Shale Math Coming Into Play Sooner Than Expected For Gastar Exploration

| About: Gastar Exploration (GST)

I recently wrote an article referencing a valuation approach that is being used by sell side researchers and investors to analyze small cap e&p stocks, and that seems to have driven stock prices of certain small e&ps to high valuations on other metrics like EV/EBITDA. That approach is "shale math", where the NPV of acreage on a development basis is calculated and then discounted heavily to come up with a risk-adjusted value of undeveloped or partially developed unconventional assets. That math has driven small cap stocks like Goodrich Petroleum (GDP), Rex Energy (NASDAQ:REXX) and Synergy Resources (NYSEMKT:SYRG) to multiples higher than 10x 2013 EV/EBITDA (in Synergy's case, well over 20x!).

In that article, I suggested that due to a number of positive changes at Gastar Exploration (NYSEMKT:GST) such as acquisitions, financings, and well results, Gastar could start to be viewed from a "shale math" valuation approach and could drive analyst price targets higher, potentially driving the stock price higher too. And it could drive very low levels of institutional investment in the stock higher. Fortunately, my article was well timed, as it came out on Friday after the market close, and Monday morning before the open an analyst at an investment bank raised its target price on Gastar by $1.25 to $5.75 per share (versus a current ~$4.40 per share, and ~$4.24 per share at the close on Friday). The analyst cited an increased value per acre on undeveloped Hunton acreage as well as positive well results and an accretive acquisition as the justification for the higher target price, and mentioned that with further well results the target could move up.

This $5.75 target is closer to the $7 per share estimate the CEO recently made for the value of the company's legacy core asset, its liquids rich Marcellus shale play. And while $5.75 and $7 numbers might seem high compared to a current $4.40 per share price, and while investors might be hesitant to invest after a remarkable stock price run (GST is up from ~$1 at the beginning of 2013!), Gastar still trades at a large discount to the "shale math" potential value and on an EV/EBITDA multiple basis.

Gastar's current EV/2013 EBTIDA multiple is ~6.5x, versus GDP and REXX at ~10x and SYRG over 20x (according to analyst estimates). GDP has run because of the TMS, REXX because of the Marcellus and Utica, and SYRG because of the Wattenberg Niobrara and Codell. Gastar is very similar on an asset basis to both GDP and REXX, and actually its production mix, growth profile and rates of return on drilling are not that different from SYRG.

This leaves a lot of room for Gastar's stock to appreciate. Obviously there are risks inherent in the stock, such as financing the recent acquisition (can tack on to preferred and senior debt and put a lot on the revolver, and can JV before closing, but its never done until its done), potential infrastructure issues in the Marcellus (had been weighing on the stock until recently, its Marcellus has been materially outperforming by not declining despite very low capex recently), and of course commodity prices or the stock market. Despite all that, Gastar's large discount to its closest comparable companies on key metrics like EV/2013 EBITDA increases the chances that shale math comes into play and the stock appreciates considerably.

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.

Additional disclosure: I am also short SYRG. I may buy or sell any security mentioned without further notice.