Oil & Gas NAV Model Case Study and Investment Recommendation: Stock Pitch Guidelines

Transcription

1 Oil & Gas NAV Model Case Study and Investment Recommendation: Stock Pitch Guidelines In this document, we ll lay out guidelines for making investment recommendations / stock pitches for oil & gas companies and explain how you might use the results of a NAV analysis to argue that a company is overvalued, undervalued, or valued appropriately. In a separate document, we ll give you the actual investment recommendation for this case study of Ultra Petroleum, and you ll learn how to put together all the pieces to build your own recommendations. DISCLAIMER: First, please do not construe this as investment advice. We are NOT recommending that you invest in any of the companies discussed here. This is a tutorial about how to research and pitch companies that you think are interesting, and how to use what you ve learned in this modeling course to support your arguments. Table of Contents: What You Will Learn Why Stock Pitches Are Important What You Need for a Stock Pitch How You Structure a Stock Pitch o Recommendation o Company Background o Investment Thesis o Catalysts Tips and Energy-Specific Examples o Valuation o Risk Factors and How to Mitigate Them The Top 3 Most Common Mistakes in Stock Pitches and How to Avoid Them

2 What You Will Learn: Why stock pitches and case studies are so critically important in hedge fund / asset management, equity research, and even in fields like investment banking, private equity, and corporate finance. What kind of information and analysis you need to properly pitch a stock, plus the 6- point structure that you can apply to ANY type of investment pitch even outside of equities, in fields like fixed income or commodities. How to structure a stock pitch, including the 6 key points that you always need to mention, how to research each of the 6 points, and the top 3 stock pitch mistakes to avoid. Why Are Stock Pitches Important? They re Critical in Interviews Even outside of public market roles, you must be able to pitch ideas for investments, clients, potential buyers/sellers, and so on, for interviews across the buy-side and sell-side and sometimes even at normal companies outside the finance industry. They Level the Playing Field If you don t have a 4.0 GPA from Harvard or top A-Levels and an Oxbridge degree, presenting an exceptionally well-thought out stock pitch is a great way to set yourself apart and get firms to hire you over the Ivy League crowd. And if you are in that crowd, you also need a great stock pitch to set yourself apart from your competition. They ARE What You Do on the Job You ll make these pitches all the time when presenting ideas to the investment committee or others at your firm and attempting to sell them on your ideas. Even in sell-side roles such as investment banking, you ll have to write CIMs and other documents that pitch companies to investors, and to do that you need to understand how investors think about companies. What Do You Need for a Stock Pitch? You need a combination of market/industry research, company-specific research, and ideas about the valuation. For oil & gas specifically, there are some additional requirements and documents to look at beyond the standard materials.

3 In this case study, we ve mostly focused on the valuation and running the numbers for UPL. In a few parts, we mentioned that it is important to contact professionals such as petroleum engineers and get their estimates for reserves data and the proper risk adjustment factors to use, but we did not show you the steps for that in video format. However, all of those are important and you would need to do (more of) them in an on the job pitch (interview / case study pitches are more time-pressured). Here are the 5 major document categories we need in this pitch for Ultra Petroleum: 1. Company Research Read their filings, investor presentations, and equity research. What we ve done so far in this case study is a good start since we have lots of granular data on the company s wells and reserves in each region. You could always consult more sources, but in a time-pressured case study this is about the best you can do. 2. Industry Research Read industry reports issued by IDC, the Big 4 accounting firms, and any industry-specific journals you can find. Look at recent M&A and financing activity, read any recent articles about the industry in The Wall Street Journal or Financial Times, and leave no stone unturned as you figure out the key drivers. For UPL, we might consult reserve reports issued by other firms in the same regions, the Oil & Gas Financial Journal, and even academic sources such as the papers we looked at on the geology and oil/gas production capacity of different regions. 3. Company Documents Their most recent annual report (the 10-K for US-based companies) and any interim reports (10-Qs in the US), recent investor presentations (see the Investor Relations section of their site), earnings call transcripts, and potentially even equity research (but be careful see the section below on mistakes to avoid). 4. Channel Checks and Experts The idea here is to talk to people in real life and to contact suppliers, partners, and even employees of other companies in the same market and probe them for information on overall trends and the company s prospects. It is tricky to do this for E&P companies because they don t have customers and suppliers in the same way that, say, a manufacturing company does but you could always speak with engineers and technicians who have worked in specific regions. 5. Valuation In the context of a stock pitch, the purpose of a valuation is to say, Even with conservative assumptions, this company is still substantially undervalued (if you re

