3 Undervalued Oil & Gas Stocks
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The conventional wisdom in natural gas is that prices will be volatile over at least the next few years. For whatever it's worth, the experts are almost always wrong. And the riskiest assets tend to outperform as discount rates come down to meet growth trends. Below, I review several companies that are exposed to natural gas and have tremendous untapped potential yet to be appreciated by the market.
Buy Devon Energy (NYSE: DVN), Growth Curve Underappreciated
This major oil & natural gas producer trades at a respective 9.7x and 12.7x past and forward earnings with a dividend yield of 1.4%. The Street currently rates it a 2 on 1 to 5 scale where "1" is a "buy". Analysts forecast EPS growing by 6.4% annually over the next half decade. This is good turnaround from the 2.7% rate of decline experienced over the past half-decade, but it is ultimately not optimistic enough in my view.
Though the company was considerably below expectations in the last 2 quarters, the 11.1% price decline was unwarranted for several reasons. First, the company will consolidate domestic E&P operations to save around $80 million per year. With an average of 30,000 net acres and an exploratory well averaging 7,350 boe/d in just the first eight days, the company's growth curve has been underappreciated. Moreover, the company is making aggressive investments that are well positioned to capitalize on a rise in natural gas prices. For example, it recently made a $1.4 billion joint venture with Sumitomo Corporation to develop the Midland Wolfcamp Shale and the Cline Shale. This will mitigate risk, since Sumitomo will contribute nearly four-fifths of the drilling and completion costs. It is also developing the Tuscaloosa Marine Shale under a JV with Sinopec. The potential for large returns is substantial given that Tuscaloosa--frequently compared to the Eagle Ford play--may carry as high as 7 bboe. With Eagle Ford seeing a dramatic decline in production rates, Tuscaloosa is likely to see a rise from substitute demand.
Marathon is another attractive stock for natural gas exposure. It trades at a respective 12.3x and 9.3x past and forward earnings and is forecasted for just 2.8% annual EPS growth over the next half decade--again, far too bearish.
There are several reasons why I am optimistic that Marathon will outperform in the near term. First, despite weakness over the last few months, EPS targets have still gone up. This is illustrative of how the secular outlook will overshadow short-term hiccups to make for attractive risk/reward. Second, the company is divesting assets, which will improve the company's financial position while lowering access to cheaper debt. In addition, gross margins and operating margins have gone up to 58.8% and 35.4%, respectively.
If you want to back a stock with even more upside that has been overly beaten down by bear attacks, I recommend Chesapeake Energy. The world's second largest natural producer has successfully divested extraneous assets to improve its financial position and generates enormous cash flow underappreciated by the market. Though shares dipped on poor 3Q12 results, EPS of $0.10 was still 11.1% ahead of consensus and $1.9 billion in quarterly operating cash flow was generated. Moreover, revenue was ahead of consensus by $600 million. The company is valued at just $12.2 billion, which gives you a good sense of how much liquidity its plays are providing.
Much of the reason for the 10% dip over the last 5 days has to do with a poor outlook on debt reduction. Fears were fueled when management mentioned in its earnings call that asset sales could be delayed--a signal that the company has yet to receive offers at attractive pricing. They were fueled even more by the announcement that positions were more or less unhedged for 2013. I believe, however, that this is a good thing given my expectation for a large rise in natural gas prices. In turn, this will solve much of the debt problem and unlock tremendous shareholder value.
While Marathon and Chesapeake carry considerable risk, risk brings reward. Their strong leverage and large economic moats grant efficient cost structures that will capitalize on burgeoning industrial activity. Buy before the bears exit!
TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Devon Energy and has the following options: long JAN 2013 $16.00 calls on Chesapeake Energy, short JAN 2014 $15.00 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.