Will Oil & Gas Exploration & Production stocks prove a rich discovery for your portfolio?
Tuesday December 10, 11:40 am ET
{emphasis added}
67 WALL STREET, New York--December 10, 2002-- In an in-depth (2,500 words) Analyst interview, Rehan Rashid, a Vice President at Friedman, Billings, Ramsey and Co., examines the outlook for the sector and shares specific stock recommendations. This interview is part of a 235-page Friedman Billing Ramsey 9th Annual Investor Conference Issue featuring in-depth interviews from seven analysts and top management of sixty six sector firms and is available by telephoning 212-952-7400 x1799 or through The Wall Street Transcript
TWST: What is included in your coverage area? What are the general criteria for that coverage?
Mr. Rashid: I cover the oil and gas exploration and production companies, regardless of market size. Coverage includes large cap names such as Anadarko Petroleum (APC) down to micro-cap names such as Callon Petroleum (CPE).
My basic thought process on these companies is to seek some sort of a fundamental change that the market has not yet fully appreciated and given the company full credit for. These companies are more than just a pure oil- and gas-related commodity play.
TWST: Where are those catalysts generally falling? What characterizes the types of companies that fall into that set of circumstances?
Mr. Rashid: There's a combination of things. It could arise from a change of management or from the same management team having restructured and repositioned the company for growth. We'll come back to specific names later, but two of my favorite names are Pioneer Natural Resources (PXD) and Range Resources (RRC). Both of them had gone through their restructuring phases and then were ready to deliver on growth, but the market was hung up on historical performance leading to quite a significant downdraft on the stocks. Hence, the market was failing to pay attention to the progress these companies had made.
Sometimes it is an improving asset performance story, something like Pogo Producing (PPP), which is still one of my better names, where there was so much growth coming and the market - for whatever reasons - was not paying any attention. The market was not giving any credit to the growth that was going to occur.It did not take a genius to figure out that the execution risk on that 30% annualized growth for the next two to three years is minimal. Yes, leverage was a bit high, but it's going to work itself down. Sure, after the ensuing two years, management will have to find other projects to replace it with. But in the meantime, the stock has to be valued much higher than where it was.
TWST: Regarding the companies that you cover in general, have valuations been through a trough - reflecting the weak economy and the weak demand?
Mr. Rashid: No. Actually the oil and gas group - E&P specifically - have really held very steady and have outperformed the S&P and other indices quite significantly. There are several reasons for that performance, including the global geopolitical outlook. I don't need to elaborate on that further, but I just would simply point out that as things have evolved in the Middle East, oil prices have hung in pretty strongly. That has resulted in the valuation of these E&P companies holding in much more strongly than anybody had ever anticipated.
Fundamentals have been very strong for the last two or three years, and one of the primary drivers on the natural gas side has been not having any kind of overcapacity issues in the space. There's a phenomenon going on - it's not that new but it's continuing to play out as people have thought - that phenomenon is the sustained strength in natural gas prces. Natural gas supply is probably one of the very few sectors in our economy today that does not have overcapacity issues. As a result of that, supply/demand balance has been pretty tight and prices have been pretty strong and the outlook is for sustained strength for the next couple of years.
TWST: What key metrics would allow you to make the call that, "Here's a company that hasn't been well-valued for reasons that are now behind them"?
Mr. Rashid: The basic valuation metric is net asset value or liquidation value and the second is enterprise value and/or cash flow multiples. Range, which is trading at $5 a share, has a cash flow next year of roughly $2.35-$2.40, so it's trading just a tad bit over 2 times cash flow. </>Give me any company that's trading in that range and if they've put their problems behind them, it has become a good deep value play. It has an asset value in the range of $8.65 a share. It's trading at $5, so it's trading at a significant discount to its asset value. With Pioneer, there are the same kinds of issues.
I'm using both net asset value and enterprise value multiples and comparing them to the rest of the group and looking at what kind of balance sheet improvements those two specific companies have going on. I also look at how that relates to multiple expansion over the course of the next two years - while the rest of the group has some improvement, but maybe not as dramatic as you would see for these two companies, for example.
