Egypt has become a major focus of attention and sore point for Apache (NYSE:APA) investors due to political instability. At the company's recent investor day, CEO Steven Farris stated that he fielded more questions about Egypt than about any other single topic, highlighting the importance of the issue to investors. The company generates some 25-30% of its cash flow from Egypt, making a change of regime quite risky due to the possibility of higher tax rates or a confiscation of assets. Even with the loss of a substantial portion of Egyptian cash flow, the company remains at worst fairly valued and at best significantly undervalued, in my view, and the market does not need to recognize the discrepancy for investors to benefit over the long-term.
Recent political trends in Egypt are not giving investors much in the way of positive news. The country's recently elected parliament, dominated as it was by the Muslim Brotherhood, was dissolved by the nominal order of the country's high court, a move supported and enforced by the ruling military government. The dissolution occurred on the brink of a presidential election which some are saying was likely won by the Muslim Brotherhood candidate Mohammed Morsy. From Reuters:
...at least one electoral official privately endorsed Morsy's claim to be leading by 52 percent to 48 with the bulk of votes counted...
Further, the military government preemptively constrained the powers of the new president in a decree issued on Sunday June 17th as reported by Reuters. Seeing the possibility of both a Muslim Brotherhood controlled parliament and presidency, it is possible the military government put the brakes on the process to tilt the playing field in its favor. The Muslim Brotherhood suffered for decades under the rule of Hosni Mubarak, who was aligned with the current members of the military government and previously was Commander of the Air Force. Morsy himself was a political prisoner under the former regime so it should be clear that the two sides are diametrically opposed.
The ultimate risk to Apache is complex, but can be thought of in a few parts. The most direct risk is that a government controlled by the Muslim Brotherhood will be less friendly to Apache. The government could claim that the former regime was too friendly to international oil companies and nullify existing business arrangements. A related risk is that in the absence of what the population believes are fair elections, a new, more serious round of instability emerges, more to the tune of what has occurred in Libya or Syria. This could lead to an environment where it becomes impossible to continue producing oil as happened in Libya.
A bigger concern may be a continuation of the status quo because although the military government is providing a safe operating environment for Apache, Egypt is experiencing something of a financial crisis due to the uncertainty. As reported by Reuters, the country's balance of payments deficit increased to $11 billion in the first nine months of the current fiscal year, compared to half that in the prior fiscal year period. While $11 billion may seem a small number, it is significant in Egypt's case where foreign exchange reserves are about $15 billion and the country carries a single-B credit rating.
The country is currently attempting to negotiate an IMF program, but without political consensus it is unlikely to come into effect. If Egypt cannot raise additional hard currency, it may seek to keep a greater percentage of its oil sales by raising taxes on oil. Another possibility is instituting capital controls thereby prohibiting Apache from taking dollars out of the country.
In a previous article, I discussed the value of Apache as a whole. To summarize, the value ascribed to the company based on the then current earnings profile (essentially then current commodity pricing) was $120 per share. Having rebuilt the model, the value of the company remains broadly similar with one change driven by information coming from the recent investor day and another coming from slightly adjusted commodity pricing estimates. Apache is now projecting little growth in Egyptian production which should impact future returns on capital downward. Egyptian production is extremely capital efficient and projected growth there is worth quite a bit per share. Together, these factors have led me to conclude a fair value more in the area of $110 to $115 per share based on current estimates including Egyptian operations.
The aforementioned value estimate included a higher discount rate for Egyptian operations. While non-Egyptian operations are modeled to have a 5.1% real (inflation adjusted) IRR-based discount rate, the Egyptian portion was modeled at about 7%, or two percentage points higher. It may however be more insightful to value Apache excluding Egyptian operations and make a separate value estimate for that business. Investors wanting to learn more about the operational profile of the company can see the previous article and listen to the investor day presentation which is quite detailed and insightful; for this article, we will skip directly to the valuation which again excludes the Egyptian operations.
