EXCO Resources (XCO) reported results recently and the market breathed a collective sigh of relief with the shares rallying back to the $5 level which has been a point of mean reversion. While the tone of the conference call was optimistic, we believe significant challenges remain for the company. In particular, cash flow stress shows no sign of abatement with 2015 looking to be a peak in the need for additional capital. In addition, muted expectations regarding their recently acquired Eagle Ford acreage, both in terms of IP rates and the need for artificial lifts, raises questions on the ultimate return on equity for that play. Given that leverage and other metrics remain elevated, we see no alternative but for EXCO to eliminate their dividend, most likely this quarter, and we would not rule out another equity infusion next year. All total, we see little upside from current share price levels and believe that $4 is more worthy of a potential speculative buy.
There are many so-called heavyweight investors in EXCO that have incentives to see the company succeed. These investors participated in the recent capital infusion (via a rights offering) with two prominent ones backing the deal at $5/share. This has proven to be a point of mean-reversion for the share price given the belief that a potential take-out of the company might render a $6-7 share price. It goes without saying that without this investor "backing" the shares would most likely be lower. We are not sanguine on the prospects for a buy-out and, using traditional metrics (P/B, PE, etc.), the shares look pricey. Our cash flow analysis, indicates that the shares are currently priced at about a 12-13% equity premium (above bond rates) and we believe that is not enough compensation for the risk investors accept owning the common shares.
Much of the discussion on XCO's recent conference call centered on their Eagle Ford transaction that they partnered with KKR Financial (KFN) on. We originally analyzed the transaction (link here) and found that the deal was fairly valued at PV-10 but, for XCO equity investors, it looked simply like a leverage play and a play on the backwardation of the WTI futures strip curve. We've updated our analysis, given changes in prices and type-curve, and the estimate cash flows for the deal are shown in the chart below. Shown are net cash flows which, for XCO, includes required capital expenditures and KKR buy-outs as well revenue. As can be seen, the transaction is not expected to turn cash flow positive for XCO until 2018 as they purchase wells from KKR at future PV-10 levels. The numbers are not all that much different from our previous analysis but recent XCO comments raised some concerns. First, they stated that they are installing a non-trivial number of artificial lifts (nodding donkeys) on the PDP wells. This raises concerns regarding the geology and production curve for their acreage. Second, they stated that 30 day IP rates were 450 BOE/d (OIL) which was below the original ~550 we used based off XCO's original statements. The original IP rates, and decline curve, made the deal look considerably more favorable on a PV-10 basis.
Estimated Cash Flows from KKR/XCO Eagle Ford Transaction
On a stand-alone basis, one would not necessarily balk at the cash flow chart shown above as clearly investment must be made for future returns - that is what E&P companies do. However, XCO is still a fairly indebted company and the increased financing needs should raise concerns for investors. They recently performed an equity infusion, raising $273mn, and another asset sale allowing net-debt to be reduced to ~1.45bn. Leverage still remains high at ~3.5 x EBITDA and free-free cashflow (FFCF) for 2013 (after dividends paid and capital expenditures) was roughly negative $50mn. So the dividend was effectively paid for with new equity. Looking forward, XCO's guidance for 2014 is for $370mn in capital expenditures. We estimate that $110mn is for the Eagle Ford (KKR deal), $150mn for their Haynesville play (nat gas), and the residual for other uses (e.g. corporate, field ops, etc..). This implies that drilling in the Haynesville should be down again in 2014 leading to a continued decline in natural gas production.
Our analysis for XCO's consolidated financials is shown below. Any analysis should be viewed as a point of departure and we caution readers that this is our "best guess" given information to date. Noteworthy are the continued base revenue decline (not including the KKR deal) through 2015 as drilling slows in their natural gas plays. We estimate EBITDA for 2014 will be above guidance, leading to a potential positive surprise. That said, FFCF will be negative and, in 2015, there will be a significant financing need and leverage would climb back into the upper 3s. This is the reason we believe that the dividend (at roughly $55mn/annum) will be eliminated soon. It makes no sense to be returning capital given their cash flow needs and the current state of the balance sheet.
Estimated XCO Financials
As can be seen, if XCO sleds though the next few years with no hiccups they should return to a more stable state in 2017/18 with EBITDA, FFCF, and leverage all looking more positive. That said, we do not see the shares trading significantly above (the then) net reserve value or at a significant multiple (e.g. ~5x EBITDA) putting the share price at roughly $10 in the distant future. Discounting to today, sans the dividend, gives a roughly 20% IRR rate which is 12.5% over the current bond ('18 maturity) yield of 7.5%. As a note, we still own some XCO bonds but have lightened up recently given they are trading near par. While that premium, and IRR, may be enticing to some investors, we are more cautious given XCO's history and the need to see the ultimate outcome from their recent acquisitions and production profile. In our view, at a share price of $4 the equity becomes more interesting as a speculative buy but, regardless, this stock is not for the faint at heart.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
Additional disclosure: We own XCO bonds
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