2 Oil & Gas Stocks to Buy, 1 to Avoid
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
From greater economic activity to unusually low multiples, oil & gas is one of the most undervalued sectors right now. However, only some companies are worth the risk of backing plays that end up yielding disappointing earnings: Occidental Petroleum (NYSE: OXY) and Cabot Oil & Gas (NYSE: COG) being two of them. Both look well positioned in the regions that they are developing. Linn Energy (NASDAQ: LINE), on the other hand, looks too expensive.
First, on a multiples perspective, Cabot looks like an anomaly trading at a respective 85.9x and 50.7x past and forward earnings. However, that was just due to unusually low activity as production is elected to ramp - sending EPS up by a CAGR of 22.8% over the next 5 years. In addition to seeing strong promise in Eagle Ford, Cabot has high-rate Marcellus wells and a realistic capital allocation program. Shares are currently at $44.64 and Bernstein just announced a $50 price target.
Cabot operates principally in Texas, Oklahoma, and Appalachia. Production went up 40% y-o-y in 2Q and is nearly doubling returns in liquids through Eagle Ford. It owns 60,000 acres in that region and thus is well leveraged to this growth. Production has been better-than-expected in the five horizontal rigs, and a record of 752 Mmcf (7% higher than average) was produced in the Marcellus in just one day's time period. Although there have been some delays in gathering natural gas, production has been overall strong on a sequential and y-o-y basis.
If you are looking for actual cash in your bank instead of paper valuation, consider buying Linn Energy which pays out a 7.2% dividend yield. In my view, however, dividends are overrated for a few reasons. First, the obvious: they are taxable. Second, they are just the opposite of retained earnings and thus, in a sense, are a tacit admission from management that they might not generate strong returns through investments. After growing EPS at just 1.8% annually over the past 5 years, investors have reason to be on the fence about the next 5 years. Shares are now valued at nearly 2x book value, so future growth that will be generated through the less than 40% that is not given directly back to shareholders probably won't be enough to justify the current valuation. Indeed, analysts forecast earnings to go up only 8.5% annually over the next 5 years as the economy recovers from the worst macro downturn since the Great Depression.
I am also not optimistic about the firm is playing "scaredy-cat" with its 100% hedged production of natural gas until 2016, which reduces upside. Furthermore, results were fairly weak in the second quarter with an increase of 15% in revenue y-o-y. Fortunately, the strong return was a result of greater production in hydrocarbons and not the price, which went down. EPS of $0.31 were 27% below expectations, however, due to low LNG prices. While I am optimistic about the company's interest in hunting out $2.8 billion worth of acquisitions and JVs, I believe that it is not increasing scale significantly enough to create meaningful economies of scale.
Oxy has already created one of the largest economies of scale as a leading integrated oil & gas producer. For the relative stability that it offers, it trades at a respective 11.3x and 11.4x past and forward earnings. Margins and shareholder value have both been on the upswing. After growing 10.8% annually over the past 5 years, analysts now expect the company to increase earnings 10.9% annually over the next 5 years.
Assuming Oxy is able to meet expectations, 2016 EPS will come out to $10.49. At a 15x multiple, this translates to a future stock value of $157.35. So, already there is the potential to increase your holdings by 80% in just 5 years. But, in present terms, how much is that near doubling worth? Discounting backwards by 10% yields a present value of $97.70, which is at a 10% premium to the current market cap. Although this is not a great margin of safety, it is large enough to justify making an investment with the intentions of getting an 80% return in 5 year's time.
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