Ultra Petroleum (UPL) is an independent oil and gas firm competing for market share in the basic material sector. UPL's operations are heavily oriented to prosper off an increase in the price of natural gas, and while this has been a major deterrent for many investors, UPL's valuation is now more attractive. Intrinsic valuation suggests UPL is severely undervalued trading at a mere discount of nearly 40%. UPL's efficient management practices has enabled UPL to maintain market share during suppressed price levels of natural gas. The bull case for a play off natural gas is attractive, yet short sellers still constitute roughly 15% of UPL's shares outstanding. Now that ULP is heavily undervalued, its time to figure out the right moment to initiate a position. For a good primer, here is an overview to UPL's business.
UPL was incorporated on November 14, 1979, under the laws of the Province of British Columbia, in Canada. According to legislation, UPL exists today as a Canadian company, but since March 2000, it has operated under the laws of the Yukon Territory. As previously mentioned, UPL's main focus is oil and natural gas, but specifically its operations engage in the development, production, operation, exploration, and acquisition of oil and natural gas properties. UPL's primary operations are conducted at its properties in the two locations including:
- Green River Basin - The Green River Basin is located in southwest Wyoming and entails the core operations that are responsible for the development of UPL's natural gas reserves. At this location, UPL own approximately 93,000 acres of leases in and surrounding the Jonah and Pinedale natural gas fields. Among its peers, UPL has the largest acreage position in the Pinedale natural gas field. UPL has been acquiring leasehold interest in the Pinedale natural gas field since 1997, and today currently owns nearly 60% of the field with over 1,700 active producing wells. Overall, UPL has a strong foothold given the Pinedale field is rated as one of the top five natural gas fields in the country.
- Appalachian Basin - In 2001, UPL began acquiring acreage in the Appalachian Basin, and first began drilling in 2005. Today, the underlying acreage in this region is the second most lucrative set of properties UPL owns. As of FY ended 2011, UPL's position in this region contains 500,000 acres of leases spread across five counties in north central Pennsylvania including Potter, Tioga, Clinton, Centre, and Lycoming. The counties provide the potential for 2,500 future net wells and 9.5Tcfe of net resource. UPL's management strongly feels these properties contain what is necessary to expand profitability and capture an industry-leading position.
Management, Revenue, & The Role of Natural Gas Prices
UPL's management strives to meet its long-term objective of constructing a robust portfolio of high return investment opportunities, maintaining a disciplined approach to capital investment, and maximizing earnings through its cost control measures at the operating level and through its access to lucrative financial resources. However, the price of natural gas remains the primary barrier holding UPL back from increasing its margins. Nearly 80% of UPL's revenue derives from natural gas and lowered prices due to an excess supply among the industry is only forcing margins to compress. UPL's final revenue for FY ended 2012 was 24% lower than its revenue in the previous year. This translated to a gross margin of roughly 77.4%. The dramatic reduction in UPL's revenue is entirely attributed to the decline in the price of natural gas.
On a positive note, the 2012 decline in the price of natural gas allowed UPL's management to clearly demonstrate its cost control measures. From FY 2011 to FY 2012, UPL's earnings before taxes (EBT) fell by nearly $600 from $700 mm to $100 million. The most detrimental impact was reflected through UPL's cash flow from operations, but fortunately UPL's management responded quickly making a substantial effort to reduce its operating activities. This aided in capital preservation for shareholders and decreased the magnitude of margin compression. Cost controls measures can be highly effective, but can not be used to offset price decreases for ever. This raises the question of sustainability. How sustainable are these low natural gas prices?
Given natural gas is a commodity in nature, short-term price fluctuations are highly prevalent. In the short-run, economic inefficiencies as well as volatility tend to have the largest impact on these price fluctuations. However, in the long-run, low natural gas prices are unsustainable and capital allocations across the industry strive to support this. Industry wide there has been a tremendous reduction in the amount of capital investments that have been allocated towards natural gas drilling, which will inevitably result in a large decline in its supply.
Although the short-term outlook for natural gas prices as not as appealing as analysts would like to see, UPL's management is increasing its stake in the company. On March 4th, controller and vice president Garland Shaw purchased 3,000 additional shares of UPL, which increased his increased his position to a total of 13,000 shares.
Historically, for the past three years ULP has maintained an EV/EBITDA multiple of right around 10.0 times. Looking forward, I am anticipating UPL forward EV/EBITDA multiple will be 10.5 times for FY 2013 and FY 2014, respectively. I feel 10.5 times may be a little low, however I am going with this estimate to be conservative. Using traditional discounted cash flow techniques, I arrived at a current fair value estimate of roughly $36 per share. This may seem substantially high, however this provides a clear illustration for as how much UPL is actually undervalued. Its assets are substantial and profit margins have the potential to prosper significantly from UPL's attractive pricing dynamics. UPL is positioned to benefit from extremely low development as well as production costs.
UPL has a strong asset set and wide range of resources across its properties, but the key underlying issue still exists. The presence of low natural gas prices will effectively yield a poor return on the UPL's assets, which will translate to the market and eventually become priced in. From a technical standpoint, UPL's thirty day relative strength index indication remains high in the overbought range at 65.5. Clearly, an increase in the price of natural gas is desired by and directly in line to benefit both short- and long-term investors, but the length of time before natural gas prices increase significantly is uncertain. Therefore, I recommend investors continue to watch UPL and look for changes in its technicals as well as the supply of natural gas before initiating a position in this heavily undervalued security.