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Equitable Resources EQT
November 27, 2006 - 5:31pm EST by
hao777
2006 2007
Price: 42.56 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 5,140 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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Description

       Equitable Resources (EQT) is an integrated natural gas company with E&P (Equitable Supply) and distribution (Equitable Utilities) segments. Supply is focused on natural gas production in the Appalachian region, while Utilities is a regulated utility with commensurate returns, focused on the gathering, transportation, storage, distribution and sale of natural gas. EQT supplemented the latter segment with the acquisition – announced on March 2 – of two of Dominion Resources’ local distribution utilities for about $970mm (Dominion Peoples in PA and Dominion Hope in WV). This deal will add approximately 475k customers, 33 Bcf of gas storage, 936 miles of gathering pipelines, and 466 miles of high-pressure transmission lines to EQT’s current operations in the region. Management described the deal as accretive and returning above its WACC, beyond being a strong strategic fit. The deal should be approved by early 2007, at which point management will disclose its plan to finance the purchase and be freer to discuss synergies (which it has hesitated to do thus far given the approval process and the likelihood that customers and other stakeholders would demand a portion of whatever savings management projects). EQT is seeking to maintain a strong investment-grade rating but has admitted that its current A-rating is probably unnecessary. As a result, the company is seeking a change in its corporate structure to a holding company form so that it can better optimize its balance sheet in conjunction with the closing of the deal.

 
        The company’s other evolution is occurring in the Supply segment. The Appalachian Basin has been a producing region for decades and is characterized by wells with comparatively low rates of annual decline and low production costs per well, offset by lower per-well reserves and thus frequent drilling. EQT is assuming a leadership position with its extensive acreage inventory (2,365 Bcfe proved reserves at YE2005), undertaking two pilot programs which may together be able to increase reserves and production, and thus overall create value. One program entails going from 60-acre density in its drilled wells to 30-acre density, with 17 wells anticipated by year-end. Per management, production results are not yet advanced sufficiently in order to make definitive comments on the program’s economics, but the goals are to accelerate production and to add reserves. The second program entails horizontal drilling, a developing technique in the Appalachian Basin. With five wells currently planned for 2006 (two wells drilled, two wells drilling, and one well in the permit process), the initial results encouraged CEO Murray Gerber on the most recent conference call to characterize the approach as “a game-changer for this basin”.  Horizontal wells, per management, have higher initial costs but should initially produce six times more than a traditional vertical well, leading to a higher present value. Investors should hear more detail on both these programs through 2007.
 
        Other improvements in Supply include the construction of the Big Sandy pipeline to help alleviate bottlenecks in the region’s takeaway capability, which would help grow earnings in both EQT segments (i.e. improve the basis differential and add another strong regulated asset to Utilities). Currently, EQT and others are forced to occasionally sell production at a discount to natural gas in other regions due to lack of export capacity (and EQT’s own hedging), even though Appalachia's proximity to the Northeast consuming region would suggest a premium to WTI would be more appropriate.
 
 
        Valuation. EQT on first blush does not appear cheap on a P/E basis, trading at 23.4x 2006 and 19.2x 2007. However, this approach ignores the fact that there are two legs to the business which have significant asset value, and, in the case of Supply, it is in the near-term generating low cash flows and earnings as it ramps up its growth profile (production and reserves). A more reasonable sum of parts is as follows:
 

$ in millions
07 EBITDA Multiple EV
Distribution 205 8.5 1743
Pipes 44 8.5 374
Gathering 82 8.5 697
Parent/Other (43) 8.0 (344)
05 YE Proven Reserves
E&P 2365 2.00 4730
Net Debt (pf YE07) (1724)
Equity 5476
Shares O/S pf 130
Per Share $42.12

 
        The share price upside comes from the following set of opportunities (described above, with timing described in the next section). The bottom two opportunities are longer-term but have been included here to show what the potential unlocking of Equitable Supply might create in terms of value.

