Concho Resources: An Exceptional Permian Play Beaten Down

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About: Concho Resources Inc. (CXO)
by: Quad 7 Capital
Summary

Concho Resource's has seen its stock get hammered in recent weeks following what many consider disappointing 2019 guidance.

Digging into the numbers we see that substantial progress has been made in cash flow generation, reduction of controllable expenses, and investments into the company.

While Concho Resources has fallen into the 'me too' trap of upping production to boost revenues and offset oil and gas price weakness, realized energy prices have been solid.

Wide differentials persist in the Permian but the real wildcard for pinpointing estimates for 2019 is the impact of derivative gains.

Several assumptions are made by our firm to calculate an expected range for GAAP and adjusted earnings and EBITDAX and we believe a price of $90 would be an exceptional entry point.

Concho Resources (CXO) has caught our attention as the stock has been falling dramatically in recent sessions. The company is in our opinion rather high-quality. Concho Resources' operations are centered on oil and natural gas exploration and production in the Permian Basin, which is one of the most prolific oil and gas regions in the U.S. The company's core operating areas include the Delaware Basin and the Midland Basin and spans nearly one million gross acres in southeast New Mexico and west Texas. We believe ultimately that at oil prices at $55 and natural gas around $3, that Concho Resources offers a compelling entry point under $100 for a long-term holding. Let us discuss.

Price Action Of Concho Resources Over The Last 5 Years

Our company is always screening stocks that are getting beaten down and may offer rebound potential or good value. In the case of Concho Resources, the chart certainly fits this criteria:

Source: BAD BEAT Investing

Our chartist drew up this rudimentary and easy to understand five-year chart highlighting some zones of interest from our perspective. We believe an ideal buy zone exists between $90 and $100 here from both a chart perspective (where both $100 and $90 are support lines), as well as from a fundamental perspective. Let us discuss further the operations of the company, our thoughts on oil prices, and projected performance that suggests this is a compelling entry point for the stock.

Understanding key operations

We don't want to reinvent the wheel here on describing the company's operations but for our many followers who may not be familiar with the Permian Basin or Concho Resources operations, we believe sharing some key facts regarding holdings is absolutely imperative. Below is a map highlighting the operations of Concho Resources:

Source: Concho Resources' Operational Highlights

As we alluded to above the company operates in very oil friendly areas of New Mexico and Texas. We feel this is an important point to make for this domestic producer, as unlike some of our more global picks, the geopolitical risk here is minimal.

There are a few key points about Concho Resources that we believe are relevant for a potential investor. First, while dozens of companies operate in Texas, Concho Resources is in the top 12 for oil production. This means there is room for growth, and it currently operates a total of 6,000 wells with more coming online every quarter. For the New Mexican operations, Concho Resources is the number one producer of oil in the state and number three for natural gas production.

The company's reserves are impressive, with a base of nearly 8 billion BOE potential, while proven reserves are at 1.2 billion BOE:

Source: Investor Presentation

In terms of operational rigs, this is both a strength and a risk to the company. You see, more production means more revenues, assuming prices haven't completely plummeted. However, when the company and most competitors are also flooding the market with supply, it can hurt oil pricing. During Q4 2018, Concho Resources averaged an operation level of 34 rigs, up from 31 rigs in Q3 2018. Concho Resources is currently running 34 rigs, including 22 rigs in the Delaware Basin and 12 rigs in the Midland Basin.

In the Delaware Basin, (excluding the New Mexico Shelf), there were 50 wells added with at least 60 days of production in Q4 2018. The average 30-day and 60-day peak rates for these wells were 1,594 Boepd (73% oil) and 1,454 Boepd (72% oil), respectively. Growth was seen in the Midland Basin as well. Concho added 23 wells with at least 60 days of production as of the end of Q4 2018. The average 30-day and 60-day peak rates for these wells were 1,202 Boepd (86% oil) and 1,070 Boepd (85% oil), respectively. This growth has helped fuel increases in production.

Production and pricing

To offset declines in oil prices, the company has upped production. Production for Q4 2018 was 28 MMBoe, or an average of 307 MBoepd, an increase of 45% from Q4 2017 and 7% higher compared to Q3 2018. Average daily oil production forQ4 2018 totaled 199 MBopd, an increase of 53% from last year's comparable quarter and up 8% from Q3 2018. Natural gas production for Q4 2018 totaled 649 MMcfpd. That was also up big time from a year ago, rising from 487 MMcfpd. This is significant, and helped increase revenues from a year ago, despite weaker pricing. Increasing quarterly production led to annual growth as well:

Source: Investor Q4 slides

The growth per day is dramatic. We all know pricing has been an issue for energy producers, though we were actually surprised to see the declines in pricing were less than we thought they would be consider the rapid decline we saw in oil prices in the last months of 2018. Concho Resources' average realized price for oil and natural gas for Q4 2018 was $49.10 per Bbl and $2.82 per Mcf. Both were lower compared with $52.84 per Bbl and $3.33 per Mcf, respectively, for Q4 2017. But even at these pricing levels, the company remains profitable. Oil was in decent shape for most of the year, and 2018 saw improvement over 2017 for pricing. For all of 2018, the average realized price for oil and natural gas was $56.22 per Bbl and $3.40 per Mcf, respectively, compared with $48.13 per Bbl and $3.07 per Mcf, respectively, for 2017. While realized prices for 2019 are likely to fluctuate, it seems that at these levels, earnings remain solid.

