Description

Rosetta Resources (ROSE) $12.60
 Rosetta Resources is small cap North America E&P with assets primarily in South Texas, the Rockies and the Sacramento Basin. We believe at the current share price Rosetta is one cheaper natural gas plays in the US with resource leverage to the Eagleford and Bakken shales. Using 6.50/65 long term pricing we believe Rosetta's core assets are worth $18 per share (42% upside) and could see another $8-10 per share in upside if the Eagleford and Bakken prove to be successful (100-120% upside).

Market Cap: $663
Net Debt 2009: $240
Enterprise Value: $903

2010E Metrics (6.50 gas/ 65 crude)
Production: 146 mmcf/d
EV/EBITDA: 4.4x
Proved Reserves: 437
EV/flowing mcf: 6,326
EV/Proved reserves: $2.06

Background:
The company was formed in mid-2005 through a $1.05 billion spin-off of the E&P assets of Calpine Corporation. Due to Calpine bankruptcy and the creditor's desire to claw back additional value from Rosetta the company was subsequently sued in June 2007 under claims that the spin out undervalued the assets by some $400 million, implying a fair value at the time of $1.5 billion (almost double current EV). The parties settled the litigation in Q4 2008 for approximately $12 million cash and $84.6 in withheld payments from the original transaction. Since the spin off the company significantly strengthened it resource base and management team.
In terms of management Rosetta was able to add of number of Burlington Resource alums including the current CEO Randy Limbacher who was EVP and COO of Burlington. The new management team is intently focused on transitioning the company away from short RLI higher cost assets into longer-life unconventional resource plays.
Management has targeted 4 primary assets for development including the Sacramento Basin, the DJ Basin Niobrara Chalk, the Eagle Ford shale and the Alberta Basin Bakken.

Sacramento Basin "By-pass" (30,000 net acres):
 In the Sacramento basin the company is primarily targeting recompletions in several pay zones which have historically been by-passed. The first 6 wells tested this year had an average IP rate of 650 mcfe/d with the second 10 averaging 967 mcfe/d. Management is currently targeting the Middle Capay and Martinez zones with recompletions cost now running as low as $50,000 per well on an estimate .5 bcf EUR (excludes frac cost). Given an expected F&D cost between $.5-.75 per mcf and an LOE less than $1 per mcf management believes the company can recognize a 20% ROR at $3.50 NYMEX. Currently the 375 net projected well locations on 80 acre spacing for a net risked resource potential of 100 bcfe. Based on recent conversations with management I believe the company will put together a development plan to accelerate production well beyond the streets expectation given recent well results and apparent economics of this play.

Eagle Ford (40,000 net acres):
 While still early stage the Eagle Ford shale is gradually becoming recognized as top tier gas resource in the US. By year end the company plans to drill and complete three wells in the play. Springer Ranch #1H and Vela #1 which are in the fairway of Petrohawk' s recent well results targeting dry gas and the Gates Ranch #9-5H which will be closer to APC/SM/TXCO wells near Dimmit County. The industry has done a good job of reducing well cost in the region with estimates now forecasted to be $4-5 million targeting a net 4-5 EUR or ~$1 F&D. Rosetta's first successful well (Springer Ranch) came in north 5 mmcf/d per day on a shorter lateral and fewer frac stages then its recent peer well (Petrohawk is now up to 18 stages). Based on conservations with management incremental wells will lengthen laterals and increase frac stages with the intention of targeting rates in the 7-9 mmcf/d range for dry gas fairway (note PXD latest well came on at 11.3 mmcf/d). With recent IP's  between 5-9 mmcf/d, LOE estimated in the range of $.5-1 per mcf, and F&D ~$1 the Eagleford should be a game changer for the company. At 160 acre spacing the company expects to hold 220 net locations with an estimated resource of 650 bcfe

Alberta Basin Bakken (231,000 net acres)
 Primarily due to Burlington's previous experience in the Williston Basin management wished to have a position in the Bakken. However, given acreage cost management was not willing to pay up to enter the resource. Therefore they decided to move into northern Montana and leased up 231,000 net acres from the Blackfeet Indian National for an average cost of $15/acre plus a carry of an additional $10/acre if the play becomes successful. Rosetta must drill two wells per year to hold the entire acerage. During their initial analysis Rosetta found that 24 wells have previous been drilled on the acreage during the 1950's of which 6 had drill stem test completed. All of these showed the presences of hydrocarbons and two flowed oil to surface without stimulation. Furthermore, the field runs along side the Cut Bank field which has produced almost 120 mmbbls of oil to date. Based on initial estimates well cost should run between $2-2.5 million (shallower then Williston counterpart. Due to the lack of data it is hard to discuss the economics but this is clearly a free call option for the stock at this point and would add significant value longer term if successful. Management estimates there could be 720 net locations on 320 acre spacing and a potential net resource of 60-300 mmboe

DJ Basin Niobrara Chalk (90,000 net acres):
 Management is focusing on a highly repeatable drilling resource that overtime could significantly improve returns through scale and cost efficiencies. With over 1750 wells still to be booked the DJ Basin represent a potential resource base of 350 bcfe. An average well should cost ~200k and targeting an EUR of .25 bcfe however given the higher differentials and LOE this is a play that wont see much capital allocation until prices recover north of $5.50 NYMEX. Management recently hedged out 5 bbtu/d at $5.65 in H2 2010 to drill up acreage and prove the economics and scalability of the asset

Other Assets:
Other than the South Texas Lobo play which has recently seen well cost fall from $1.8 to $1.3 million and returns improve to 20% at $4.5 NYMEX we expect little capital to be deployed until gas prices rise above $6.

Divestitures:
Management was able to recognize 16 million in asset divestitures during Q2. They have publicly commented that they will look to divest further non core assets as the opportunity arises. Given the current commodity environment and solid balance sheet we see no reason for management to rush a deal but we do feel assets such as those in the Gulf of Mexico and State Waters could be sold off. Using conservative metrics we feel the company could recognize another $50 million in asset sales

Balance Sheet:
 We believe Rosetta maintains a health balance sheet with Net/EBITDA expected to be 1.5x in 2010 and debt/cap to remain below 35%. The company has a revolver maturing in July 2012 with a borrowing base of 375 million and a second lien term loan of 100 million with a maturity of October 2012. We estimate the company has approximately 225 million liquidity available under current reserve base.

Downside:
As of the 2008 annual filing Rosetta PV-10 value using 5.62 gas and 44.62 oil is worth 838 million less net debt of 240 million we arrive at a value per share of $11.73. Since we believe gas prices will at some point have to rebound to incentivize marginal producers and conventional players to invest in growth we expect prices will move longer terms towards $6-6.50 per mmbtu or service cost will have to fall further. Either way we feel Rosetta's balance sheet and current assets place it in a comfortable spot relative to its peer group

Risk:

• Gas prices remain depressed for the next 2-3 years and service cost do not correct further. Creating a decline in production beyond 2009
• 8 year RLI versus unconventional resources of 15+ years
• Company is unsuccessful in continuing to move away from higher cost historical asset base

Catalyst