Despite a weak economic recovery in the U.S., a recession in Europe, and decelerating growth elsewhere (notably in emerging economies China, India, and Brazil), the S&P 500 has rallied 15% since early June. Low volumes helped encourage the rally.
Equity participation in the rally from both institutional and retail accounts has been lower than normal. U.S. equity mutual funds have experienced outflows of nearly $90 billion this year, while bond inflows have exceeded $200 billion. Under-invested money managers are looking to put money to work ahead of year-end, which for some is October 31. If funds continue to raise their exposure, the current rally could have further to go. Against this backdrop, we highlight some investments that have lagged their peers or the market this year, and where we see specific catalysts, which could propel them to catch up in coming months.
In my previous article "4 Health Care Stocks that could rally in end 2012", we looked at four stocks: Mead Johnson (MJN), St Jude Medical (STJ), Universal Health Services (UHS) and Eli Lilly (LLY). In this section, we will focus on companies in the energy sector.
Kinder Morgan Management (KMR)
Investment Thesis: KMR is a more tax efficient way to participate in growth at Kinder Morgan Energy Partners L.P. (KMP), and get paid 10% less.
Catalysts: Discount to KMP has blown out again to nearly 10%. The two issues are economically equivalent, though KMR is a more tax-efficient way to participate in growth at KMP.
Potential Investor Pushback: KMR always trades at a discount to KMP, and KMP has to issue a lot of equity in the next 12 months. KMR units were issued as part of the recent dropdown to KMP, which took a while to digest -- that period appears to be ending.
Valuation: In a perfect world, KMR would trade in lockstep with KMP. Currently, KMP yields 5.9%, while KMR effective yields 6.5%. Modeling 7% distribution growth at KMP equates to total return potential in the high 20%.
PDC Energy (PDCE)
Investment Thesis: PDCE is the best way to play one of the best oil plays in U.S. onshore in Niobrara, and offers best leverage to emerging Utica shale play.
Potential Investor Pushback: PDCE burned investors with its production guidance reduction on its 2Q conference call, having sold equity in 2Q12 to fund Niobrara acquisition. Investors are still concerned regarding the DJ Basin takeaway.
Catalysts: PDCE is expected to have the first horizontal Utica well in Guernsey County, OH online by mid-November. PDCE is also guiding 20% sequential production growth in 3Q and 4Q12.
Valuation: Trades at a 27% discount to "PD Plus" NAV vs. CS SMID-cap E&Ps at only a 2% discount.
Enbridge Energy Partners (EEP)
Investment Thesis: EEP is one of only two U.S.-traded companies that is investment grade rated, market cap over $8B, but yields over 7.5%. The re-focus on the Liquids (Crude Oil) segment combined with the coming boom in North American crude oil production should push the yield on EEP down as many of its announced expansions are cost-of-service arrangements with an implicit return for EEP.
Potential Investor Pushback: EEP has disappointed in the past -- recent pipeline ruptures raise operational questions. EEP is spending $300mm to upgrade older pipelines and is allowed to get a return on what would normally be maintenance capex. Distribution growth forecast is below sector average. This is true, but is it so low at 4% vs. 7% sector to justify a 150 bp discount.
Catalysts: There has been immediate equity overhang behind with recent the offering. EEP is bolstering its dominant position as transporter of Canadian crude (60%). EEP is well positioned to offer Canadian, Bakken producers optionality to deliver barrels to PADD 1, 2, and 3.
Valuation: I feel a 50 bp discount to the AMZX is justified given EEP's 2-5% distribution growth guidance. A target yield of 6.5% and $35 TP better reflects EEP's size and security.
Cobalt International Energy (CIE)
Investment Thesis: Cobalt is drilling $47/share un-risked of resource through 2013 with the value of currently found resources around $11-$15/share. With the stock trading well below the risked and un-risked value of resource to be drilled, there is a compelling risk reward on the stock in the short and medium term.
Catalysts: CIE is drilling at least 10 exploration wells and two appraisal wells over the next 18 months. It is announcing appraisal results likely in the next 30 days of the lower zone of Cameia #2, its significant oil find in Angola. This appraisal will help the market assess if there is extra resource possible on top of the estimated 600mboe in the main "super pay" zone. CIE is also announcing results of the North Platte well in the Gulf of Mexico before the end of the year, which is worth up to $7.50/share in a success case.
Potential Investor Pushback: Investor pushback is that the shares are already pricing in exploration success. Based on current price, the shares are valuing the chance of success in the next 18 months at 30%, much lower than the historical success rate of Cobalt over the past two years.
Valuation: Target price of $40 is slightly above the risked NAV of $36/share, as the market should ascribe some value to prospects scheduled to be drilled beyond 2013-2014.
Anadarko Petroleum (APC)
Investment Thesis: APC has an outstanding upstream portfolio, given long-term growth visibility through its giant gas discoveries in Mozambique, domestic liquids-rich growth opportunities in the DJ Basin, and exploration upside (domestic and international). In particular, the company has seen outstanding success in the Wattenberg, as it has successfully transitioned its program from vertical to horizontal wells. In order to narrow the discount relative to intrinsic value, I expect the company to monetize a portion of its stake in Mozambique, helping to crystallize the value of this significant asset. I feel the Mozambique asset has to be valued at $11/share on Net Asset Value (NAV) basis. However, based on the valuation for Cove, APC's stake could be worth closer to $15/share.
Catalysts: The Tronox Litigation has been a key overhang on the Anadarko stock, and could potentially be resolved near-term, given the conclusion of the defense testimony last week. In my view, a potential settlement could unlock significant value as APC trades at a wide discount to intrinsic value by eliminating investors' perceived tail risk associated with the litigation. The embedded USD2.75 billion litigation risk in the stock leaves management ample running room to settle the litigation above its estimated range of a zero to $1.4 billion loss while still insuring a favorable outcome for the shares. Another incentive for management to settle the litigation relates to tax benefits in contrast to a judgment, whereby APC could take a tax deduction if it settles the litigation.
Potential Investor Pushback: Investor pushback revolves around the uncertainty over the Tronox settlement price. At current prices, the stock is pricing in a USD2.75 billion litigation accrual, but the maximum potential judgment could be USD5 billion or higher. Meanwhile, there are no guarantees on settlement, and a decision by the judge could stretch into mid 1Q13.
Valuation: The stock is trading at a 30% discount to consensus NAV estimate of $107/share, compared to an average of 18% for its peers. This valuation gap should narrow if the company begins to bring value forward by monetizing its underappreciated assets, such as Mozambique. My NAV estimate could prove conservative, as it does not give value for ~$13 per share of incremental upside associated with Mozambique, the Utica Shale, Lucius, and the favorable outcome in its tax dispute with Algeria.