Market Overreacts - Gastar And Goodrich, Hunton And TMS

Includes: DVN, GDPM, GST
by: Josh Young

Gastar (NYSEMKT:GST) released its quarterly operations and financial update recently. Updates included revenue growth of 122% year over year, production higher than previous guidance, clarification on the timing of announced divestitures (Hunton closing August 6th, E Texas by August 15th), and additional information on Hunton drilling activity and well results.

When the market opened, the stock proceeded to trade down more than 11% intraday before closing down 6% at $3.14 per share. The reasons cited in the news included an earnings "miss" and disappointing well results in the Hunton.

However, earnings are not a very relevant metric for small cap E&P companies, due to high levels of capex and depreciation and due to complexities around accounting for hedges. And Gastar had already disclosed the well results over a month ago.

This presents an interesting opportunity, particularly surrounding one of the most important pieces of information disclosed by the company. Gastar shared that another private operator has another ~20 well results, which meet Gastar's Hunton type curve. And I confirmed in separate due diligence that there is a third private operator which has another 5 well results in the Hunton in close proximity to Gastar's acreage, and those wells also are in line with Gastar's type curve.

This means that, rather than the common misconception of Gastar's type curve being composed of a few early wells, the type curve is validated by dozens of data points and thus much more robust and predictive.

Gastar Hunton Type Curve
(Click to enlarge)

What is particularly intriguing to me is that there is another small cap E&P that has a similar type curve in a similar play. However, that small cap trades at over 12x EV/EBITA, versus Gastar's ~5.5x 2013 EV/EBTIDA. And there are only a few good well results in that small cap's play and a number of disappointing results by large operators, while in the Hunton there have been numerous excellent results and only a few misses.

That small cap is Goodrich Petroleum (GDP) and its new resource play is the Tuscaloosa Marine Shale, commonly abbreviated as the TMS. The economics of this play can be seen below, and on a single well basis they look remarkably similar to the Hunton play. Gastar announced that on a development basis it expects its wells to cost $4.5 million, which likely translates to similar development economics as Goodrich's TMS development economics.

GDP TMS Economics
(Click to enlarge)

Goodrich recently executed an acquisition of additional acreage in the TMS from Devon Energy (NYSE:DVN). Obviously Devon did not achieve success in the TMS, as it sold acreage and production with an estimated $100 million + cost basis to Goodrich for $26.7 million. This acquisition looks very similar to the deal Gastar did with Chesapeake (NYSE:CHK) in the Hunton, and Goodrich stock has reacted similarly, trading up from around $12 before the acquisition to a recent price of over $19 per share.

This was clearly a good deal for Goodrich. However, at over 12x EV/EBITDA, the stock is pricing in substantial upside in the TMS. At under 6x E EV/EBITDA, Gastar stock is not pricing in much Hunton upside, despite the much larger number of successful Hunton horizontal wells. Also, with an enterprise value of roughly 1/3 of Goodrich's and a similar sized acreage position, the Hunton could be more impactful to Gastar than the TMS is to Goodrich.

Obviously much has been written about Gastar in the past few months. It has been one of the highest performing energy stocks in 2013. Its Thrasher well has been one of the most economic wells drilled onshore North America in 2013. And its management's deal making has secured an incremental 75,000+ net acres in the Hunton play and $20+ million of proved reserves at effectively no cost after the resale of an acquisition from Chesapeake. With these developments, Gastar has been worthy of attention. And despite these developments, the stock trades at less than 6x 2013 EV/EBTIDA, which is lower than the multiple its peers in the Marcellus trade at and is also half of the multiple similar small cap growth stocks like Goodrich trade at.

Disclosure: I am long GST. 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. I am long GST and may buy or sell it or any other stock mentioned at any time with no further notice.