3 Reasons to Buy Plains Exploration & Production

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

Trans-form (verb) – to alter or be altered radically in form, function, etc.

It takes a backbone to realize that the current path isn’t the one that will lead to the desired goal.  It takes even more moxie to undertake the transformation necessary to get on a better path.  To transform a business adds both risks and unknowns to the situation that justifiably breeds skepticism.

Management teams are faced with either a continued stagnant share price or transforming their business and seeing their stock take an immediate hit.  That’s one reason why truly transformative deals are rare these days.   The deals that are designed to take a company to the next level of growth and shareholder returns are those that the market tends to quickly price in added risk for. 

The management team at Plains Exploration & Production (NYSE: PXP), though, had the backbone and the moxie to announce a series of transformative deals.  These deals have altered the makeup of the company by transforming it into a pure play in oil.  In so doing they loaded up on debt in order to take advantage of an extraordinary set of assets that were too good to pass up.  This transformation forced them to absorb a 10% hit to the shares but in the long run they’ve begun taking the necessary steps that will put the company on the pathway to profits.  I think that the new PXP is a buy, and here are three easy to remember reasons why. 

Pure play on oil

The first thing you need to know about PXP is that the final step of their transformation will include selling all of their non-operated and therefore non-core natural gas assets.  These gas assets include an interest in the Conoco Phillips (NYSE: COP) operated Madden field in Wyoming and a 20% stake in Chesapeake’s (NYSE: CHK) Haynesville acreage.  Combined they add next to nothing to their bottom line but are worth between $1.5 and $2.0 billion if sold to another producer.   

Of course they still do have to actually find a buyer for both of these assets.  One could certainly surmise that Conoco Phillips might be interested in picking up PXP’s interest in Madden.  They have the access to capital and could easily consolidate their interest.  On the other hand the Haynesville position is unlikely to be targeted by the operator.  Chesapeake is overly levered to natural gas and is working to shift toward more liquid rich areas.  They’re also overly levered in general, which is why they sold the minority interest to PXP in the first place.  Getting the gas assets off the books is the final piece of the puzzle, which management expects to complete by the end of the year.

Once they find buyers, they’ll reinvest that cash along with the copious cash flows from their other oil assets into the much more profitable oil assets they’re acquiring.  They plan to hedge up to 90% of their oil production through 2015 to lock in more than a billion dollars a year in free cash flow.  With an equity value of $5 billion, this company will be trading at a 20% cash flow yield.  That is incredibly cheap and won’t last once the market realizes what this company is capable of.

eXtraordinary Gulf of Mexico acquisition

PXP’s deal with BP (NYSE: BP) and Shell (NYSE: RDS-A) for $6.1 billion is unbelievable.  These assets should generate between $4 billion and $5 billion in cash between 2013 and 2016, which is why they could buy them without issuing any equity.  They’d not have been available if BP didn’t need to shed assets to fill their need for more capital.  Meanwhile, Shell decided to accept the unsolicited offer from PXP for their 50% interest in the BP operated Holstein asset.  By monetizing this mature deep water asset, they were able to free up some capital for new opportunities elsewhere.  

For PXP the opportunity to pick up assets for 3.5 times enterprise value to cash flow is worth the risk.  Before the deal, the whole company was trading for 5.4 times EV/CF, which is why these assets really take PXP to another level.  Production is increased by 40% while cash flow doubles.  Production costs per barrel of oil equivalent drop by 4% while G&A expenses per BOE drop by 15%.  By any metric you look at, PXP has transformed the company into a more profitable pure play on oil.  As they reduce their leverage, shareholders will see more value being created on their behalf.

Paying down debt

The key to making this transformation work is their ability to quickly reduce their debt to slowly transfer control from the debt holders back to the equity holders.  By the end of 2013 they will have reduced debt to below $7 billion.  By 2015 their plan is to reduce net debt to capitalization from its current 72% to just 40%.  Their hedging program reduces risk by locking in the cash flow.

Think about it this way, each year the company will take a billion dollars and transfer it from debt to equity on the balance sheet while reducing the interest expense, which will free up even more cash.  Deleveraging stories can be very profitable and PXP’s hedging program all but guarantees they’ll be able to successfully delver over the next few years.   

Conclusion

I like what PXP is doing and I’m confident that they’ll handily outperform the market over the next few years.  That’s why I’m giving them a thumb up in my CAPS profile.  However, the company is not without risks.  For the bearish view check out fellow blogger Robert Zimmerman’s 3 reasons you should sell here.


latimerburned owns shares of ConocoPhillips. The Motley Fool has the following options: long JAN 2013 $16.00 calls on Chesapeake Energy, long JAN 2013 $25.00 calls on Chesapeake Energy, short JAN 2014 $17.00 puts on Chesapeake Energy, long JAN 2014 $20.00 calls on Chesapeake Energy, and long JAN 2014 $30.00 calls on Chesapeake Energy. 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.

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