If there is a company that seems to have leveraged itself for permanently higher oil prices, Apache is it. The company went on an acquisition spree last year (biggest in its history), with $11 billion in transactions in 2010. It also picked up its exploration pace, apparently expecting oil prices to stay elevated for years to come. Altogether it invested a total of $15.79 billion on exploration, development and acquisitions last year.
The company was in the news last week when it announced five new discoveries in its Egyptian fields, acquired from BP along with other assets for $7 billion, bringing this year’s total to eight discoveries in Egypt alone. It has stated that current Egyptian production stands at 215,000 barrels of oil and 900 million of cubic feet of gas per day. While many skeptics question Apache’s deep dive into a country undergoing a tectonic political shift not seen in 30 years, APA bulls would argue that what Egypt needs, if it is to satisfy its growing population’s hunger for higher living standards, is higher economic growth. In a Middle Eastern country famous for having very limited oil reserves in an oil rich neighborhood, oil and gas might be precisely the best place to start. As such, Egyptians may need Western oil companies as much as the companies need access to the country’s promising fields. Nevertheless, the purpose of this article isn’t to argue the political risks of investing in Egypt but rather the cost of Apache’s bet and whether it might be in a good position to capitalize on growing global demand for oil and higher crude prices.
With a market capitalization of $45 billion, Apache is no slouch. The company has been smartly run for years and, while suffering from a significant revenue and earnings decline in 2008, it had revenues of $13.37 billion during the last 12 months and net income of $3.46 billion, increasing by 20.2% and 3.6% respectively compared to the equivalent period three years before. While it has enough size to finance relatively large acquisitions, doing so while staying profitable is another story. So, how has the company financed its aggressive growth plans?
In the last 12 months Apache issued 17% more common shares than it had a year ago. The cost to existing shareholders has been significant. While the company reported fully diluted EPS of $2.81 in April for the quarter ended March 31st, the number would have been $3.29 had it maintained its shares at the same level as Q1 2010. We understand, of course, that in a growth environment share counts seldom remain steady; however, a 17% dilution affects shareholders’ bottom line directly. In other words, those owning the company’s shares prior to the beginning of the ongoing expansion paid $0.48 per share in the last year to pay for future growth; this before accounting for the company’s increase in debt. In contrast, during the prior three years, from Q1 2007 to Q1 2010 Apache increased its common share count only by 1.7%, enough perhaps to maintain a regular stock-based compensation plan in place.
The company also increased its debt in the last year at a higher pace than it had in previous years. Its long-term debt increased by 64% from quarter to quarter, with virtually all debt coming due beyond one year. Total debt stood at $8.16 billion at the end of last quarter, with only $30 million in short term debt. Despite this increase the company’s total debt still accounts for less than a quarter of its total capital (24.5% to be exact). Considering how cheap credit has been in the last two years and the opportunities the company has had to acquire assets at reasonable prices, this seems like a sound strategy. Based on fiscal year 2010 financial statements, Apache’s effective interest rate last year was approximately 2.6%. If it can borrow at this rate and produce 14.23% return on equity and 19.06% return on invested capital (both based on trailing 12-month figures), management could do worse than pursue current opportunities. Based on MarketGrader’s Economic Value indicator, part of our Cash Flow analysis, Apache’s combined after-tax cost of capital was 7.3% during this same period. The company could be hardly faulted for diluting shareholders and increasing its debt load, particularly given its history of strong financial results and the fact that BP needed to sell assets in a hurry. Now it needs to execute.
What could go wrong?
While Apache’s financials are strong and the company is growing profitably while expanding its margins, the strains of the added expenditures and debt do show in a few of our indicators. Our overall grade is currently 73.7 (out of 100). For those unfamiliar with MarketGrader’s research methodology please refer to this page or watch a brief video describing some of the tools on our web site. Essentially we grade companies’ financial statements from four perspectives: Growth, Value, Profitability and Cash Flow. Each category is comprised of 24 fundamental indicators, all of which are summed up in a final numerical grade. Apache’s 73.7 ranks it 7th among 254 companies followed by MarketGrader in the Oil & Gas Exploration & Production industry. In addition to the numbers highlighted before it should be noted that the company’s margins have remained very healthy during the last 12 months and seem to be expanding. Trailing 12-month operating margins were a remarkable 47.5% compared to 43.6% for the equivalent period ended a year earlier. As mentioned before its growth indicators are mostly positive and its value indicators make a strong case for investing at these levels. At current prices the shares are trading at 9.5 times the fiscal year 2011 consensus estimate. Where the company is weakest, understandably given its rising level of capital expenditures, is in its cash flow indicators. Despite generating $1.98 billion in cash flow last quarter, the company’s trailing 12-month free cash flow has been a negative $5.69 billion. Its capital expenditures over this same period were $12.99 billion. Apache does pay a dividend of $0.15 per share, which translates into a yield of 0.5%. It has sustained the same payout since 2006 and, at the current rate, its dividends account for only 3% of cash flow and 7% of earnings; so, despite its need for capital to expand, the dividend seems quite safe.
In conclusion, Apache seems to us like a good way to play elevated oil prices; not necessarily at $120 a barrel levels but within the current $80-$90 a barrel range. We say this not only because oil producers are more sensitive to oil prices than integrated companies or refiners but also because of the company’s history of well managed growth. Investors will be well served to monitor ongoing cash outlays and further shareholder dilution. So far the stock has held up reasonably well amid recent weakness among energy shares; a good way to monitor deterioration in investor sentiment is with our Sentiment indicator, which gauges non-fundamental factors affecting the company’s shares. Its current Sentiment indicator is ‘Positive’ based on a score of 8.4 (out of 10). You may read more about our Sentiment score here. Investors buying here, with expectations of continued global growth, even at a reduced rate, will be paying a good price for a well managed company striving to become a leader in its field.
