Apache: Risks Are Well Discounted

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 |  About: Apache Corporation (APA), Includes: ECA, EOG, LNG, RDS.A
by: Timothy McIntosh

The energy sector should always have a prominent place in any investor's portfolio. As I wrote about in my focus article on the energy sector, the sector has maintained the third-highest return (10.54%) of any major sector since 1986. The sector also maintains a high degree of inflation protection and has a very low cross-correlation with the other major sectors. My first candidate within this compelling sector is Apache (NYSE:APA) Apache's share price has fallen 8% this year after a 23% price decline in 2011. Apache stands out within the sector not only for its low historical valuation, but also for its dominant market position in exploration, high level of international sales, excellent sales per share expansion, and increasing dividend growth.

As a review from earlier articles, here are my nine key criteria for consideration;

Key Selection Criteria - Energy

  1. A market capitalization over $10 billion.
  2. A leadership position within a growing industry.
  3. A dominant, or large, market share within its product mix.
  4. A strong position internationally, especially in emerging markets.
  5. A strong balance sheet and high credit rating.
  6. A high free cash flow number.
  7. A low historical relative valuation as measured by price/sales and/or price/cash flow ratio.
  8. A strong dividend growth rate.
  9. A catalyst of new revenue opportunities.

Firm Description & Capitalization

Apache Corporation, an independent energy company, explores and develops natural gas, crude oil, and natural gas liquids throughout the world. It has exploration and production interests in the Permian, Central, Gulf of Mexico Shelf, Gulf of Mexico Deepwater, and Gulf Coast Onshore in the United States; British Columbia, Alberta, and Saskatchewan provinces in Canada; Egypt; offshore Western Australia in the Carnarvon basin; offshore the United Kingdom in the North Sea; and in the Mendoza provinces of Argentina. Apache currently has a market capitalization of $32.2 billion.

Leadership

Apache has maintained a leadership position in oil and natural gas development for over a decade. Apache is unique in the fact that it is more of a development company instead of an exploration company. Thus the company has taken a safer route to meet internal goals. It has historically purchased assets from other energy firms and developed these fields more efficiently. The firm has an excellent price discipline for acquired assets and generally funds purchases through cash flow. The firm maintains one of the best balance sheets within the industry.

International

Apache's International Sales

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U.S. Revenue Intl./ %Total
2011 4134M 7686M/65%
2010 2683M 6358M/69%
2009 1922M 4166M/67%
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International revenue has remained a large portion of Apache's revenue for the previous decade. It generally has accounted for two thirds of total revenue. Although Apache's North American growth prospects currently outweigh international, foreign sales will continue to be a large portion of Apache's revenue for years to come.

Balance Sheet/FCF

FCF Debt/Equity
2011 2896M 0.24
2010 1804M 0.35
2009 593M 0.31
2008 1093M 0.29
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In April 2012 Standard & Poor's Ratings Service assigned a 'A-' rating

to Apache Corp.'s new senior unsecured note offering. The oil and

gas exploration and production company utilized the proceeds from the offering to finance the $2.2 billion cash portion of the purchase price of its acquisition of Cordillera Energy Partners III LLC. The 'A-' rating and stable outlook on Houston-based independent exploration was reaffirmed. S&P wrote "Apache Corp. rating reflects a large, geographically diversified reserve base, balanced exposure to natural gas and crude oil, favorable multi-year reserve replacement and production trends, and "modest" financial risk profile. Apache has funded most of its acquisitions in the past from cash flow, utilizing debt when necessary. As the table above demonstrates, Apache's debt ratio has actually declined since 2008 despite some large acquisitions. Its free cash flow continues to advance off the bottom of 2009. Free cash flow is also much higher than in 2007, the year before the capital markets collapsed. Free cash flow in 2007 was only 875M, less than a third of 2011's level.

Relative Valuation

As for relative valuation, Apache is trading toward its lower range in history in terms of both sales and cash flow. Apache has traded at a price/sales ratio range of 1.8 to 4.2 over the preceding decade. The highest price/sales ratio in the past decade occurred in March 2008 (4.2).

