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After Its Bakken Acquisition, Is QEP Fairly Valued?
Like many natural gas companies, QEP Resources' ( QEP ) stock price has struggled during the past several years. Since peaking at $45.20 on July 26, 2011, the company's stock has tumbled 36% to $28.80 at market close on August 24, 2012. Also like many natural gas companies, QEP has been looking for ways to increase its oil/liquids production cut in response to a depressed natural gas price environment. For the most part, the company's transition to liquids production has occurred internally, with a shift in focus to the liquids portion of its midcontinent acreage, the continued development of its legacy Bakken acreage, and the completion of its Black Forks II NGL processing plant in Wyoming. QEP recently proved it's not opposed to making a bold acquisition in an oil play, and did so by spending $1.38 billion to acquire 27,600 net acres in the Bakken, bringing its total to 118,000 net acres in the play.
While the company's shift to liquids may seem like a logical move for a natural gas company at present, it's an expensive endeavor and not without risk, just ask Chesapeake Energy ( CHK ) and GMX Resources ( GMXR ) who've both experienced financing difficulties during their respective transitions. Of course, both CHK and GMXR were highly levered before they bought into oil plays, leaving them with inadequate cash flow to finance their capital budgets. By contrast, Permian operator Approach Resources ( AREX ) emerged from its transition to oil with minimal debt and has subsequently had success developing its assets. So where does QEP stand amongst these companies?
Pre-acquisition, the company had a responsible debt-to-market cap of 36.3% and an interest coverage ratio of 13.1x. QEP financed the Bakken acquisition with its credit facility, increasing its debt level 68% to $3.2 billion in the process. Its debt-to-market cap ratio increased to 61.5% (see table below) and its interest coverage ratio declined to 10.3x. The company did mention in its acquisition conference call that it plans to deleverage soon; however, unless deleveraging comes in the form of a large divestiture, this process will take some time. In the near-term, we have a highly levered company whose production was 80% natural gas during the six-months ended June 30, 2012.
Note regarding calculations: LOE, G&A and DD&A margins were computed as a percent of sales.
While QEP is highly levered, it's a well-run company that's both cost-effective and adept at extracting cash flow from its production. The company's LOE margin is average for its peer group, but its G&A and DD&A margins are actually lower. Its cash margin of $4.07 ranks second in its peer group, indicating the company is efficiently extracting cash flow from production despite its leverage to natural gas. It's worth noting that QEP's costs have been trending up as the company has increased its liquids production cut (the main culprit is transportation and handling costs), and this will be something to monitor as the company continues its transition to liquids. Its cash margin improved to $4.17x during this span, but will take a hit post-acquisition due to higher interest payments.
Effect on Credit Facility
QEP was undrawn from its $1.5 billion credit facility prior to this acquisition, which will draw approximately $1.4 billion. The company paid 2.05% on its credit facility draw during the first half of 2012, which translates to an increase in quarterly interest payments of $7.4 million ($29.5 million annually) based on its new balance. By my estimation, QEP will still have a strong interest coverage ratio of 10.3x post-acquisition. Approximately $55 million remains undrawn on the facility at present; however, the company does have an option to increase its draw to $2.0 billion. The facility matures in 2016 with options to extend to 2018, presumably at a higher interest rate.
Considering low gas prices and high financial leverage, should we be worried about QEP's ability to finance its capital expenditures? The company will be getting a modest bump in oil production of 10.5 thousand barrels of oil equivalent per day (MBOEPD) from its Bakken acquisition. This has bumped the company's full year production guidance by 5 Bcfe (midpoint of guidance) or 833 MBOE, which translates to a $20.4 million increase in operating cash flow (assuming current cash margin) by the end of 2012. During the six-months ended June 30, 2012, operating cash flow was $694.3 million. If the company keeps its current production (including new properties) flat, I estimate QEP will generate $1.5 billion in operating cash flow for 2013. If the company keeps its capital budget at $1.525 billion in 2013 (the company will announce guidance at Q3 conference call), it will have a budget shortfall of $25 million. Now QEP increased operating cash flow by $66 million year-over-year during the six-months ended June 30 despite low natural gas prices. With more liquids production coming online during the next year, operating cash flows will continue to increase. I do expect the company to divest assets during the next year to relieve its financial situation, and spinning of its low-margin marketing arm might make some sense.
QEP's reserves prior to the Bakken acquisition were 76.1% natural gas and had a reserve life of 13.1 years (see table below). The company has been steadily growing its oil percentage from reserves to 76.1% from 91.9% in 2009 and has done so at a strong three-year finding and development cost of $1.75 per Mcf. QEP added 125 MMBOE of proved and probable reserves with the transaction (81% oil, 9% NGLs, 10% natural gas) and didn't break-out the proved and probable split, meaning the market doesn't know how the company should be trading on an EV/Reserve basis post transaction.
One thing we do know is that QEP's reserves are going to get even oilier over the next year for the following reasons: 1) 91% of its capital budget was spent on liquids plays in 2012, meaning the company is investing to increase its production and proved reserves from these plays 2) QEP plans to grow its rig count in the Bakken to eight rigs by next year from three currently, meaning more rigs and capital will be spent in oil plays moving forward. What does this mean for the company's valuation?
Pre-acquisition, QEP was trading at a slight premium to the peer group on a production basis and a 14% discount on a reserve basis. Based on the trading multiples of these peers, QEP should have been trading at a share price of $31.64 or 10% higher than on August 24, 2012 when its stock closed at $28.80. If we give the company credit for daily production from the new assets and 50% of its proved and probable reserve total (62.5 MMBOE) while adjusting EV accordingly, I find QEP should be trading at a share price of $28.03 or 3% lower than the company's stock closed at on August 24, 2012. So where does all this leave us?
QEP's current value is being muted by two factors: its high debt level and uncertainty surrounding the reserves associated with its new Bakken acquisition. In spite of paying a premium for the Bakken acreage, I believe the company has the liquidity available to finance its capex; however, it will need to monetize an asset to pay down its debt levels. I believe $28.03 represents a floor for the company moving forward and if it's able to reduce its debt to pre-Bakken acquisition levels, I estimate a target share price of $35.28. QEP is setting itself up to have a balanced portfolio of oil and gas assets with plenty of upside once natural gas prices recover.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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