4 making a LONG recommendation) or to say, Even with aggressive assumptions, this company is still substantially overvalued, so its stock price may fall in the future (if you re making a SHORT recommendation). The NAV model is the most important methodology for E&P companies, so that s what we focus on here; you could also look at precedent transactions or public comps, as we do in the other parts of the Oil & Gas course. How can you tell when you already have enough research? Ask yourself whether or not you have specific answers to the following questions: Are you recommending for or against investing in this company, and what are the 3 main qualitative and quantitative reasons why? How much money could you make if it increased or decreased to the share price that you think it s actually worth? What are 2-3 key events or potential events ( catalysts see the action below) over the next 6-12 months that could cause its stock price to change? What are the top 2-3 risks to your targeted stock price, what s the approximate numerical impact of each risk, and how could you mitigate each risk? If you CANNOT come up with good answers to those questions, keep working until you can. What to AVOID When Gathering Information: Over-Reliance on Equity Research Yes, get industry data from equity research and use it to find out more about the market, but DO NOT form your own investment thesis based on sell-side research. These reports tend to be overly optimistic and fail to consider the risk factors in many cases. Online-Only Research You might be able to get away with this, but do you want to take the chance in a competitive interview process? Candidates who perform the best talk to real people in the market and do the channel checks described above. Again, this point is sometimes not quite as relevant for oil & gas case studies since suppliers/partners/customers don t work the same way as they do for normal

5 companies, but some offline research is still helpful, time permitted. Only One Source Just as you would diversify your portfolio to reduce risk, you also need to diversify your sources or you ll risk using biased, incomplete information. In this case study, for example, we consulted other companies production data, industry reports, and even academic sources for the IP rates and decline rates in different regions. How Do You Structure a Stock Pitch? Here s the 6-point structure we recommend using: 1. Recommendation Long or short, and what do you think the company/asset is really worth? Neutral recommendations are not recommended because you need a pricing imperfection to make money. 2. Company Background For oil & gas, you need to indicate the segment the company is in, its reserves and production information, regions of operation, and its market cap and valuation multiples. Bonus points for a stock price/volume chart. 3. Investment Thesis The stock is priced imperfectly because of these 2-3 key factors. The market has not factored them in because. But you believe they ve been overlooked, and that there s a chance to gain significantly by longing/shorting this stock. Or, on the flipside, the market has incorrectly factored in certain things that do not matter that much. 4. Catalysts And certain key events in the next 6-12 months will cause the market to realize this pricing imperfection, resulting in a correction and the potential to make money. For an E&P company, these key events might include geographic expansion, the deployment of new extraction technology, improved well spacing on acreage, pipeline developments, acquisitions or divestitures, earnings announcements, competitors entering or leaving a region, and even financing activities such as share repurchases and issuing debt/equity. While commodity prices are very important for valuation purposes, you should generally NOT cite commodity price movements as catalysts because they re hard to predict and since they affect all companies in the market.

6 5. Valuation For a long recommendation, you need to show that there s a good chance that the stock is undervalued in some way (e.g. right now it s trading at $25, but there s a reasonable chance it s worth $30-$35) by showing your public comps, precedent transactions, and NAV analyses; for a short recommendation, you do the opposite and show why the stock is overvalued. 6. Risk Factors and How to Mitigate Them What are the main reasons why you might be wrong? And yes, everyone is wrong sometimes. You have to lay out the top 2-3 market and company-specific reasons why your investment thesis might be wrong, and then explain what you can do to hedge against these risks even if you re wrong, could you at least limit your losses? In many cases, the risk factors will be directly related to the catalysts you cited above. Here are a more tips and tricks on each section: Recommendation The goal of every single stock or investment pitch is to convince the other person that your idea has an asymmetric risk profile. In other words, by investing, they have a 75% chance of gaining 15% and only a 25% chance of losing 15%... or whatever the actual numbers are. The expected value must be positive for the pitch to be convincing. The trick is that you don t want to be super-specific because that will just lead to questions you cannot answer, such as, So how do you know there s exactly a 75% chance of gaining 15%? You can be (relatively) specific with the potential to gain or lose a certain percentage since that should come from your valuation, but you don t want to get into specific probabilities it s better to leave it as a significant chance or a greater than 50% chance or something like that. You should structure the initial recommendation like this: 1. Long or short, current share price, percentage by which it s overvalued or undervalued, and the top 2-3 reasons why the stock price will change in the next 6-12 months.

