SM Energy (SM 5.00%) has undergone a dramatic transformation over the past two years. In 2016, the company controlled drillable land in the Eagle Ford, Bakken shale, Powder River Basin, and Permian Basin, as well as several other areas in between. However, a string of transactions the company has made since then has narrowed its focus to the Eagle Ford and Permian Basin while also vastly improving its balance sheet. As a result, the company is now in the position to grow production and cash flow at a rapid pace over the next few years.
Wheeling and dealing
SM Energy's transformation started in mid-2016 when the company announced plans to spend $980 million in expanding its position in the Permian. It would go on to sell several small asset packages in New Mexico, Montana, North Dakota, and Wyoming for $186.7 million that October to help pay for that deal, as it put more assets in North Dakota up for sale. A few weeks later, the company found a buyer for those assets in Oasis Petroleum (OAS), which paid $785 million for the bulk of the North Dakota properties. However, along with announcing that deal, SM Energy also unveiled that it had agreed to purchase more land in the Permian, buying QStar for $1.6 billion in cash and stock.
The transaction activity has continued since. Last January, SM Energy sold its non-operated assets in the Eagle Ford for $800 million. The company continued coring up its portfolio this year by selling its Powder River Basin assets for $500 million, and finding buyers for its remaining properties in North Dakota and a non-operated one in Texas for a total of $292.3 million. These sales will reduce the company's debt by 30% from where it was at the end of last year, pushing its debt-to-EBITDA ratio to less than 3. While that leverage ratio is higher than most peers would prefer -- many want it to be below 2 -- it's a step in the right direction.
Repositioned and ready to grow
The most recent asset sales also helped narrow SM Energy's focus to its core Eagle Ford and Permian Basin properties. The company expects these two high-margin growth engines to increase production and earnings at a rapid pace over the next few years. Overall, the company expects production to rise from last year's level of 44.5 million barrels of oil equivalent (BOE) to near 55 million BOE in 2019, and that's even after accounting for the impact of recent asset sales. Even better, this production will boost margins by 45% per barrel. That combination of margin expansion and production uptick should fuel 35% compound annual growth in cash flow per debt-adjusted share while pushing leverage down to a more comfortable 1.5 times by 2019.
One thing that's worth noting about SM Energy's current strategy is that the company is outspending cash flow to grow at this rapid pace. This makes it riskier as an investment, since most peers are planning to live within cash flow even as they increase output. Oasis Petroleum is one of the many with that goal, aiming to boost production 15% to 20% in 2018 and 2019 while living within cash flow. And several others are in a position where they can grow at a rapid pace and generate excess cash to return to shareholders. However, if everything goes according to plan, SM Energy expects to be able to balance capital spending with cash flow by the middle of next year.
An interesting oil stock
SM Energy has transformed itself from a shale producer with widespread assets to a company focused on the two areas where it can deliver the highest-margin growth. This transformation has weighed on SM Energy's value in the past year, sending shares down 30% even though oil is up nearly 30%. However, that underperformance could reverse in the coming years as the company's growth plan starts paying off. While SM Energy is certainly riskier than most other oil stocks, it also could deliver a much richer reward, making it an opportunity worth considering.