Don't Give Up On Natural Gas Just Yet, Consider These 3 Stocks

Includes: CEO, ECA, TLM
by: Takeover Analyst

It has been no secret that I am a long-term bull on natural gas. I believe that, aside from foreign policy concerns, natural gas will become the prime energy source within the next decade. From comparatively low CO2 emissions to a 100-year supply, the demand will be high from both government and businesses. Accordingly, I recommend investors broadly diversify across the oil & gas sector. Nexen, EnCana, and Talisman are three stocks to consider under this bullish thesis. Below, I review the fundamentals of each stock.

Nexen, Inc. (NXY)

Last month, Cnooc Ltd offered to buyout Nexen for $15.1B cash - the largest overseas takeover by a Chinese producer. The bid was placed at a substantial 61% premium to the July 20 closing price and will be backed by $5B in offshore financing. The assets Cnooc will be acquiring include oil-sands reserves at Alberta and production platforms in Nigeria, Gulf of Mexico, and the North Sea. With the company currently valued at $13.42B, shareholders have 12.5% to gain from the buyout being approved. Management recommended the sale to shareholders.

I do not believe the acquisition will be blocked by either the Canadian or Chinese regulators. The company has not seen these levels in a while - brief rises in 2Q09 and 1Q11 were soon compromised by weakness in Long Lake, absent significant capital expenditures. Management turnover helped provide a more optimistic story, but the Long Lake project has still held value back. This worry is not worth it at the premium that Cnooc is offering for shareholders. It is noteworthy, for example, that the transaction prices the company at the upper end of the 2.5x-5x historical consensus cash flow multiple.

I recommend shareholders buy to capitalize off of the deal closing. While I don't expect competing bids to rise, I think the upside meaningfully compensates any risk left. Even if the bid does not go through, Nexen still trades at 13x currently and is well worth a "buy" with any subsequent decline in shareholder value.

Talisman Energy Inc. (NYSE:TLM)

Talisman currently trades at a respective 14.7x and 17.9x past and forward earnings with a low 2% dividend yield. While these multiples are high, future growth is compelling, as evidenced by the 0.50 PEG ratio. Annual EPS growth is forecasted for 29.4% over the next five years. This is a major turnaround from the double-digit declines over the past five years, and hence a risky investment to make.

In my view, however, upside outweighs downside. The firm has aimed to nearly half of its UK North Sea Assets to Sinopec for $1.5B in cash. These assets are generating around $66M of 2Q12 annualized cash flow, which means the divestiture is coming at a 2.3x multiple. While the short-life of these assets may justify some the cheapness, it still looks a tad too low. I do not like the idea of divesting risky assets just because macro trends are uncertain. With the economy heading in the right direction, there is no reason to sell when oil and gas is already substantially undervalued. At the same time, the divestiture will provide greater flexibility in buying faster-growing assets.

Compared to what Cnooc was willing to buy for Nexen, Talisman is meaningfully undervalued. The 61% premium is indicative of substantial international demand, and TLM has 55% of its production abroad. Despite the lack of long-life oil sands, prospects look bright in Southeast Asia. Management is also restructuring the business and it is much more of a takeover target with Sinopec out. Complemented with high growth, I recommend buying shares now.

Encana Corporation (NYSE:ECA)

At current levels, Encana looks overpriced. While the company offers a 3.6% dividend yield, the stock still trades at an outrageous respective PE and forward PE multiple of 372.2x and 60.4x, respectively. Analysts currently rate the stock a 3.1 out of 5 where "5" is a "sell", so there is not too much love on the Street.

What I like about Encana, however, is that the company is busy acquiring liquids-rich gas and oil assets. The capex budget has been increased by $600M for 2012 and will be supplemented by divestures. But I do not like how the company is cutting back spending on existing gas plays (shutting 250M cubic feet each day this year). In fact, the company is moving from natural gas to liquids & oils, which will fail to capitalize off the former's surge from lows.

During the second quarter earnings call, management released weak operating results. A loss of $1.5B was made worse by the top-line missing expectations. Hedges are coming off by 2012's end, which will put increasing pressure on management to de-risk operations. Morningstar believes that even if the firm only spends at the low-end of the $4B-$5B capex budget, it will still have to double liquids production to 60K boe/d in order to breakeven in 2013.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.