7 potential catalysts that will result in the stock price changing in the next 6-12 months (see the section below on catalysts) investment risks (company-specific and/or market-specific) and how you might mitigate those risks through other investments, protective options, etc. Company Background This is the easiest section of the entire stock pitch because you just list key financial stats about the company (production, reserves, market cap, and current multiples) and a quick overview of what it does and its key business segments. Don t just copy in the descriptions from the company s filings or annual reports you need to summarize and focus on the most important points, while leaving out the corporate-speak and boilerplate language. Investment Thesis Here s your template for this section: Currently, the market thinks of this company in X way, and as a result it trades at approximately $Y per share. However, I think the stock is priced imperfectly because of reasons W and Z. The market hasn t priced in these factors yet because of reasons A, B, and C. As a result, I am making a [LONG/SHORT] recommendation on the company, with a target price of [$D $F] in the next 6-12 months. These reasons are significant because [Explain how each of them directly ties into the company s implied valuation, ideally showing sensitivity tables or any other output from your analysis your reasons must be specific to be effective]. Even if only one of these reasons ends up making an impact, there s still significant upside potential in the stock price because [And then point to any other analysis linking just one of these factors to the implied share price].

8 Catalysts It s difficult to give a template for this section because each company and industry is different but here s a list of possible catalysts for energy companies: Reserve Reports / Drill Results These are almost like clinical trial results for healthcare companies positive results (i.e. commercially producible oil/gas is found) in a new region will almost always boost the stock price, and vice versa for negative results. Well Drilling Schedules / Expanded Drilling on Existing Sites If the company announces plans to increase or reduce its rate of drilling in an existing region, the future cash flows will change, and therefore the stock price will also be impacted. Produce / No Produce Decisions Sometimes, a company may decide to stop producing in a certain region even if it has PDP wells there or it may decide to turn some of its PDNP wells on and start producing there, both of which will impact its stock price. Geographic Expansion Has the market not properly factored in a company s recently announced expansion into a new region? New Technology Deployment Will new technology improve the EUR or IP rate, or reduce the decline rate of wells, especially for unconventional resources? Improved Well Spacing Generally, the closer together wells are, the lower the EUR of each well but the right technology can flatten that trade-off curve and some companies use this to gain an advantage, e.g. 50% more wells in the same acreage but only 30% reduced EURs rather than a 1-to-1 trade-off. Of course, sometimes it can work the other way and 50% more wells results in a 60% lower EUR not a great result. Technology Deployment to Reduce CapEx / D&C Costs These costs, and to a lesser extent, production costs, can be influenced by technology and they will also make a substantial impact on the implied share price. Pipeline Developments If an area is far away from major pipelines, there may be a big difference in market prices vs. realized prices. So a new pipeline being developed or shut down could significantly impact realized commodity prices. Hedging Contracts If a company is buying or selling swaps, puts, or collars, those could also significantly impact its revenue, especially for smaller E&P companies. Acquisitions An acquisition can also change a company s future cash flow profile substantially, which will impact its share price. Be on the lookout for cases where the acquisition price is significantly off from the NPV of future cash flows under reasonable assumptions.

9 Divestitures The same concept as above applies might the company receive more or less cash than what the asset or business line it just sold was worth? Earnings Announcements These can often indicate better-than-expected or worsethan-expected production/drilling results, expenses, profits, and so on, which reflect all of the factors above. Competitors Activities There is only so much resource-rich land available, so competitors moving into or out of areas can affect how much acreage a company can acquire and its future drilling activities, both of which impact its share price. Financing Activities Share repurchases and debt/equity issuances also impact the company s share price by sending signals to the market. As stated above, it is NOT a great idea to use Oil/gas prices might rise or fall by XX% as one of your catalysts because it is almost impossible to predict such price movements, and because movements like that would affect all companies not just the one you re analyzing. Instead, you should use commodity prices to support your argument about the company s valuation for example, Even if gas prices rise to an all-time high, this company would still be overvalued because or, Even if gas prices fall to a 10-year low, this company would still be undervalued because Here are a few examples of how you might cite catalysts in your recommendation: 1. Catalysts in the next 6-12 months include [Summarize them briefly in the beginning]. 2. Catalyst #1 is significant because the company could produce an additional XX Bcfe from it over the next 10 years, which would result in additional future cash flows of $Y, boosting its share price by $Z if the other assumptions remain the same. 3. Catalyst #2 is significant because the market has not yet priced in the true upside from the additional reserves and production capacity in [Region X], which will be a major source of growth for the company going forward. If its recent acquisition there closes on schedule, in its first earnings call XX months from now it will announce results that could lead to a market correction. 4. Catalyst #3 is significant because a competitor recently paid a high premium for acreage that has not yet been de-risked, and which is also in a politically unstable country, which means that investors may flee the stock as the deal closes in the next 12

