Why Hess's Spin-Off Is Exactly What The Firm Needs

| About: Hess Corporation (HES)

Hess Corp. (NYSE:HES) is a global energy company that operates in two segments, exploration/ production and marketing/refining. Last year activist investor Paul Singer began investing heavily in the company with the hopes of trying to get the company to streamline some of its operations. After repeated attempts to get the company to see things his way, Singer was finally successful. Earlier this month Hess announced that it had filed paperwork to engage in a tax free spinoff of its gas station/convince store operations into a new public entity known as Hess Retail Corp.

This move has all been a part of a larger strategic consolidation play. In the past year the company has divested some $7.8 billion in assets associated with its marketing and refining segments. Doing this has allowed Hess to become more of a pure exploration and production play. Additionally, it has provided Hess with the extra capital for it to boost its dividend and increase its current share buyback program while simultaneously working on the reduction of debt, that currently sits at $5.4 billion, down from $7.2 billion a year ago.

Below I have highlighted three main reasons why I think the Hess spin-off will actually create a stronger core company and ultimately create greater returns for shareholders down the road.

Increased Focus Core Business:

Hess is not the first company to spin off a business segment. Lately, it seems that spinning-off a business segment into its own separate entity or MLP is the new way that a lot of the major oil companies are extracting value from the firm. In the past 24 months investors have seen these types of spin-offs from Conoco Phillips (NYSE:COP), Valero Energy Corp (NYSE:VLO), and Marathon Oil (NYSE:MRO) to name a few.

Conoco spun-off its refining business into what is now called Phillips 66 (NYSE:PSX). Valero did both a spin-off and an MLP offering. Similar to the Hess plan Valero spun-off its retain gas and convince store business into what is now called CST Brands (NYSE:CST) and just recently went public with its own MLP called Valero Energy Partners LP (NYSE:VLP). Marathon Oil spun-off its downstream segment now known as Marathon Petroleum Corporation (NYSE:MPC).

Valero and Marathon doing these spin-offs has proven to be extremely profitable for the company and shareholders, while also helping the stock performance. Prior to the CST spin-off last May Valero was trading in the mid $30s when CST broke-off and went public at $28.50 per share. Since then both stocks have increased a great deal in value, with Valero now trading in the low $50s and CST trading as high as $36 per share earlier this month. Valero's MLP has also done very well in the short time it has been trading. VLP went public at $28 per share and now trades at $33 per share.

In the case of Marathon, after the initial spin-off Marathon's stock dropped down into the low $30s and has since seen its price move up only slightly to the mid to high $30 per share range, but the real value creation happened with the spin-off of MPC Holdings. MPC originally went public for around $37.50 per share and now trades for $85.25 per share, a 127% rate of return.

I think one of the reasons that these spin-offs are becoming so popular is because it allows the core company to really define and focus on what they are good at, while allowing their non-focus business segments to go their own way and establish themselves as market leaders, rather than being lost as some bullet point on a quarterly presentation. More importantly, as shareholders we benefit by receiving the two entities as separate stocks and being able to benefit from the continued growth of each independently.

Shale Potential:

Once Hess does spin-off its retail business the one area where it will have a great deal of opportunity is in the Bakken. In reviewing the annual and quarterly conference call transcripts Hess has been very successful in lowering its completion costs in the Bakken. This past quarter it brought costs down by $1.2 million, currently $7.8 million compared to $9 million the year prior. Hess has gotten very good at bringing additional wells online in a short period of time, which in turn has helped lower completion costs.

With the advent of the Bakken and the massive amount of opportunity that the oil field provides I think it makes perfect sense for Hess to sell off the divisions that do not directly correlate to the Bakken exploration and focus its efforts on further exploration and development there. In addition to the Bakken, Hess announced plans this last year to get more involved in the Utica shale exploration. The company plans to spend $6.8 billion on exploration and production of unconventional and conventional shale resources. The Utica shale well is in the Appalachian Basin and underlies much of the northeastern part of the county. The Utica well is getting a lot of attention as of late due to the large amount of natural gas, natural gas liquids, and crude oil that is present within the well. Current estimates put the Utica well at about 38 trillion cubic feet of natural gas, 940 million barrels of crude oil, and 208 million barrels of natural gas liquids.

John Hess, Chairman and CEO, said in its most recent quarterly statement, "Our Corporation's capital and exploratory budget for 2013 is focused on attractive investment opportunities and consistent with our plan, announced in July 2012, to significantly reduce overall expenditures in 2013."

As Hess continues to reduce its costs, while bringing on new wells in both the Bakken and the newly untapped Utica should continue to prove very profitable for the company and its shareholders. As these developments continue to advance with a continued focus on midstream operations it would not surprise me to ultimately see Hess roll out an MLP, similar to what Valero did.


Overall, I remain bullish on Hess, but I would be remiss to not mention some of the obvious risks that I see related to this stock and company as a whole. Midstream operations have a great deal of potential and could prove to be quite profitable, but only if the company is successful in monetizing those operations. If not, it could prove to be a major drag on any possible momentum that is coming out of its newly developed shale resources.

In conjunction with its midstream operations, offshore drilling is another area that is a bit of a wildcard in Hess' future. These efforts will greatly determine the future growth and profitability of the company. Even while the company decreases its spending efforts on exploration it is going to be a bit of a dual edged sword on how profitable or unprofitable those endeavors ultimately end up being.

Lastly, the biggest risk to the company is what I consider to be misguided leadership in the boardroom. Hess has been run by John Hess, the son of Leon Hess (prior CEO) for the past 17 years. John has a board of directors who most would consider to be a bunch of 'yes' men and basically allow him to do whatever he wants, when he wants to do it. Additionally, during 2008 when oil prices were approaching $150 per barrel, John was one of the biggest advocates of peak oil and believed that $150 was only the beginning. John continues to be obsessed with making Hess into the next Exxon Mobil (NYSE:XOM) or Chevron (NYSE:CVX), even though Hess is only a fraction of each firm's size. To try to accomplish this John has been successful in convincing the board to invest billions of capital in high risk international exploration opportunities that unfortunately have not panned out as well as he had hoped.

In addition to his high risk international expenditures, John Hess has been allowed to start his own hedge fund within the company that placed large bets on the price of oil increasing well beyond $150 per barrel. These bets have allegedly lost billions for the company. These types of actions coupled with a very compromising board sounds very familiar to me like the actions that were witnessed under the iron fist of Aubrey McClendon at Chesapeake Energy (NYSE:CHK).

Overall, if it was not for the action coming from activist investor Singer and the fact that the company has been increasing its buyback, dividend, and ultimately engaging in the spin-off of its retail division, I would not be nearly as bullish as I am on this stock's future and the opportunity that this spin-off will create.

Disclosure: I am long HES, COP, VLO. 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.