Berry Petroleum (IL/A): Piceance acquisition comes at a high price but with significant upside potential - Goldman Sachs - January 29, 2006
We believe Berry Petroleum's recently announced $150 mn acquisition of properties with 26 Bcf of proved natural gas reserves in the Piceance Basin from a private seller will require substantial drilling success to ultimately prove value-additive. For the time being, we believe investors will give Berry the benefit of the doubt, given the company's impressive track record of success in Rockies exploration and development, most recently illustrated by two successful exploration wells in the shallow zone at Lake Canyon (Utah). Still, to the extent this acquisition indicates a desire on Berry's part to assume a more aggressive and higher-risk growth strategy, we believe the company will need to show a tangible ramp-up in drilling success in the Piceance for the market to accept further acquisitions of this nature. We continue to rate Berry In-Line relative to an Attractive coverage view.
RECENT SUCCESS ADDS FURTHER CREDIBILITY TO ROCKIES PROGRAM...
Thus far, Berry's attempts at expanding through acquiring, developing, and exploring properties in the Rockies have been generally successful. The company has executed well in ramping up production from both of its producing property acquisitions in Brundage Canyon and the Niobrara gas field. In addition, two exploration wells at Berry's shallow Lake Canyon prospect, the Nielsen Marsing and Taylor Herrick wells, respectively tested production of 98 BOE/d and 163 BOE/d--rates sufficient to indicate the play's commercial potential. We believe this exploration discovery at Lake Canyon, which Berry operates at a 56.25% working interest, represents an important milestone in demonstrating the company's ability to find new reserves in its various exploration plays.
...THOUGH THIS ACQUISITION SEEMS A STEP-UP IN THE RISK/REWARD PROFILE
In light of its early successes, Berry may (justifiably) feel it has gained license to become somewhat more aggressive in pursuing opportunities in the Rockies. The just announced Piceance acquisition seems to mark a significant departure from Berry's prior Rockies transactions. Berry's strategy heretofore has generally been to acquire existing producing properties at a reasonable price and then to purchase exploration acreage in nearby, geologically analogous but untested areas for upside opportunities. In its Piceance acquisition, Berry is admittedly paying for not just the proved reserves but also some of the resource upside in one package--and is doing so right in the sweet spot of a well-known play, with established operators such as EnCana (ECA; OP/A) and Williams Corp. (WMB; Not Covered) having offsetting acreage. As such, Berry is paying a much higher price on a proved reserves basis for its Piceance properties than it has in previous Rockies acquisitions (please see exhibit 1).
THE PROOF IS IN THE PROBABLES
We remain bullish on the Piceance Basin generally (see our June 23, 2005 report, "Piceance Basin: potential material upside for super- and small-caps"), but would note that other players about whose Piceance prospects we have written favorably generally either have had large legacy acreage positions (e.g., EnCana and Exxon Mobil) or bought into the play at much cheaper terms than is Berry (e.g., XTO Energy and Bill Barrett Corporation). (Investment funds affiliated with The Goldman Sachs Group, Inc. have a principal investment in Bill Barrett Corp. (BBG). As a result of its position in BBG securities, The Goldman Sachs Group, Inc. may be deemed an affiliate of BBG.)
At $5.77 per Mcf of proved reserves, Berry is paying a very high price even by the elevated standards of today's M&A market. In our view, the success of the transaction will therefore largely hinge on Berry's ability to rapidly and cost-effectively increase production (currently estimated at about 1 MMcf/d) and prove up the properties' probable and possible reserves (estimated by Berry to be 304 Bcf, assuming 10-acre downspacing). In this sense, the transaction underscores the trend in today's oil and gas M&A market of companies (and investors) being willing to consider "3P" (proved plus probable plus possible) resources in valuations--an indication of the increasing scarcity of North America reserves. From an operational standpoint, we believe the key risk to Berry's realizing its reserve booking targets in the Piceance will be whether the company's 10-acre downspacing assumption is realized, though it is a positive sign that the company has already received regulatory approval for most of its acreage.
RISK/REWARD AND VALUATION At 6.0X 2007E EV/DACF, Berry trades at a premium to its small-cap E&P peer group average of 5.1X 2007E EV/DACF, and has performed particularly well recently, with the shares up a sector-leading 31.5% year-to-date. We believe Berry's valuation is justified given its high returns and attractive growth prospects, and expect the shares to perform well on an absolute basis given our bullish view of commodity prices. However, we see better relative risk/reward in other small-cap E&Ps at this time. For Berry, we see upside of 7% to an estimated "traditional" (i.e., based on 1990s-cycle valuation parameters) peak value of $80 per share and 35% upside to a "super-spike"-adjusted peak value of $101 per share. Our top small-cap growth pick remains Bill Barrett (BBG; OP/A), where we see 23% upside to traditional peak, and for more value-oriented investors our top small-cap stocks are Forest Oil (FST; IL/A) followed by Cabot Oil and Gas (COG; IL/A), where we see 32% and 31% upside to traditional peak, respectively. As a result of its strong year-to-date performance, Berry is now in the middle-tier of our In-Line rated E&Ps, with potential upside to this status from execution in the Piceance, along with further success in its other key growth prospects such as Lake Canyon and Niobrara in the Rockies and the Diatomite formation in California.
UPDATING ESTIMATES AND INTRODUCING 2006 QUARTERLY FORECASTS We are introducing quarterly 2006 EPS estimates and updating our 2005-2010 EPS estimates to reflect revised assumptions for production, commodity price realizations, the Piceance transaction, and minor other adjustments. Our 4Q 2005 EPS estimate is now $1.34 ($1.30 previously), and our 2005 EPS estimate is now $5.04 ($5.01 previously). Our 1Q, 2Q, 3Q, and 4Q 2006 EPS estimates are now $1.69, $1.78, $1.85, and $2.27, respectively, with our full-year 2006 EPS estimate now $7.59 ($7.49 previously). Our 2007 EPS estimate is now $8.33 ($8.18 previously). Our 2008 (normalized) EPS estimate is now $4.09 ($3.83 previously). Our 2009 (normalized) EPS estimate is now $4.35 ($3.89 previously). Our 2010 (normalized) EPS estimate is now $3.29 ($2.62 previously). Please see exhibit 2 for our summary financial model for Berry.
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: Arjun Murti, Brian Singer. |
