Western Gas Resources (U/A): Ultra fuzzy math gaining acceptance, but Powder cash flow is key - Goldman Sachs - February 23, 2006
We believe there is some danger in assuming that Western Gas Resources' Pinedale Anticline assets should receive the same valuation as those of Ultra Petroleum, which in part has led to a sharp rise in Western Gas' stock as the company again begins to explore ways to isolate its E&P business from its midstream business. We continue to rate Western Underperform relative to peers, because we still do not believe that Western's non-Pinedale assets (mainly in the Powder River Basin) are on par with other unconventional gas basins, which makes valuation seem less attractive versus other E&Ps. Midstream assets continue to perform well (especially in West Texas) - but without the midstream and the Pinedale, Western's returns and free cash flow would be below average. Overall we see 21% upside to a $58 traditional peak value versus about 28% upside for other E&Ps.
PINEDALE: ULTRA DESERVES A PREMIUM DESPITE ASSET OVERLAP
Western management has become more vocal in echoing concerns from many investors that Western's Pinedale Anticline assets - essentially a 10% non-operated stake in the Anticline - should be valued at a similar multiple to Ultra Petroleum, which currently trades around 16x 2006 EV/debt-adjusted cash flow. Given almost complete overlap in assets between Ultra and Pinedale, we believe that Western's cash flows mirror those of Ultra's. Western's Pinedale assets represent a similar level to 22% of Ultra's assets, which management reiterated on the conference call.
There are two reasons why we believe Western's Pinedale assets should be at a discount to Ultra's:
(1) Greater reinvestment risk at Western versus Ultra. We have high conviction that that Ultra management will either redeploy almost all the free cash flow from the Pinedale back into the Pinedale or return that cash to shareholders via share repurchase and/or dividends. Aside from Ultra's small stake in Bohai Bay, Ultra is a pure-play Pinedale-area company, and we continue to believe investing in Pinedale will lead to superior returns versus almost any other onshore US basin. Western, however, is using its free cash flow from both Pinedale and its midstream business to invest in the Powder River and San Juan Basin development and exploration in the DJ Basin, Canada and Montana. There is much greater risk that Western's Pinedale cash flows get deployed in lower-returning investments. For this reason, we believe it is fair to discount Ultra's Pinedale free cash flow at a lower rate than Western's.
(2) Reduced likelihood of a takeout at an Ultra multiple. We believe that Ultra would look to consolidate Pinedale assets, and Western's would be quite appealing in our view considering the significant overlap. However, we do not believe that Ultra management would pay Ultra's multiple and give the entire difference between Ultra's multiple and Western's multiple to Western shareholders. We believe it is more likely that Ultra would split the valuation difference between Ultra and Western shareholders. Beyond Ultra, we wonder whether there is willingness by other oil and gas companies to pay a full Ultra multiple for a non-operated Pinedale stake. Ultimately, we believe the Pinedale, including a non-operating position, could be phased into a Master Limited Partnership (MLP) structure. However, as long as operators continue to aggressively drill, potential dividends would likely be far less than expected percentage of net income, which temporarily makes the MLP structure less attractive.
MIDSTREAM: MID-CONTINENT MARGINS, EXPANSION DRIVING STRONG CASH FLOW
We believe the midstream business represents the major source of free cash flow for Western and helps to fund its E&P business. In particular, margins in the Mid-Continent have been strong and are a key source of throughput growth expected over the next year. We recently visited Western's Midkiff, Texas gathering plant and came away with a positive view of its management, the potential for growth from mainly the Spraberry field in the near term and the plant's ability to take on additional throughput without a major expansion. We believe that Western's Mid-Continent business could be a likely candidate for spinoff or sale as the company re-looks at the appropriateness of integration. We believe that overall margins after operating in the Rockies are lower relative to the Mid-Continent. Together, however, we expect free cash flow of almost $100 million in 2006 and $150 million in 2007. In part the higher free cash flow projections is driven by our views on the spread between crude prices and natural gas prices, so using normalized assumptions we see steady-state free cash flow closer to $50-$60 million. We believe the Street is focused on a 7x-10x EBITDA multiple, and we are assuming 9x mid-cycle EBITDA for a total value of $1.5 billion.
