Devon, Chesapeake Ideal Natural Gas Plays Over Cabot

 |  Includes: CHK, COG, DVN, EOG
by: Takeover Analyst

Despite a disappointing 21.4% miss in the first quarter, Cabot Oil & Gas (NYSE:COG) has gained 36.3% over the last three months. The general performance has been strong, with management beating expectations by an average of 6% during the last three quarters. Like many oil & gas companies, the company has negative free cash flow due to heavy capital expenditures that are rising from the $850M range. At 17.2x 2011 operating cash flow, the company also isn't cheap before land acquisitions are taken into account.

The company is now valued at its target price, which appears somewhat high by my estimates. Assuming EPS grows 25%, 2016 EPS will be around $1.84. Even if the multiple is 35x, the future value of the stock comes out to $64.40. That means a $40 price target when you discount back annually by 10%. It's hard to justify a 35x multiple in an industry that is ripe with generous dividend yields and low multiples.

Devon Energy (NYSE:DVN) is one alternative that is worth a look. It trades at a respective 10.9x and 9.1x past and forward earnings, with a price target 45% higher than the trading value. Aside from liquidity being fairly strong at a quick ratio of 1.4, Devon has attractive natural gas exposure. As I have explained earlier here, the secular trends in the industry are both positive and substantial. The exposure to the Permian Basin is a particular catalyst in light of the expectation for 30% oil growth in 2012. The 1Q12 miss of 27.1% was, however, devastating after soft performance in the preceding four quarters. At the same time, the 18.9% decline over the last three months appears to be overblown.

The Permian Basin isn't the only catalyst that Devon has going for it. The company is developing the Barnett Shale and has been so pleased with the result that it is increasing exploration. Like other companies willing to take a contrarian approach, Devon has unabashedly sought natural gas investments over diversification.

Assuming EPS grows 7.9% annually, 2016 EPS will be around $8.47. At a 12.5x multiple, the future value of the stock is north of $100. Discounting backwards by 10% yields a present value of $65.74 per share. While this provides less than the 20% margin of safety recommended for value investors, it is still decent considering that analysts aren't bullish enough about natural gas.

EOG Resources (NYSE:EOG) is more expensive than Devon, but far cheaper than Cabot. It trades at 1.8x book value and is currently rated near a "buy". The target price on the company is $124.26. If EPS hits $12.44 by 2016, a 12.5x multiple would put the future value at $155.50 per share. Under those assumptions, the current target price would only be justified if the discount rate was a very low 4.5%. At a more reasonable 10% discount rate, the present value of my 18.6% growth assumption would be just 8% higher than the current market value. This is not worth the risk of investing in a company with a low quick ratio of 0.9.

By contrast, Chesapeake (NYSE:CHK) is both cheap and highly valuable. It is valued at only 7.4x past earnings and 30% less than book value with a 2% dividend yield. Assuming 15% EPS growth on top of the $1.70 EPS expected in 2013, 2016 EPS will be $3.42. A 12.5x multiple would put the future value at $41.04 per share. Discounting backwards by 10% yields a fair value of $25.50 per share - in-line with consensus. It would take nearly a 15% discount rate to make Chesapeake's current value justifiable. I thus strongly recommend opening a long position in the second largest natural gas producer. This long position should be complemented with additional ownership in Devon.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CHK over the next 72 hours.