When to Buy This Energy Stock?

Shas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Since Hess (NYSE: HES) publicly announced their strategic transformation into a more focused and higher growth exploration and production company in July 2012, the stock has given returns of more than 70% to its shareholders. This is a phenomenal capital appreciation for investors within the last nine months. The company has also announced a $4 billion stock repurchase plan and is raising its dividends by 150% to $1 annually. Now the question is what the fair value of the stock will be after its transformation strategy is implemented completely and whether it is the right time to buy the stock after such a dream bull run?

Volatility in the Stock

Long term investors in the stock have seen a lot of volatility in the stock over the last ten years. The stock has even given a return of around 400% over the last decade. From a high of around $130 in 2008, it fell to around $40 in the following year. It touched $85 again in 2011, before dropping again to $40 in the middle of 2012. Since then it has been rising and is currently trading at around $70-75. But the recent volatility is not a result of any external economic factors, rather it is due to the complete restructuring process that the company is going through.

Bull Run

The company now aims to be a pure play E&P, focus on production in North America and reduce investments in lesser profitable geographies like Indonesia and Thailand. It is also planning to exit all its downstream businesses like retail and energy marketing/trading. Shareholders believe that this strategy will unlock value for them as the sum of parts of the company is worth more than the prevailing share price. The surge of 2.7% in stock prices in response to the recent sale of its Russian subsidiary Samara-Nafta to LUKOIL substantiates the fact that the shareholders are anticipating an increase in production levels, efficiency, and therefore profitability due to this transformation strategy. The stock reached its 52 week high due to this development. According to Elliott management, which owns 4.4% of the stock estimates the stock value to be worth as much as $126.

There has been a dispute between the management and Elliott regarding the restructuring process. In either case, there is a win-win situation for Hess, according to analyst Paul Sankey. This is because both are in favor of the steps undertaken so far, and it will ultimately lead to price appreciation if the proper implementation can take place.

Positives of the Deal

Once the strategy to transform into a pure play E&P company is implemented completely, analysts will apply a valuation multiple, which is similar to faster growing player in the industry. This would be a significant improvement over the current valuation multiples which are applied to the company due to its scattered assets. Apart from this, selling off the assets in its downstream businesses would release cash for shareholders, like the recent sale of its Russian subsidiary. The move will also free more than $1 billion of working capital, which could be used to fund its other growth prospects. It can also help the company to reduce its debt with the proceeds its receives from the divestiture. Streamlining of the international operation would further improve the efficiency and production levels of the company by selling off the loss-making part of the business.

Some Possible Limitations

The strategy involves a lot of capital investment, which would need outside funding if the investments are not met with the sale of unwanted assets simultaneously. Also, due to the diversity in Hess's business, this task would take a significant amount of effort and time, which will reduce the annualized return of the stock. This also runs the risk of external economic factors affecting the stock in the meantime.

Competitor Analysis

Its competitor ConocoPhillips (NYSE: COP) has also been adopting a similar strategy of separating its E&P business from its downstream businesses. The only difference is that ConocoPhillips will be the parent company for both the businesses while Hess is completely divesting its downstream business. The company has bought back shares and its payout ratio has also been 0.39 since 2011. Its P/E ratio is around 11, which is almost equal to the industry average.

Another competitor, Petrobas (NYSE: PBR), is currently trading at a P/E ratio of 7.7, which is the lowest among its peers. This is despite the highest reduction in its EPS growth in the last five years. Its stock is currently trading at around $17 and the analysts expect the stock to reach around $25. Even Credit Suisse upgraded the stock from neutral to outperform recently.

Future Outlook

In the recent conference call following the annual results of 2012, the management announced its production forecasts to be between 375,000 to 390,000 barrels of oil-equivalent per day in 2013. This is despite the sell-off of its Russian subsidiary, which signifies the management's confidence in increasing the production in its existing facilities in 2014. Following the completion of strategic change, a growing and focused company will be left, which will be much more attractive for investors. Increased dividends and share repurchases will also help the stock. Overall, the stock is still very attractive if an investor is ready to stay invested for the long term, i.e. till the completion of this strategic transformation within the company.

Shas Dey has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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