Based on actual 1Q12 results and analyst estimates for 2Q12 through 4Q12 earnings, gross cash flow excluding Egyptian operations should be about $6.9 billion. To help investors reconcile this level of gross cash flow with more commonly reported financial information, EBITDA would be about $8.7 billion at this level of gross cash flow. This compares to gross cash flow of $9.6 billion and EBITDA of $13.1 billion including Egyptian operations.
Gross invested capital of $83.4 billion is primarily related to fixed assets and the main adjustment that has been made other than removal of the Egyptian assets (close to $7 billion on a gross basis) is to inflation adjust historical fixed asset investment at a 4% rate. This rate is driven by a combination of general inflation rates across the economy and inflation in the underlying commodities: oil and natural gas. Due to a large number of recent property acquisitions at Apache, the stated balance sheet is fairly close to the current cost accounted balance sheet, and therefore the adjustment is relatively small.
Running the IRR, we find a rate of 5.2% which compares to a real cost of capital of 5.1%. In other words, Apache is basically earning the cost of capital on its non-Egyptian assets. This implies that the total value of the firm is more or less equal to the economic capital employed of $53.4 billion. After deducting liabilities from firm value including bonded debt, the present value of deferred taxes and other non-current liabilities such as asset retirement obligations, we find a per share equity value of about $93. In essence, it appears the market is discounting a complete loss of Egyptian earnings based on today's trading price of around $86 per share.
It is possible that either the market is undervaluing all oil and gas producers based on current earnings or that the model is faulty. To check this we can compare the calculated value for other E&Ps. One good comparative firm is Devon Energy (NYSE:DVN) because the asset base is similar, although Devon is tilted toward the production of natural gas and is in the middle of changing its asset base having recently sold a large number of assets and reinvesting the proceeds into undeveloped fields. This is reflected in what appears to be returns on capital below cost for the existing asset base. Even using the assumption that reinvested capital is at the cost of capital, or in other words, better than historical returns, Devon appears overvalued, in my view.
Anadarko Petroleum (NYSE:APC) has a similar production profile in terms of its liquids to natural gas split compared to Apache, although it is more heavily focused on higher risk opportunities such as offshore. Running the company through the same residual income model, it appears returns on capital are better than Apache's by about half a point, which is slightly above the cost of capital. Although not as seemingly overvalued as Devon, Anadarko appears to trade at a slight premium.
Taking EOG Resources (NYSE:EOG) through the same process, it is my view that the company has an IRR about 1 to 1.5 percentage points above the cost of capital and trades at a slight premium to fair value. In summary, by looking at three of Apache's peers through the same valuation process, it appears they all trade at fair value or above, quite in contrast to Apache.
The market is likely already discounting a relatively bad outcome for Apache's Egyptian assets perhaps even above the actual impact from a potential renegotiation of Apache's contractual rights there. In reality, even the worst case scenario is probably better than a full confiscation since the Egyptian government can accomplish much of the same economic impact with a rise in the tax rate from the current rate of about 48% without taking on the risk of actually operating the assets itself or further driving away foreign capital.
Some may say there is little catalyst for a change in market perception or the underlying situation in Egypt. However, the market does not need to suddenly recognize the full value of Egyptian cash flow for investors to benefit. Every year, Apache generates significant cash flow from Egypt which is largely reinvested in politically stable jurisdictions such as the U.S., Canada and Australia, a trend management expects to continue based on projected production growth included in the investor day presentation. Value will therefore accrete to shareholders over time regardless of market perceptions about Egypt.
Still, in an actual confiscation or tax increase scenario it is hard not to see Apache's shares suffering in the short-term meaning some investor fortitude will likely be required at various times in future. However there could be great opportunity here if the stock sells off significantly below what the existing business is worth. It would likely surprise a lot of investors for a major tax change to occur and the shares hardly budge to the downside and yet this could easily happen.
Another risk to discuss is the long-term price of oil and natural gas. The valuation is predicated on largely stable commodity pricing over the long-term. Without opening the debate on the fair price of oil or natural gas, it should be noted that if either performs significantly differently than the current futures have been performing, then the valuation will change.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in APA over the next 72 hours.