Drip Portfolio Report

<THE DRIP PORTFOLIO>
A Look at Apache
First on the oil and gas totem pole

by Brian Graney ([email protected])

Alexandria, VA (Feb. 3, 1999) -- Today kicks off the individual company-by-company analysis of the oil and gas industry that Drippers everywhere have been awaiting with bated breath. Our first victim... er... company is Apache Corp. (NYSE: APA).

Description: Houston-based Apache is the only independent oil and gas exploration and production "pure play" on our list. The company operates primarily in the U.S., Canada, and the Gulf of Mexico, home to about three-quarters of its proven reserves. It also has E&P interests in Western Australia and Egypt and exploration interests in China, Poland, the Ivory Coast, and Indonesia.

Yesterday, the company reported that its total reserves at the end of 1998 were 613 million barrels of oil equivalent (BOE) -- up 5% from a year ago -- even after taking into account a $243 million write-off on the book value of those reserves due to low oil and gas prices. Those reserves are split 56% for gas, 44% for oil, according to Merrill Lynch. While the company could be an attractive acquisition in its own right, the more likely near-term scenario is that Apache will take advantage of the current low-price environment to snatch-up some new reserves on the cheap. Late last year, the company spent $117.5 million to add properties in the Gulf of Mexico and Australia. It also reportedly has $1 billion in debt securities and bank credit at its disposal, which it could use to buy any small fields divested as part of the Exxon Mobil merger.

Financial Overview: Following the analysis trail blazed by past Drip Port industry studies, our overview of the company will be focused on just a few key elements: How is the company valued by the market? How profitable are its operations? How does the company finance those operations? And finally, what does it do with the money it earns?

Valuation: At $18 15/16, Apache currently has a market capitalization of $1.85 billion (share price multiplied by the 97.765 million weighted average shares outstanding reported at the end of Q4). That is about $1.23 billion less than the company's market valuation exactly one year ago, thanks to a 44% drop in Apache's share price over that span.

Factoring in $59.3 million in cash and $1.3 billion in long-term debt (as of the end of Q3) gives Apache an enterprise value of $3.09 billion. That's far smaller than the major international integrated firms on our list, but roughly the same size as Kerr-McGee, Pennzoil-Quaker State, and Ultramar Diamond Shamrock.

Based on the $0.27 per share earned by Apache in 1998 (excluding charges for the bigtime write-off), the company is trading at 70 times trailing earnings. The write-off warps things quite a bit, so the better gauge is the company's forward P/E ratio of 32.1, which is based on the Zacks mean estimate of earnings of $0.59 per share in fiscal 1999. That's pretty comparable to the S&P 500's current P/E of 33.3 and the 36.4 ratio for the S&P Energy Composite, a list of 24 oil and gas stocks that includes all of the stocks on our final list except Pennzoil-Quaker State and Ultramar. The Zacks mean estimated 5-year earnings growth rate is 11%.

Profitability: The company's net profit margins (net income divided by revenues) fell sharply in 1998 to 3.05% from 13.2% the year before, showing the strain that the low oil and gas price environment has placed on the company's financial structure.

To add some more context, we will rely on the common industry profitability measurement of return on capital employed (ROCE), which most firms appear to define as after-tax operating earnings divided by the sum of shareholders' equity plus long-term debt. In short, this equation attempts to show how much money comes out of the business compared to how much goes into it. It's also a modification of the better-known (and much more preferred) return on invested capital (ROIC) metric.

Apache's 12-month estimated after-tax operating earnings work out to $40.3 million (annualized pre-tax income through Sept. 30 + annualized interest income multiplied by a base tax rate of 40%). Equity plus debt equaled $5.45 billion on Sept. 30, giving us a quite meager ROCE of 0.7%. In 1997 (a more "normal" year for the firm), ROCE worked out to 2.7%. That means for every dollar invested in the business, Apache was able to return a bit under $1.03. Compare that figure to the 5.25% risk-free return currently offered by long-term U.S. Treasury bonds, and you will begin to understand why we are a bit underwhelmed by Apache's recent profitability.

Leverage: Looking for oil and gas is an expensive proposition, so it's no surprise that Apache carries a good amount of debt on its balance sheet. Long-term debt dropped 13% to $1.3 billion between Sept. 31, 1997 and Sept. 30, 1998, which puts the company's debt load at 1.5 times 1998 revenues and 0.66 times total shareholders' equity. That's high in our eyes, but not out-of-line considering the business Apache is in.

The Snapshot for Apache

Ticker: APA
Recent Price: $18 15/16

1998 Revenues: $875.7 million
1998 Earnings: $26.7 million
Net Profit Margin: 3.05%
1997 ROCE: 2.7%
1998 EPS: $0.27
(excluding charge for reserves write-off)

Fiscal 1998 Estimate: $0.31
Fiscal 1999 Estimate: $0.59

Enterprise Value: $3.09 billion
Total Reserves: 613 MMboe
P/E on 1999 EPS: 32.1
Dividend Yield: 1.48%

Conclusion: Apache's dividend yield is 1.48%, which is higher than the 1.25% average dividend yield of the S&P 500 but below the 2.92% average yield of the S&P Energy stocks. The company's average weighted sharecount increased by 8.1% from 1997 to 1998, a trend that we do not prefer. We like to see companies decrease their sharecounts over time through share buybacks, if possible.

If we are going achieve our stated goal of finding a company that will return on average 15.5% annually, we are going to have to look beyond Apache. As much as we would like to regularly take advantage of the plentiful bad-pun and joke opportunities presented by its corporate name, Apache's future growth and profitability potentials are below our investment standards.

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