XTO Energy (OP/A): Remains top pick due to continued confidence in trifecta of superior growth, returns and free cash flow - Goldman Sachs - April 20, 2006
We continue to recommend XTO Energy as a top pick among gas-focused E&Ps due to its superior combination of production growth, returns and free cash flow. We believe that there is less of a probability relative to consensus views that we will see a period of $5-$6 per MMBtu Henry Hub natural gas prices this summer. Quality long-lived E&P equities such as XTO are particularly attractive as we believe that current valuations assume low gas prices are not just a short-term phenomenon. We remain optimistic that future developments on XTO's Piceance Basin acreage can boost Street expectations for organic growth beyond 2007, and the company is making progress towards increasing recoverable resource potential with attractive rates of return in East Texas and the Permian Basin. We rate XTO Outperform relative to an Attractive coverage view.
2006 PRODUCTION GROWTH ON TRACK
XTO's 1Q 2006 production was at the top of its guidance, and the company raised the bottom end of its projected growth range for full-year 2006 (guidance is now for 11%-12% growth from 10%-12% previously). We continue to believe that management is conservative in its guidance, and we are assuming 13% total growth (representing about a 10% organic growth rate) this year. We continue to see upside from natural gas production in the Barnett Shale, the Freestone Trend, other East Texas and the Mid-Continent as well as rising oil production in the Permian Basin. We believe XTO's high-single digit organic growth rate is not only superior among large E&Ps but can continue in 2007 and into 2008.
CONTINUE TO EXPECT SUPERIOR RETURNS
We continue to believe XTO will show superior near-term and long-term returns relative to other E&Ps. In 2005, XTO's cash return on cash invested was 26% versus 18% for large-cap gas-focused E&Ps. We expect a 25% CROCI for XTO in 2006 and 2007 versus a 19% industry average. We do not view the slight contraction relative to industry negatively, as it is mainly a function of out-of-the-money hedging for industry peers rolling off in 2006 versus 2005. We continue to expect stronger mid-cycle returns versus peers, mainly because of XTO's low finding and development cost ($1.40 per Mcfe via the drillbit expected in 2006). While XTO noted cost increases both in its 1Q 2006 results and in future guidance, we do not believe that the company will be unique in seeing rising capital and operating costs.
FREE CASH FLOW GIVES UNIQUE FLEXIBILITY
XTO's greatest point of differentiation considering its higher growth and higher returns is in its strong free cash flow. While EOG Resources, for example, has higher return on capital employed than XTO and has a similar (though slightly lower) CROCI, XTO's free CROCI in 2006 is expected to be 11% versus 1% for EOG. In 2000, we expect 13% for XTO versus 6% for EOG. Free cash flow gives XTO the optionality of acquiring additional assets, which given the company's strategy of focusing on producing properties with additional drilling upsides, lowers XTO's decline rate relative to growth peers such as EOG. We expect XTO to continue to pursue primarily asset acquisitions with free cash flow, and the company's continued ability to moderate its decline rate while maintaining its overall drillbit F&D cost advantage can allow for continued low-risk growth going forward.
PICEANCE BASIN SHOWS POTENTIAL FOLLOWING FIRST EXXON JV WELL
We continue to believe that the company's Piceance Basin acreage, acquired through a joint venture with Exxon Mobil, could hold upside of $5 or so per share not currently being valued. XTO announced its first well has been drilled and is currently flaring gas from a 4,000-foot gas column. The well is expected to be completed in 2Q 2006, and we remain optimistic that the combination of high gas-in-place with XTO and Exxon's deep tight gas technology know-how could turn the play into larger-scale development in the 2008 time period. XTO is preparing its second Piceance location and hopes to drill three wells overall this year.
KEY OTHER RESOURCE CATALYSTS
(1) Horizontal drilling in East Texas. We believe XTO is making positive progress in increasing recoverable resource at attracive rates of return from horizontal drilling in East Texas, both in the Cotton Valley lime at the Freestone Trend and in the slightly shallower Petit formation outside Freestone. The company indicated on its conference call that both costs and initial expected recoveries are in-line with expectations which imply potentially a sub $1.00 per Mcfe development cost. We expect more details from existing and future wells over the course of the year.
(2) 20-acre downspacing potential in Freestone field. The company indicated that it is seeing well performance in line with an expected 2 Bcfe estimated ultimate recovery rate from initial drilling at 20-acre spacing. We believe this represents a large opportunity to add additional production in a legacy field for XTO, and we would note that production at Freestone has been up the past two quarters, reversing a downtrend through much of 2004 and 2005. We would note that the combination of horizontal drilling mentioned above with downspacing could lead to an additional 1-2 Tcfe of upside not being factored into our estimates.
(3) CO2 flooding success in the Permian Basin. We believe the company's burgeoning oil production, mainly from CO2 flooding in the Permian Basin, is also not being fully factored into the stock. Oil production reached about 45,000 bpd during 1Q 2006 in part on the strength of a 1,000 bpd well drilled in the University Block 9 unit. The company will attempt to apply stimulation lessons learned from this well to other units at Permian, and we believe success could lead to upside to oil production estimates at a time when oil prices continue to rise versus expectations.
ADJUSTED EPS HIGHER THAN OUR ESTIMATE ON DERIVATIVE GAIN, LOWER THAN EXPECTED ESO EXPENSE
XTO reported adjusted 1Q 2006 EPS (including the effects of ESO) of $1.22, higher than our estimate of $1.18 and in-line with First Call consensus estimate. XTO's effective derivatives fair value gain of $15 million and employee stock option expense of $3 million (both pre-tax) caused the delta between actual EPS and our estimate. Operationally, XTO was generally in-line. Total production was 1.46 Bcf/d, slightly higher than our estimate of 1.44 Bcf/d, due to higher-than-expected oil production. Realized gas prices of $9.25 per Mcf were lower than our estimate of $9.58 per Mcf. Total unit costs were generally in-line at $3.55/Mcfe. Operating cash flow of $803 million was in-line with our estimate of $801 million. Current net debt to tangible capital is at 40% versus 43% in 4Q 2005.
UPDATED ESTIMATES
We are updating our 2Q, 3Q, 4Q, and full-year 2006 EPS estimates on higher costs, slightly lower production, and minor other company adjustments. Our new estimates are $0.80 ($0.83 previously), $0.93 ($0.98 previously), $1.14 ($1.21 previously), and $4.14 ($4.19 previously) respectively. We are also updating our 2007E EPS estimate to $4.63 ($4.69 previously). There are no changes to our 2008-2010 (normalized) EPS estimates.
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 |
