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By Henry Hoffman

Often analysts refer to getting a part of company at a discount or even “free” citing a sum of the parts (SOTP) analysis in which they assign multiples to the other business segments. The logic goes something along the lines that if you assume business segments X and Y are worth as much as the whole company’s market valuation then you are getting business segment Z for free, even though it’s clearly worth something, right? Well, of course it all depends on what multiples you put on which business segments, and, as you can imagine, there’s a bit of ambiguity in so doing. This is illustrated by analysts having different multiple derived price targets on a pure play company, which all are often different from the market’s price. Hence, it’s not uncommon to overpay for a so called free business when relying of such SOTP analysis.

T hat being said, Williams Companies’, listed on the NYSE under symbol WMB, large ownership of publically traded Williams Pipeline Partners offers an opportunity to buy the 10 largest E&P in the U.S for relatively next to nothing. Going long WMB and short WPZ gives you an E&P business with a 4.8 trillion cubic feet of proved reserves of natural gas and another 10Tcfe of probable and possible but unproven reserves for almost free, along with an almost perfect hedge, and a synthetic call option on the short WPZ position through WMB’s general partnership ownership to help offset a strong performing short. Let me preface by saying that a minimal amount of multiple based valuations will be utilized in this SOTP examination.

Williams Companies owns 214.6M LP units (76%) of Williams Pipeline Partners L.P, which trades on the NYSE under symbol WPZ and closed today at $46.22 per share. This alone provides a publically valued security worth $9.9B to parent company WMB, which is currently valued at only $13.8B at market close of $23.61 today (November 11, 2010). Additionally, Williams Companies is the General Partner for WPZ and therefore partakes in a portion of the distributions to the tune of $217 million, for its 100% GP interest, in estimated cash flow for next year. MLP GP interests currently change hands for around 15x forward year cash flows, which puts WMB’s GP stake at $3.25 billion. This puts WMB’s interests in WPZ at roughly $13.2 billion dollars and yet WMB stock reflects little additional value. So what’s left that that you are buying for a measly $350 million? Well, you’re buying the 10th largest E&P in the country along with a Gulf of Mexico (NYSE:GOM) and Canadian pipeline assets that generate around $200M/year in recurring profits, although you do get balance sheet and corporate expenses too. Adjusting for the other business segment, corporate expenses and WMB’s balance sheet we calculate (shown below) that Williams Companies’ E&P business is valued by the market at just $2.7 billion. We think it’s is actually worth $9 to $24 billion, even with sustained low natural gas prices.

We particularity like this trade because of the opportunity the market offers following WMB’s dropdown of MLP assets into publically traded Williams Partners (WPZ). When announcing the restructuring, management argued it would provide both companies with better access to capital, which it has, and also get the market to recognize the value of WMB’s assets, which it hasn’t. However, the restructuring has provided the ability to strip most of the risks of the performance of Williams Pipeline Partners by shorting WPZ. Thus allowing one to buy the E&P assets of WMBs at enormous discounts to what we believe it is worth by purchasing WMB’s stock. In essence, the market is providing the opportunity to take advantage of different investor bases and different market sentiment for various classifications of equities for the same underlying cash flows and assets. Even better, WMB management has demonstrated a desire to reflect the value of WMB to the market by first dropping down assets into WPZ and is now realizing that value by diluting themselves out of WMB’s significant WPZ stake at market multiples for MLPs by continuing to drop down assets into WPZ, while all along benefiting from the upside to the GP interest. This happens as WMB receives cash from the transaction immediately as WPZ’s assets and liabilities increase sourced by increases in debt and equity (typically 50/50 for MLPs). What results is a smaller percentage interest for WMB in a larger WPZ market capitalization, cash for WMB, and again, increasing WPZ distributions from their 100% GP interest.

Why Williams Companies is stock so unloved vs Williams Pipeline Partners? We think WMB is somewhat overlooked stock, which recently has been exacerbated by the apathy shown to the natural gas E&P sector due to low natural gas prices. Thus the market has put a much lower multiple on WMB’s cash flows while it has rewarded the “safe”, tax advantaged yield of WPZ in step with other MLP stocks. Even investors who are bullish on natural gas E&Ps would likely favor a pure play and WMB’s significant WPZ stake makes it a bet on boring pipelines and MLPs which has been a common reason given by friends working for at large long-only shops (as they can’t hedge out WPZ). For MLP investors, a tax sensitive and yield seeking class, you would not be enticed by WMB’s much lower dividend yield that lacks the advantages of the MLPs structure. To us, it’s appears WMB has the characteristics of an orphan stock, thus presenting a great opportunity to take advantage of diverging market sentiment on the same underlying cash flows.

