Magnolia Oil & Gas: High Margin, Free Cash Flow Story Continues

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About: Magnolia Oil & Gas Corporation (MGY)
by: Steve Zachritz
Summary

Magnolia is easily under-spending capex.

Magnolia sports some of the highest margins in the U.S. upstream.

Magnolia's balance sheets is pristine.

Magnolia's plan is sustainable with a long prospect inventory runway.

This is a pre-quarter update note. For our original piece on Magnolia Oil & Gas (NYSE:MGY), please click here.

4Q18 and the view ahead:

  • Volumes Beat But Were Slightly Gassy Versus the Street. Magnolia beat on volumes (better than expected well performance) but were gassier than Street expectations resulting in modest misses on the revenue and EBITDA lines for the quarter.
  • Magnolia realized 110% of Nymex for oil in the quarter (a $5.85 premium to our daily average 4Q WTI price).
  • Capex Guidance Methodology Maintained. The company maintained their target Capex vs. EBITDA ratio at less than or equal to 60%. This takes them from 3 rigs to 2 as we enter the second quarter and with the rally in prices (and estimated EBITDA) since the 4Q report, it's possible that the third rig could come back again later this year. We don't think this is likely as higher non-operated activity should obviate any need to pump up the rig count again this year (EOG is about 2/3rds of their current and MUR is another good-sized piece and both are likely to be busy).
  • 2019 Volume Guidance is "Moderate." Management doesn't give guidance ranges but pointed to an expectation of moderate growth. The Street liked the word moderate and increased 2019 from 61.6 MBOEpd up 15% (54% oil) to the current consensus of 63.2 MBOEpd (57% oil) noted in the cheat sheet below. Production growth is expected to accelerate at mid year and given program timing, we expect 1Q19 to be sequentially flat.
  • 2020 Street Looks Low. We have previously noted that for 2020, the Street, which before the 4Q18 earnings report was at 62 MBOEpd, was "very likely too low" and since the 4Q call, 2020 Consensus has risen to 67.2 MBOEpd (up 6% vs. 2019 Street consensus). Given exit rate guidance for 2019 (up about 6,000 BOEpd prior to thoughts of likely acquisitions) and current oil prices which auger for a steady pace of completions, 2020 Consensus remains "very likely too low."
  • As noted, this is before considering that the 2019 expected growth is all organic; there is no acquisition wedge included here despite strong free cash generation and the likelihood of bolt-on deals that will likely be first use of excess funds. A recent conversation with the company elevated a special dividend as more likely than we previously have thought. While we understand they don't want to bank cash and buybacks are not in the cards, we do think acquisitions are the most likely use of cash in 2019 (focused on oily Karnes).

Why We Own What We Own - Magnolia Oil & Gas

  • The company remains oily with extremely high oil price realizations. Per unit costs are low resulting in near best in group EBITDA margins. This is not your friend's Permian stock. There is no negative differential here.
  • Management remains committed to under-spend cash flow while achieving modest growth... we see no danger of a game plan change here. Note that even with the drop in oil prices in 4Q18, they added $100 mm to their cash position (instead of just spending the extra cash via a higher well count).
  • The company's balance sheet is under-leveraged relative to the group, at just 0.3x net to debt to 4Q18 annualized EBITDA, and management simply does not like debt. They do like their own stock however as noted in recent sizable insider buys.
  • We hear from investors that there is a perception that the name doesn't have enough acreage in Karnes, the oily, high return acreage, and yet, the inventory approaches 10 years there at the current pace of drilling. We see this as more than adequate and they are likely to continue to add to this inventory near term.
  • Valuation is compelling given the mix of modest growth, low leverage, high margins, and under-spend. Our 2019 upside valuation target is $17 (based upon 6.0x TEV/EBITDA of our long-held (since December 2017) 2019 oil price average of $60.
  • The ZLT owns a roughly 10% position in (currently the largest position in the long term portfolio, roughly tied with another disciplined, free cash generating but otherwise very different story, COG).

Disclosure: I am/we are long MGY. 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.