Description

Adding to the oil/gas ideas thrown around lately, I believe Plains Exploration & Production (Ticker: PXP) presents an interesting opportunity for value-oriented investors. I believe it combines some interesting aspects of special situations and value investing.

PXP is an independent oil and gas company primarily engaged in the upstream activities of acquisition, exploitation, development and production of crude oil and natural gas. PXP’s main operations are in California, where they are the fifth largest producer of crude oil. The company also has operations in Illinois. Currently, 93% of its production is oil and 7% gas. The company has approximately 27 years of reserve life. In January 2003, PXP agreed to acquire a company called 3TEC Energy (Ticker: TTEN). According to an interview w/ PXP CEO James Flores, PXP acquired TTEN “at a valuation that would warrant probably a $3.50 to $4 gas price, but we were able to hedge much of the gas volumes going forward for the next two years at around $5/Mcf. So we built an accretive arbitrage of cash flow for our PXP shareholders.” TTEN currently has 50% of its 2003 and 2004 production hedged at $5.00/Mcf. Given current spot pricing, the other 50% should be equally, if not more attractively, priced.

At the current price of $8.70 per share, PXP is valued at 2.4x Price / 2003 DCFPS, one of the least expensive valuations in its peer universe. I believe it is relatively and absolutely inexpensive for the following reasons:

-- SPINOFF DYNAMICS: PXP was spun-out of Plains Resources (Ticker:PLX) in December of 2002. PXP is a small-cap oil/gas company with a current market capitalization of $208 million (pre 3TEC deal). There may be some indiscriminate selling of the stock as a result of the spin. I think this is a very minor contributor to the stock being down.

-- ACQUISITION DYNAMICS: PXP agreed to acquire TTEN in January 2003. Since that time, according to the CFO, short sellers have shorted approximately 2 million shares of PXP. The deal is that each share of TTEN is worth $8.50 of cash and 0.85 shares of PXP (subject to a collar, which looks as though it will not be breached). The current arbitrage spread is very tight. It looks like most people are looking for the deal to close in early June.

-- LACK OF COVERAGE: There is only one regional bank that covers the stock. Management expects there to be 5-6 banks covering the stock by year end. The current management team appears to be very impressive. Mr. Flores (Chairman/CEO) began his career in 1982 and subsequently was responsible for helping build Ocean Energy, which was ranked the third highest performing stock in 1996 by the NYSE. Much of his management team has followed him from Ocean Energy to PXP.

-- INVESTOR SENTIMENT: Some people may be shying away from the stock because they do not fully understand the acquisition (which will add a good deal of financial leverage to the company) or they believe the management team will be too aggressive in acquiring gas properties (they intend to use their long-lived oil assets to acquire gas assets). TTEN may be the first acquisition in an attempt to build a balanced oil/gas company. The company’s pro-forma production will be about 33% gas and 67% oil. The pro forma company should have a debt/capitalization ratio in the 60%+ range. The company has expressed an interest in getting that down to the mid-40%’s in a short time frame. Some may worry about a secondary equity offering. I believe they will be able to get to this ratio through free cash flow of approximately $75 million in the next 18 months.

Valuation:

Stock Price: $8.70
PF Equity Market Capitalization: $348 million

PF Net Debt: $519 million

PF Enterprise Value: $867 million

Prior to the 3TEC acquisition, PXP had over 75% of its 2003 production in fixed hedges at around $23.50 a barrel. After 3TEC, it will have the effect of having, on a combined oil-equivalent basis, two-thirds of the production hedged at over $27.50 a barrel on a blended gas/oil basis.

Guidance was given as early as last week. Using the mid-point of production and cost guidance given by the company, I expect 12 month pro-forma 2003 profitability to look like this:

Gas Revenue: $142.2
Oil Revenue: 187.7
Total Revenue: $329.8

Production Expenses: 99.1
Production and ad valorem taxes: 16.5
G&A Expenses: 20.8
D, D&A: 50.3

EBIT: $143.1 million
DISCRETIONARY CASH FLOW: $142.8

DCF/ SHARE: $3.57

P / DCFPS: 2.4x

Management appears extremely capable and has shown a track record of building a successful oil/gas company. The letter to shareholders in the 2002 annual reports of both PXP and PLX are incredibly well-crafted and shareholder friendly, especially PLX.

The company has its 1st quarter earnings call on May 14.

In a recent interview with the WSJ, Chairman/CEO James Flores stated, “The investor base is probably going to be shifting somewhat from a deep value universe to a growth universe… Right now the deep value universe is enjoying picking up shares at a pretty reasonable valuation.” I agree.

There are also quite a few very well-respected hedge funds who are currently shareholders, for those who find comfort in such things.

Catalysts:

-- Attractive absolute and relative valuation
-- Closing of TTEN acquisition in early June
-- Analysts and the investment community will become more aware of PXP
-- Debt paydown and free cash flow generation
-- Excellent management team
-- Long-lived reserve life (27 years PXP, 20 years proforma for TTEN)

Catalyst

-- Attractive absolute and relative valuation
-- Closing of TTEN acquisition in early June
-- Analysts and the investment community will become more aware of PXP
-- Debt paydown and free cash flow generation
-- Excellent management team
-- Long-lived reserve life (27 years PXP, 20 years proforma for TTEN)