WMB holders may not need to wait for the market to see the value in its E&P assets. Management is actively unlocking value. Though unnoticed they are exiting their position in WPZ. Over time it is disadvantageous for WMB to hold a large ownership of WPZ as it negates the tax advantageous of the MLP structure. The cash flows passed up to WMB from WPZ would then be taxed at the typical corporations rate, which is similar to what many MLP investors would pay, but would then be taxed again when returned to shareholders through dividends or increased share price. Therefore, it makes sense for WMB to divest itself of its significant stake in WPZ. We believe that Williams Companies management will do this by diluting themselves out over time through equity offerings of WPZ at current premium prices and additional dropdowns, in which WMB receives cash for a lowered stake in the WPZ. The substantial dropdown of pipelines into WPZ earlier this year and the resent dropdown of WMB Midstream Piceance assets illustrates managements plan and committed to execute it. However, we would expect WMB to keep its GP interest and continue to receive a stable stream of cash which flows right to the bottom line.

Despite all the reasons we’ve laid out for this pair trade, it is not crowded. In fact, less than 2% of the float of WPZ is short. However, this is not too surprising given short sellers distaste for shorting stocks with large dividend payouts.

Below we include a brief summary of our Sum of the Parts Analysis for Williams companies’

Williams Companies’ Williams Pipeline Partners Interest

The LP interest:

First and easiest calculation is WMB’s ownership of WPZ. Since this is a pair trade and we are short WPZ to strip out its performance out from WMB’s stock, this important valuation is simply WMB’s LP interest multiplied by WPZ’s current market price. Williams companies’ owns 214.6M shares of WPZ which is trading at $46.22/share thus the public market is placing a valuation of their Williams LP stake at $9.9B.

The GP units value:

WMB owns 100% of the GP units in WPZ. These units earned 200M in 2009 and are expected to earn 217M in 2010. As this income comes at virtually no expenses and requires no equity, we apply a 15x multiple. This gives $3.25B. Adding comfort is the fact that the GP units split the income 50/50 with the LP beyond the required distribution. So long as WPZ performs well, WMB should do just as well. And if WPZ runs into trouble, well you’ll be short the stock and WPZ’s distribution is a healthy margin above the rate at which the GP’s interest would come under pressure.

Canadian Midstream and Other

This business includes Pipeline transportation in Canada as well as interests in a pipeline in the Gulf of Mexico they have not yet dropped down into WPZ. Additionally, it includes the production of ethylene, propylene and NGLs in GOM and Canada, NGL fractionation and storage and marketing services. Using average segment profits expected over 2010-2012 & a tax rate of 35%, a conservative multiple of 12x values this business at $1.4B, which we believe is reasonable.

Segment Profits - Company Guidance

2010E

2011E

2012E

Avg

Segment Profits - Recurring Guidance

Low

$175

$160

$210

$182

Segment Profits - Recurring Guidance

High

$190

$220

$285

$232

Estimated Valuation

Average expected annual profit '10-'12

Average expected annual profit '10-'12

$182

$207

$232

Pure play earnings multiple

Multiple

12x

$2,180

$2,480

$2,780

14x

$2,543

$2,893

$3,243

16x

$2,907

$3,307

$3,707

GOM, Canadian Midstream & Other

$1,417

Assumed tax rate

35%

Corporate expenses and balance sheet liabilities:

Corporate expenses run about $165 to $180 million a year. We arrive at a value of negative $1.6 billion after adjusting for the tax benefit and assigning a market multiple of 14x.

WMB’s parent company balance sheet: LT debt ex WPZ and other liabilities account for $3 billion, and another cost of $500M for Marcellus acreage is offset by $580M after-tax gain from Piceance dropdown. WMB has another $1.5B in net working capital, investments and other assets. Overall, we approximate their balance sheet to have about $1.5B in net liabilities ex a $3.7B tax liability. There is a debate how to treat the tax liability since is can easily exist in perpetuity and even grow for a growing E&P. Thus suggesting little to no negative value should be assigned to this liability. In our base scenario we project it is realized far in the future and discount it back to a present value of only $500M. Thus, we value the balance sheet to remove about $2B of value.

So what is the E&P business worth?