10 months and move into [Our Company] instead, pushing up its share price. Additionally, the competitor has only offered vague guidance on the EUR of wells in this region, which may result in even more of a sell-off. Valuation In this particular case study, and for E&P companies in general, the NAV model and its assumptions and output are the most important parts. You could also include public comps and precedent transactions but those tend to be less useful for stock pitch purposes because it s harder to show the implied share price under different assumptions. And in this part of the Oil & Gas course, we haven t even completed a set of public comps and precedent transactions because those are already covered in the earlier portions of the course. You do NOT want to paste in giant screens of drilling assumptions, production output, discounted cash flows over 40 years, and so on instead, focus on showing the output of the model and justifying your assumptions in the beginning. For example, if you assume different EURs, IP rates, and D&C costs in different regions, where are you getting those numbers from? How are you sensitizing them? Do you think the company-provided figures are accurate, or have you found inconsistencies? Companies often give very wide ranges for figures such as the EUR per average well, so it is critical to look at a range of different values and calculate the implied share price across that range. So if you ve only considered the case where the EUR per well in each region is exactly what the company has stated in its filings or investor presentations, you re going to have a difficult time justifying that when you present the case study in a real interview or on the job. It s better to look at a range of possible EURs, highlight the ones that seem more likely, and then also show what the downside cases look like. With public comps and precedent transactions, you re not defending your assumptions so much as explaining why your selection criteria was correct and how these companies and M&A deals apply directly to the company you re pitching.

11 With Ultra Petroleum, for example, it would be completely inappropriate to create a set of public comps that includes Exxon-Mobil, or even Chesapeake Energy or Occidental Petroleum, because those companies are all much bigger and/or more diversified. Instead, you would focus on smaller, independent E&P producers (see the list of Related Companies in Google Finance to get ideas) with similar reserve and production levels. Risk Factors and How to Mitigate Them This is the most commonly overlooked or misinterpreted section of any stock pitch. Yes, the most obvious risk for a long/short recommendation is that the stock price moves in the opposite direction but what causes that to happen? To determine that, you have to go back to your investment thesis and catalysts and link the risk factors directly to those points. The key here is specificity. Whenever possible, you need to tie each risk factor to a specific dollar impact on the company s implied share price and indicate how you might protect against it, or at least reduce your potential losses. As with the catalysts, it s not a great idea to list commodity prices falling/rising as one of your risk factors because that affects all companies and isn t specific to your own investment thesis. Here is the structure we recommend: 1. The Top 2-3 Risk Factors For example, if your investment thesis argues that the market has undervalued newly acquired reserves in a certain region, one risk factor might be that the acquisition of those reserves fails to close on schedule (or at all). Another risk factor might be that the EUR or IP rates might be lower than your estimates, or that the D&C costs for wells in that region might be higher than expected. If you argue that new technology can improve the company s well spacing, one risk is that the well spacing might not work out, or that the EUR of each well will decrease by more than expected. 2. How to Mitigate the Risks For long/short equity stock pitches, you mitigate the risks mostly via protective options (e.g. put options for long recommendations and call options for short recommendations) and by longing or shorting other companies stocks that may move in the opposite direction from the company you re analyzing. For oil &

12 gas companies, the swaps/puts/collars they use can also mitigate the risk of commodity prices falling or rising, but as an investor in the company, you have very little control over this. 3. And Even in the Worst Case Let s say that you re really, really wrong. How much are the company s net assets worth if it goes bankrupt? Does it have any assets or divisions that it could sell off in the case of extreme financial distress? For short recommendations, how will you limit your losses if you re completely wrong and the company s stock price skyrockets? Does your valuation indicate that even in the worst case, there s a low probability of the company s share price falling below a certain number or rising above a certain number? The Top 3 Most Common Mistakes in Your Stock Pitch Structure and How to Avoid Them Here are the 3 most common mistakes we ve seen with clients and students of our courses who are researching and valuing companies (or other assets) for use in their own pitches: 1. Inability to Support Assumptions Why are you assuming a higher or lower EUR / IP rate / D&C cost / decline rate than what the company has stated? How did you select the particular range you re looking at? Have you found 3 rd party sources that back up your data? What about geological reports of the oil/gas production potential in the regions the company is operating in? If they get into a detailed discussion and you can t back up all the numbers in your analysis, you ll be in trouble. 2. Poor or Non-Existent Catalysts If your catalysts are beyond the 6-12 month range, that s too far into the future for most hedge funds and asset management firms (remember, they report performance to their LPs frequently). Also, if you list catalysts but you re vague about the specific price per share impact, or your catalysts are not company-specific (e.g. The economy will rebound due to new monetary policy! ) you re also making a mistake. 3. Poor or Non-Existent Risk Factors and Mitigants The most common mistake is to leave these risk factors out altogether, or to give risk factors that are too vague (e.g. Drilling for new wells in a certain region will take longer than expected or cost more than expected yes, but what dollar amount of potential losses does that translate

13 into?). Failing to properly match mitigants to the risks you state is another common mistake in this section.