Untapped Potential: Southwestern Energy

Warning: If you don’t like to read about moderately speculative high growth stocks in a volatile sector, I recommend turning around and checking out another article about a “safe” stock (I doubt there is such a thing as a safe stock in this market). Many investors are worried about their equity holdings right now but prudent investors should be gearing up to open new positions. A wise investor named Warren Buffet once said, “be fearful when others are greedy and greedy when others are fearful.” I think this statement is the best possible primer for an article about Southwestern Energy Company (NYSE:SWN).

Background

Founded in 1929, Southwestern is an independent exploration and production company based out of Houston, Texas.  They primarily focus on natural gas, which accounts for close to 95% of all of their production. Geographically they are located in five main areas: the Fayetteville Shale, East Texas, the Arkoma Basin (of which the Fayetteville Shale is a portion), the Permian Basin, and the Gulf Coast. The breakdown by reserves and production is as follows (reserves listed first followed by production; Note: Bcfe stands for Billion Cubic Feet Equivalent):

• Fayetteville Shale - 713 Bcfe (49%), 53.5 Bcfe (47%)
  
• East Texas - 353 Bcfe (24%), 29.9 Bcfe (26%)
  
• Arkoma Basin - 304 Bcfe (21%), 23.8 (21%)
  
• Permian Basin - 60 Bcfe (4%), 4.7 Bcfe (4%)
  
• Gulf Coast - 12 Bcfe (1%), 1.4 Bcfe (1%)

Obviously the company is mainly focused in the south-central portion of the United States, and besides the Marcellus Shale in Appalachia, this area is the hot bed of domestic natural gas production.

Risks

Generally when people talk about a company they throw risks in at the end, but I feel that when you are dealing with a company like Southwestern it is better to address the risks up front. There are a few main concerns with companies in this sub-sector, the first of which is natural gas spot pricing.  Obviously natural gas has had a vicious fall from $13.60 to $6.75 per MMBtu this year but the price has breached break-even levels and it is extremely likely that production will begin to become shut in during the next few weeks.  This should stabilize the price somewhere above the $6.00 per MMBtu region.  These much lower natural gas prices will not be a problem for Southwestern, as they have the lowest lifting cost per Mcfe of production in the industry, about $0.92.  The peer group average is closer to $1.50 per Mcfe.

Another important characteristic to note about Southwestern is their hedging strategy.  Before this credit crisis, it was viewed as a negative if a natural gas company did not hedge.  For 2008, Southwestern has 39% of its production hedged through swaps averaging $8.43 per Mcfe and 27% of its production hedged through capped collars at $7.92/$11.60 (collar floor/collar ceiling).  This means that Southwestern is more reliant on natural gas spot pricing than its competitors.  Obviously this is inherently more risky under normal market conditions, but now that counterparty risk has hit companies that hedged a large portion of their production it actually can make a company like Southwestern look much less risky than its competitors.  Whether or not Southwestern’s hedging strategy makes them more or less risky is almost impossible to tell, but it is something that investors should be very aware of before taking a position.

Potential

There is potential for Southwestern to eclipse its competitors by a wide margin.  Even though the Fayetteville Shale is not the best of the four shales, Southwestern has proven that it can be an effective rig operator.  If this trend continues, they will not be able to be priced out of the market by any of the larger players.  This will also allow Southwestern to be in control of whether or not they want to shut down production instead of being at the liberty of a tight balance sheet and income statement.

Another extremely attractive aspect of Southwestern is their reserve replacement ratio.  Below are the reserve replacement ratios from 1999 through 2007:

• 1999 - 148%
• 2000 - 211%
• 2001 - 155%
• 2002 - 215%
• 2003 - 313%
• 2004 - 365%
• 2005 - 399%
• 2006 - 386%
• 2007 - 474%

As you can see this number has been accelerating upward over the last few years, always a great indicator of an energy company’s future strength (any ratio over 100% is considered good while any ratio over 150% is considered superb).  This ratio has increased considerably since 1999 despite production growing at an ever greater rate, growing from 33 Bcfe per year in 1999 to 133 Bcfe in 2007.  This sort of organic growth is unparalleled by any other company in the industry, while allowing Southwestern to focus on being an efficient producer of natural gas rather than panicking to find more resources.

Southwestern has also increased the average lateral drilling length of their wells over the last 6 fiscal quarters.  From Q1 2007 to Q2 2008 the average lateral drilling length grew a staggering 69.2%.  This will allow Southwestern to cut down on CAPEX costs over time as they will need to use less rigs to tap into the same number of resources.  Lateral drilling will be one of the key drivers for industry growth going forward, and Southwestern has shown that they are an industry leader in advancing their technology as quickly as possible.

The last major driver for upside is with rising commodity spot prices.  With natural gas at $6.86 and crude oil at $69.72, Southwestern was able to deliver $651.2M of net cash flow.  The 2008 average commodity prices should be higher than these levels.  The below list is the projected net cash flow at different average yearly commodity spot prices:

• $8.00 Natural Gas and $80.00 Crude - $1.09B-$1.10B
• $9.00 Natural Gas and $90.00 Crude - $1.14B-$1.15B
• $10.00 Natural Gas and $100.00 Crude - $1.19B-$1.20B

At this point I would say that the middle option is the mostly likely outcome for average pricing during 2008.  This would leave their debt percentage somewhere between 25%-26%, an extremely low level for a company experiencing growth at such a break-neck pace.

Valuation

Southwestern’s basic fundamental valuation may throw up red flags for many investors, but it is important to remember that this is a high growth company in a high growth industry.  It is also important to understand that at this early point in the company’s life-cycle the normal level of free cash flow will not be present, especially considering that this is an energy company.  Here is a quick look at a few of the important basic ratios:

• Enterprise Value - $10.55B
• Trailing P/E - 27.53x
• Forward P/E - 16.72x
• Forward PEG - 0.58x
• Price/Sales - 4.96x
• Price/Book - 6.19x
• EV/EBITDA - 10.53
• Profit Margin - 20.13%
• ROE - 34.58%
• Debt to Equity: 0.503
• Book Value Per Share: $4.27

Obviously the price/sales number is high, but do not forget that the price to book and book value per share numbers do not include a vast number of the company’s reserves under current accounting rules.  The EV/EBITDA is actually fairly impressive for the industry, and I foresee this number coming down to even more attractive levels over the course of the next few years.  The ROE is outstanding, and this number could go up with a jump in natural gas spot pricing.  The key point is not to be hung up on fundamentals that are not completely telling of the underlying strength of the company, especially if they are inherently backward looking numbers.

Conclusion

Southwestern is up off of its recent lows of $20.81 by more than 55%, but its should not stop investors from looking at it as a possible long idea going into the future.  Even with the recent run up, Southwestern is still at a price that is 62% of its current 52-week trading high.  The valuations are extremely attractive relative to historical levels, and any correction in overall market fundamentals should yield a correction in Southwestern’s stock price.

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