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Investment Thesis

Founded in 2010 by a group of former executives, Athlon Energy (ATHL) is a good vehicle for pure-play exposure to the Permian Basin and potential resource expansion in the Wolfcamp and Cline Shales. Athlon's 98,000 net acres in the Midland Basin provide investors pure-play exposure to emerging horizontal development opportunities across multiple stacked intervals. The company has not only identified a deep inventory of low-risk, bread and butter vertical Wolfberry drilling locations on 40-acre spacing, the asset base is also exposed to substantial upside potential from high-impact horizontal drilling primarily in the Wolfcamp Shale and, to a lesser extent, the Cline Shale. The 20-acre down-spacing in the Wolfberry provides further upside potential.

Although ATHL has not drilled any horizontal wells in the Midland Basin to date, it has a very attractive exposure to the emerging horizontal Wolfcamp Shale play. Recent industry success has further consolidated Wolfcamp as one of the important evolving horizontal plays. Confidence in industry horizontal potential in the Midland Basin is rising. ATHL's pure-play exposure to emerging horizontal development and its low-risk vertical Wolfberry drilling program offers a good foundation of production and cash flow growth for many years to come.

Company Overview

Athlon Energy is an independent exploration and production company focused on the acquisition, development and exploitation of unconventional oil and liquids-rich natural gas reserves in the Permian Basin. Although the Permian Basin is comprised of 3 primary sub-basins: The Midland Basin, The Central Basin Platform, and the Delaware Basin, all of ATHL's assets are located in the Midland Basin. Athlon has about 98,000 net acres in the eastern portion of the greater Permian Basin, the Midland Basin. ATHL has identified a deep inventory of low-risk vertical Wolfberry drilling locations on 40-acre spacing and Athlon asset base is also exposed to substantial upside potential from emerging horizontal plays (Wolfcamp and Cline Shales) in the region and from 20-acre down-spacing.

Source: Company Documents

Athlon was formed in August 2010 by a group of former executives of Encore Acquisition Company, and at that time Apollo Global Management (APO) made an initial commitment of $200 million. In January 2011, the company acquired 19,000 net acres in the Permian Basin in Texas from SandRidge Energy (SD) for $156 million. The acquisition included 1.6 MBOE/d of production and 19.1 MMBOE of proved reserves. Later in October 2011, Athlon made another acquisition in the Permian Basin (Howard and Glasscock counties). The company acquired 34,000 net acres $253 million from Element Petroleum. The acquisition included 14 MBOE/d of production and 16.4 MMBOE of proved reserves. At this time APO also increased its equity commitment to $400 million.

ATHL recently completed its IPO and raised net proceeds of $293.4 million (18.1 million shares of common stock at $20 per share).

(click to enlarge)

Source: Company Documents

Focused Operations On The Permian Basin

According to Credit Suisse estimates, the Permian Basin would be responsible for a quarter of the domestic oil growth in the next 10 years. Despite large expected growth out of the Basin, there aren't many opportunities to gain exposure particularly in the small cap stocks. Athlon Energy provides investor a perfect opportunity to gain exposure to the Permian Basin in the small-cap group. The stock is up by more than 13% since it started trading last month.

Athlon's portfolio of ~98,000 net acres in the eastern portion of the Permian Basin has great upside potential from high impact drilling, mostly in the Wolfcamp Shale and, to some extent, the Cline Shale. The portfolio is characterized by a deep inventory of low-risk vertical drilling locations on 40-acre spacing in the Wolfberry play and has additional upside potential from 20-acre down-spacing in the Wolfberry. While the proven low-risk vertical drilling program is a source of steady cash flow and provides a solid foundation production and cash flow growth, the recent horizontal industry success also establishes Wolfcamp as an important evolving horizontal play. Thus ATHL offers investors a very attractive asset base.

Vertical Program Provides Solid Base and Offers Growth

ATHL is currently running a 7 rig vertical program. Vertical program not only provides solid base but also offers potential resource expansion. The foundation of Athlon's Permian Basin program is its vertical Wolfberry drilling campaign. Centered on the low-risk vertical development, the company since its inception through May 2013 has drilled 230 gross wells with a 99% success rate. The company has further identified about 2,298 gross (1,797 net) low-risk future drilling locations on 40-acre spacing. Based on the 2013 program of 150 net wells, this inventory alone represents 12 years of drilling, while 10 years is generally considered a healthy inventory level. Furthermore, Athlon has identified an additional 2604 gross (2,060 net) vertical locations on higher-risk 20-acre spacing with initial results from pilot projects indicating well results similar to 40-acre spaced wells. This represents another 13.7 years' worth of drilling if all were to prove commercial.