TWST: Have there been any specific companies that have undergone a significant management change and that are ready to reward the shareholders?
Mr. Rashid: Nothing immediately comes to mind where there's been a significant management change that we're seeing benefits from. Both Pioneer and Range have had the same old management teams in place that have turned the companies around. Actually, that helps my cause in that some investors still get hung up on the fact that these are the same folks who basically took the company down. That may be the case and over time everybody makes mistakes, but as long as the basic fundamentals have improved and the market continues to excessively discount old management, I am interested. I don't need management change necessarily to make a difference - sometimes it's necessary, but sometimes it's not.
TWST: Within the room-to-improve game plan, which are the companies that you would then focus on?
Mr. Rashid: Pioneer has an outperform rating. They've made significant improvements on their growth profiles and balance sheet - and the improvements are not done yet, so the balance sheet is going to improve dramatically over the course of the next two years because there's so much free cash flow coming out of all the projects that they are going to be bringing on line over that time. Valuation-wise, the asset valuation with Pioneer is $28, and I could make a case, based on free cash flows over the next three years, for the asset value to be actually $35. When I take a look at that and see what the free cash flow does to my balance sheet, for example, for Pioneer the debt/book cap is going from the 54% it is right now to, year-end 2004, 38%. So over the next two years you'll have free cash flows to a very significant degree - almost to the tune of $6-$7 a share, and the stock is trading at $22-$23. So a lot of improvement is being made on the Pioneer front. Valuation reflects some portion of that improvement, but it does not fully reflect the outcome in 2003 and 2004 when you will definitely see much more paydown of debt and then growth continuing beyond 2004.
TWST: What's your overall recommendation with respect to Range Resources?
Mr. Rashid: It's the same kind of story. The basic plot is that it's a deep value play where asset value at $8.65 a share and the stock at $5 per share represents it trading at slightly over 2 times cash flow. Where the market gets lost on that is, yes, it's the same management team that's taken the company to where it is (from a high in the $20s to a low of $3-and-change for the stock), but then, in the same breath, I'd look at the improvements that have been made. Let's not get stuck on what happened, or what was done, but at how much debt they've paid off over the course of the last three years. Let's look at how much they're going to pay off over the next two years. Let's look at the stability of cash flow based on their hedging program and at the growth profile improving over the next two years. Then look at valuation. Pick up the stock and be patient, and it will pay you huge rewards.
TWST: Who else has a good story?
Mr. Rashid: Pogo Producing is a good story. There's definitely strong growth, 30% production growth 2002 versus 2001 and another 20% plus possible for 2003 versus 2002 and, hopefully, some level of growth continuing in 2004. The company is paying down debt massively with debt/book cap of 38%, becoming virtually debt-free by the end of 2005. With current asset value of close to $40, the stock at $36-and-change is getting to a point where it's closer to my price target of $42, but it's one of those names that if investors are looking for domestic oil and gas, growthier names to play in a global economic or political crisis, this is a good name to have. Valuation-wise, it compares reasonably favorably to its comparable peer group as well.
Beyond that, there are multiple names that for different reasons may not be right for some investors but could be right for others. Callon Petroleum has an asset value of $11.50 a share, and the stock is trading at $5.50. My 2004 cash flow estimate is close to $5 a share. But there's a lot of execution risk between now and the $5 a share in cash flow in 2004. So it's a bit risky, but the upside is stronger than something you would see in a Pioneer or Range or a Pogo, for that matter. Callon is a name for somebody who is looking for a higher-risk/higher-reward micro-cap name, not the ideal kind of investment for everybody.
$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$
Thanks for the comments, Jim. This guy from Friedman Billings thinks very much like myself.
ATPG fits the profile of the kind of company discussed above. The North Sea is gonna put these guys on the map, IMO. They have all UK nationals in their UK office, not seconded Americans. So they have the benefit of all the local knowledge. |