Date Price/Sales Ratio Sales Per Share
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Sept. 30, 2012 1.8 45.35
Sept. 30, 2011 2.0 43.94
Sept. 30, 2010 3.3 31.59
Sept. 30, 2009 3.1 25.60
Sept. 30, 2008 1.8 37.01
Sept. 30, 2007 3.7 29.96
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The average price/sales ratio since 2002 has been 3.03. Sales per share for Apache has averaged a compound growth rate of 8.7% Remarkably, Apache has grown sales strictly through production growth and acquisitions. Apache has not grown its sales per share by buybacks, as it has utilized cash for internal growth. At the current pace in sales per share growth, Apache could present investors with sizeable capital gains. Based upon a return to a 3.05 price/sales ratio, my expected price for Apache would be $177 a share within a three year time frame.

2015 SPS Projected 58.25
Price/Sales 2015 3.05
Target Price $177.66
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Apache is also trading at a historical low price/cash flow ratio. The ten year range has fallen between 3.3 to 8.2 Currently, Apache is trading at the very low end of this valuation spectrum. On a free cash flow yield basis, Apache is now trading at a 7.5% FCF yield.

Dividends

The Board of Directors of Apache announced in February that it had raised the regular quarterly cash dividend on the company's common shares to 17 cents per share, an increase of 13 percent. The CEO of Apache commented "Apache's Board of Directors decided to increase the dividend based on the company's strong future growth prospects and financial position. Apache earned more in the first three quarters of 2011 than in any other full year and is on track to extend production growth to 31 out of the past 33 years. With a balanced mix of oil and gas producing assets and a deep inventory of growth projects, we have confidence in Apache's future," Apache has a strong historical record of paying dividends and now marks 48 consecutive years of payments since 1965. Although Apache's dividend remained stable at $0.60 cents a share from 2007 to 2011, the company has demonstrated the ability to substantially raise dividends during good economic times. From 2004 to 2007, Apache increased its annual dividend payment from $0.26 cents a share to the aforementioned $0.60 cent level. In fact, despite the respite in dividend growth during the financial crisis, Apache has raised its dividend by an annualized 13.2% since 2002. Thus I feel confident that the company will continue to raise dividends at an above-market double-digit level in the next five years.

Future Catalysts

Apache's primary growth methodology over the past decade has been prudent acquisitions of previously developed assets or land. In the past two years, the company has gone on an extended buying spree. In 2010, its bought rival Mariner Energy for $2.7 billion. The Mariner deal continued Apache's extension into deepwater projects in the Gulf of Mexico. As important, the acquisition also increased its onshore capabilities in the Permian Basin in West Texas and New Mexico. In that same period, Apache also acquired Devon Energy's oil and gas assets in the Gulf of Mexico for $1.05 billion. In 2011, Apache purchased Exxon Mobil's assets in the North Sea, including the Beryl field for $1.75 billion. Apache had previous experience in this area as in 2003 Apache bought BP's Forties field in the North Sea for $630 million. Although considered "tapped out" at the time, Apache typically was more successful at bringing production up at these legacy assets. Apache expects the same results for the Beryl field assets. This year, Apache acquired privately held Cordillera Energy Partners for $2.8 billion. The purchase gave Apache access to 254,000 acres of potential energy reserves in the Granite Wash, a region along the Texas-Oklahoma border. It now maintains large weights in the Permian Basin, Anadarko Basin, and the Gulf of Mexico. With the Mariner acquisition, Apache retains a leadership position in the deep water market of the Gulf. The company announced this summer that it was the high bidder on 90 shelf and deep water blocks in the Central Gulf of Mexico offshore lease sale held by the Bureau of Ocean Energy Management. Of the 56 companies submitting bids for Gulf of Mexico acreage, Apache indicated it was ranked No. 1 overall for its 61 high bids on the shelf.

In addition to the new deep water projects in the gulf, the Permian Basin also is a large part of Apache's growth plans over the next decade. Apache's total investment in the Permian Basin has increased to $1.9 billion in 2012 from $400 million in 2010. Much of the growth is coming from the new technology creating horizontal wells. During Apache's investor day, Vice President Rob Johnston noted in 2008 the company only used rigs that drilled vertical wells. Today, all but one of the rigs operating in the central region are horizontal. Over the past two years, the company has increased its rig count in the Permian Basin from five to 32. Apache plans to drill 760 wells in the Permian this year, compared with 263 in 2010. And the company has more than doubled its employees based there to 792. Production has increased by 11% per year since 2010. Apache is also top three in the area in rigs, wells, and net production. Granite Wash is also an area of accelerating growth for Apache. It will account for a large majority of Apache's production growth and holds the greatest potential among all the firm's U.S. onshore candidates. Out of the total Apache 32,500 previously known drilling locations in the central region, over two thirds are from the Granite Wash region. Apache has drilled 92 Granite Wash horizontals wells in the last three years with consistently strong results.