 

Big Sandy Downspacing (partial) Horizontal Drilling
Cost 190 Locations 4000 Incremental Reserves 900
ROE 11% Already drilled 1200 Net Royalty 90%
% Equity 50% Net 2800 Reserve Adds 810
Net Income 10.5 Reserves/well 0.3 Valuation/mcf 2.00
EPS 0.08 Interest 50% NAV Impact 1620
P/E Multiple 14x Net Royalty 90% NAV Impact /sh
$12.56
NAV Impact /sh $1.13 Reserve Adds 378
Valuation/mcf 2.00
NAV Impact 756
NAV Impact /sh $5.82
Splitting Utility Off Splitting E&P Off
EBITDA 249 Proven Reserves 2365
Multiple to 9.5x from 8.5x 1.0 Per Reserve to $3 from $2 1.00
NAV Impact 249 NAV Impact 2365
NAV Impact /sh $1.92 NAV Impact /sh $18.19

 

        The assumption regarding the upside valuation for EQT Supply is supported by the two closest peers in Appalachia, CXG and RRC, which trade at $3.35 and $3.33/Mcfe, respectively.

 
        Catalysts. In expected chronological order: 1) final permitting of Big Sandy pipeline (November/December) and start-up (mid-2007); 2) financing, closing and disclosure of synergies related to the Peoples and Hope Gas deals (Q1/Q2 2007); 3) more visibility on horizontal drilling program (update on next call, 2007); 4) more visibility on down-spacing pilot program (throughout 2007); 5) change to holding company structure (filing imminent, approval possible in 2007); 6) other corporate structure adjustments (MLP of midstream? spin-off of one of the two segments? selling of utility? timing unclear but expect more discussion late-2007, 2008). Each of these, if resolved positively, is additive to EQT’s per share value. Management – as per the most recent quarterly call – appears quite confident on catalysts 1 through 5. The last catalyst is something they will “consider” but have not yet hinted as to their conclusions.
 
 
        Other Considerations. CEO Gerber is highly motivated and aligned with shareholders’ interests, in that he owns 786k shares. He understands the levers available to the company in order to maximize shareholder returns, and if that requires a splitting of the company or some other type of corporate transaction, he is more likely than most executives to pursue this route. EQT is a classic sum-of-parts story, but unlike a number of managers, Gerber is keenly aware of this and will strive to correct the situation. With the repeal of PUHCA, M&A is likely to be a more frequent feature of the utility landscape, and it would not be surprising to see EQT explore at some point in the intermediate future a dual-track process for divesting the Utilities business, especially now that it has critical mass.

Pros

1.        Defined set of catalysts, within a 12-month timeframe.

2.        Multiple ways to win, especially in the Supply segment. Even if none of the programs pan out, valuation for the most part is undemanding and does not suggest much downside from current levels.

3.        Closing of deal with Dominion will reveal synergies that the company can achieve; opportunity to get to normal earnings in WV (~$16mm net income opportunity).  

4.        Highly motivated and shareholder-aligned management team.

5.        Other M&A opportunities as both a buyer and seller, in addition to capex in projects similar to Big Sandy.

Cons

1.        Clear risk that neither pilot program (or only one) in Supply is successful.

2.        Some risk surrounding expected settlements/approvals surrounding LDC deals and Big Sandy approval.

3.        Nat gas basis differentials in Appalachia could persist (currently at higher end of $0.20-0.50 historical spread), and hedging has locked in small but still relevant volumes at lower prices. This is partly offset by EQT’s low-cost position.

Catalyst

1) final permitting of Big Sandy pipeline (November/December) and start-up (mid-2007); 2) financing, closing and disclosure of synergies related to the Peoples and Hope Gas deals (Q1/Q2 2007); 3) more visibility on horizontal drilling program (update on next call, 2007); 4) more visibility on down-spacing pilot program (throughout 2007); 5) change to holding company structure (filing imminent, approval possible in 2007); 6) other corporate structure adjustments (MLP of midstream? spin-off of one of the two segments? selling of utility? timing unclear but expect more discussion late-2007, 2008).
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