Why Apache Stock Is Heading To $115

Jul.29.14 | About: Apache Corporation (APA)

Summary

Based on next year's estimates of $7.22, which drops the P/E down to 14, which is 5 points lower than the industry average.

Apache management continues to make the best out of a bad situation. But expectations have been raised.

On the basis of growing free cash flow and debt-adjusted production growth, these shares can command a fair-market value of $115, which still represents 13% premium.

With year-to-date gains of 19%, oil services giant Apache (NYSE:APA) has become one of the best stories in an energy sector that has posted gains of only 5% in 2014. The stock closed Friday at $101.85. And since Apache hit a year-low of $77.31 on Feb. 5 shares have surged roughly 32%.

The company reports second-quarter earnings Thursday. With such strong outperformance, investors want to know whether Apache has what it takes to energize their portfolios in the next 6 months, especially with the likes of Chesapeake Energy (NYSE:CHK) and Anadarko Petroleum (NYSE:APC) coming on its heels in the areas of exploration and production of oil and gas.

But beating rivals should be a secondary focus. What's more important, though, is to what extent Apache management can create value from the company's overseas energy assets. Management must also figure out ways to extract value from recent acquisitions and rededicate resources to drilling programs.

Doing these will avert fears about demand weakness and bring more stability to a business that have suffered amid high periods of volatility. On Thursday, these and other questions will be answered. But management must first deliver the numbers that affirms why this company continues to outperform its sector.

Wall Street will be looking for $1.65 in earnings per share on revenue of $3.64 billion. These numbers suggests year-over-year declines in both categories. While that's not the sort of performance presumed by a soaring stock, it does reflect the industry's overall struggles. Even then, Apache's results has stood out.

Consider, in the most recent quarter, Apache reported better-than-expected results even though expectations had come down considerably. Helped by higher prices for natural gas, revenue of $3.67 billion, despite being down 7% year-over-year, was enough to beat Street estimates of $3.62 billion. Investors should understand that unlike other sectors, revenue is not what drives energy. It is production outputs that sent the shares higher.

In that regard, Apache's production of oil and natural gas averaged out to 639,804 oil-equivalent barrels per day, or BOE/d. While this was not Apache's best quarter in terms of production, it did affirm that the worst was over. What's more, Apache's results outperformed that of both Chesapeake and Anadarko.

Equally impressive was that Apache was able to achieve this despite suffering from a slight decrease in crude oil prices, which registered at $101.03 per barrel, down 1.4% year-over-year. The good news is that the average realized natural gas price, which is measured in per thousand cubic feet (NMCF), was up almost 20% year-over-year.

These numbers demonstrate that management continues to make the best out of a bad situation. On Thursday, investors will want to see continued improvement. Expectations are now going to be raised, as evident by the recent popularity in the stock. But investors shouldn't ignore that this is still a highly volatile, commodity-driven industry - albeit one that is in recovery mode.

And with improved conditions in areas like Egypt, where Apache has some strong, albeit risky, assets, the future suddenly looks brighter for one of the best, and at times underrated, names in energy.

On Thursday, investors should want to see the extent to which Apache's strong cost controls can grow the bottom line. In the May quarter, Apache's lease operating expenses totaled $597.0 million, down 17.3% from $722.0 million. More than anything, this is what led to such a strong beat in earnings and why I've always considered Apache's management as one of the best teams in the energy space.

With the shares trading at around $101 and a P/E of 23, I'm not as in love with the stock as much as I was three months ago. But there is still value here, especially based on next year's estimates of $7.22, which drops the P/E down to 14, which is 5 points lower than the industry average.

On the basis of growing free cash flow and debt-adjusted production growth, these shares can command a fair-market value of $115, which still represents 13% premium.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Wall Street Playbook's energy sector analyst. Wall Street Playbook is not receiving compensation for it (other than from Seeking Alpha). Wall Street Playbook has no business relationship with any company whose stock is mentioned in this article.