Apache's international operations are in Egypt, Australia, and the U.K. region of the North Sea. Egypt still has a primary impact on Apache, as it remains its largest overseas operational area. Apache's commitment to Egypt began in 1994 and the firm now controls 9.7 million gross acres. Apache Corp.'s proved reserves in Egypt totaled 292 million BOE at the end of 2011, or about 10% of the company's total. Apache is currently the largest producer of natural gas in the Western Desert and the third largest in Egypt. The region currently represents for nearly one quarter of total production. Risk is high in Egypt due to political uncertainty. Apache seems to have a strong position with the new government though. Egypt has reached out to the IMF requesting nearly $5 billion in IMF loans. A successful loan to Egypt by the IMF would no doubt quash some of the uncertainty in the country's financial position. Additionally, Egypt's cabinet recently approved a request by the Multilateral Investment Guarantee Agency to insure Apache's investments in Egypt. The company is moving ahead with development in Egypt, albeit at a moderate pace. Apache is advancing its Hydra project and is set to initiate production in 2013. It is also working on its new Qasr Compression Plant in the western Desert area. The plant is scheduled to come on line in 2014. Due to the uncertainty and lack of future growth in the region, Apache's attention has been re-focused back on its U.S. assets. Although Egypt will continue to represent a large and growing area of production, Apache's management team has projected it will account for only 15% production by 2016, with only 1% production growth. This could change over time if the prospects for stability in Egypt become more apparent. The United Kingdom assets will demonstrate the highest overseas growth at 9% CAGR through the same period. The Forties Alpha platform will start up in 2013, while the aforementioned Beryl field will also contribute to growth. Apache is also expanding development in Alaska, New Zealand, Argentina, and Kenya.

A longer-term area of growth for Apache involves two LNG projects, Kitimat and Wheatstone. Kitimat is a proposed LNG terminal off the coast of British Columbia. The project has partners including EOG Resources (NYSE:EOG) and Encana (NYSE:ECA). Apache is competing with a Royal Dutch Shell (NYSE:RDS.A) LNG project as well. The nearly $3 billion export project, which involved LNG shipments beginning in 2017 gained Canadian approval last year. Unfortunately for Apache, Royal Dutch Shell has a competing project. Its consortium has hindered Apache's ability to sign customers to long-term supply contracts. In October, Cheniere Energy (NYSEMKT:LNG), a player in the Royal Dutch Shell group, secured new contracts with Spanish, British and Asian clients by promising prices pegged to the cheap natural gas rates now prevailing in the U.S. With Apache's inability to sign its own customers to long-term supply contracts, it has left the Kitimat project in doubt. At this point there is no firm date for construction. It could be delayed well into 2018. The Wheatstone project has more near term viability. Apache recently announced it had better luck with contracting its LNG for Wheatstone, agreeing to sell liquefied natural gas from the Chevron-operated (NYSE:CVX) Wheatstone Project in Australia to Tohoku Electric Power Company Incorporated. The Wheatstone partners and THE signed a Heads of Agreement to supply up to 1 million metric tons per annum (MTPA) of LNG for up to 20 years.

Overall, Apache's stock has been discounted due to the fact that the company is in the midst of a significant transition in its portfolio, shifting growth towards more U.S. properties. Combined with the uncertainty of Egypt, which accounts for a large portion of cash flow, Apache's stock has dropped from $133 a share in May 2011 to $82 today. Despite the risks, Apache has continued to generate substantial revenue and free cash flow growth since the collapse of the global economy in 2008. It has a seasoned management team, a high credit rating and low debt, and growing dividend. It is trading at a trough historical valuation based upon price/sales and price/cash flow analysis. With its recent U.S. acquisitions, Apache will be less reliant on Egypt. With any good news on production growth, Egypt, or LNG contracting, the stock can easily return to $100 + per share. I believe Apache is the most compelling energy investment within the large cap universe today.

Disclosure: I am long APA, RDS.A. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.