EXCO Resources (NYSE:XCO) is a pummeled stock. From being in the mid-$20s less than two years ago, it has drifted down to $6 per share of late. In mid-2011, management tried to buy the company out at a premium ($20.5) but was rejected for being too low of a price.
Wow! How times have changed. The big decline in natural gas prices, particularly the dry kind (methane), has hurt leveraged E&P companies like XCO. They've been saddled with poor earnings, little cash flow, and the need to raise capital. Chesapeake Energy (NYSE:CHK) is probably the poster child for the sector, but XCO has been a short sellers' paradise too. Just recently, the company had to sell off a chunk of decent producing properties at cheap prices to improve liquidity. All that said, brighter days could very well be ahead for XCO and, assuming natural gas prices do not trip over themselves again, we could be looking at the bottom for this speculative investment. We've been an investor in EXCO's bonds for some time (here is our original article), but we have now taken a stake in the common stock too.
EXCO reported earnings on Thursday which, for the most part, were in line with analyst expectations. Some news reports indicated that XCO "whiffed" on revenue by a significant margin, but that is because its hedge performance is not included in the base number. For example, the reported revenue was $547mn for the year. However, with nearly 50% of its production hedged at higher gas prices, the true revenue, which includes the benefit of hedging, was $748mn. EBITDA came in at a healthy $445mn, implying the stock currently trades at a multiple of less than 3. Net income was horrible at -$6.50 a share, due to impairments. Adjusted net income was 38 cents a share, in line with expectations, and analysts are pretty much looking for flat earnings for 2013 and 2014.
Now a word on impairments. The way XCO values its assets (i.e., gas in the ground) for SEC reporting purposes is to use the trailing 12 month average natural gas price for estimating future cash flows. These are then discounted to today at 10%, creating what is called PV-10. Last year, the average natural gas price was about $2.65 per Mcfe. Using that price for future natural gas prices basically means the value of XCO's net assets are pretty much nil. Now, for sure, the assets are not gone. They have simply been moved from the so-called proven reserves to the probable category, and the latter does not get any value on the balance sheet according to SEC rules. This helps to explain why XCO shareholder equity has gone from $7.25 per share to 70c. Yes, I said 70c per share. However, the current natural gas spot price is about $3.25 and based on CME futures (i.e., the "strip"), the price is expected to be about $3.5 for 2013 and about 25 cents higher for each year thereafter. These are prices that can be locked in so they are, in effect, reality. The nut here is that, because of XCO's stated reserve methodology, the impairments and negative earnings are a bit of a mirage. According to the company's statements on its recent conference call, proven reserves have actually grown, using strip pricing, and are worth about $1.8bn in PV-10 terms.
EXCO did a deal last November with Harbinger Group (NYSE:HRG) where it sold 75% of its conventional, shallow, assets in the Permian basin and a portion of its Haynesville shallow acreage; it still owns the deep shale assets. We thought the assets were sold at fairly cheap levels, but given its liquidity needs, XCO did not really have too many choices. Using that deal as a guide, we backed out a shareholder equity value (details available on request) north of $7 per share not including the embedded call option on natural gas prices. Given the sentiment around the name, however, we looked for the stock to suffer and set a $6ish price target to buy. Our reasoning for "catching the knife" is that we feel the forces that worked to push XCO stock down in 2012 are set to reverse going forward. Let us state that we are not bulls on natural gas prices - we use the futures market in our analysis - but do think there is a healthy chance that spot prices will trade higher than where futures are implying a few years down the road.
Using EXCO's guidance for 2013, revenue and EBITDA will decline due to lower production. One might argue this is a negative, but it is merely a reflection of the economics of well drilling currently. On a side note, check out this article discussing the impact of new technology on Haynesville well costs by Richard Zeits - he is a must read for anyone investing in this sector. Okay, where were we. So the numbers are going to be down, but interestingly, net income should be much higher. First, the company will be using a low depreciation of $1.05 per Mcfe, which is a by-product of the 2012 impairments. In addition, because of the "antique" way it values its assets, our analysis indicates we should see a write-up of ~$125mn in 2013 due to a higher 12-month trailing natural gas price. All in, we see net income of about $1.2 a share, which implies it currently trades at forward P/E of 5. Note that analysts are expecting 35c for this year, which we believe is way too low. Even netting out the write-up, adjusted net income should be about 60c per share, so we expect positive surprises as 2013 unfolds. Most importantly, with lower capital expenditure, EXCO is living within its means and should be cash flow flat even after paying out 16c/share in dividends (2.67% yield).
Our model for future cash flows discounted to today generates a fair value of $9/share. We use a required IRR of 18.5%, which is a 10% premium over its bonds; pretty conservative, we believe. Changing the IRR hurdle will impact fair value a lot, so investors should always take model results with caution. That said, given its cautious approach to capital expenditures and production going forward, XCO is on a sustainable path for future earnings growth. The recent deal with HRG gave EXCO a much needed infusion of cash, which went to pay off debt, and the company has plans to sell off its midstream assets to further reduce debt and preserve leverage ratios. All in all, the liquidity risks that were significant last year have been mitigated and EXCO is in a position to reap the benefits of a rising natural gas price. To some degree this is not surprising given the list of big-time value investors that are on board - Wilbur Ross, Howard Marks, and, recently, Prem Watsa, amongst others. Nearly half the shares outstanding are owned by some pretty deep pockets and, with 18mn shares shorted, this stock price can move violently. Finally, owning XCO is an option on natural gas prices. If, starting in 2015, the price of natural gas was to be 25% higher than the futures market implies, fair value for the shares would double today. We use 2015 as that is when liquefied natural gas exports should begin and demand should respond. Now that we are comfortable with XCO surviving until then, we have increased our exposure down in the capital structure and own the common stock in addition to our bond exposure.
Additional disclosure: We are also long XCO bonds.
Disclosure: I 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.