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Summary

  • The shale boom has been ongoing for seven years now and as a result, valuations of exploration and production companies are quite high.
  • However, Approach Resources is one shale play that is still significantly undervalued.
  • Approach Resources’ low valuation is not justified given the increase in production, reasonable debt levels and the company’s shift towards oil from natural gas.
  • Approach Resources should be valued at around $60 per share, which represents substantial upside from current level.

The shale boom in the U.S. has changed the dynamics of the global energy market. The International Energy Agency and Bank of America have said in reports this year that the U.S. has already surpassed Saudi Arabia and Russia as the world's top oil producer. Bank of America even notes that the U.S. will maintain its position as the top producer for the remainder of 2014.

U.S. oil production has been boosted by new technology that has enabled companies extract oil and gas from shale rocks. Higher oil prices have also helped as it has made extracting oil from shale formation feasible. Interestingly, the shale boom has not been led by majors such as Exxon Mobil Corp. (NYSE:XOM) and Chevron Corp. (NYSE:CVX) but smaller and nimbler independent oil and gas companies such as Continental Resources Inc. (NYSE:CLR) and Pioneer Natural Resources (NYSE:PXD).

Indeed, if you want to play the shale boom, then you need to look at smaller independent oil and gas companies. However, the shale boom has been ongoing for almost seven years now, and as a result, valuations for most companies focusing on shale are quite high. But there are some value stocks still available. One such stock is Approach Resources Inc. (NASDAQ:AREX). Approach Resources is a pure Permian Basin play. But when compared to other companies focusing primarily on the Permian Basin, Approach Resources is a huge bargain.

Undervalued Compared To Other Permian Basin Plays

By any measure, Approach Resources is significantly undervalued when compared to other companies operating in the Permian Basin. I compared the usual ratios used to value oil and gas companies, which include EV/EBITDA, EV/Daily Production, EV/2P1, Price/Cash Flow Per Share2, and EV/PV-103. The other Permian Basin plays that I looked at include Concho Resources Inc. (NYSE:CXO), Pioneer Natural Resources, Diamondback Energy Inc. (NASDAQ:FANG) and Athlon Energy Inc. (NYSE:ATHL).

Company

EV/EBITDA

EV/Daily Production

EV/2P

P/CF

EV/P-10

Approach Resources

7.3

71

8.70

4.26

0.91

Diamondback Energy

19.3

292.7

73.9

17.6

4

Concho Resources

11.9

170.5

36.54

9.03

2.04

Pioneer Natural Resources

19.09

177.4

38.41

12.4

3.53

Athlon Energy

21.51

242

41.6

16.7

3.31

Based on these ratios, the average for the five Permian Basin plays is; EV/EBITDA-15.80, EV/Daily Production-190.7, EV/2P-39.83, P/CF-12, EV/P-10-2.76

The question is why Approach Resources is so significantly undervalued when compared to its peers.

Possible Reasons

The following are the possible reasons for Approach's low valuation. However, I will discuss in the next subsection why each of these reasons is not valid.

The first reason could be Approach's increasing capital spending. In the first six months of 2014, the company's capital spending was $194.94 million. At this pace, the company will meet its targeted capex of $400 million for the year. In 2013, the company's capex was $296.84 million.

Approach is boosting its capex at a time when there is growing concern about shale drillers' high capital spending and increasing debt. Bloomberg, in a report earlier this year, noted that debt levels of 61 shale drillers has almost doubled over the last four years even though revenue has gained just 5.6%. Speaking to Bloomberg, Virendra Chauhan, a London-based oil analyst with Energy Aspects, said, "The risk for shale producers is that because of the production decline rates, you have constantly elevated capital expenditures."

The table below shows Approach's capex and operating cash flows for 2011, 2012 and 2013, and the estimated capex and operating cash flow for 2014.

Year

Capex (Millions)

Operating Cash Flow (Millions)

2011

295.11

95.77

2012

297.41

90.58

2013

296.84

125.58

2014 (Projected)

400

170

As we can see, after keeping it steady for three years, Approach is boosting its capex significantly this year. The company will continue to outspend its operating cash flow4 through 2014. The negative free cash flow means that the company will have to finance the deficit through debt or equity. At the end of the second quarter, the company's total debt stood at $296 million, up from $250 million.

