Kerr-McGee (IL/A): E&P turnaround appears on-track; continued execution, CAPEX, and GoM exploration key to shares - Goldman Sachs - May 04, 2006
Kerr-McGee's E&P turnaround appears on-track, as evidenced by strong 1Q 2006 E&P production, robust reserve bookings year-to-date, and encouraging management remarks regarding its drilling program in the Rockies. However, the risks of increasing capital intensity, still below average reserve life, and a less than stellar track-record keep us from a more favorable view of its shares. In our view, the company's 4.2X 2007E EV/DACF valuation is consistent with a peer group range of 3.9X-4.5X for Amerada Hess, Anadarko Petroleum, Apache, Devon Energy, and Chesapeake Energy (all IL/A except for Apache which is NR). We maintain an In-Line rating on Kerr-McGee relative to an Attractive coverage view. On an absolute basis, we see 22% upside to our $125 "traditional" peak value for Kerr-McGee, consistent with discounting a $45 per barrel long-term WTI oil price. (Goldman Sachs & Co., and or one of its affiliates, is acting as financial advisor to Apache Corp in the proposed acquisition of BP's producing properties on the Outer Continental Shelf of the Gulf of Mexico. Goldman Sachs & Col, and or one of its affiliates will receive a fee for its financial advisor role.)
1Q 2006 E&P VOLUMES ROBUST, CAN KMG CONTINUE TO DELIVER WITHOUT LARGE INCREASES IN CAPEX?
While the drillbit program in the Greater Natural Buttes and Wattenberg fields appear to be progressing better than expected, we believe it is key for Kerr-McGee to continue delivering on its production guidance without large increases in capital spending. Kerr-McGee's 1Q 2006 capital spending of over $400 million excluding dry-hole costs compares to the roughly $325 million quarterly run-rate implied by management's $1,300 million full-year 2006 guidance given at its January 19 analyst meeting. Although CAPEX can be (and usually is) lumpy due to the timing of drilling programs, management on its earnings conference call alluded to an accelerated drilling program especially in the Rockies through the remainder of 2006. Offsetting potentially higher-than-expected capital intensity could be higher E&P production expectations or reserve bookings, though to-date management has not changed its previous production guidance.
CONFIDENCE IN PROFITABLE GROWTH LONGER-TERM KEY TO HIGHER VALUATIONS
In our view, for Kerr-McGee to trade towards a premium over the large-cap E&Ps, greater investor confidence in the company's ability to grow production over a multi-year period at robust rates of return is needed. Although the upper-end of the 5%-9% per annum growth range management expects through 2008 is attractive, we see a largely flat production profile thereafter. We estimate Kerr-McGee's production to grow at a 3% per annum clip through 2010, which compares to the high single-digit to double-digit annual growth rates expected for our top mid- to large-cap E&P picks, which include among others XTO Energy, Newfield Energy, and Murphy Oil (all OP/A rated). In terms of returns, although Kerr-McGee's profitability has improved dramatically following its corporate strategy revamp (including the modified Dutch auction tender offer), we wonder if Kerr-McGee will be able to sustain its ROCE improvement over the long-run given its below-average E&P asset life. In our view, Kerr-McGee's current 4.2X 2007E EV/DACF (enterprise value to debt-adjusted cash flow) valuation sufficiently reflects an improvement in its E&P outlook over its historical below-average ROCE and production growth. With a comparable "peer" group--including among others Hess, Anadarko, Apache, Devon, and Chesapeake--averaging 4.2X 2007E EV/DACF, we see Kerr-McGee's relative risk/reward as balanced at this time.
ON AN ABSOLUTE BASIS, WE SEE 22% UPSIDE TO A $125 "TRADITIONAL" PEAK VALUE FOR KERR-MCGEE
Given our bullish commodity price outlook, we see meaningful absolute upside in Kerr-McGee shares. We estimate 22% upside to a $125 "traditional" peak value, which implies a $45 per barrel long-term WTI oil price. Assuming a $60 per barrel long-term oil, consistent with current commodity strip prices, we estimate 59% upside to a $163 "super-spike"-adjusted peak value. This compares to the large-cap gas E&Ps on average showing 24%/53% upside to "traditional" peak/"super-spike"-adjusted peak values. With Kerr-McGee trading only 7% above our $95 "traditional" mid-cycle value (consistent with discounting $35 per barrel long-term oil), we believe downside trading risk is likely limited to 10%-15%.
KEY COMPANY-SPECIFIC CATALYSTS
(1) Gulf of Mexico exploration program. Kerr-McGee is expected to have a fairly active high-risk/high-reward exploration program over the coming months. Currently drilling are the Caesar (20% working interest; 75-200 million BOE pre-drill resource estimate) and Claymore (33% w.i.; 100-250 million BOE) prospects, with results expected towards the end of May. Future drilling includes, among others, Grand Cayman (35% w.i.; 250-800 million BOE), Mission Deep (50% w.i.; 80-250 million BOE), Norman (35% w.i., 120-300 million BOE), and Andros Deep (50%; 150-500 million BOE). Success in its overall Gulf of Mexico exploration program could enhance Kerr-McGee's long-term production growth profile.
(2) Low-risk/development drilling in the Rockies. Enhanced confidence in Kerr-McGee's ability to produce the 6+ Tcfe of reserves management claims it has in the Rockies timely and profitably we think is key to Kerr-McGee's long-term E&P outlook vis-a-vis an increased reserve life. Per management comments on its 1Q earnings release and earnings conference call, results thus far appear encouraging.
(3) Closing of Gulf of Mexico shelf asset sales. Management expects the announced Gulf of Mexico shelf asset sales to close sometime in the "summer". We estimate net after-tax proceeds could be over $850 million, with the proceeds potentially accelerating or expanding the company's current $1 billion open-market share repurchase program.
"CLEAN" 1Q 2006 RESULTS ABOVE EXPECTATIONS
Kerr-McGee reported adjusted 1Q 2006 EPS of $1.80, which includes a $53 million ($0.46 per share) charge on the early repayment and modification of debt. Adjusting for this item (Kerr-McGee elected not to add back the loss when presenting its "adjusted EPS"), we estimate "clean" 1Q 2006 EPS to be $2.26, above the $2.12 First Call consensus and below our $2.41 forecast. The negative variance between reported results and our forecast was primarily driven by higher-than-expected G&A expenses and lower-than-expected realized natural gas prices. 1Q 2006 E&P volumes were higher than expected at 261,000 BOE/d versus our 252,000 BOE/d forecast.
UPDATED ESTIMATES
We have updated our 2Q-4Q and full-year 2006 EPS estimates, which now stand at $2.36 ($2.41 before), $1.94 ($2.09 before), $2.66 ($2.69 before), and $9.21 ($9.60 before), respectively. Our updated EPS estimates reflect actual reported 1Q results, higher assumed differentials between Henry Hub spot and realized natural gas prices, greater expected production in 2Q due to the earlier-than-expected start-up of the Ticonderoga and Constitution fields, higher assumed unit costs, and minor other adjustments. We have made no change to our full-year 2007-2010 EPS estimates. See Exhibit 1 for a summary model of Kerr-McGee.
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, Luis Ahn. |
