The last three months or so haven't been particularly kind to a number of E&P companies, and PDC Energy (NASDAQ:PDCE) is most definitely in that group. While regional rivals like Antero (NYSE:AR) and Bill Barrett (BBG) are still in the black over that short span of time (and PDC has done fine over the past year), the recent performance has left a lot to be desired.
Some of the problems with PDC Energy shares can be tied to overheated expectations earlier in the year, coupled with a disappointing third quarter and year-ahead guide. Some of it is also likely due to ongoing mixed data from the companies Utica acreage. Although I don't think the Utica results have been that bad, PDC Energy looks attractive even excluding the Utica, making this an interesting name to me at current prices given the ongoing success in the Codell and Niobrara formations in the Wattenberg. I've been stubborn to lift my long-term price estimates for natural gas, and I'm still less bullish than most, but at $4 gas, PDC Energy starts looking like a very interesting stock to me.
Increased Focus, Increased Value
Although some investors follow the idea that more acreage in more locations gives a company additional shots on goal and reduces the overall risk, I don't completely subscribe to this point of view or at least not in the case of small players. It seems to me that more value is generated more often in situations where a company focuses on a small number of high-potential/high-value assets and concentrates its capital spending on those.
That basically fits the PDC Energy model. After divesting acreage in the Permian and Pineance (as well as some other areas in Colorado), the company is now focused on the very attractive Wattenberg, the interesting-but-still unproven Utica, and the interesting-if-gas-really-gets-going dry gas Marcellus.
PDC Energy owns almost 100K acres in the Wattenberg and even with a gross drilling inventory of close to 2,000 wells, the company is the third-largest producer in the area (behind Anadarko (NYSE:APC) and Noble (NYSE:NBL). Well costs here have been reasonable (a little more than $4 million), while recoveries appear to be solidly above the 300M boe level. All told, pre-tax IRRs from this region should be in the high 20%'s to low 30%'s, if not into the mid-30%'s or better if the Codell results really work out.
All told, the Wattenberg is showing itself to be a very appealing area, and I'm interested in names like Bill Barrett and Bonanza Creek (NYSE:BCEI) in this region as well. If there is one thing that concerns me a bit it is public policy. Anti-fracking measures in multiple Colorado cities got a lot of attention this past fall and while the legal challenges over jurisdiction and enforcement could take a while to play out, it is a potential risk factor.
Utica And Marcellus Are Wild-Cards
I can all but erase the potential contributions from PDC Energy's acreage in the Utica and Marcellus and still arrive at a net asset value that suggests these shares are worth owning. To me, that suggests solid upside amidst some persistent concerns about these areas.
PDC Energy controls nearly 50,000 net acres in the Ohio part of the Utica shale. About one-quarter of these holdings are in southern Guernsey and northern Noble counties, while the remaining three-quarters are in southern Noble, northern Washington, and eastern Morgan counties. As Michael Filloon recently highlighted, PDC Energy is a major player in the area on a "net acres per share" basis, with more than double the holdings of Anadarko, Magnum Hunter (MHR), and Antero. The picture changes if you look at the acreage relative to market cap (Magnum Hunter moves up considerably, while Anadarko and Antero are even smaller players relative to PDC Energy), but the point stands that PDC Energy has made a sizable commitment to this area.
It still has yet to be proven if this commitment will be richly rewarded. Comparisons have been made between the Utica and Eagle Ford, but concerns have emerged about initial well production figures and steeper than expected well declines. The much-watched Garvin well, for instance, had a so-so initial result that was explained in part by a conservative choke, but the follow-on data haven't been great. Likewise, while there were explanations for why the Niel 1H well underwhelmed with its initial production (in part due to drilling segments outside of the targeted formation), sooner or later "we'll get 'em next time" isn't going to work.
I think it's way too early to throw in the towel in the Utica, but well costs of over $8 million and underwhelming production figures do have me questioning whether this is a 30%-IRR type of play. My base case scenario only factors in about $6 to $7 per share in value for the unbooked Utica assets, but that figure could go $10 higher if the well numbers start looking better.
PDC Energy owns sizable acreage in the Appalachia Basin (northern West Virginia) through a joint venture with Lime Rock Partners. While the JV's funding is non-recourse to PDC Energy, it's going to take natural gas prices of more than $5 (and perhaps closer to $6) for this acreage to generate significant per-share value for PDC Energy. To that end, I would note that the company has suspended drilling in that area for the time being.
Bringing The Value Together
Until an equity offering in 2013, PDC Energy was running at a pretty high debt-to-EBITDA level relative to its peers. Even now the company uses more debt than most of its peers and I do have some concerns about the company's debt-adjusted production growth. If energy prices march higher, the company will drill itself out of those liquidity risks, but it's something to keep in mind as part of the downside risk should prices weaken again.
In calculating the net asset value, I admit I've been stubborn and slow to lift my long-term natural gas price estimate, but I'm now modeling on the basis of $4 natural gas prices. With that, I get a net asset value of between $72 and $73 for PDC Energy, with about $27 from net proved reserves and around $40 in potential Wattenberg developments. As I said, I value Utica at between $6 and $7 per share today, with upside into the teens if drilling results improve.
The Bottom Line
PDC Energy isn't all that cheap on an EV/EBITDA basis, but I wouldn't expect that it would be given how much of the company's value lies outside of its proved reserves. Even so, a 7x multiple to the current average estimate for 2014 EBITDA suggests that the shares are 10% undervalued, which really isn't bad at all. Going back to that NAV estimate, PDC Energy could be nearly 50% undervalued provided that the Wattenberg wells continue to deliver strong, profitable results.
I would never recommend buying a stock because of its M&A potential, but I would not be surprised if PDC Energy drew a bid. I believe the Wattenberg is a high-quality area and the Utica, while perhaps initially disappointing, still offers worthwhile upside. All told, I'd be a buyer of PDC Energy.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.