The Permian Basin in West Texas has been exploding with activity recently. It seems that every month or two there is a new Permian Basin E&P company completing their IPO. The latest was Parsley Energy (NYSE:PE) which happened at the end of May. To validate this claim, you can see from the chart below courtesy of Pioneer (NYSE:PXD) that the Permian has attracted significant growth in the number of horizontal rigs while it appears that the Eagle Ford and Bakken plays are leveling out.
The Permian Basin may have been late to the party but it is quickly catching up. In fact, EOG Resources (NYSE:EOG), the king of horizontal oil plays, recently made the claim that the Leonard Shale found in the Permian basin is their 3rd best play from an ROR perspective behind the Bakken and the Eagle Ford. That should get your attention.
So if the Permian is such a great place to invest, what are some of the companies that one could focus on? Well, like I said earlier, there is a plethora of companies that have come out with multi-billion dollar IPOs in the past year or two. But at first glance, many of them seem over priced and somewhat speculative as many of them have been on a tear as of late. Most of these companies are located in the Midland basin portion of the Permian basin which is in the North around Odessa and Midland. That seems to be the sweet spot or at least the place that Wall Street is most excited about at the moment.
Some of the companies in the Midland Basin are Diamondback Energy (NASDAQ:FANG), Athlon (NYSE:ATHL), and the top producer in all of the Permian, Pioneer Resources. But if you look at the prices that these companies are trading at, you might think that they look expensive. And in fact they are! Not one of these companies trades below 4x book value. If you don't think that is expensive, compare that to the "best of breed" EOG Resources which trades at just around 4x book value. Why would you pay that much for these other companies if you can just have EOG for 4x book value? Especially when EOG is typically the first mover in most of these plays and invests in assets at bottom dollar. (Not to mention the many other reasons EOG is better)
Why am I trying to make a case for EOG Resources? I am not. I only use it to show how crazy you are if you pay more than 4x book value for these companies.
Now are there companies in the Permian Basin trading for less than 4x book value? Of course there are but I wanted to highlight these companies to illustrate the fact that there are rich valuations for some companies in the Permian Basin compared to the company I am about to talk about.
The company I really want to talk about today is Approach Resources (NASDAQ:AREX). Approach Resources is one of the unloved stocks right now in the Permian Basin. You will not find a cheaper oil stock in the Permian basin than Approach Resources. Just look at the chart I've created below to highlight Approach's valuation against the aforementioned Permian producers.
Approach trades at a measly 1x book value. What a deal! A 5th grader could tell you which company to buy out of these 4. You could buy Approach Resource's assets for the same as what they cost Approach to buy. Essentially any cash flow that Approach generates is free! That's putting the "free" in free cash flow.
I will let you look at the other valuation metrics in the chart and decide for yourself but let's take a look at Approach's operating cash flow. Approach generated $48M of operating cash flow in Q1. If each quarter matches the first, Approach will generate ~$200M of operating cash flow in full year 2014. Approach will have negative FCF however due to the fact that they are going to make $400M in capital investments during the year. That's not a bad thing when your capital investments are projected to make a 40 to 50% BTAX IRR. See Approach's chart below to see a graphic representation of the IRR sensitivity.
What does all this mean to you the investor? Let me break it down for you. If you bought Approach Resources today, you would be paying around ~$850M for the company. That is just above book value of ~$715M. The company generates operating cash flow of ~$200M. As I said before, this means you are buying the company for about what the company paid for its assets, and you get ~$200M in operating cash flow free. They are plowing this cash flow back into the company as well as increasing leverage so there's no doubt if oil prices don't fall, operating cash flow will increase.
So why is Approach valued so poorly compared to its peers? Their acreage is in the more southern portion of the Permian Basin where EURs (Estimated Ultimate Recovery) are slightly lower than they are in the north. For example, Diamondback energy is estimating EURs from most of its wells to be around 600 MBOE, while Approach's is estimated to be around 450 MBOE. This is only half of the story though. Approach is spending around $5.5M per horizontal well drilled while Diamondback is spending around $7M per horizontal well drilled. So based on the cost to drill a well versus the results, Approach Resources is right in step with some of the more richly valued Permian companies.
The other reason Approach may be valued less compared to its peers is its Oil, NGL, and NG ratios. Investors like companies that have more oil weighted assets because oil has a higher price per BTU of energy. I can explain this but for purposes of this article, that is really all you need to know.
However, I also don't find this claim to be valid when you look at the charts below comparing Approach's Wolfcamp production mix compared to Diamondback's production mix. This chart is taken from Approach's most recent investor presentation.
Compare it to Diamondback's portfolio mix shown at the bottom of this graphic.
You can see that they are essentially apples to apples and yet Diamondback is valued at 4.5x book value while Approach is valued at 1x book value with just as much growth potential.
So that is my case for buying Approach Resources. When you buy Approach Resources, you are getting a financially disciplined company, with great assets, that they acquired at a first mover price, that is valued at a fraction to what its Permian peers are valued at. Based on the assumption that it moves up to meet the valuations of its peers rather than the peers coming down to meet Approach's valuation, I see no reason why Approach won't trade north of $50 in the near future.
Disclosure: The author is long AREX. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.