All of the current production comes from the bread and butter vertical program. The company plans to drill 162 gross (150 net) vertical Wolfberry wells in 2013 and is expected post 63% (CS estimates) production growth in the current year and as the impact of horizontal program is felt next year, the production is expected to grow by further 57% (CS estimates).

Significant Horizontal Potential

Due to expected improvements in capital efficiency, industry activity in the Midland Basin has been increasingly moving to horizontal development in the last 2 years. The Fort Worth, Texas based company has acreage that is attractive for horizontal development. While ATHL will drill its first horizontal well in 3Q13, offset operators including Pioneer Natural Resources (PXD), Laredo Petroleum Holdings (LPI), and Apache Corp (APA) have experienced commercial success from the Wolfcamp and Cline Shales in Midland, Glasscock, Reagan, Martin, and Irion counties, where Athlon holds ~47,000 net acres.

Athlon has identified 931 net (1079 gross) horizontal drilling locations across its asset base, primarily in the Wolfcamp and the Cline. These locations are distributed as follows: Wolfcamp A (272 net); Wolfcamp B (317 net); Wolfcamp C (125 net); Cline (193 net); and Mississippian (24 net). The company estimates 444 MMBOE of net reserve potential from these horizontal locations, which represents 5.2x the year-end 2012 proven reserve base of 86 MMBOE.

To better understand horizontal development potential across its 4 main operating countries, ATHL plans to execute an eight well delineation program through 2Q14. Before year end 2013, ATHL expects to spud four horizontal wells between Midland and Glasscock Counties. The company plans to target the Wolfcamp B in Midland County with its first two wells. In addition, four horizontal well tests are expected in Irion and Howard Counties over 1H14.

Historically, the company has seen successful vertical development drilling in Howard and has drilled ~120 successful vertical wells in Howard to date. Horizontal activity in Howard County has been limited, which is the reason market will remain skeptical until further well results potentially de-risk the commerciality of about 52,000 net acreage. Horizontal potential in the Howard County will be very important for ATHL stock price performance; therefore, additional horizontal results coming out of Howard County are important potential catalysts for Athlon's shares.

Acreage Spread Across Midland Basin

Around half of Athlon's ~98,000 net acres are in the Howard County, where horizontal activity to date has been limited; however, the Country is important due to legacy vertical development. About 25% of company's land is distributed equally between Glasscock Country and along the Midland/Upton Country border. In both these areas, successful third-party horizontal results have been observed, and some operators are expected to move into development programs across multiple intervals. Rest of Athlon's acreage is largely spread throughout Martin, Irion, and Andrews counties. Industry results have been encouraging in all these areas.

Long Resource Life Compared To Peers

Athlon's asset base provides a long resource life and warrants premium valuation relative to its peers. Goldman Sachs (GS) estimates 484 MMBOE of total risked resource, including 86 MMBOE of year-end 2012 proven reserves and 398 MMBOE of risked un-booked resource, which according to 2014 estimated production, implies a strong resource life of 75 years for Athlon. This is considerably higher than both the Permian peer average of 59 years (74 years for LPI, 64 years for PXD, and 38 years for Concho Resources (CXO)), and the oily peer average of 46 years (GS estimates).

Source: Goldman Sachs

Valuation

As mentioned earlier in the article, the company long resourceful life warrants premium valuation relative to its peers. ATHL's resource life of 75 years is significantly higher than both the Permian peer average of 59 years, and the oily peer average of 46 years. But that is not it; the company also has stronger production and EBITDA growth outlooks and is boosting strong returns. ATHL's premium valuation reflects strength.

The company is trading at a price to earnings ratio of 50.0 compared to the industry average of 52.1. It has price to book ratio of 8.6 (industry 1.9) and price to sales ratio of 10.3 (industry 2.7). ATHL's price to cash flow ratio of 16.2 is also higher than the industry average of 7.2.