Financials

The growth in earnings has been quite solid, and it has been driven by organic and inorganic growth, as well as higher production, and a better overall realized price of oil. Adjusted EBITDAX for 2018 totaled $2.8 billion, compared with $1.9 billion in 2017. That is solid growth. Net income for 2018 was $2.3 billion, or $13.25 per share, compared with net income of $956 million, or $6.41 per share, in 2017. That is on a GAAP basis however, but very impressive. Excluding non-cash and special items, 2018 adjusted net income was $792 million, or $4.59 per share, compared with adjusted net income of $311 million, or $2.09 per share, for all of 2017. If you are keeping score this is more than a double.

How did Concho Resources manage this? Well, revenue growth was solid, with Q4 revenue rising 37% to $1.06 billion from $0.78 billion last year in Q4 2017. For the year, revenue skyrocketed on the back of growth in oil and natural gas sales, hitting $4.15 billion, versus $2.6 billion. But that is not all. The company is also trimming costs and improving its cash flow generation, and this is what we are most impressed with. Controllable cash expenses are declining each year, despite the solid growth in revenue.

Source: Investor Q4 slides

The growth in operational cash compared to investing cash flow is impressive. While we would like to see the gap widen even more between operational and investing cash, the key is that both are growing and free cash flow is being generated.

Source: Investor Q4 slides

In 2018, the company generated $2.6 billion of cash from operating activities, exceeding $2.5 billion of cash used in investing activities for additions to oil and natural gas properties, so this positive gap is welcomed. As we look ahead, we believe the company will continue to work to boost its cash flow by moderating spending capex projects as it waits for an oil rebound.

Forward considerations

We mentioned we like the stock between $90 and $100. This is based on several factors. Make no mistake, the best thing that could happen to the company is a $10 rally or more in oil, as well as keeping natural gas over $3. But the company cannot control that.

What we love about Concho Resources is its discipline. Outside of an acquisition last year, the company is pretty conservative, and that makes it a defensive play to protect against deep downside. As we move forward, we anticipate 2019 to be a transitional year to setup for the next decade. We anticipate:

1) Reductions in rig counts

  • Per management and to control expenses, look for rig counts to decline:

Source: Q4 investor presentation

2) Continued cuts to controllable expenses

  • As discussed above, the company has repeatedly lowered its expenses that are controllable each year. As all of the efforts to strengthen the balance sheet continue we are projecting that interest payments decline to $1.2-$1.3 billion based on the outstanding debt of $4.2 billion. We also are looking for general and administrative expenses to remain flat to down.

3) The company will plan for $50 oil prices (so above this is going to feed the bottom line as a stronger top line will emerge)

  • The company is planning for $50 oil which we fully agree with. This is not to say we agree with the price target our outlook for this price. What we agree with is using this figure for planning 2019 operations. This is a conservative move by the company. The outlook for oil pricing, which we will discuss below, is a bit more bullish than this, so this conservative outlook means higher oil prices will lead to growth in margins. Planning capex around this level is an underappreciated strength of the company and its management team.

4) Continued production growth

  • We continue to expect the company to ramp up production. We reiterate that along with the sector doing the same there is a risk of putting put a lid on pricing, but we expect production growth to continue at a rate of 15%-20% based on rig and well counts, historical patterns of growth, and the average 30-day rates we have been seeing, which continue to grow.

5) Enhance free cash flow opportunities

  • As the company strengthens its balance sheet each year and controls its investments, the company will have ample opportunity to use free cash flow to boost returns to shareholders. The company pays a dividend currently, and we would love to see the dividend increased significantly, whilst possibly repurchasing shares at depressed levels. This can happen with increased free cash flow generation, which we expect to see given the company is suggesting that it will reduce and then hold capex flat through 2020:

Source: Q4 investor presentation

Valuation relative to the outlook

A lot of players in the domestic energy space are seeing increased production but also margins and earnings pressure. Given the aforementioned cuts to spending, and assuming oil prices actually moderate and settle out to $55 per barrel, we think that revenue growth will be in the 25%-30% range once again, based on production growth of 15%-20%. Production growth is easily attainable based on even flat performance at the well level considering the number of new wells that came on in the second half of 2018 and the acquisition of RSP Permian.

