A few weeks ago, we looked at the merits of Rosetta Stone (RST), the investment idea presented by David Nierenberg of D3 funds at the Value Investor Congress in Las Vegas. In this article, we are going to examine, WPX Energy (WPX). The idea was presented by Guy Gottfried of Rational Investment Group. The presentation can be found here. Readers will have to scroll down the page to find it. What intrigued us about WPX initially was that at the time it was presented it was trading for 66% of TANGIBLE BOOK value. While that might be expected if the company was a bank or insurance company or had a huge debt maturity looming, it is rare for an E&P company to trade at less than even 1.5X book.
Using reasonable estimates for the value of the company's oil and gas reserves, WPX appears to be even more undervalued. In this article, we will expand on Mr. Gottfried's analysis to show that WPX appears to have considerable upside with a reasonable margin of safety for investors.
Background
In 2011, WPX was spun out of the energy infrastructure company Williams (WMB). While a part of WMB, WPX's asset development was not necessarily a focus of the parent company other than to supply gas to fill its pipelines. The company's assets encompass a wide variety of oil and gas plays from predominantly gas plays like the Piceance Basin and the Marcellus Shale, to oil plays like the Bakken Shale, to international opportunities with Apco (APAGF) in Argentina and the San Juan and Powder River Basin plays. Investors might ask the question, "if these assets are so great, why is the company trading for such a discount to its NAV, let alone tangible book value?" That is a great place to start with our analysis.
(click to enlarge)
Source: WPX Investor Presentation
Within the last few years, investors have become well aware of the tendency of corporate spin-offs to outperform the market over time. There is even an ETF that invests in them, the Guggenheim Spin-Off ETF (CSD), which has had a fairly decent track record. So why has WPX languished until recently at such a discount to book value? The honest answer is "who knows?" or "does it really matter?" Without assigning any particular merit to any of them, here are some excuses we have come across while doing our research:
- Revenue in 2012 declined 19% due to lower realized natural gas prices as hedges rolled off and production growth flattened.
- Costs for gathering, processing and transportation were higher due to previously negotiated WMB contracts ($1.02 per Mcfe in 2012 vs. $0.75 Mcfe in 2010).
- WPX was spun out when natural gas was at its nadir, management cut back the number of rigs it was using, thus reducing revenue, EBITDA and growth prospects.
- WMB shareholders wanted yield and an infrastructure play.
- Its main asset base is in the Piceance Basin, which has been considered a mature natural gas play (no growth and no hot commodity play). 80% of WPX's asset base is dry gas.
- Their Marcellus assets are in the dry gas area and not wet gas like Range Resources (RRC) and others.
- Bakken Shale is hot area, but not a huge part of the company yet.
- 69% stake in APAGF was given a 40% haircut after Argentina moved to seize control of YPF (YPF) in 2012.
- Management has less experience in exploration and development than many other public E&P companies, adding execution risk to the ever present commodity price risk.
- No standalone operating results due to affiliation with WMB.
- Capital expenditure funding gap of $600M in 2012 and at least $200M in 2013.
To be clear, just because we reside in Dallas, Texas, we are under no delusions that we are oil and gas analysts and do not claim to have any unique or proprietary insight into the future reserve potential of the company's asset plays. Investing in oil and gas companies incorporates many factors, such as the direction of commodity prices and macro growth issues, that we typically do not concern ourselves with when we are analyzing a company. Fortunately, in the case of WPX, there seems to be a sufficient margin of safety reflected in the valuation of the company which makes us more comfortable with the investment.
Margin of Safety
This is probably one of the most overused phrases in the value investing world (and the phrase "value investing" itself is probably the most misused phrase in investing). We like to say it is an attitude as much as it is a calculation and it can manifest itself in many different ways. In the case of WPX, the margin of safety (which we mean "reduction in the risk of permanent loss of investment capital) appears to be in the discounted valuation of the stock relative to the company's assets.
Price to Tangible Book Value
At the time we are writing this, WPX is trading for approximately 75% of tangible book value. In a time when many of its peers are trading for 2.5X+ tangible book value, this is truly remarkable. Approximately 90% of the company's assets are net Property and Equipment. The net figure is only 60% of gross PP&E. Even more importantly, the property value on the balance sheet is not inflated by unsuccessful exploration costs.
There are two ways in which a company can treat expenses associated with unsuccessful wells - the successful efforts method and the full cost method. Without getting into a full blown debate about the pros and cons of each method (for investors looking for more information they can start here), one major difference is that, under successful efforts accounting, unsuccessful well costs are expensed immediately. Under full cost accounting, unsuccessful wells are capitalized on the balance sheet. WPX uses what is usually considered the more conservative successful efforts method, which means that the balance sheet does not contain unsuccessful well costs. Since WPX has been successful in its wells about 99% of the time, it really hasn't mattered that much, but for companies that do a lot of wildcat drilling, investors need to know what method of accounting is used. This is especially true when comparing different E&P company book values. The fact that WPX stock is trading for less than the more conservative accounting method balance sheet value is the first margin of safety. A second margin of safety comes from the estimated value of the company's reserves, which is admittedly a much more subjective estimate and subject to a great deal of uncertainty and debate.