REMAINING WGR E&P ASSETS: LOWER RETURNS AND FREE CASH FLOW...
We believe that Western's remaining E&P assets rank poorly versus those of other unconventional gas companies, in part because of sharply higher costs and a lack of visibility for free cash flow. In Exhibit 1, which follows the text of this note, we show the derivation of Western's 2005 and 2006E operating income and cash flow from the company's non-Pinedale assets, calculated by reducing overall E&P revenues and costs by 22% of Ultra's US revenues and costs. The remaining assets - chiefly in the Powder River Basin - have among the lowest netbacks among visible growth E&P companies with no projection for free cash flow throughthe rest of the decade (we reduce both revenues and costs beginning in 2008 to reflect normalized assumptions). We project $95 million in negative free cash flow from these assets in 2006 with operating cash flow per Mcfe at about half that of the Pinedale and a DD&A rate about 50% greater than the Pinedale. Relative to other E&Ps, however, capital costs are lower which offset low netbacks - we project cash return on cash invested from remaining E&P assets of about 17%, versus 22% expected for other small-cap E&Ps and mid- and large-cap unconventional gas companies.
REMAINING E&P ASSETS: ... DESERVE DISCOUNTED MULTIPLE
We believe that even in the event that Ultra or another acquirer and Western split the value of the valuation gap between the two company's E&P assets that Western's remaining assets seem fairly valued considering lower returns and free cash flow. Exhibit 2, we show Western's remaining E&P enterprise value assuming a 9.0x mid-cycle EBITDA multiple for its midstream assets and a value for its Pinedale assets that close different levels of the gap between its E&P valuation and Ultra's valuation. Assuming the value for Western's Pinedale assets is 25% of the difference (10.6x 2006 EV/DACF), Western's remaining E&P business trades at 9.7x 2006 EV/DACF. We do not believe this represents an attractive multiple unless Powder River Basin returns and free cash flow improve. Assuming the value for Western's Pinedale assets is 75% of the difference (14.5x 2006 EV/DACF), Western's remaining E&P business trades at 7.4x 2006 EV/DACF. While this multiple is more attractive, it is still not "dirt cheap" in our view, as it lies above the levels of conventional E&Ps and exploration-oriented unconventional gas E&Ps.
WE SEE UPSIDE FOR SHARES, THOUGH AT LOWER LEVELS THAN PEERS
While we disagree with the concept that Western's (or Questar's) Pinedale assets should trade at the same multiple as Ultra's, we nevertheless believe there is upside for Western shares, including from its Pinedale position. The upside for Pinedale assets is consistent with the upside we see for Questar's Pinedale assets (we have more confidence in Questar's other assets). Overall, we see 21% upside for Western to a $58 traditional peak value, less than the 28% upside we see for E&Ps in general.
UPDATED ESTIMATES
We have updated our estimates to reflect changes to production, realized prices, costs, the company's recent Powder River Basin acquisition announcement and 4Q 2005 results, which were generally in-line with expectations (adjusted EPS of $1.00 versus our $1.15 estimates and a Street consensus of $1.01 and operating cash flow of $150 million versus our $155 million estimate). We are introducing quarterly EPS estimates for 2006: $0.93 in 1Q, $0.76 in 2Q, $0.92 in 3Q and $1.37 in 4Q. We now estimate 2006 EPS of $3.97 ($4.54 previously). Our 2007-10 estimates are now $4.58 (4.71 previously), $1.87 ($2.06 previously), $2.03 ($2.28 previously) and $2.12 ($2.50 previously).
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: Brian Singer, Arjun Murti |
