Kerr-McGee (IL/A): Asset rationalization progressing well, Westport exploitation and use of free cash remain key - Goldman Sachs - October 27, 2005
We maintain an In-Line rating on Kerr-McGee shares relative to an Attractive coverage view as we continue to see a more favorable risk/reward in our top domestic oil picks Amerada Hess, Murphy Oil, and Suncor (all OP/A rated). In our view, while KMG's E&P portfolio rationalization is progressing well, we are not yet convinced that it has a sustainable resource base from which it can grow production on a multi-year basis and at attractive rates of return. In order for us to become more positive on the shares, we believe KMG needs to show consistent drillbit success at its Westport acreage and maintain discipline in its use of free cash. The risk, in our view, is that the company engages in ill-conceived acquisitions or regresses to its historical strategy of aggressive exploration. We do not believe KMG's parity EV/DACF valuation has yet been earned.
SCOPE AND VALUATION OF E&P ASSET SALES BETTER THAN EXPECTED
In our view, Kerr-McGee's recent sale of its entire North Sea E&P operations highlights management's increased willingness to dramatically reshape its E&P portfolio into a longer-lived asset base with higher long-run returns on capital employed (ROCE). The scope of the North Sea sales, which we had originally thought would be roughly 50 million BOE, was significantly larger than expected at over 230 million BOE. Although high asset valuations of roughly $15/BOE pre-tax ($13/BOE after-tax) likely encouraged Kerr-McGee management to sell more than was originally planned, the strategic merits of stretching Kerr-McGee's overall E&P reserve life and reducing capital intensity undoubtedly played a key role as well.
Including an additional estimated 100 million BOE of asset sales in select US Gulf of Mexico shelf and US onshore properties, we estimate that Kerr-McGee's PD R/P (proved developed reserves-to-production) will improve from the year-end 2004 ratio of 6.2 years (adjusted for full-year production from Westport) to 7.5 years over the next several years. Although dilutive to EPS over the near-term given robust commodity prices, 2008 normalized ROCE for Kerr-McGee is expected to improve by roughly 0.3% to roughly 10.3% which compares favorably to the peer group average of 9.5%.
WITH THE E&P ASSET SALES PROGRAM EXPECTED TO BE COMPLETED BY YEAR-END, THE FOCUS NOW SHIFTS TO ADDING GROWTH AT ATTRACTIVE RETURNS
On its 3Q 2005 earnings conference call, Kerr-McGee management indicated that all bids for its US Gulf of Mexico shelf and US onshore assets have been received and that decisions to sell the assets (if any) will be made by year-end. This will complete the company's intended E&P asset sales program. With net debt-to-tangible capital expected to be roughly 41% at year-end 2005, down from 91% at the end of 2Q 2005, we believe the focus will begin shifting to Kerr-McGee's ability to grow production at attractive rates of return. In our view, although Kerr-McGee's Constitution project will contribute considerably to its 2006/2007 E&P production (first oil is expected in 2006), we do not see great visibilty in the company's production growth beyond 2007. Even considering the Blind Faith, Ticonderoga, and Merganser/Vortex/San Jacinto fields, we estimate a ~1% E&P production growth beyond 2007 and a 2.7% CAGR for 2006-2010.
In our view, the key to Kerr-McGee's E&P outlook continues to be drillbit success from the exploitation of its Westport acreage. If management can successfully commercialize 300 million BOE of additional resources from the Westport acquisition it indicated existed at the time of the merger, we believe the risk of excessive exploration or potential ill-conceived acquisitions could be significantly reduced.
KEY COMPANY-SPECIFIC CATALYSTS
(1) US E&P asset sales. Although E&P asset valuations likely remain robust, given the pull-back in WTI strip prices over recent weeks, bids on US E&P assets likely appear less compelling than when Kerr-McGee announced its North Sea asset sales. Nevertheless, we would view it positively if Kerr-McGee could monetize reserves somewhere in the 75-135 million BOE range it planned several months ago at still high asset valuations. Despite management assurance that it would not spend more than maintenance capex on the assets it does not sell, monetizing the reserves today with buyers potentially paying up at an equivalent of $57 per barrel 5-year strip prices is preferable, in our view.
(2) Chemicals business IPO and spinoff. The initial public offering of Kerr-McGee's chemicals business is expected to occur in the fourth quarter, with a full spin-off to shareholders occurring in 2006. Management stated it expects to retain a 55%-65% ownership interest until spin-off.
(3) Drillbit program. Beyond exploitation drilling in the Greater Natural Buttes and Wattenberg fields, Kerr-McGee plans to be active with exploration wells in the deepwater Gulf of Mexico (Castleton, Covington, Caesar, Nansen), Gulf of Mexico deep shelf, and Angola over the next several quarters.
(4) Use of free cash. With Kerr-McGee's debt reduction program making excellent progress given its asset sales program and healthy free cash flow, we believe investors will be keen to know how Kerr-McGee intends to use future free cash. Under our $68 per barrel WTI oil and commensurate commodity price assumptions for 2006, we expect net debt-to-tangible capital to reach a healthy 28% by year-end 2006. If we were to gain confidence in Kerr-McGee management's commitment to capital discipline and returning excess cash to shareholders, our view on Kerr-McGee shares could be more favorable.
3Q 2005 RESULTS ABOVE OUR EXPECTATIONS
Kerr-McGee reported adjusted 3Q 2005 EPS of $2.53, above our $1.90 forecast. The positive variance between reported results and our expectations was primarily driven by lower-than-expected exploration expense, as well as higher-than-expected realized prices relative to benchmark indicators and lower-than-expected interest expense. Although the First Call consensus was $2.59, given likely inconsistent treatment of discontinued operations related to Kerr-McGee's North Sea E&P assets, we believe it is not a meaningful figure. First Call estimates for 3Q 2005 ranged from $1.98 to $3.05, excluding our estimate.
UPDATING ESTIMATES
We are updating our 4Q and full-year 2005, 2006, and 2007 EPS estimates for Kerr-McGee, which now stand at $2.75 ($2.54 previously), $10.31 ($9.59 previously), $11.15 ($10.95 previously), and $16.10 ($15.85 previously). Our updated EPS estimates reflect actual 2Q results, adjusted E&P production profile, lower corporate and exploration charges, and minor other adjustments. We have made no change to our normalized 2008-2010 EPS estimates. See Exhibit 1 for a summary model of Kerr-McGee. |