Price to Estimated NAV
Most investors in E&P companies attempt to estimate the value of the company's reserves in the ground. In an E&P company's 10K, it proves an SEC approved NAV calculation (PV-10). For WPX, the estimated value was $2.3B. However, depending on what the price of the commodity is used (average or year ending) the estimated value can vary widely. In fact, in a recent presentation (page 17) the company provided a calculation of a second estimated value to be as high as $5B, which is much closer to book value. Due to the fact that there are a tremendous number of highly subjective assumptions that go into the calculation and most of the intrinsic value resides in the out years that are highly uncertain, we are not huge fans of using discounted cash flows to calculate a company's worth. Small changes in any of the assumptions can make a huge difference in the end result. But it does give us some sense for a valuation range even acknowledging the limitations on its accuracy.
(click to enlarge)
Source: WPX Investor Presentation
(click to enlarge)
Source: WPX Investor Presentation
However, there have been several transactions in assets that are similar to WPX's that we can also estimate the value of the company. In his presentation (pages 28-32), Guy Gottfried highlights several transactions that, when applied to WPX's assets, produce estimated NAVs of between $28 to $36 a share or 50-90% above the current share price. The examples used ranged from applying the valuation of past sales of other WPX properties across the portfolio (roughly $1.36-$1.38 per Bcfe of proved reserves), to using valuations of property sales near WPX's acreage in the Piceance by Bill Barrett (BBG) and Anero Resources.
We also like it when other value investors whom we respect come to similar conclusions on valuations and investment thesis. In addition to reading company annual reports, we read the reports and commentaries of mutual fund companies such as FPA, Third Avenue Value, GMO and Aegis. Many times these funds go into detail on an idea and the methodology used to analyze a company. In the latest Aegis Fund quarterly commentary, the portfolio manager Scott Barbee makes his case for WPX in the following excerpt. Mr. Barbee also expands on the thesis a bit more in the latest Value Investor Insight publication.
(click to enlarge)
Source: Aegis Fund Q1 Shareholder Letter.
Here is a summary table of his valuation metrics. Please do not let the precision of the numbers give you a false sense of certainty in them.
Aegis Value Fund Valuation | Price per Unit | Value ($M) | |
Nat Gas Proved Reserves (TCF) | 4.1 | $1.25 | $5,130 |
Bakken Oil (MBBL) | 68 | $20.00 | $1,360 |
NGLs (MBBL) | 132 | $6 | $792 |
Undeveloped Bakken/Marcellus | $450 | ||
Total | $7,732 | ||
Net Debt | $1,500 | ||
NAV | $6,232 | ||
NAV per share | $31.16 | ||
Current Price | $19.00 | ||
Upside | 64% |
While it is true that we have been to the ranches in Texas where J. R. Ewing of the TV show "Dallas" ruled over the family's vast oil empire, we are certainly not claiming that this fact allows us to claim that we are experts in the valuation of oil reserves any more than J. R. could. These are simply educated guesses and should not be considered absolute valuations by any means. Reasonable people can disagree as to what these reserves are worth and the fact that the company's valuation currently trades at 50-100% discounts to these estimates illustrates the wide difference of opinion. But we are comfortable owning a stock in a company that is currently priced at such a substantial discount to what could be described as plausible, yet theoretical valuations.
Company operations
While the company's stock seems to trade at a reasonable margin of safety to both tangible and theoretical valuation of its assets, the fact is the management of the company still is in charge of the day-to-day operations of the company and a non-control investor like us must rely on their skills in running the company to help, as every management says, "maximize shareholder value." In this section, we are going to look at the operations to see how management is doing on that front.
Cost management to boost EBITDAX by $125-$165M by end of 2014
Mr. Barbee mentioned the potential $150M increase in EBITDAX over the next two years. WPX management has spoken about this too. This is a hidden, or I guess by now not so hidden, catalyst for valuation creation. Here are the basic components of the savings and revenue-enhancing endeavors the company has embarked on.
(click to enlarge)
Source: WPX Investor Presentation
The company has made progress on these initiatives and we believe that the remaining goals can be achieved in the expected time frame. Because these are legacy contracts from the time the company was part of WMB, we think investors have not been able to model or understand all of the reasons for the under-earning of EBITDAX and have assigned little value to them. However, as they become a reality, the increased EBITDAX will help push up valuations.