WMB E&P business is the 10th largest natural gas producer in the U.S. The diversified portfolio is predominantly owned and long-dated leases so WMB is not under pressure to drill uneconomic wells to hold leases like so many other E&P companies today. Management has demonstrated a focus keeping costs under control through prudent land acquisitions and operation efficiencies earning them the title of the 4th ranked in lowest production costs averaged over the past 5-years. Both of these traits give them flexibility around capital expenditures and the ability to ramp up production quickly if/when natural gas prices improve.

They just spent approximately $700M for 97,000 acres in the Marcellus. Based on other recent acquisitions, we’ll assume that’s an appropriate price: $700M

Below is a table showing resource potential and full costs of releasing the resources in WMB’s shale plays:

Downside Scenario for natural gas prices

$4.00

Upside Scenario for natural gas prices

$8.00

**2009 YE 3P

Piceance Valley

Piceance Highlands

Powder River CBM

Barnett Shale

San Juan Mesa Verde

Proven Reserves (Bcfe)

3,554

411

304

210

467

PDP

1,638

145

PUD

1,916

266

Probability of recovery

90%

90%

90%

90%

90%

Risked PDP

1,474

131

-

-

-

Risked PUD

1,724

239

-

-

-

Unproven Reserves (Bcfe)

1,977

5,260

-

-

-

Probable

562

2,528

Probability of recovery

50%

50%

50%

50%

50%

Risked probable

281

1,264

-

-

-

Possible

1,415

2,732

Probability of recovery

10%

10%

10%

10%

10%

Risked Possible

142

273

-

-

-

Risked

Total Proven

3,199

370

304

210

467

Total Unproven

423

1,537

-

-

-

Total

3,621

1,907

304

210

467

NYMEX Gas Price (3yr avg market)

$5.41

$5.41

$5.41

$5.41

$5.41

Basin Differential

-$0.20

-$0.20

-$0.22

-$0.13

-$0.22

Liquids Contribution

$0.32

$0.36

$0.00

$0.00

$0.00

Transportation, Fuel, & Other

-$0.40

-$0.45

-$1.55

-$1.59

-$1.02

Production Taxes

-$0.31

-$0.31

-$0.47

-$0.28

-$0.38

Lifting Cost

-$0.25

-$0.04

-$0.79

-$0.54

-$0.44

Drilling & Completion Cost

-$1.39

-$1.74

-$0.75

-$1.21

-$1.12

Total Costs

-$2.23

-$2.38

-$3.78

-$3.75

-$3.18

Net Cash Margin - based on stress case

$1.77

$1.62

$0.22

$0.25

$0.82

Net Cash Margin - based on 3yr avg market

$3.18

$3.03

$1.63

$1.66

$2.23

Net Cash Margin - based on upside scenario

$5.77

$5.62

$4.22

$4.25

$4.82

Value of Reserves in Downside Scenario

Value of Resoures

$profit/mcfe

Proven (millions$)

Potential Value

Risked Adj Value

Powder River

$0.22

$67

$308

$0

Piceance Valley

$1.77

$5,662

$747,825

$748

Piceance Highlands

$1.62

$598

$2,484,115

$2,484

San Juan

$0.82

$383

$0

$0

Other

$0.70

$0

$0

$0

Mid-continent

$0.70

$147

$0

$0

Marcellus

$1.00

$0

$300

$166

Marcellus (recently acquired)

$1.00

$0

$1,200

$500

Total

$6,856

$3,233,748

$3,898

Total Adj Value

est additional costs

-588

-1218

Proved value

$6,268

Risked Unproven value

$2,680

The above analysis uses the downside scenario of $4 flat natural gas curve and arrives at a E&P valuation of $9B. In our base case scenario, using $5.40 natural gas suggests the E&P business could be worth $18B. Interestingly, Chevron’s recent acquisition of Atlas Energy in the low cost Marcellus valued placed a greater than $5 per proven mcfe of natural gas. This would value WMB’s low cost proven reserves above $24B.

Sum of the Parts

E&P business discount

WMB price

23.61

WPZ + WMB BS+Other

$19.06

Market's assumed E&P Price

$4.55

E&P Proven

$10.73

discount to proven

57.6%

E&P Unproven

$4.59

Total E&P

$15.32

E&P's discount

70%

Disclosure: Author long WMB and short WPZ

Source: Williams: Pair Trade Offers E&P Business at Huge Discount to Net Asset Value