Stock Picking in the Oil Patch

Domestic producer of oil and natural gas Magnum Hunter has been a successful acquirer over the years, expanding its production capability and reserves at a much higher rate than share dilution. Its heavy debt load is of some concern, but management is taking prudent steps to reduce leverage. At the same time, given the weakness in its stock price, management is aggressively buying back shares. At only 3.6 times cash flow, the stock looks cheap.

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By Matt Richey (TMF Matt)
October 8, 2002

You heard it last night from President Bush: Iraq "gathers the most serious dangers of our age in one place." I'm no expert on oil prices, but I don't see how this situation in the Middle East is going to give way to cheaper oil. That makes the oil and gas sector an interesting investment consideration.

I'm new to evaluating oil and gas companies, but one that's caught my eye is Magnum Hunter Resources (NYSE: MHR), a producer of oil (32%) and natural gas (68%). The company is paying off debt, buying back shares, and has a stock that trades around book value and at a low multiple to cash flow.

Magnum Hunter came to my attention through a write-up in the May edition of Exclusive Outlook, an excellent publication provided free of charge by West Coast Asset Management (WCAM), a value-oriented investment management firm. As WCAM points out in its report, Magnum Hunter's business is 100% domestic, making the company a prime beneficiary in the case of any oil supply disruptions caused by geopolitical turmoil.

In Magnum Hunter's 2001 annual report (PDF file, Acrobat Reader required), CEO Gary Evans said the following about the importance of a domestic energy supply:

The heightened awareness of the importance of a secure source of domestic energy supply has become a top priority. Energy is the lifeblood of our economy. The remarkable growth the U.S. has experienced during the past decade could not have been attained if energy supplies had been scarce and expensive. Natural gas in particular will provide a greater portion of our domestic energy needs. Although natural gas prices are likely to remain volatile due to infrastructure constraints, such as limited storage and pipeline capacity, the long-term outlook remains most favorable. We believe the added demand for natural gas will combine with diminishing supply to push average commodity prices higher.

As you might imagine, this is a business ruled by the vagaries of energy prices. When commodity prices are low, Magnum Hunter aims to acquire new properties while assets are available on the cheap. The company has a pretty good track record in this regard, and is actually one of the fastest growing oil and gas producers on the public markets.

Since 1995, Magnum Hunter's proved reserves have increased 25 times, and daily production has increased 23 times, all while shares outstanding have increased only 5.7 times, albeit with a growing balance of debt. The company's ratio of long-term debt to capital increased from 24% at the end of 1995 to 70.6% at the end of 2001.

At the end of 2001, Magnum Hunter was among the top 10% of most highly leveraged operators in its industry. Going into 2002, the company took steps to improve its balance sheet by acquiring a less-leveraged player with complementary assets. The deal closed in March when Magnum Hunter acquired Prize Energy for $550 million (85% stock, 15% cash). Prize brought with it a less-levered balance sheet, an even mix of oil and gas production, and properties concentrated in the same geographies as Magnum Hunter's. The combined company's long-term debt-to-capital ratio at the end of June was down to 65.2% -- still high, but improved. Magnum Hunter's goal is to eventually bring this ratio closer to 50%.

Recently, Magnum Hunter has been taking positive steps to reduce its debt by selling off non-core assets. On Sept. 9, it announced it had completed asset sales of $60 million. CEO Evans commented:

These properties sold represent our lowest tier properties that have the distinct profile of also being our highest operating cost assets. Therefore, their net margins are the smallest. With current commodity prices at very favorable levels, the future commodity price curve at historically high levels, and significant demand from the private sector remaining with very limited supply of properties on the market, we plan to continue this asset rationalization effort over the foreseeable future.

Magnum Hunter's goal is to sell a total of $100 million of assets by year-end. If the company's successful, its long-term debt-to-capital ratio should wind up around 60%. Not great, but better.

Even with these improvements, however, Magnum Hunter stock has been under pressure all year, falling from above $8 to around $5.35. Word is that former Prize Energy shareholders have been dumping the stock. Meanwhile, Magnum Hunter has been using the price weakness to repurchase shares. On May 1, the company increased its repurchase authorization to 2 million shares, of which 735,000 had already been utilized, including the purchase of 432,000 shares in the month of April alone. Then in June, Magnum Hunter repurchased an additional 1 million shares from a selling institution. All told, the company has already utilized more than 75% of its repurchase authorization.

The stock appears to be cheap, trading at only a slight premium to its book value per share of $5.06. By way of comparison, the average oil and gas company trades for 1.3 times book. Magnum Hunter also looks undervalued on a cash flow basis. In the most recent quarter, which was the first combined quarter of operations with Prize, cash flow (as in, net income plus depreciation and amortization) was $25.8 million. If we annualize that figure and divide it by shares outstanding, we find Magnum Hunter trades at only 3.6 times its cash flow of $1.48 per share. That compares to an industry average price-to-cash flow multiple of 6.2.

One final nugget: CEO Evans owns over 3 million shares and hasn't sold a single one over the past two years.

I'm still getting to know the company and the industry, but based on what I've seen, Magnum Hunter looks pretty interesting at current levels.

Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he had no position in any of the companies mentioned in this article. Matt's personal portfolio is available for view in his profile. The Motley Fool is investors writing for investors.