- As the company increases production, the company should hit a level where the Laser pipeline will give the company a volume discount. Even if this slips by a quarter or two, it should be achieved.
- The company is one of several companies who are using the highly touted Rockies Express (REX) pipeline to move gas eastward. The current contract expires at the end of 2014 and the company expects to achieve additional revenue for its gas as the current contract deducts a fee relative to natural gas prices for transport.
- According to company filings, the company has been paying $35-$46M a year in fees because it hasn't been using all of the allotted space on pipelines that transport its production. The company is "aggressively" negotiating with several parties to buy their unused allotted volume.
(click to enlarge)
Source: WPX Investor Presentation
May 2, 2013 Conference call:
Our contractual cost savings did kick in at Willow Creek and Piceance gathering. Saved us $11 million in the first quarter alone from the new Willow Creek and this Piceance gathering contract.
Efficient, low-cost producer is a plus in low commodity price environment.
When owning a natural resource producer, there is generally an implied favorable assumption on the direction of the underlying commodity (flat to up) that is unavoidable. Arguments can be made that, if you believe a commodity is going to increase, an investor would rather own the unprofitable high-cost marginal producer than the profitable low-cost producer because of the huge incremental increase in income at the high-cost producer as the commodity price rises. We are not willing to make any predictions on the future direction of nat gas prices other than to say, we would rather own a low-cost producer at $4 nat gas than a high cost one at $12 nat gas. Many people who are much smarter than us have made predictions on the future of nat gas and we will leave readers to make their own guesses on that.
While WPX has not really been independent long enough to evaluate management's ability to operate their assets in a value creating way, the small sample size is at least leaning in the right direction. For example, the company has decreased the time it takes to complete a well in the Piceance from 30 days to 10. In fact, they recently completed a well in 3.7 days. This helps reduce costs per well. In the Bakken, the company has reduced drilling days from 40 to 25 and claims it is at cost parity ($11M a well) with its peers even though it spends $1M a well using ceramic proppant instead of cheaper sand.
(click to enlarge)
Source: WPX Investor Presentation
(click to enlarge)
Source: WPX Investor Presentation
A Few Intangibles
Huge upside in Niobrara
In this article, we didn't even discuss the huge upside to the company's estimated probable and possible reserves if exploration efforts in the Niobrara are successful. Every estimate we have seen puts the potential at the current equivalent of the company's reserves. In other words, the company could double its reserve base if their exploration efforts are successful. This initial well was a huge one. But a sample size of one is too small to draw any conclusions.
Here is how management described the well results on the last earnings call:
In Niobrara, our Niobrara well continues to perform well above our expectations. It produced 1 Bcf in the first 107 days of production. And at this rate, the Niobrara well will produce in the first 4 months what a typical Piceance Basin's Williams Fork well will do over its estimated life cycle of 25 to 30 years.
(click to enlarge)
Source: WPX Investor Presentation
Impressive list of value investors + Activist
We always look at the shareholder base to see if any other successful investors are buying or selling the stock. While an investor should never buy or sell based on the actions of others, we have to admit it is always more comforting to know you might not be alone in your thoughts. Besides the Aegis Value Fund, Taconic Capital Advisors LP announced in May that it now has a 6.39 percent interest in WPX Energy. In addition to them, we found the following investors are also shareholders of WPX:
Murray Stahl of Horizon Kinetics (presenter at VIC and largest shareholder of another stock we recently wrote favorably about, Texas Pacific Land (TPL) at 20%) owns 5.5M shares (+2.5M in Q1).
Donald Smith a very well respected deep value investment firm owns 8.6m shares and doubled its stake in the last year.
Arnold Schneider, fund manager of the Schneider Small Cap Value Fund owns 1.3M shares.
Apathy by Analysts
There are currently nine holds and only two buy ratings on the company. On the last conference call, only four analysts even bothered to ask a question. We like to see a lack of Wall Street attention to a company. As the analysts and their clients change their minds, this is where the incremental buyer comes from.
Guidance
We always take company guidance with a grain of salt and actually prefer companies that do not issue guidance. When a company issues guidance, most investors will tend to "anchor" their expectations around the numbers provided. Anchoring is one of the most difficult things investors have to overcome to be successful. As long-term investors, we are also not that interested in what the next few quarters' results will be, nor do we think they will necessarily be indicative of the future.
(click to enlarge)
Source: WPX Investor Presentation
Risks
While it is always more enjoyable to think about the upside of an investment, prudent investors must always consider the risks that the investment entail. When considering an investment in a company, we are more interested in how management deals with things they can control and how they may have tried to reduce exposure to risks they can't control or are generic to all companies in their industry.
