Last week, the Permian oil producer Concho Resources (CXO) announced a definitive agreement to sell its New Mexico Shelf assets for C$925 million. Also, the board of directors authorized a repurchase program of up to $1.5 billion.
These developments are taking place a few weeks after management communicated disappointing results of a spacing test and reduced production guidance.
Management still expects the company to generate free cash flow while growing production, though. Yet, despite the significant drop in the stock price over the last several quarters, I estimate the investment proposition is still not attractive.
Following the acquisition of RSP Permian in July 2018, management expressed its confidence in initiating a sustainable dividend:
Further, our financial strength and outlook for free cash flow drives our plans to initiate a regular quarterly dividend beginning in the first quarter of 2019. The indicated annual rate is $0.50 per share and it signals our confidence in the outlook of our business and the strength of our machine today and confidence in our outlook for us to return additional free cash flow to shareholders as an increasingly meaningful part of our overall investment thesis over the long-term." - Source: earnings call Q3 2018
Yet, since this announcement, the stock price has been declining. And the disappointing results related to reduced spacing tests during Q2 earnings accelerated this trend.
Also, a few days ago, management announced the definitive agreement to sell its New Mexico Shelf assets for $925 million. But the market didn't react to this news and the stock price is staying close to its 52-week lows.
Thus, over the last 12 months, the market capitalization was divided by two. Besides the spacing issue, the lack of free cash flow may explain the negative market reaction.
No free cash flow yet
The criticism towards some U.S. shale oil producers around negative free cash flow isn't always fair. Free cash flow must be considered in the context of the associated production growth.
The reason management initiated a dividend is the expected double-digit production growth while generating free cash flow in 2020 at a WTI price of $50/bbl. And with a WTI price of $60, management forecasted $1 billion of free cash flow. Despite the disappointing outcome of its spacing tests with its Dominator project, management confirmed:
We described 2020 as production numbers that translated into double-digit production growth with oil production outpacing the overall growth where we saw free cash flow at $50 oil and where we saw free cash flow approaching $1 billion at $60 oil. And that's still what we see today under that same base budget scenario." - Source: earnings call Q2 2019
These must still materialize, though. During H1 2019, free cash flow was negative while oil prices averaged $57.38/bbl. The capital program of $1.7 billion exceeded EBITDAX by more than $200 million.
The first-half 2019 production of 328,586 boe/d is close to the midpoint of the expected 2019 production at 328,750 boe/d. Assuming similar oil prices during the second half of the year, EBITDAX will reach about $2.94 billion in 2019. This level of EBITDAX corresponds to the high range of the capital program of $2.8 billion to $3 billion. And taking into account the interests costs above $200 million, full-year free cash flow will largely be negative. The dividend will have to be supported by assets sales or debt.
But the expected negative free cash flow in 2019 comes with a strong production growth accelerated by the RSP Permian acquisition.
Management indicated the capital required to hold the 2019 exit production flat would amount to about $1.5 billion. Assuming stable production, costs, and prices, the free cash flow potential while holding production flat is real. Even after taking into account $200 million of interests costs and $100 million of exploration expenses on top of the $1.5 billion capital program, free cash flow would reach about $1.1 billion.
But this level of free cash flow assumes a WTI price of $57.38/bbl and a flat production. While management didn't communicate its 2020 capital program, it indicated it planned to grow production. Thus, free cash flow will be lower due to production growth. But the $1.1 billion free cash flow potential shows the company can generate strong free cash flow with reasonable assumptions.
The New Mexico Shelf assets sale
Management provided limited information about the New Mexico Shelf assets it agreed to sell.
Net acres represent 10.9% of the total net acres the company owns. And the 25,000 boe/d production corresponds to about 7.6% of Concho's total production during H1.
Based on these metrics, the company sold its Shelf assets at a significant discount to its total enterprise value (with a stock price of $69.68).
The lower valuation of the Shelf assets compared to Concho's valuation makes sense if these assets generate lower netbacks. But management didn't provide such information.
In any case, the company will use the proceeds to reduce net debt by about $555 million, which would drop to $3.8 billion. Before the transaction, the net debt to annualized EBITDAX ratio of 1.52x was already reasonable. And management highlighted leverage targets would be achieved with this transaction. Again, there's not enough information to estimate the leverage post-transaction. But, in any case, the debt load will stay reasonable.
Given the free cash flow potential and the moderate leverage, returning capital to shareholders while growing production makes sense. Thus, besides the dividend, management announced a $1.5 billion share repurchase program. It will use the remaining $370 million of the assets sale to buy back shares.
Let's have a look at the valuation to estimate the impact of the share repurchase program.
Given the lack of information about the New Mexico shelf assets and the small amount it represents relative to the size of the company, I'll value Concho Resources based on the Q2 results.
Assuming the free cash flow potential of $1.1 billion I discussed above, the market values the company at a 7.9% free cash flow yield (with a share price of $69.68).
Considering the corresponding oil price assumption of $57.38/bbl and the associated flat production, the free cash flow yield isn't attractive.
Besides, compared to some other Permian oil producers, there's no obvious discount.
The market values Concho's land at a discount to its peers. But the other metrics don't show a similar valuation gap. Parsley Energy (PE) is even cheaper based on flowing barrels, EV/EBITDAX, and EV/reserves ratios.
Thus, I estimate Concho Resources is fairly valued. Given the fair valuation, share buybacks and dividend provide a similar value to shareholders. But share buybacks give management with more flexibility instead of committing to a regular dividend.
A lot of things happened over the last twelve months: acquisitions, new dividend, asset sales, new share buyback program, spacing issues, reduced production guidance, etc.
Overall, the market didn't appreciate these developments as the stock price dropped by almost 50% since last year.
Yet, despite the real free cash flow potential and the drop in the stock price to $69.68, I estimate the company is fairly valued. I don't see any investment opportunity at this price.
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Disclosure: I/we 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.