Concho Resources Is Way Too Expensive
- Concho Resources reported its Q3 results on Tuesday.
- Investors liked the results, bidding up the stock price by 4.5% in the past couple of days.
- From a discounted cash flow perspective, CXO is worth half, or less, of its existing market capitalization.
Concho Resources (NYSE:CXO) reported its Q3 results on Tuesday, October 31. The market seems to have liked the news. In the past 3 days, CXO’s stock price has climbed around 4.5%.
Here’s my problem, though. CXO has a market capitalization between $20 and $21 billion. And based on the numbers I see, I would struggle to justify half of that valuation.
Nowhere close to funding their own capital expenditures
Before we get into some valuation arithmetic, let’s look at CXO’s broader financial performance. Since 2012, CXO has consistently outspent its cash flow, as you can see in the chart below. The yellow line shows capital spending. The blue, orange, and gray bars show cash from operations, new debt, and new stock, respectively. The data are from CXO's 2016 and 2014 10-K reports.
We can see that cash from operations falls considerably short of funding capital expenditures. In each of 2012 through 2015, CXO took on $4.3, $3.3, and $2.1 billion in debt, respectively. In 2015 and 2016, CXO captured $1.5 and $1.3 billion in cash from issuing new stock. These are the only reasons CXO has been able to fund its capital spending program. Cash from operations simply hasn’t cut it.
What about 2017? Have we seen improvement year to date?
Not really. So far in 2017, CXO has generate $1.2 billion in cash from operations, but has spent $2.0 billion in capital expenditures. How has the company filled the gap? By selling $0.8 billion in assets and taking on $2.3 billion in debt.
That’s a classic growth play. Grow with other people’s capital. Forego profit dollars today, so you can capture many more profit dollars in the future.
The question is, where are these future profit dollars coming from? And at what cost is CXO capturing them? CXO is devouring other people’s capital, in the hopes of collecting future dollars. But the time value of money is working against the company. And with a 40% downward reset in oil prices, the growth story has become that much less compelling.
Some valuation arithmetic
Let’s do a very rough discounted cash flow analysis to get an idea of what CXO might be worth. We’ll assume CXO has executed on its growth plan. It’s a coiled snake, ready to strike.
In the first 3 quarters of 2017, CXO has generated $1,185 million in cash from operations. Let’s pro-rate that out for the rest of 2017, and say that CXO will generate $1,580 million in cash from operations for the year.
What happens going forward? We have no capital expenditures, since we’re simply deflating this huge balloon that CXO has spent years inflating. We do have some debt payments coming up. I put those in the respect years of their maturities.
I’ll assume that production declines at a 10% annual rate. That’s almost certainly generous. According to the U.S. EIA Drilling Productivity Report, legacy Permian production declines between 5% and 6% per month, or around 50% per year. We’ll assume that CXO’s production only falls 10% per year.
For the next 5 years, I’ll assume that oil prices rise 10% annually, to around $80/bbl in 2022. After that, oil prices stay flat, and production continues to fall at 10% annually.
These assumptions mean that CXO’s nominal cash from operations stays flat over the next 5 years (a 10% production decline netted against a 10% oil price increase), then starts falling at 10% per year. I’ll use the existing U.S. treasury curve to discount future cash flows to current dollars.
The table below shows the projected results through 2050. You’ll see the year, the nominal cash from operations, the nominal debt load, and the net present value (NPV) of the resulting net cash. You’ll also see a running total of those cash values, in the far right column. You’ll see that if you let CXO unwind in this way through 2050, you have only returned $15.4 billion in cash, far short of CXO’s existing $20 to $21 billion market capitalization.
A ton of risk in these projections
In a lot of ways, these projections are a generous estimation of CXO’s future performance. Remember, I assume that CXO’s production, in the absence of new capital expenditures, will only decline 10% annually. According to the U.S. EIA Drilling Productivity Report, legacy Permian production declines 5% to 6% per month, or around 50% per year.
Also, I don’t even consider the finite nature of CXO’s reserves. In its 2016 10-K, the company reported 720 million BOE total proved reserves, of which 466 million BOE were proved developed. If we assume 2017 annual production at 190,000 BOE/day, and let that number decline by 10% annually, CXO would deplete its proved developed reserves in 2027. In that year, the net present value of its cumulative cash return would be $10.8 billion.
I also ignored taxes entirely. Unless CXO has some clever tax tricks up their sleeves, you would probably expect a 20% to 35% haircut on the cash flow values above, depending on how the tax infrastructure looks going forward. Still, I wanted to be as generous as possible with the projections to see if I could reasonably get to $20 billion or so. I couldn't.
We also haven’t accounted for the significant uncertainty that exists in oil markets starting in the late 2020’s. The further we go into the future, the less confidently we can assess the impact of electric vehicles, or climate-focused regulatory action, or any of the countless factors that can impact both the supply and demand of hydrocarbons. Trying to bank on performance ten or more years in the future is incredibly risky.
While oil prices will likely go up, I don’t see how CXO justifies its existing market capitalization
The short version of my advice for investors? Stay away from CXO. It’s priced under the most optimistic of assumptions. I understand the sentiment, that oil and gas markets have been beat up for years now, and we’re due for a recovery. But CXO has been immune to that. Its stock price is up 8% over the past year, and 58% over the past 5 years. Even though it posted a $1.5 billion net loss in 2016, a loss which consumed most of its profit since 2012, the company is still flying high.
I know the Permian is attractive. I know operators are publishing absurdly low cash-level breakeven prices. Still, I am just not seeing anything in CXO’s aggregated financial performance that comes close to justifying a $20 to $21 billion valuation. It’s seemingly a very good company, run very well, but priced exceptionally high.
You might be able to find well-priced investments in oil and gas. CXO is almost certainly not one of them.
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