Another possible reason for the low valuation could be the mix of Approach's proved reserves. Approach primarily focused on natural gas until five years ago. Natural gas accounted for 77% of the company's proved reserves, while oil and NGLs made up just 23% five years ago. The sharp decline in natural gas prices in 2012 prompted investors to favor tight oil plays more than natural gas-focused companies. In fact, several natural gas-focused companies have shifted to tight oil in the last few years.

Why the Reasons For Low Valuation Are Not Justified

Although Approach's capex is expected to rise significantly this year, the higher spending is yielding results. In the second quarter of 2014, Approach's production was 1,286 MBoe or 14.1 MBoe/d, which represents a 58% increase over the same period in the previous year and a 19% increase over the previous quarter. Additionally, the company also raised its production outlook to 4,950 MBoe for 2014.

Clearly, Approach's increased spending this year is paying off. While the company's debt has increased 20% this year, it is still at reasonable levels. In fact, among the companies mentioned in the table, Approach's debt/equity ratio is the second lowest at 0.41. Pioneer's debt/equity ratio is the lowest at 0.39. Concho Resources has a debt/equity ratio of 0.70, Diamondback has a debt/equity ratio of 0.54, and Athlon has a ratio of 0.94. Even if Approach raises more debt this year, its debt levels should not be a worry.

When it comes to proved reserves, again Approach has been shifting from natural gas to oil. In fact, at the end of 2013 oil and natural gas liquids made up 69% of its proved reserves. Natural gas accounted for 31% of the proved reserves. The table below shows breakup of proved reserves5 at Permian Basin plays.

Company

Oil

Natural Gas Liquids

Natural Gas

Approach Resources

40%

29%

31%

Pioneer Natural Resources

40%

22%

38%

Athlon Energy

56%

24%

20%

Diamondback Energy

67%

15%

18%

Concho Resources

61.1%

-

38.9%

As we can see from the table, Approach's reserve mix isn't as bad as the stock price suggests. While oil accounts for 40% of the total proved reserves, the important thing is that the company is continuing its shift from gas to oil and natural gas liquids. In fact, as we can see above, Approach's reserve mix is not very different from that of the top player in the Permian Basin, Pioneer Natural Resources.

Approach Resources' operating margin6 is 28.40%, compared to Pioneer Natural Resources' 29.80%, Athlon Energy's 46.20%, Diamondback Energy's 49.70% and Concho Resources' 35.50%. The margins reflect the product mix at the companies. Diamondback Energy, not surprisingly, has the best operating margin as oil accounts for 67% of the company's proved reserves. Approach's operating margin though is close to Pioneer's, which has a similar breakup.

How Much is Approach's Value

I used different methods to come up with potential valuations for Approach and here are the results. The valuations are based on the average multiples for the five companies I have discussed.

EV/EBITDA

$47.70

EV/Daily Production

$60.78

EV/2P

$108.85

EV/P-10

$70

P/CF

$50.8

In my opinion, a realistic valuation of Approach is around $60. On August 27th, the stock had closed at $17.87. Even at $60, Approach shares would trade at 3.3x the book value, which is in line with the multiple for other companies operating in the Permian Basin. Indeed, Approach Resources looks like a huge bargain at current level.

Notes:

1-2P-Refers to Proved Developed and Undeveloped Reserves at the end of 2013

2-Cash Flow is the Operating Cash Flow for the Trailing Twelve Months as Per Data from Capital IQ

3-PV-10-is estimate of the present value of future net revenues from proved oil, NGL and gas reserves.

EV/EBITDA calculated based on data from Capital IQ

EBITDA is for the trailing twelve months

Data on Daily Production as per companies' press releases

4-Operating Cash Flow Projects based on half-year operating cash flows of $85 million

5-Reserve Mix as provided by companies in their 2013 annual report and investor presentations

6-Operating Margin Data obtained from Finviz.com

Source: Approach Resources Is Significantly Undervalued