Seeking Alpha

Conservative Guidance At Laredo Petroleum Has Few Peers

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About: Laredo Petroleum, Inc. (LPI)
by: Long Player
Long Player
Long/short equity, value, special situations, contrarian
Summary

Guidance was increased again, as expected.

Enterprise value is now less than three times projected future cash flow.

Production has grown about 13,000 BOED since the 2018 fourth quarter.

6 additional wells have been added to the capital budget.

Recovery from the Shell contract breach and the gas takeaway capacity issues now appears complete.

When it comes to poor-mouthing the company prospects, the management of Laredo Petroleum (LPI) appears to make some football coaches look like amateurs. Earlier this year, management put out guidance that the oil percentage of production would drop for the year. Anyone who believed that forecast needed to do a whole lot more homework on this company when it comes to guidance and then actual results. This management has long been extremely conservative in its guidance. As a result, this author forecast steady revisions throughout the year.

Another revision upward has now been released. Management announced that the production forecast was again beaten by actual results (as if that never happened before). More importantly, the higher-than-expected oil production will result in more free cash flow than predicted for the second half of the year.

(Source: Laredo Petroleum Investor Presentation, November 2019)

The market got overly concerned when all of the production increase was gas (as shown above) in the last fiscal year. This happened at the same time that gas prices were sinking to unbelievably low levels due to takeaway midstream capacity issues. The company had just recovered from the Shell contract abrogation, and the market figured another crisis was in the making. But management quickly figured how to raise the oil production percentage in new wells.

The "transition" year has resulted in a production increase of about 13,000 BOED since the fourth quarter. There could be far worse transition years than the current year. Admittedly, much of that increase is natural gas and natural gas liquids, because management is recovering from a strategy that led to a large expansion of natural gas and some liquids in the previous year. Therefore, the increasing oil production of new wells is merely "making up" for the previous strategy divergence.

Had management not changed production strategies, the percentage of oil produced would have declined this year again. The hard comparisons that resulted from the newer gassier wells in the previous fiscal year will be over with in another quarter. Beginning the next fiscal year, oil production should grow in sync with the rest of the production. The percentage of oil produced may even increase some as management refines the new strategy.

Best of all, well costs declined, as some key steps are now more efficient and service costs have declined. As well production has improved, this has raised the rate of return achieved for new wells drilled. Not only are the wells more profitable, but management figures there is now enough money to drill six more wells before year end. This transition year is turning out to be far better for shareholders than management first advertised at the beginning of the year.

More importantly, as midstream capacity catches up with demand, the discounts for production should decrease. Even though oil pricing is now weak, Laredo stands to benefit from lower discounts. Natural gas pricing should dramatically improve in the future as more markets become available for that gas production.

Stock Price Action

Mr. Market is ignoring the fundamental improvement to the point where the stock is at bargain levels seldom seen in modern-day markets. The first slide demonstrates that this company generally trades at an enterprise value of less than 3 times EBITDA. That is extremely cheap for a company that can easily grow production.

(Source: Seeking Alpha, December 1, 2019)

The downward swings continue to outpace the upward moves. Nonetheless, sooner or later, that healthy cash flow will maintain the price. There is probably not much downward movement left given the hefty cash flow. Even a recession that many predict would not drive the price much lower from current levels.

(Source: Laredo Petroleum Shareholder Presentation, September 2019)

The rising percentage of gas production clearly affected the cash flow of the company. Weakening oil pricing that began towards the end of the last fiscal year doubled the negative effect on cash flow. Now, the rising percentage of oil production has begun to reverse that process. As long as oil pricing maintains itself in the current range, cash flow should grow about 20% next year over the annual amount forecast for the current year.

Enterprise value hovers under $1.6 billion (approximately), which makes this company a huge bargain based upon cash flow in relation to that enterprise value. Rarely do companies that grow production by 15% a year trade at ratios this low.

The debt ratio shown above is projected to be relatively conservative. Management has shown healthy production growth in the current year within cash flow. The relatively low debt ratios would allow for more borrowing should the oil price outlook become favorable enough to warrant higher debt levels.

This management has a very easy time reacting to oil price levels. Management will simply wait out lower oil prices while cashing the checks received for current production. On the other hand, increasing activity is also simple to take advantage of stronger pricing, if and when that occurs. Decent balance sheet ratios give this company a lot of advantages. In the meantime, the latest operational improvements to increase the percentage of oil produced almost ensure increasing cash flows regardless of oil pricing and the capital budget. It would take a major "across the board" commodity price decrease to eliminate projected cash flow growth over the next few years. The currently decreasing rig count instead points to firming commodity prices that Mr. Market clearly disagrees with.

