higher growth is strong momentum in Canadian gas production in the aftermath of the Exxon Mobil acreage farm-ins, new gas field start-ups in Egypt and Australia, and higher oil volumes in the North Sea (less maintenance downtime) and Australia (a stabilization of previous declines). Our estimates do not assume Apache makes any material acquisitions, which is always a possibility. We believe Apache has the potential to maintain high single digit volume growth into 2006, though the ability to keep US oil and gas production flat, as we assume, would likely require at least some amount of tactical acquisitions.
(2) Can Apache regain bellwether status? Over the last 12-18 months, Apache has lost its bellwether status among large-cap E&Ps, with the premium valuation now being received by EnCana, EOG Resources, and XTO Energy. Investors today are placing a particularly high value on companies where confidence exists in visible, multi-year, high-single digit (or better) annual organic production growth. Apache is currently trading at 4.6X 2006E EV/DACF, which contrasts with EnCana at 6.1X, EOG at 6.6X, XTO at 6.5X, and the overall large-cap E&P sector average of 5.5X. With a large Gulf of Mexico exposure, Apache likely will not be able to show the type of multi-year organic growth outlook being valued in the trio of EnCana, EOG, and XTO.
With that said, Apache has a very long track record of creating shareholder value through a variety of commodity price and investor sentiment cycles. While it may not seem like Apache is on-track to regain a bellwether premium valuation in the next several quarters, we would be very surprised if did not regain premium valuation status at some point in the next few years. The catalyst and timing is uncertain, but Apache's strong management team and track record suggests that it is unlikely to be a "middle of the pack" E&P company over the long run. In our view, the key to Apache regaining a premium valuation likely resides in its advantaged international position relative to its large-cap North America gas-focused E&P peers.
(3) Increasing cash returned to shareholders. Apache's balance sheet looks to be on-track to get to ultra-healthy levels over the next several quarters, as we forecast net debt-to-tangible capital will fall below 10% by year-end 2005. In our view, Apache may need to start considering more meaningful common dividend increases or initiate a first-ever (to the best of our knowledge) stock buyback program. On its 2Q earnings conference call, management indicated a strong preference to build balance sheet liquidity during the cyclically high portion of the commodity cycle. We agree with the logic but think that some amount of additional cash returned to shareholders could make sense, especially as net-debt-to-tangible capital ratios fall below 10%.
2Q 2005 RESULTS WERE BELOW EXPECTATIONS
Apache reported 2Q 2005 EPS of $1.76 (no special items), which was below the $1.81 First Call consensus estimate and our $1.90 projection. The negative variance was due to a slight shortfall in production volumes versus our expectations and slightly higher costs. 2Q 2005 production rose 6% year-over-year just as it did in 1Q, though the 2Q growth rate was below our 8% forecast due primarily to lower-than-expected international oil production. Though costs were above our forecasts, the variances were consistent with industry-wide trends and we do not consider this to be an Apache-specific issue.
UPDATING ESTIMATES
We have lowered our 2005 EPS estimate for Apache to $7.59 from $7.79 to account for the 2Q shortfall and minor downward revisions we made to 3Q and 4Q. We now forecast $1.97 ($2.00 before) for 3Q and $2.18 ($2.21 before) for 4Q. There is no change to our $8.65 2006 EPS forecast nor our 2007-2010 normalized projections.
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. |
