On September 10, Kurdistan-focused upstream company Gulf Keystone Petroleum (OTCQX:GUKYF, OTCQX:GFKSY) presented its 1H19 results. Unfortunately, there is no reason to feel elated as 1H19 performance was mediocre due to "operational delays" and workovers that took a toll on the production and added pressure on margins amid weak oil price. At the same time, higher capex, together with one-off payment related to the exit from Algeria, significantly reduced FCF, but it still remained well above zero.
On the London Stock Exchange, the stock was down in the morning hours on September 10, then it recovered in the evening and dropped again on September 11.
However, after the recent financial update, I reiterate my medium-term bullish outlook that stems from noticeable mispricing of GKP's equity and its revenue growth prospects backed by the Shaikan block, despite operational delays that will take a toll on 2019 production, as far as Jurassic reservoir performance is still decent enough to sustain output growth. Now, let's take a more in-depth look.
Share performance YTD
Gulf Keystone Petroleum has shown more than inspiring performance this year, as, on the London Stock Exchange, the stock climbed ~23.43%. This is way better than the performance of the UK market benchmarks FTSE 100 and FTSE 250, and also substantially better than return its peers DNO ASA (OTCPK:DTNOF) and Genel Energy (OTCPK:GEGYF) have delivered since the beginning of the year.
Neither Brexit nor Brent gyrations caused by concerns that global economic slowdown which stems from the US-China trade war would take a toll on demand for commodities hindered GKP from delivering a superb return (it's even higher with dividend factored in). Yet, if Brent was more supportive of bullish sentiment, GKP's investors might enjoy an even higher capital gain, as until April, when oil price had rallied, the stock gained close to ~40% but then was dragged down by oil bears.
The top line
First and foremost, payments from the Kurdistan Regional Government are no longer an issue. In the past, GKP had to tackle severe liquidity constraints, as the company simply did not receive cash from its key stakeholder - the regional authorities - on time. After the issue was finally settled, clarity regarding payments even allowed it to introduce a dividend and buyback in 2019 that shore up investor confidence, which was tested by capital restructuring in 2016; back then, restructuring was inevitable to stay afloat as Debt/Equity approached 2.9x.
After the obstacles were eliminated, on the back of high-margin Kurdistani oil production, GKP has started to recuperate quickly; 2017-2018 revenue, operating cash flow, and profit have been consistently improving. Unfortunately, in 1H19, that trend was broken as oil production was bleak; in June, a gross figure even plummeted to 23,200 bopd (see p. 5 of the presentation). This issue is worthy of concern, but Gulf Keystone offered a trustworthy explanation. Necessary maintenance and debottlenecking at PF-1, workover at SH-1 and SH-3, export pipeline shutdown in February were the main culprits. To rewind, GKP is a single-asset company, as its revenue entirely depends on the Shaikan oil field not far from Erbil, the KRI's capital. Hence, its top line is exposed to apparent risks as it could not offset the repercussions of operational issues at the block. While supermajors have vast portfolios that help mitigate effects of oil fields shutdowns, small E&P players do not have such versatility and have to opportunistically manage their balance sheets to avoid liquidity issues amid lower output and revenue.
As a result of maintenance and workover, net production at Shaikan dropped to 29,362 bopd compared to 31,563 bopd in 2018. Also, 2019 full-year guidance was cut to 30-33 kbopd from an initial 32-38 kbopd. Revenue, EBITDA, and profit tumbled amid lower output, weaker oil price, and higher operating costs caused by "growth in activity required to bring production to 55,000 bopd." All in all, there is no reason to feel elated.
LTM revenue dipped to $230 million compared to 2018 result of $250.6 million. Apart from workovers, the reason for the decrease was tumbled realized price. The firm sells oil at a substantial discount to Brent, $21.7, "for quality, pipeline tariff, and transportation costs." So, in 1H19, its realized price was only $44.8. Opex rose considerably, equaled $3.9 per barrel compared to $3 per barrel in 2018. But, to be frank, even despite higher expenses in the first half of the year, GKP remains an ultra-low-cost producer.
I titled the previous article "Gulf Keystone Petroleum: Potential To Double Revenue By 2021," as, back then, GKP's medium-term production guidance was 55 kbopd by Q1 2020 and 75 kbopd by 2021 (see p. 38 of the 2018 presentation), and analysts anticipated 2021 revenue to equal $537.2 million (2.14x higher than 2018 sales). In 1H19 presentation, GKP assured that a 55 kbopd target would be reached in Q2 2020 (see page 8); put another way, the milestone was delayed by a quarter. Also, due to downward revisions, analysts' forecast was lowered to $426.5 million (see Earnings Estimates), perhaps as the less favorable oil price was factored in the DCF, for instance. However, the potential increase is still staggering, 1.7x. So, with such revenue prospects, GKP remains a hybrid stock with both attributes of growth and value equity.