Plus, this company generally reports decent profits in an industry that is still recovering from the big oil price crash at the end of 2015. There are many companies out there still reporting losses.

(Source: Laredo Petroleum Shareholder Presentation, September 2019)

Cash flow does vary with gas pricing. The increasing takeaway capacity available in the Permian will benefit the gas pricing received for gas produced even with the hedges in place. Free cash flow the market claims to look for has already arrived. More free cash flow is clearly in sight in the near future.

More importantly, management clearly recovered from the breach of contract by Shell (RDS.A) that led to a mad scramble to sell oil at reasonable prices. The settlement of the lawsuit by the company led to a one-time payment of $42.5 million shown above in the latest quarter on page 23.

Both the price drop resulting from the Shell refusal to take oil produced as well as the gas takeaway capacity issues are now behind the company. This is one company that should show decent cash flow growth even if oil prices weaken slightly compared to the previous year.

Operations

Part of the reason for those profits was an early embrace of a comprehensive water handling system. That system keeps costs very low compared to the competition.

Not many realize that sizable chunks of the oil producing parts of Texas are arid or semi-arid. A drought in these areas often produces a mad scramble for the water needed in the fracking or well completion process. This company recycles water used, and therefore, is not a hostage when drought conditions create water restrictions.

(Source: Laredo Petroleum Shareholder Presentation, September 2019)

A tight-fisted approach to costs can do wonders when the acreage produces more gas and natural gas liquids than desired. Combine that with a decent hedging program and management has a recipe for decent profits on below-Tier 1 acreage. This is actually one of the ways to increase satisfactory results on below-Tier 1 acreage. It is also one of the ways that Tier 1 acreage "grows" over time.

Mr. Market tends to concentrate on visible Tier 1 acreage. But sometimes, costs are low enough on other acreage that profits are as good or better than the competition reports on the prime acreage. Laredo Petroleum is a prime example of a decently profitable producer with acreage that would not be considered first class by many.

So many times Mr. Market gets fixated on selling price or costs. But the total picture that results in a rather generous cash flow from operating activities is the most important of all. California Resources Corp. (CRC), for example, manages to report one of the best margins in the industry combined with one of the lowest cash flows in relation to its debt load and enterprise value. There are other companies out there with low costs and still lousy margins. Therefore, a comprehensive picture is very important.

Summary

Laredo Petroleum is a company with a history of significant annual growth that is now set to both grow fast and deliver some free cash flow.

(Source: Laredo Petroleum Investor Presentation, November 2019)

Management earns a decent rate of return solely on the oil produced as shown above. Now, with the increasing midstream capacity, that profitability will increase as gas contributes more to profitability. Mr. Market was so concerned about the gas production percentage that the underlying profitability was missed. In the meantime, the hedging program provides considerable downside protection. Sometimes, Mr. Market forgets that a company such as Laredo can take advantage of upward pricing moves simply by producing in excess of the hedging program.

Next year, management will have lower drill times and lower costs brought on by the currently perceived weak oil pricing. This company has low enough costs to continue to expand production by at least 15% at a time when many will grow at a much slower rate. In addition, management will continue to pay down the bank line with some extra cash flow.

The financial flexibility is enough to allow management to take advantage of any distressed sales that would be available. Rarely can one find a growing company at less than three times projected 2020 cash flow from operating activities. This company is one of very few that is currently selling at a very low enterprise value when compared to cash flow from operating activities.

The downside risk at the current price of the stock is probably very minimal for long-term investors. Both the price-to-earnings ratio and the tremendous cash flow per share as well as the production growth should protect against further significant price decline. A return to a far more normal enterprise value of 8-10 times cash flow provides plenty of upside potential.

Some patience is advised, as it always is hard to tell when companies like these are recognized by the market. But a low price-to-earnings ratio strategy usually will outperform the market in the long term. If the stock price remains where it is, earnings can only grow. At some point, Mr. Market will recognize the bargain.

Disclosure: I am/we are long LPI. 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.

Additional disclosure: I own two CRC calls.

Disclaimer: I am not an investment advisor, and this article is not meant to be a recommendation of the purchase or sale of stock. Investors are advised to review all company documents and press releases to see if the company fits their own investment qualifications.