- Healthy production prospects and improved capital efficiency should drive strong cash flow generation.
- Free cash flow should turn positive by 2015/2016.
- Conservative DCF model suggests a 20%+ upside.
- Valuation multiple should expand on higher visibility for deleveraging potential.
Share price of Kodiak Oil & Gas (NYSE:KOG) has risen by 72% over the past 12 months, significantly outpacing a 19% return for the S&P 500 index. In my view, the shares still offer great value at the this level, as it appears the company's improving cash flow outlook is underappreciated by the market, and the current stock price is trading below my intrinsic value estimate.
KOG has been a solid cash flow generator. Over the past 3 years, the company has managed to grow its operating cash flow margin from 45% in 2011 to 61% in 2013, primarily due to production growth and continued improvement in capital efficiency (i.e. cost per production). Given that most of KOG's acreage is currently held by production, it is expected that costs per well/production are expected to decline over time, while production will gain momentum. In my view, these dynamics should drive up operating cash flow margin, which should even exceed its record level of 67% seen in 2012, as current well costs at $10M is notably below $12M in 2012, and it is forecasted to drop to $9M in 2014, according to management. Moreover, management has provided capex budget of $940M for 2014, which is in line with the actual level at $1B in 2013 (additional $0.8B was mainly due to the acquisition of Liberty). I expect capex to remain somewhat flattish over the next few years given that most of KOG's assets are in production stage and management will likely focus on deleveraging, rather than pursuing major acquisitions.
I have performed a conservative analysis to estimate the free cash flow breakeven point. My calculation started with current consensus revenue estimates, which predict KOG's top line to reach $1.82B by 2016. I applied a 2.5% haircut on these revenue estimates, resulting in a revenue forecast of $1.77B in 2016. I then assumed the operating cash flow margin to stay flattish at 61% through 2016, which is consistent with the actual level in 2013. Based on management's capex budget of $940M for 2014, I assumed a capex of $950M for 2014, and applied a 2.5% annual growth rate through 2016. Even with these conservative assumptions, free cash flow will turn positive by 2016 (see chart below). Further, management continues to evaluate down-spacing programs at Polar and Smokey regions, which has seen favorable initial results. I expect additional cash flow upside to materialize, should the test end up successfully.
I also built a DCF model to gauge various assumptions that are currently embedded in the share price. The following assumptions were used in the model (see chart below):
- Similar to the free cash flow breakeven analysis, I applied a 2.5% haircut on the consensus revenue estimates from 2014 to 2016. Revenue growth rate was assumed to quickly decelerate to 3.0% by terminal year (i.e. 2019).
- I assumed that the operating cash flow margin to slowly expand by just 1% per annum. Thus, the margin will rise to 67% by the terminal year, which is in line with the record level in 2012 and below my expectation that operating margin should exceed historical level over a near term.
- Based on management's 2014 capex budget of $940M, I used a slightly higher capex at $950M for 2014, and assumed a 2.5% annual growth rate through the terminal year.
- Terminal value was calculated based on estimated operating cash flow and a forward EV/Operating Cash Flow multiple assumption of 7.0x, which is lower than 7.4x that KOG is currently trading at.
Given the above and a 12.5% WACC, I estimated a share value of $16, representing a 21% upside from the current level at ~$13.4. As a reminder, the assumptions used in the model are fairly conservative, in my view, especially for the operating cash flow margin. According to the sensitivity tables shown below, it seems KOG's current valuation has a fair margin of safety. With an extreme assumption mix of 15% WACC and 60% terminal-year operating cash flow margin, the stock price would be $11.4, representing just a 14% downside.
On a relative basis, KOG's valuation also looks cheap. The stock trades at 5.2x consensus estimated 2015 EBITDA and 12.7x consensus estimated 2015 EPS, both of which are at an average discount of 8% to the average level of KOG's Bakken peers. Given KOG's superior consensus long-term EPS growth estimate (33% vs. peer average at 23%) and the company's high-quality Williston Basin assets (e.g. contiguous lands, lower cost per well trend, great potential for down-spacing), I believe KOG should reasonably command a premium valuation over peer average. I understand that KOG's high leverage has been dragging on the share valuation. As demonstrated earlier, the company would generate positive free cash flow by 2015/2016, and deleveraging should follow. Hence, we should see valuation multiple expansion as the market gains more visibility on the cash flow potential going forward.
In conclusion, it appears KOG's heavy debt load is still weighing on the share valuation, provided that both of my absolute and relative valuation analyses are pointing to a higher stock value. Given that free cash flow will likely turn positive in about 1-2 years, I recommend buying the shares now before the market fully recognizes KOG's cash flow potential.
All charts are created by the author, and data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified