As an Apache (NYSE:APA) shareholder I want to know whether or not the company is building or destroying wealth. Is APA just spinning its wheels faster over more territory, or is the company making investments that will increase long-term value for shareholders?
It's clear that the company has an impressive roster of capital projects, but the company has significantly increased its leverage to fund these projects. And shareholders need to be adequately compensated for bearing this additional risk.
I've reviewed APA's 2012 annual report in an effort to project 2013.
Using numbers similar to 2012 (which are far from certain given the volatile nature of oil and gas prices), we can project $8.5 billion in 2013 cash flow.
APA has a 2013 capital budget of $10.5 billion. The company plans to cover the difference with $2 billion in unspecified asset sales. This plan was announced to investors in the recent earnings release, and the news devalued APA's stock.
Here's why: Selling assets impairs the debt to capital ratio. Utilizing the capital markets with a weaker debt to capital ratio could make borrowing money more expensive. (However, I checked Moody's, and the company is not yet on credit watch.) If APA sells assets, they will have fewer assets to generate revenue. If APA is unable to sell assets, they will have to either halt capital projects or further indebt the company. With an increased debt to capital ratio, APA has heightened exposure to a downturn in energy prices.
Here's my take on how the market is presently projecting and pricing APA: energy prices hold within a similar range as 2012, APA sells 3.5% of production and replaces 3.5% of production through organic growth from past investments. APA makes no progress this year, but the destroyed shareholder value (whether it comes from asset sales or further indebtedness) has largely already occurred.
If these projections do not hold, there is further downside in the stock.
Now, we need to understand whether or not the company is destroying wealth or building long-term value to answer the most important question, Where does APA stock go from here?
To some degree the stock's fate depends on the assets APA sells, the prices APA gets for the assets, the amount of production APA adds from past and present capital spend initiatives and the rates of return APA achieves on the production projects, past and future.
If APA is unable to sell assets and the company has to go to the capital markets, it will likely impair APA's credit rating, which is not factored into the current stock price.
If APA can continue to grow production at 4% during the out years, that is only one leg of the stool towards increasing shareholder value, what ultimately drives stock price is EPS.
If APA can increase production 4% and EPS 10%, then we have the potential for significant upside in the stock. This will require management to focus on growing EPS, which means cutting costs, buying back stock and paying down debt versus continuing to grow production at deference to EPS growth.
A downturn in energy prices makes APA extremely vulnerable due to its recently increased leverage, and the stock will trade with more downside volatility as correlated to energy prices.
Using the present market projections, most of the downside ought to be out of the way. All bets are off if any of the following occur: energy prices tank, APA has problems in the credit markets or APA gets hit with a myriad of other unforeseen risks associated with investments in energy E&P.
The return on our investment from here is dependent on APA's ability to grow EPS. In my first article, Apache: Can You Make Money Buying APA Below Book Value?, I outlined a strategy for management that included focusing on shareholders through cutting costs, buying back stock, increasing dividends and paying down debt. Under my plan, leverage would be significantly reduced through a reduced capital budget ($7.5 billion versus $10.5 billion) and paying down debt with growth investments to come in 3 years after shareholders are taken care of (and yes, if you communicate with shareholders, work with shareholders when it makes sense to do so and compensate shareholders, you can develop loyal shareholders who stay with the company for the long haul, remove supply from the market and ultimately increase the value of the shares).
However, I recognize that I don't hold enough sway with management to bring about the changes that I've outlined. Management is most likely going to increase our leverage, so if that is the case, I expect them to increase our returns as well. The proof will be in the EPS. It's very difficult to grow at a rapid pace and control costs, and we saw this in APA's 2012 substantially increased operating costs.
Analysts are forecasting EPS growth of 6% over the next five years, which means that it would take 12 years to double APA's book value at this pace.
Given the risk associated with investing in oil and gas E&P, a 6% rate of return is wholly unacceptable for shareholders.
The bottom line, management does not appear to be focused on shareholders. It appears to be a story of increasing the company's domain without regard for increasing EPS.
I have emailed Mr. Farris (Apache CEO) and requested that management refute my position. And I will write a follow-up article based on any feedback provided by management. I believe that there is a tremendous opportunity for APA to grow EPS, however, it will require making EPS growth the company's goal.
I own the stock, because if management focuses on EPS, there is huge value at the current price. Therefore, I'm going to give management a chance to present their case to shareholders. But if it's just more of the same, I believe our dollars can grow safer and potentially faster elsewhere.