Description

After hitting an all time high of over $73 in 2001, KMG has been on the slow downward train ride of tears for shareholders. Management and the company are truly despised on Wall Street after announcing disappointment upon disappointment from everything from production growth and expenses.

After two years of a painful restructuring and selling off over $1 billion in assets, KMG is a very interesting speculation due to Wall Street apathy and it’s below average valuation. Investors at current prices will enjoy a 4.2% dividend while they wait for Wall Street to appreciate its turnaround. Trading at 85% of its net asset value, while comps trade at 117% of NAV, and with a 2004 price to estimated cash flow ratio of 2.9, KMG is trading at a fire sale price that does not recognize its improved position and potential.

Disappointments and Disappointing Management

2002 was a humbling year for Kerr McGee. It ended with significant asset impairments, totaling $828 million in 2002. The disappointments centered especially on its Leadon Field in the UK North Sea, which alone cost KMG $541 million.

Costs spiraled out of control as the company’s oil & gas division impaired assets and disappointments mounted in 2001 and 2002. KMG’s finding costs were around $20 a barrel in 2002.

Its Chemical division was not much better.

Chemical Abyss

Investors for years have wanted KMG to exit its chemical division, which has $1 billion in sales and currently produces no profits. In 2000, the chemical division produced $147 million in operating profit. In 2001, it plunged to a loss of $39 million. In 2002, it produced $1 million of profit and it will not be much higher in 2003.

The company's primary chemical product is titanium dioxide pigment (TiO2), a white pigment used in a wide range of products, including paint, coatings, plastics and paper. TiO2 is used in these products for its unique ability to impart whiteness, brightness and opacity. The product is a commodity product, which is sensitive to economic activity.

There is a hope that the improving economy could bring back operating profits to this division. However, the real hope investors should have is a sale or in a worst case scenario a closing of this division. Wall Street is clearly valuing this division as a negative asset.

Restructuring is showing signs of progress

KMG has undergone a painful restructuring since 2002. This has involved a wholesale sell-off of its various far-flung oil and gas properties around the world. KMG has sold off E&P assets in Australia, Kazakhstan, Ecuador, and Indonesia. By focusing on a couple of key locations such as the North Sea, Gulf of Mexico and China, KMG can control its costs and retain its focus.

In addition to selling off its E&P assets, the company exited its forest products division and closed its high cost Mobile, Alabama synthetic chemical plant.

The results of the restructuring are encouraging. So far in 2003, oil and gas costs are down substantially. Lease operating costs are down $0.50 to $3.33 a BOE in the first nine months alone. And finding costs are down from the ridiculous $20 a BOE to a more manageable $8.50-$11 a BOE.

Due to its asset sales in 2002, KMG reduced debt by $760 million, will have reduced debt by another $300 million in 2003.

Balance Sheet

KMG has $194.9 in cash million in cash and almost $4 billion in debt (includes liability reserves). KMG also owns 8.4 million shares of Devon Energy (NYSE: DVN) through a convertible bond it owns. So, KMG has $3.34 billion in net debt. KMG’s debt to equity is 1.5 times.

The balance sheet is improving. KMG paid off $300 million in debt 2003, and the company plans to pay off another $500 million in 2004. KMG plans these cash uses despite a $182 million a year dividend requirement.

3 Major Development Projects

The best part of the KMG turnaround is its three new projects, Gunnison, Red Hawk and Bohai Bay. Two of the fields, Gunnison and Red Hawk could represent a triumph for KMG, which has sunk hundreds of millions into deep water exploration.

The Gunnison field, of which KMG has a 50% interest, is scheduled for full production as of the first quarter of 2004. This field is in deepwater in the Gulf of Mexico and should represent 40 Bopd and 200 MMcf/d of gas. Wall Street estimates for this field appear conservative.

The company’s Red Hawk field, which is also owned 50%, is all natural gas and should produce 120 mmcf/d. The company is utilizing a state of the art spar to get the natural gas out and should start production in mid 2004.

Bohai Bay is an oilfield off of China that should start production in 2004 and is 81.8% owned. Wall Street also appears to be underestimating this field.

Expectations for 2004 and beyond are low

The attractiveness of KMG story is how much Wall Street dislikes the company. Of the four analysts covering the company, two have underperform ratings, one has a neutral and a minor firm has an outperform rating.

The disappointments from 2001 and 2002 appear to still be tainting the stock. Analysts and other investors are clearly missing out on the potential for the refocused KMG to start growing reserves, paying down debt and start beating production estimates in 2004.

One interesting discovery is KMG’s 100% owned Constitution field in the Gulf of Mexico, in which estimates of reserves continue to increase. This field alone maybe a surprise to Wall Street if the company can book strong proved reserves by this year end.

Expectations are so low because of past defeats and hundreds of millions of in spending that has not produced anything of significance in the past two years. This is going to change in 2004.

What is exciting longer term is the company’s focus on deepwater drilling, which while high risk, is also the last frontier of drilling in the Gulf of Mexico. KMG’s expertise and experience could serve the company well as there are very few targets left in shallow water in the Gulf.

Catalysts

1) Growth in Reserves

2) Upgrade by brokerage firms in the face of improving operations

3) Potential buyout

4) Sale or Closure of Chemical Division

5) Upward revision of Bohai Bay, Gunnison, Red Hawk or Constitution Fields

Summary

There are many positives to investing in Kerr McGee. The most attractive part of KMG is that investors get to collect a 4.2% dividend, while they wait for the turnaround.

Another positive is the company’s changing production profile, in which more than 50% is natural gas. And that natural gas is more and more being produced in the U.S., which is suffering from a long term problem of supply of natural gas.

I estimate the company will earn $3.40 a share due to its better than expected production (north of consensus estimates of $3.21 a share for 2004). On a cash flow basis, KMG should produce north of $15 a share.

With a 4 multiple times $15 a share in cash flow, and then adding in $2 a share for the chemical division either being sold off or operations improving due to the improving economy, KMG would trade at $62 a share. With the annual dividend, that should bring investors a total return of 45%.

Catalyst

1) Growth in Reserves

2) Upgrade by brokerage firms in the face of improving operations

3) Potential buyout

4) Sale or Closure of Chemical Division

5) Upward revision of Bohai Bay, Gunnison, Red Hawk or Constitution Fields