According to the guidance mentioned in the announcement, the company remains on track "to deliver 55,000 bopd in Q2 2020." But, most importantly, it has other targets, 75, 85, and 110 kbopd by approximately 2021, 2022, and 2024, respectively. The problem is that a field development plan (FDP) essential to reach the milestones has not been approved by the Kurdistan Ministry of Natural Resources yet. GKP mentioned that it was "in discussions with MNR to reach approval." As a reminder, the MNR previously rejected the plan as the ministry was not content with the management of produced gas and flaring issues. So, Gulf Keystone and its partner Hungarian MOL made a few adjustments and resubmitted the FDP in May. As it was mentioned in the report,
We remain confident that the FDP will be approved by the new MNR administration, although with some uncertainty on the timing of such approval.
However, readers should bear in mind that there is a risk if the project does not receive approval, the stock price could head lower; the rational explanation is that, with production delays, its intrinsic value decreases respectively.
Free cash flow, capex, return on capital
When an oil company did not put effort into production growth, it will ultimately face an ineluctable decay. On the flip side, growth at all costs and wasteful, nugatory capital investments should be avoided, and more responsible capital allocation should be prioritized. So, this year, Gulf Keystone has stepped up investment activity necessary to fund its growth story and magnify production at the Shaikan block but still remained FCF positive due to minuscule opex and even increased cash by $7 million.
Yet, there was a substantial difference between free cash flows generated in 1H18 and 1H19. Sure, lower production and weak commodity price took a toll. Also, GKP had to pay $11.06 million to exit Algerian operations; the payment was one-off in nature and will not weigh on free cash flow in the future, so, I had not factored it in while calculating FCFE. Speaking more specifically:
- 1H19 operating activities (net of interest paid) brought $55.04 million,
- Capex (intangibles & tangibles) consumed $36.72 million,
- The surplus equaled $18.3 million, compared to $58.2 million a year ago.
Here, I want to draw the attention of my esteemed readers to the fact that GKP's LTM Levered Free Cash Flow Return on Equity equals an astounding 18.9%, while Unlevered FCF Return on Total Capital stands at 17.2%.
For the sake of clarity, here are the formulas I used to arrive at the figures mentioned above:
- FCF to Equity was calculated as the difference between net operating cash flows and capex (investments in intangibles & tangibles);
- FCF ROE has FCFE in the nominator and Average Shareholder Equity in the denominator.
- Unlevered FCF or FCF to the Firm was calculated as the difference between net operating cash flows and capex (investments in intangibles & tangibles) with interest paid added back.
- FCFF ROTC has FCFF in the nominator and Average Total Capital (Total debt & Equity) in the denominator.
A brief update on valuation
GKP's closest peers are DNO ASA and Genel Energy. The latter is more akin to it as DNO's portfolio is now more North Sea-focused and diversified after the takeover of Faroe Petroleum. I suppose it is worth taking a look at their DD&A and debt-adjusted earnings yields to uncover if their market values fully reflect their merits (or flaws) or not. More specifically, DNO trades at LTM EV/EBITDA of 2.84x, Genel's debt and equity investors pay $1.88 per dollar of EBITDA, while GKP trades at 3.2x. Amongst the peers, Gulf Keystone looks overpriced, but it surely is not so, especially considering its anticipated revenue growth and prodigious use of capital. In sum, even with Kurdistan-specific issues factored in, I still believe all three companies are undervalued.
An interesting combination of low valuation and substantial growth prospects makes GKP a top pick compared to DNO and Genel Energy, which are also deeply underappreciated due to the risks of the region of their operations; I highly rate all these companies, yet, the peers have weaker revenue growth prospects in the medium and long term.
The key risk is that the Ministry of Natural Resources might again reject the FDP. It is not predictable, but such an issue could hinder GKP from increasing output as planned. So, its valuation will inevitably reflect investor skepticism. Another critical matter worth bearing in mind is that GKP sells oil at a substantial discount to Brent.
As the company vitally depends on the oil price movements, which are closely correlated with global economic growth, there is also a systematic risk that stems from a trade war and volatility in the markets. With all variables factored in, I still have a bullish sentiment on the stock.
Note: Ordinary shares listed in London have better liquidity than the ADRs.
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.