We are looking for revenue of $5.2-$6.2 billion, depending on production growth and estimating $53-$56 oil and about $3 natural gas. Our target growth rate would put total production around 110-120 MMBoe. Going into this figure is growth to approximately 70-75 MBbl of oil and natural gas production of 240-255 MMcf. The unknown here really will be the impact of operating costs and expenses. While we are definitely projecting declines in controllable expenses, operating expenses for direct production have crept up year-over-year and we are projecting this to continue. Management has guided a very wide lease operating expense of 6.00-$6.50 per barrel on the year. At the bottom end of this range there would be a decline from 2018's lease operating expenses of $5.76, but inflationary factors are part of the reason for these increases. However, this is substantial growth in this expense line and muddies the possible ballpark calculation for the bottom line. But factoring all of this in, it's reasonable to estimate adjusted EBITDAX grows to well over $3.2-$3.5 billion, while the more well understood net income figure rises to $2.6-$2.9 billion.

This net income figure would yield an approximate GAAP EPS target for 2019 of $13.00-$14.50 based on 200 million shares outstanding. Remember EBITDAX is net income plus things like depreciation, derivatives gains/losses, extinguishment of debt, etc. Last year in 2018 there was a large gap in adjusted EBITDAX and net income. This year we see that as narrowing given we do not see plans for asset disposition, or income tax changes. More color on that will come as the year unfolds, but the gap was quite wide in years past. The biggest contributor to our target EBITDAX figure will be depreciation, depletion, and amortization, which grows each year, and was $1.4 billion in 2018. The other wild card will be derivative gains and losses. Assuming however our numbers are in the ballpark and we back these items out of the GAAP EPS figures of $13.00-$14.50 (and we are estimating an impact on derivative strategy in area of ($6.00-$7.50), a tax impact of $1.00-2.00, and the summation of all other items to be in the ($1.00-$1.50) range, we believe adjusted EPS will approximate at the best and worst ends of GAAP and adjustments to be in the range of $5.00 to $8.50. That is pretty wide. Using the midpoint of each of these ranges, we arrive at an estimated EPS figure of $7.25 estimated for the year.

We then compared our calculations to analyst consensus for 2019. Turns out, we're not too far off. Our overall range is $5.00-$8.50, with the latter end being the best case scenario on GAAP and adjustments (not counting any major moves in pricing of course) and we came in just above the highest estimate of $8.32. We are bullish, but not that much. The analyst range is $3.29 to $8.32 right now for 2019 EPS. At the lowest end of our calculated range we are at 20.5X forward EPS, and at the midpoint of $7.25, we are at 14.2X. We have said the $90-$100 range looks solid. This would price the stock at our midpoint at 12.4X to 13.8X. That is very compelling in our opinion.

A few more words on oil to consider

All of our calculations assume oil is around $55 for the year. But the numbers would be likely much more bearish at say $40 oil, and extremely conservative at $70 oil. After falling so terribly in 2018, oil prices recovered here so far in 2019, with the price of the U.S. benchmark WTI crude climbing to $56 at the time of this writing from $42.50 level seen at the end of 2018. Where it goes is up for debate but we do know that oil continues to face short-term supply and demand headwinds, which could keep oil prices in check. Let us not forget there is still a possible trade war with China and some fears over declines in global economic activity, particularly within China.

China is the number two in oil usage, responsible for 13% of global demand (behind the U.S.' 20%) and declines in the economy there could further erode demand. We know China's economic growth slowed recently to a 28-year low, and there are still fears in the U.S. of recession as well. All of this could hamper demand, especially when you factor in major political pushes such as the Green New Deal, and when we acknowledge the major strides being made by big oil to move to clean energy and biofuels.

We do know that OPEC has said there will be cuts in production in reduce supply but stockpiles are growing. As such it is unclear if these cuts will be enough to offset growing production in the U.S. More and more rigs are coming online in the U.S, and they are projected to grow into March 2019:

Source: EIA drilling report

So negative hits to demand and increasing supply worries have led to the outlook for oil well below what we saw in the past. These factors could continue to weigh on oil prices throughout 2019. There is a lot of debate on where oil prices will go. Last year in the fall we were operating under the idea oil would be around $70 per barrel. As we saw in our research of the EIA data, it views the price of the U.S. around $55-56 a barrel in 2019. This is much lower than their views in 2018. With this type of back drop, we like a name like Concho Resources here, especially as the price of the stock has fallen so much of late.

Take home

Investors have been consistently early if they have tried to enter Concho Resources above $100 in recent months. We believe it would be more prudent to wait and let reactive analysts continue to put out target changes and rating changes and let the stock fall to under $100. Here we find compelling value in our humble opinion. We have a top Permian player here that has worked diligently to cut its expense profile (with the exception of lease operating expenses), is paying down debt, has made acquisitions to increase its presence, is upping production, and paying a small dividend. As shares have come down we think just a little more patience will be rewarded. This is especially true for investors who are able to buy this quality company at a fair price (which is at a $90 handle in our opinion) and are able to capture the eventual rebound in oil and gas pricing when the market dynamics of supply and demand shift more favorably.

Quad 7 Capital is a leading contributor on Seeking Alpha and pioneer of the BAD BEAT Investing service. Please click the orange follow button to receive updates on our work.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CXO over 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.