Is Cabot Still a Strong Buy?
cris is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Cabot Oil & Gas (NYSE: COG) was the number one performing stock in the S&P 500 for 2011, with a 101% increase in share price. It presently is a premier natural gas play, and it has initiated a number of liquids-centered initiatives. However, Cabot's strength in the gas market isn't exactly a positive in the present commodities market.
I recommend a five-year holding period on Cabot Oil & Gas shares. Earnings per share for the first quarter 2012 were reported on April 25 at $0.14, beating the Street's consensus estimate of $0.13. This represents a year-over-year improvement, but I do not believe that it is a basis for an increase or breakout in share price just yet. The stock needs a fundamental catalyst in the form of higher crude and natural gas prices, whether real or perceived. At the moment, a weak natural gas price and a relatively flat crude price with weak demand fundamentals due to weakened Euro and North American economies weigh on that potential catalyst.
Valuation
Cabot Oil & Gas, presently trading at around $34, is fairly priced. Book value provides a very rough estimate of drilling and acreage asset value. The present price/book ratio is 3.33, greater than the sector's top quintile of 2.54. It is unlikely that Cabot will reach its 12-month high share price of $45 within a year. Indeed, given both commodity prices and the overall asset base of Cabot Oil & Gas, I think we can expect a target of around $33 to $35. Using a cost of equity of 10%, I expect a relatively steady operating margin assumption of 24-25% over the next year to arrive at my estimate. While year over year earnings growth will likely remain north of 30%, investors are assigning an earnings multiple around 40. Thus, on a growth basis, investors are fairly valuing the stock.
The Marcellus Shale
It is not surprising that Cabot's price reflects a certain measure of optimism. To back up a quite ambitious valuation, production at the Marcellus shale in 2011 increased 141% year-over-year from 2010. With increased horizontal drilling, the company averaged a production rate of 600 million cubic feet (Mmcf) per day. Unfortunately, though this venture represents a consolidation of Cabot's efforts in natural gas, the commodities outlook does not look too promising in the context of a 12-year investment.
Long-term, a gas-heavy portfolio is not a bad idea. As many argue, and I agree, gas is likely to be a commodity of the future. In 2005, the price of natural gas was $15/ mcf, compared to around $2/ mcf now. With the rise of hydraulic fracturing (fracking), production has increased to an extent that outpaces demand-at least for the moment. Proven reserve estimates for the Marcellus shale, by and large, have been reduced by 30% across the board. Indeed, we should not expect gas prices to remain below $4/ mcf for much past the beginning of 2014. In this respect, with Cabot's robust proven holdings on the shale, the company is well-leveraged in the American gas market. (Though other companies like Chesapeake Energy (NYSE: CHK), for instance, also have strong holdings.) Enthusiastic assessments regarding the Marcellus Shale as the "Saudi Arabia of Gas" are a little out of line. The fact is that new gas wells are popping up in Europe and the Middle East at a relatively constant rate as well. Thus, Cabot's excellent stake in the Marcellus Shale makes it competitive against American E&Ps, but this does not translate into worldwide leverage.
Liquids Growth
The problem is that liquids are positioned to give investors short-term returns. Occidental Petroleum (NYSE: OXY), for example, is poised for an excellent play in the present commodities climate. Occidental posted excellent first quarter 2012 earnings per share figures and is poised for an excellent 12-month run. This is proof that a strong liquids asset base, combined with a lower cost basis, is an important ingredient for short-term returns in the energy sector.
That said, Cabot increased liquids production 68% from 2010 to 2011, a rather large increase given the fact that management hardly changed liquids output from 2009 to 2010. Furthermore, in its first quarter 2012 conference call, liquids output increased 138% year-over-year. For the most part, Cabot relies on its wells at Eagle Ford and Marmaton for consistent liquids output. Management expects anywhere from 30 to 40 wells to be dug in 2012. This is a promising trend for long-term growth, despite the lack of speed necessary for short-term returns.
There are other reasons to be optimistic about the long-term. Cabot decreased its total capital expenditures allotment for 2012 by $100 million, and it decreased its total cost base in 2011 by 25%. In 2012, management looks to decrease cost by an additional 20%. With better margins, we might look to see earnings exceed $1 per share in 2013. In 2012, Cabot Oil & Gas should be able to drill up to its cash flow constraints. In its conference call Q&A, management indicated that, though additional fracking crews will be withheld for the coming year, remaining capital expenditure allotments will be used to cover the completion of additional drilling steps. Companies like Anadarko have realized a greater hit on drilling costs than Cabot because Cabot has done a particularly good job of consolidating its upstream operations. The long-term debt of capitalization for Cabot decreased 3% from 2010 to 2011.
Regarding risk, Cabot has hedged 38% of its midpoint guidance, five gas contracts and two oil contracts. Additionally, the company is 97% institution-owned.
Conclusion
Despite its competitive, "future-oriented" natural gas holdings, Cabot Oil & Gas does not make an ideal short-term investment. A 12-month move would seem to violate two principles. (1) Do not trade on past success. Cabot did well in 2011 and reported decent earnings for the first quarter of 2012, but that does not disclose the real story about Cabot's valuation. (2) If you are buying shares of a company with heavy exposure to commodity price swings, buy on long-term value. Commodity prices are only semi-rational. On this front, Cabot does average, but not stunningly. For this reason, I recommend a look at the super majors, particularly Chevron, which seems to be trading at a substantial 12-month discount. Additionally, I think ConocoPhillips represents a more dynamic value-based stock.
jewishitalian31 has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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.If you have questions about this post or the Fool’s blog network, click here for information.
