A Classic Growth Story in Oil & Gas - What's Not to Like?

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

Earlier this month, Zacks Investment Research upgraded Cabot Oil & Gas (NYSE: COG) to a Zacks #1 Rank (Strong Buy).

Positives

The reason for the upgrade was that Cabot has been reporting rising earnings estimates following strong third-quarter 2012 results and an enhanced guidance for 2012 and 2013. The long-term expected sales growth rate for this stock is 4.97%. For the third quarter of 2012, earnings per share (excluding special items) at $0.17 was ahead of the Zacks Consensus Estimate of $0.15 per share. Cabot’s performance also improved from the year-ago adjusted profit of $0.14 per share. The increased earnings were primarily due to enhanced output, increased oil prices and lower exploration costs.

Cabot guidance estimates that its 2012 volume growth will be in the range of 38% to 44%, including expected liquid growth of 60% to 70%. For 2013, Cabot expects to see production growth in the range of 35% to 50%, including a liquid growth of 45% to 55%. For 2013, more than half of the estimates were revised higher over the last 60 days, lifting the Zacks Consensus Estimate to $1.17 per share.

Negatives

Appearing on the "Danger Zone" segment of "MoneyLife" with Chuck Jaffe, David Trainer, president of New Constructs, pointed out several issues regarding the company's balance sheet, which he said would be overlooked by many investors. The GAAP profits show moves in the opposite direction from the true economic profit because of $857 million in net deferred tax liabilities, $17 million in off-balance sheet debt and $313 million in accumulate asset write-downs. Despite what the accounting results disclose, this company is not making money.

The write-downs, which Trainer called “the ugliest thing,” show that for every dollar you give the management team, they have had to write down 10 cents.  He also pointed out that to justify its current stock price of almost $50, the company would have to grow by 20% compounded annually for the next two decades, and this is a lofty expectation. He also commented that the money the company owes the US Government in taxes has grown large and cannot be deferred forever.

Production Milestone

Cabot announced  that for the first time in its history, its Marcellus operations exceeded one Bcf of gross production per day. The achievement of this milestone resulted in total net production simultaneously exceeding the one Bcfe per day level, also a new record high. This record was the result of new Marcellus wells and additional infrastructure. Specifically, a recent turned-in-line two-well pad illustrates the production potential of the company's Marcellus assets. This pad has wells with lateral lengths of approximately 6,900' and 4,400' and a combined initial production rate of over 66 Mmcf per day. Also, additional compression and dehydration facilities allow Cabot to expand its takeaway capacities. The company is presently delivering approximately 55% of its production to Transco, 40% to Tennessee Gas Pipeline and 5% to Millennium Pipeline.

Dan O. Dinges, Chairman, President and Chief Executive Officer of Cabot Oil & Gas said, "Throughout the month of December we have been gaining production momentum and month-to-date our total Company average net production rate is 930 Mmcfe per day, which is above our exit rate expectation expressed in our third quarter call." The company also continues to monetize legacy assets and deploy the fund's released high return investments.  It has agreed to terms on the sale of four South Texas fields to an undisclosed third party which includes legacy conventional properties with approximately 18 Bcfe of booked reserves and 2.2 Mmcfe per day of current production. Proceeds from the sale will be around $29 million, subject to closing adjustments, and will result in a book loss of approximately $12 million after-tax.

The Competition

Another good bet is Linn Energy (NASDAQ: LINE). The stock has fallen from its recent 52-week high, and there are several factors that make this stock attractive. Linn Energy produces a dividend yield of around 6.8%. It has shown less volatility than the broader market, and it has a "buy" rating with a forecast of 13.6% annual EPS growth over the next five years. 

EOG Resources (NYSE: EOG) is fairly expensive at a historical price/earnings ratio of more than 26 and a forward price/earnings ratio of almost 19, yet, many analysts still rate the stock a "Buy."  The most important reason for this is the presence of oil-rich reservoirs in Texas's Eagle Ford, which should help drive production. The expansion of the Wisconsin fracking sand facility will produce cost savings of $0.5 million per well at Eagle Ford and improve profitability.

Chevron (NYSE: CVX), the second-largest U.S. oil company, has agreed to buy a 50% stake in the proposed Kitimat liquefied natural gas terminal from Encana and EOG Resources, joining the competition to ship the fuel from North America to Asian markets. The cash generation from operations of $35 billion can finance almost all of its capital spending. I predict investment and production growth will result in stronger gains in the future.

Investment Thesis

Cabot is a classic growth story due to its strong third quarter performance and positive outlook. Natural gas production of 62.7 Bcf represents a 31% year-on-year growth.  In the near future, there is reason to be optimistic about the scheduled production of 30 Marcellus wells and, with a debt-to-equity ratio of 0.5, the company is financially strong. I am not particularly bothered by the accumulated asset write-downs because this will be a non-cash charge that does not impact the cash position. However, the deferred tax liabilities of over $850 million will surely catch up with the company some day. For this reason alone, I am reluctant to recommend Cabot as a "Buy." I am placing a "Neutral" rating on the stock.


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