With natural gas prices at a low, value investors have an opportunity to profit off of myopic behavior. From energy independence to environmental concerns, secular trends are all pointing favorably for natural gas. I also strongly recommend investors back smaller under-followed producers that have the potential to be bought out. As an investor relations consultant, I believe that Altex Industries (ALTX.PK) and Avalon Oil and Gas (AOGN.PK) will be put into play from improving media coverage. They are significantly undervalued and would help the major producers secure footholds on critical resources.
In this article, I will review the top natural gas companies and explain why they are undervalued. Exxon Mobil (XOM) is the largest, followed by Chesapeake (CHK). Devon Energy (DVN) is the fourth largest. I will first run you through my DCF model on Exxon.
First, let's begin with an assumption about revenues. Exxon finished FY2011 with $486.4B in revenue, which represented a 26.9% gain off of the preceding year. This also accelerated off of 23.4% growth for FY2010. Analyst model a 7% per annum growth rate over the next five years, and I view this as conservative in light of it being nearly 400 bps below what is expected for the S&P 500. But, for the sake of being safe, I accept the project.
Moving onto the cost-side of the equation, there are several items to consider: Operating expenses, capital expenditures and taxes. I expect cost of goods sold to eat 69% of revenue. I model SG&A trending from 11.3% in 2012 to 11% in 2017 while R&D holds steady at 0.5%. Capex is estimated to trend from 6.3% to 6%. Contrary to what some politicians would have you believe, oil and gas companies are among the highest taxed firms. How would you like paying 43% to the government? Well, that is the amount that Exxon will have to fork over.
We then need to subtract out net increases in working capital. I model accounts receivable trending from 7.8% to 7.3% of revenue over the next six years; 4.3% to 4% of COGS for inventories; steady 8.5% of OPEX for accounts payable; 32% to 35% of SG&A for accrued expenses.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 9% yields a fair value figure of $118.27, implying 36% upside.
Exxon may be the largest natural gas producer, but Chesapeake's growth has been nothing short of transformative:
"A 2% gas market share company in 2000, which was us, grew its production 472% over the past decade, while the other 98% of the industry, 49x bigger than us and represented by more than 10,000 other companies, only grew its collective production 12% during the past decade."
And from a multiples perspective, Chesapeake is cheaper by virtue of the spread between past and forward multiples. It trades at just a respective 11.5x and 8.6x past and forward earnings versus 10.3x and 9.8x for Exxon, and 14.8x and 10.2x for Devon. Assuming the multiple declines to 11x and a conservative 2013 EPS of $2.92, the rough intrinsic value of Chesapeake's stock is $32.12, implying 26.2% upside.
Investors have also been irrationally opposed to Chesapeake's CEO pay. Aubrey McClendon earned $21M in 2010. If his pay were distributed directly to shareholders in the form of dividends, they would receive slightly more than 3 cents per share. Put differently, if you had $1M invested in the company, you receive a check of only $1,245. That's about one-eight hundredth of your stake. If the pay encourages the CEO to work hard (I am sure it will), great. If it doesn't then it really doesn't hold back value. The CEO has built one of the strongest energy companies in corporate America - he ought to be rewarded for a job well done.
Investors are also dead wrong about the company's capital aggressiveness. Yes, the firm is aggressive with its investment; but, no, these investments are for the firm's long-term interest. McClendon transformed Chesapeake into a leading producer through demonstrating a willingness to take on risk, buy out undervalued assets, and accelerate growth. If the bears do not bail out now, they may very well be left drowning.
So, Exxon and Chesapeake are top investors. How about Devon? Devon similarly is undervalued. Management has delivered strong execution, particularly with its Sinopec deal. In fact, the venture was so successful that management has expressed interest in further ventures of similar nature. I anticipate that Devon will experience a repeat year of double-digit growth in liquids. Modeling a CAGR of 5.2% for EPS over the next three years and then discounting backwards by a WACC of 9%, the stock can go as high as $97.68.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.