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Small-cap stocks are known for their higher volatility, and such was the case in energy late last year, when an accelerating collapse in the commodity cut the price of crude in half in about six months. Small-cap energy names took it on the chin, with stocks skidding anywhere from one-third to two-thirds or more in price, depending on size, commodity sensitivity and leverage.
But as crude prices come closer to stabilizing—and investor emphasis shifts to the larger, defensive names at this stage of the cycle—fertile ground may exist in revisiting the small-cap sector. These names have in many cases tumbled to levels few would have imagined possible six months ago. Their descent has often been hastened by year-end tax-loss selling and institutional accounts cutting back on out-of-favor energy names at the end of the period.
Analysts have identified some small caps worth investor attention, however.
Exemplifying how the commodity collapse worked against some smaller E&Ps at the lower end of the market-cap spectrum is Gastar Exploration Inc. (NYSE MKT: GST). With a market cap now around $188 million, as of early January, Gastar’s stock fell more than 70% from $8.71/share at midyear to $2.41 at the close of 2014. Daily trading volume in Gastar shares reached a recent peak of 5.7 million shares on Dec. 19, vs. a three-month average of just under 2 million shares, as investors unloaded energy names.
While Gastar has carried relatively high debt levels historically, leverage concerns were lessened by its issuance last September of 17 million shares at $6.25/share—a move that “added cash to the books just before the capital markets seemingly closed,” Jason Wangler, senior vice president covering the E&P sector for Wunderlich Securities, said.
The offering allowed Gastar to repay its credit facility and have “ample cash on the balance sheet for future activity,” he added. “We feel the concerns about Gastar’s finances have been overblown given this strong liquidity that should allow the company to continue to fund its operations and financial commitments.”
In a late December Wunderlich report, the target price for Gastar was $5/share, representing upside of 100% from a then-current price of $2.49. Upside potential is expected to come from growth in the firm’s two main assets: adding “solid oil assets” in its Hunton play in the Midcontinent, where its Oklahoma production base was built at a “great price,” as well as further testing of the Utica formation within its “strong” natural gas position in the Marcellus.
Regarding the Oklahoma holdings, Wangler anticipates “significant reserve growth from the region given Gastar’s 2014 drilling activity/success, and for production to keep moving forward in 2015, even with a lower activity level, given the solid returns seen in the last few quarters.” Currently, the Midcontinent accounts for the lion’s share of Gastar’s projected 2015 budget, although Wangler doesn’t rule out a second cut in overall capex to conserve capital in light of weakness in both commodities.
In the Marcellus, Gastar recently brought on line 10 wells at a combined gross rate of 28.7 million cubic feet per day (MMcf/d) and 3,300 barrels per day (bbl/d) of condensate, which translates into about 4,000 barrels of oil equivalent per day (boe/d) net to the company. With third-quarter production reported at 10,000 boe/d, this “starts the year off in a nice way,” Wangler noted. In addition, resolution of a legal issue has allowed Gastar to proceed with three other Marcellus wells that were awaiting completion.
At Gastar’s closing price at the time of the Wunderlich report (Dec. 30), the stock was trading at a price-to-2016 cash-flow multiple of 1.8x as compared to an average peer group multiple of 3.8x. On an enterprise value-to-2016 EBITDA, the stock price reflected a multiple of 5.3x vs. a peer group average of 6.8x. The Wunderlich target price of $5/share assumes Gastar’s stock moves higher to trade in line with the 3.8x peer group multiple of price-to-2016 cash flow.
Overall, small-cap stock prices skidded anywhere from one-third to two-thirds, or more, in the second half of 2014.
Topeka Capital Markets’ vice president of E&P, Gabriele Sorbara, also has a Buy rating on Gastar. The firm’s early January 2015 report carries a target price of $6/share, which, if realized, offers more than a double of its recent price. “With the company’s strong growth profile driven by its core Marcellus/Utica shale and emerging plays in Oklahoma, we believe a premium valuation to peers is justified,” Sorbara said. Global Hunter Securities also has a Buy rating on Gastar, with a $4/share target. If realized, the lower target would still offer more than 60% upside.
Deep value opportunities
Sanchez Energy Corp. (NYSE: SN) similarly saw its stock swoon in the back half of 2014. Its equity price dropped more than 70% from $37.59/share at midyear to $9.29 as the year closed out. Given a somewhat larger market cap—recently around $470 million, but at one point as high as $2 billion—a decline of this magnitude may come as a surprise.
