Description

1. Contribute existing XCO East TX properties ($475mm value) and $200mm in outstanding bank debt to the MLP structure
2. Complete the $1.2b acquisition of the Winchester properties in the MLP
3. Issue $667mm in bank debt and $750mm in 2^nd lien notes
4. Sell 50% of MLP to public via IPO and Rights offering.  25% via non-transferable rights and 25% via IPO
5. Use proceeds to pay down outstanding debt, leaving $197mm outstanding debt in the MLP

• MLP IPO

• Value Creation
• After contributing the East Texas properties (35.8 Mmcfe/d of production) into the MLP, we estimate the stand alone XCO asset as having an adjusted 2007 EBITDA of 246.7mm.
• Small cap E&P companies trade in a wide range between 5.0x to 10.0x EV/EBITDA.  If we assume XCO trades at 6.0x we calculate an equity value of 950.3mm.  We place a 10% liquidity discount on the 50% MLP interest and attribute a value of 1.12b to XCO to arrive at a total combined Equity Value of 2.067b.  With 106mm fully diluted shares outstanding, this provides a value for XCO of $19.51.  As Exco is currently trading at $14.70, after having run up from $10.35 on the morning of the announcement, our target price represents a 33% upside.     

• Additional Perspective
• If you assume the MLP deal gets done and XCO will receive a 50% interest in the MLP which you then haircut by 10%, this represents about $10.54 per XCO share.  Backing that out of the current XCO price @ $14.70, you get a residual share price of $4.16.  This means that the market is currently giving XCO's remaining 702Bcfe of PROVEN reserves a value of $1.38/Mcfe!  With M&A multiples and peers trading at $2.50/Mcfe, this is grossly undervalued.

Timing:

The timing is as follows:

• November:  The filing of the S-1 should be a major catalyst.  We feel that the most likely time for the S-1 filing is mid-November.  Presently, the company has disclosed no pro-forma financials on the MLP, and they have been very vague on conference calls.  The filing will make the broader street aware of this transformative transaction. (SEE THESIS UPDATE BELOW)
• We expect the deal to go through in the 1Q 2007.  XCO did their IPO in the 1Q of 2006, and they seem to like the prospect of doing the deal in 1Q 2007.  (We now believe this could be pushed back to 2Q07...SEE BELOW)

Management Assessment:

Management is a large part of this story.  XCO was set up as an acquisition vehicle for CEO, Doug Miller.  An industry veteran, Doug started his career as a sell-side broker to Boone Pickens.  He has since worked in many capacities in the industry.  Overall, this is a very experienced management team with a large ownership stake.  Doug Miller owns 4.36% of the company.  In total, management holds a 12.8% equity interest in the company post-IPO.  A large portion of executive compensation is in the form of stock options.  According to Doug Miller, all employees have a significant portion of their comp tied to the stock.

Additionally, BP Exco Holdings is an investment vehicle controlled by Boone Pickens.  They are the largest shareholder with a 12.7% stake.  Boone Pickens is also on the Board of Directors.  He and Miller are close friends, and he plays a significant part in the operations and strategy of the company. 

Risk:

• Large MLP offering
• This would be one of the largest MLP IPOs ever offered.  However, from our checks with several contacts on the street and for the reasons outlined above, they should not have a terribly hard time placing the deal.
• MLP IPO Selling Points
• Clean LP structure with no GP promote will stimulate institutional investor interest
• Large insider ownership and continued buying add confidence level
• Management and Boone Pickens plan to buy on the deal.  This should stimulate investor interest
• Sustainable growth and production profile
• XCO plans to replace and grow production and assets at 3-5% annually
• Long lived assets with 13-15 year reserve lives
• Low debt levels are critical as pervious MLPs blew up on over-levering and cutting their distribution.  The MLP will only have $197mm.
• Extensive hedging program will add investor confidence
• The company makes it very clear that it views the distribution as a “debt” obligation and thus hedges production to insure it can meet this distribution.
• XCO operates 90% of its properties.  This is important as they control the rigs operated and are not as exposed to service sector cost inflation which has been a rising cost for the industry
• Gas price volatility
• If gas prices crash when XCO is trying to place their deal, it will probably be difficult to get done, regardless of the hedged production at the MLP.  However, this is unlikely given the seasonal winter heating demand for natural gas, and the seasonality of nat gas prices. 
• Also, despite the recent crash in gas prices, two E&P MLP IPOs have had successful offerings within their original pricing range over the same period. 

Conclusion:

We feel that XCO offers sufficient upside to be considered a major position.  It is important to recognize that we are not buying the company for superior energy assets.  We are buying the financial change special situation. 

Since the date of the initial write up which was not immediately posted due to a few changes, XCO has announced they are delaying the S-1 filing of the MLP offering due to additional acquisitions that have presented themselves to the team.  They plan to pursue these new properties and add them to the MLP creating a structure of even greater added value.  While details have not been released, management has assured investors the delay is not the result of anything other than an additional opportunity arising to add value to shareholders.  We know several major industry players have announced that they are trying to divest a portion of their assets, and if you dig around in some of the properties that are on the market, a deal could have the potential to double our upside return estimates.  Given the heavy management ownership (12.7%) and experience and the close involvement of Boone Pickens and other industry leaders, we are confident the team is acting in the best interest of shareholders.  The numbers in the thesis have been updated to reflect the recent stock appreciation (since initiating the position at ~$12) and will be further updated as data on the new acquisitions is released.   An important thought to leave you with is that this management team is one of the best: they are rainmakers and they are dealmakers.  The last time they announced a major deal, in July, the stock rallied ~20% with virtually no details released and continued to rise another ~30% over the following months as investors got their head around this.  Bottom line: smart, heavily invested management, smart story, stong upside. 

Catalyst