Commodity price risk is unavoidable for anyone interested in investing in a natural resource company. Therefore, one must be willing to accept the risk as part of their thesis. If an investor believes that natural gas prices are going to decline, then clearly WPX would not be an investment idea worth considering. WPX certainly would suffer under a scenario of lower nat gas prices. The company currently has about 50% of its 2013 nat gas production hedged at $3.62 and about 50% of its oil production hedged at $100 a barrel. The company has few hedges in place for the next few years. So the company has some cash flow protection this year if prices decline, buy very little for next year and beyond.
Like every E&P company, the company must continue to spend money to offset declining production in its existing reserve base and hopefully replace those reserves at a higher rate and a lower cost. Historically, WPX has outspent its cash flow by $200M to $700M a year. The gap looks to be on the low end of that range in 2013 if all factors remain the same. Combined with the risk of a decline in the price of nat gas, this is a significant risk (look at Chesapeake Energy's (CHK) problems as a result of high leverage), unhedged gas prices and substantial capital expenditures. Lower nat gas prices would reduce the likelihood that WPX will achieve its expected 10%+ growth in production. The company duly notes the risk in the 10K:
We anticipate some recovery on natural gas prices in 2013. Should this expected recovery not occur, we would need to either significantly reduce our capital spending or utilize more of our credit facility, or a combination of both.
In defense of management, in a recent interview, the CEO recounted how going through the experience ten years ago of having to sell $1B worth of assets in 72 hours to help the parent company avoid serious financial difficulty, shows a keen awareness of the risks of excessive leverage.
In addition to slower growth, another consequence of lower prices is asset impairment. This is not a company specific risk, but the company also duly notes the potential in its risk section. So rather than speculate on the impact of declining prices on assets, the company has given us a ballpark estimate:
For the other producing assets reviewed, but for which impairment charges were not recorded, we estimate that approximately three percent could be at risk for impairment if forward prices across all future periods decline by approximately 11 percent to 12 percent, on average, as compared to the forward commodity prices at December 31, 2012. We estimate that approximately 31 percent could be at risk for impairment if forward commodity prices across all periods decline by approximately 16 percent to 18 percent. A substantial portion of the remaining carrying value of these other assets (primarily related to assets in the Piceance Basin) could be at risk for impairment if forward prices across all future periods decline by approximately 23 percent, on average, as compared to the prices at December 31, 2012 .
Here was another interesting item in the risk section:
In the Marcellus Shale/Appalachian Basin, we will focus on completing our inventory of drilled locations. Our drilling program in the Marcellus Shale/Appalachian Basin will be limited. Specifically, drilling capital in Susquehanna County will be minimal due to infrastructure constraints on our third party gatherer's system. Until those constraints have been rectified we will look to develop opportunities in Westmoreland Country in the Appalachian Basin.
As far as risks that management has more control over, execution risk is always at the top of the list. For the first time in many years, the company is spending money on exploration ($90-$100M). Successful exploration is a much more difficult accomplishment than drilling in known fields for a 100% success rate. If the company is going to expand its potential reserves, exploration is one way to accomplish this. However, at this point there is no way to handicap the company's ability to do this and should be considered a pleasant surprise if it happens. The current valuation doesn't seem to put much hope on success, which is fine with us. But the fact is, management is putting shareholder capital at risk without a track record. The company also believes that the Niobrara play has the potential to double the size of the company's reserves. While the company's first well was a good one, the results of others in the play have been inconsistent due to the geology.
Summary
We do not have any clever sounding headlines to write about a potential investment in WPX. When taken as a whole, an investment in WPX seems to offer investors a compelling risk/reward proposition. It is unusual to find an E&P company trading below tangible book value that isn't in financial distress. Several very smart and successful low price to book value investors have taken note and are accumulating shares. An activist has recently bought shares and wants management to "increase shareholder value." But don't they always want that? Using what appears to be conservative estimates of reserve valuations by several respected value investors (although totally un-provable at this time), investors seem to be giving little credit to the future potential of many of the company's development opportunities. If the estimates of the reserves are correct, the company is trading for 50-100% below its NAV. This steep discount provides a margin of safety and also allows for a larger margin of error in the calculations before the premise is invalidated. Inverting the valuation, one could say that the discount implies that investors are pricing in a $0.50-$1.00 decline in the price of nat gas.
The company's EBITDA run rate has been understated in the past due to unfavorable contracts negotiated while part of WMB. Management has shown success in its ability to renegotiate or eliminate most of these drags on cash flow. While commodity risk is ever present, the company's cost structure makes it one of the lowest-cost producers which mitigates a bit of risk. As always, do your own analysis and use this article as a starting point, not an end point.
Disclosure: I am long WPX, CHK, RRC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Investing 501 is a pair of analysts with over 60 years of professional investment experience. This article was written by Tim Heitman, one of our Founders. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.
eric holder eric holder carole king crystal renn matilda cab calloway melissa gilbert
No comments:
Post a Comment
Note: Only a member of this blog may post a comment.