Management

A group of former Encore Acquisitions Company executives with substantial technical and operational expertise founded Athlon Energy in August 2010.The founding management has on average ~20 years of industry experience and a proven acquire and exploit track record in the Permian Basin, as well as, other North American resource plays.

Robert (Bob) Reeves - is the President, CEO, and Director of ATHL. Reeves, a co-founder of the company, has served as the President and CEO since the formation of the company in 2010. From February 2007 to March 2010, before Reeves founded ATHL, he was the Senior Vice President, Chief Financial Officer and Treasurer of Encore Energy Partners GP LLC, the general partner of Encore Energy Partners LP (ENP). From November 2006 to March 2010, Reeves also served as the Senior Vice President, Chief Financial Officer and Treasurer of Encore Acquisition Company ("EAC"). He also served as Corporate Secretary for both EAC and Encore Energy Partners GP LLC from May 2008 to August 2010. Prior to joining EAC, he served as Assistant Controller for Hugoton Energy Corporation. He holds a Bachelor of Science in Accounting from the University of Kansas. He is also a CPA.

Nelson K. Treadway - is a Senior Vice President of Business Development and Land and has been in this position since 2010. Prior to that, from February 2008 to March 2010, Treadway served as Senior Vice President of Land at both EAC and ENP. He also served as EAC's Vice President of Land from April 2003 to February 2008 and as ENP's Vice President of Land from February 2007 to February 2008. Prior to joining EAC, he was a landman at Coho Resources. Treadway received a Bachelor of Science degree in Petroleum Land Management from the University of Southwestern Louisiana.

William Butler - is the Vice President and CFO and has been in these positions since March 2013. From August 2010 to March 2013, prior to joining Athlon, Butler served as Managing Director for Stephens Inc. where he developed and led its exploration & production research practice. He has also served as the Vice Present and Assistant Treasurer of XTO Energy Inc. from June 2003 to June 2010. During his time at XTO, Butler raised more than $15 billion through 21 capital markets transactions, including public equity, senior notes and bank debt. From June 2000 to June 2003, Butler served at Stephens Inc. as an investment banker. He has a Bachelor of Science degree in Commerce from Washington & Lee University with special attainments in Business Administration and History.

Conclusion

We have a buy rating on Athlon. ATHL's 98,000 net acres across the Midland Basin in West Texas provide investors pure-play exposure to emerging horizontal development opportunities across multiple stacked intervals. Exploitation of these opportunities will be initially funded by cash-flow from legacy vertical operations, as well as, $293 million raised from recent IPO. ATHL's pure-play exposure to emerging horizontal development and its low-risk vertical Wolfberry drilling program offers a good foundation of production and cash flow growth for many years to come. Despite large expected growth out of the Basin, there aren't many opportunities to gain exposure particularly in the small cap stocks. Athlon Energy provides investor that perfect opportunity to gain exposure to the Permian Basin in the small-cap group.

Since its IPO in early, the stock is up by more than 13% and future horizontal delineation activity, particularly in Howard County, should provide further upside.

Risks

Poor drilling results particularly in the Howard Country by Athlon or other operators will not only adversely affect the production growth profile of the company but will also negatively impact the stock price and our thesis on ATHL. The potential for a correction in oil and gas prices is one of the biggest risk of investing in an E&P, therefore, volatility in the commodity prices presents another risk to our thesis on ATHL.

ATHL's horizontal program execution will likely be a focus of investors. The market will be watching ATHL's first few horizontal wells very closely. Even slight operational or mechanical issues while drilling and completing these wells could have negative impacts on share price.

ATHL could also face liquidity risk. If the company is unable to generate enough CFO and/or expand its credit facility, raise debt to finance planned acceleration of development, it will not only dent the company's growth profile but will also negatively impact its share price. Finally all of the company's production comes from the Midland Basin and should the production from the region be curtailed for any reason, it could impact ATHL materially.

Source: Athlon Energy: A Permian Pure-Play With Deep Drilling Inventory

Additional disclosure: Investors should consider this report as only a single factor in making their investment decision and do their own due diligence before taking the final decision. Plenty of research goes into writing our reports and a few examples include company documents, Morningstar, Yahoo Finance, Bloomberg, Reuters, and private reports. If you need any further information please do not hesitate to contact us.