However, typical small-cap volatility—on the upside—is also reflected in the price targets offered for Sanchez. These range from Global Hunter’s relatively modest $13/share—representing a little more than 60% upside at the time of writing—to targets measured in multiples of the current stock value. RBC Capital Markets and Macquarie Capital (USA) Inc. both carry “outperform” ratings on Sanchez, with their respective price targets set at $19/share and $28/share.
“We believe Sanchez represents a favorable risk-reward at these levels, representing a deep value opportunity,” Macquarie analyst Paul Grigel said. “We continue to place Sanchez in our ‘High Octane’ group that could see a significant rally if crude oil were to recover.”
Early January reports on Sanchez followed its updated guidance for 2015 capex—now revised twice—and which now approaches maintenance capex levels. Excluding carry-over capital from 2014, the budget calls for an annualized capex rate of $400 million to $450 million and projects production to average 40,000 to 44,000 boe/d in 2015. This would represent an increase of about 40% over prior-year levels, but would be roughly flat with output for the fourth quarter of 2014.
Sanchez expects 2015 capex to be fully funded from operating cash flows and cash on hand, without needing to draw on its unused corporate credit facility. Macquarie’s Grigel noted the company’s ability to avoid tapping its revolver stemmed in part from its significant cash position, which stood at $530 million as of Dec. 7. “While the company will be outspending cash flow in 2015, the significant liquidity should help the company weather the storm for a sustained period of time,” he said.
Leo Mariani, CFA, senior analyst with RBC, views Sanchez’s move to preserve capital as prudent and suggested guidance on production is “very conservative.” Given its “high number of well completions,” totaling 88 net wells in 2015, Mariani is modeling full-year production above guidance at 46,400 boe/d, representing 11% growth over his fourth-quarter 2014 production estimate. Mariani also noted Sanchez was targeting reducing well costs to $5 million from $7.5 million in its key Caterina project area in the Eagle Ford Shale.
While re-setting his target price for Sanchez at $13/share, down from $14 previously, Global Hunter’s senior analyst, Patrick Rigamer, has maintained his “Buy” rating on valuation. With the stock trading at 3.7x 2015 EBITDA, vs. a small-cap median valuation of 4.9x 2015 EBITDA, “we see Sanchez trading at too wide a discount to peers,” Rigamer said.
As compared to the smaller, more volatile E&Ps, PDC Energy Inc. (NYSE: PDCE) has offered relative stability, with the stock losing “only” 34% in the second half of last year. J.P. Morgan analyst Joe Allman has an “overweight” rating on the stock, describing it as his “favorite small cap,” with a target price of $50/share. Ryan Oatman, CFA, equity research analyst with SunTrust Robinson Humphrey, rates the stock a “Buy” with a target of $70/share.
While PDC Energy’s relative performance is likely aided by a larger market cap, which stood at $1.4 billion in early January, it has also benefited from the positive guidance it issued late last year.
The company guided to 2015 production in a range of 13.8 to 14.5 MMboe, exceeding Street expectations, while capex was set at $557 million, some 14% below 2014 levels. Based on a 2015 Nymex price deck of $67/bbl and $3.80/Mcf, capital outspend was expected to be limited to $165 million, resulting in a year-end 2015 debt-to-EBITDAX of less than 2x. Strong hedges were in place to protect 80% of projected crude volumes at $89/bbl and 75% of natural gas volumes at $4/Mcf.
The combination of higher production on lower capital expenditure “implies higher capital productivity and should be rewarded by investors,” said Oatman, who raised his 2015 and 2016 cash-flow estimates to $10.26/share and $11.72/share, up from $9.56 and $10.32 previously. “We see an incremental $85 million in free cash flow in 2015, which is huge for a stock with a market cap just above $1 billion.”
Oatman’s target price for PDC Energy is based on a six multiple of 2016 cash flow/share. At the time of the SunTrust report last December, PDC traded roughly in line with its peer group on the basis of price to 2016 cash flow. Reflecting its relatively stronger balance sheet, on an enterprise value to 2016 EBITDA ratio, PDC Energy traded at a discount multiple of 3.8x vs. the peers’ median multiple of 4.7x.
For investors willing and able to wait for commodity prices to rally and small-cap stocks to follow suit, significant opportunities await.
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