Energy XXI Ltd fka EXXIQ

[chmcnfunds]

Energy EXXI: A Major Opportunity For Patient Investors

Oct. 1, 2014 10:30 AM ET | 3 comments | About: Energy XXI (Bermuda) Limited (EXXI)
Disclosure: The author is long EXXI. (More...)

Exploration & Production stocks suffered significant declines in the recently completed third quarter on the back of falling oil & natural gas prices. The offshore space was hit particularly hard.
I have been adding new names and additional shares to existing stakes in this sector recently as valuations have become attractive and energy prices should firm as winter approaches.
Today I am profiling an offshore play that has been cut in half recently on a big acquisition and negative sentiment on the sector.
This shares are selling for less than half the median price target held by analysts that cover the company. Read why this is my highest risk/highest reward E&P play currently.
I have done a variety of articles on the E&P sector over the last week due to big decline these stocks experienced during the recently completed third quarter of this year. This pull back was primarily driven by the significant pull back in oil and natural gas prices during the quarter. I have been adding some new positions as well as adding to my existing in these plays within my own portfolio along with that of the Small Cap Gems.

As winter approaches, I believe pricing for oil & natural gas will firm up and the sector should be a strong performer in the fourth quarter as the same pattern (down in third quarter, up in fourth quarter) played out in 2013 and I expect similar weather patterns for the rest of the year. Today, I wanted to discuss the highest risk/highest reward play within my portfolio at the current time.

Company Overview:

Energy XXI (NASDAQ:EXXI) is an independent oil and natural gas exploration and production company. EXXI is engaged in the acquisition, exploration, development and operation of oil and natural gas properties onshore in Louisiana and Texas and in the Gulf of Mexico (GoM). EXXI is the largest publically traded independent operator in the GoM shelf operating seven of the largest GoM shelf fields.

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EXXI acquired the assets of EPL Oil & Gas (NYSE:EPL) in June of this for $2.5 billion. The purchase was paid for by 65% cash and 35% via stock. EXXI owns 75% of common of the combined enterprise. The drop in EXXI's stock is attributable primarily to pessimistic post-acquisition expectations, meaningful leverage taken on with the EPL acquisition, and questions regarding management's ability to execute on its post-EPL operating plan.

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The stock has been cut in half over the past few months on these concerns as well as the general weakness in the E&P sector during the third quarter. The offshore space has been punished particularly harshly over the past three months. In my opinion, these concerns are overblown and short sighted and ignore the company's consistent past performance, growing expertise in horizontal drilling technology, and pro forma asset values, cash flow, and leverage reduction in the future.

Production Growth:

For fiscal 2014, production averaged 45,000 BOE/D (Barrels of oil equivalent/day), up 4% from production of 43,100 BOE/D the prior year, while the oil portion rose 6%, representing 67% of volumes compared to 66% in fiscal 2013. During the company's fiscal fourth quarter, production averaged approximately 46,100 BOE/D, with oil production averaging nearly 32,000 barrels per day, both of which are both of the guidance put out by the management at the time of the EPL acquisition.

Trading At A Discount To Peers:

EXXI trades at 62.8% of its PV10 (10 year present value on proved reserves) asset value, while its mid-cap and large-cap brethren trade at an average of 163.5% and 283.6% PV10, respectively. Additionally, EXXI trades at 4.4x its estimated mid-point 2015 EBITDA, while its mid and large cap brethren trade at 8.5x and 9.6x EBITDA, respectively. EXXI's EBITDA margins at 61.3% are better than both mid and large cap players at an average of 52.8% and 53.9%, respectively. Finally, EXXI's oil as a percentage of total production is 72%, in line with the mid-cap group's 74%, and well in excess of its large-cap competitors at 35%.

At just under $11.50 per share, EXXI is priced for bankruptcy, while its bonds trade above par and it has $500.0 million of liquidity on its line of credit, $145.0 million of cash on hand, and the dividend is protected for two years per management. Although EXXI is in a good liquidity position and has solid room on its covenants, a disruption in markets due to outside risks and a prolonged reduction in oil prices will have meaningful impact on EXXI and its liquidity and debt positions. At $95 a barrel oil, management estimates achieving approximately $1.0 billion in EBITDA, still well within its revised covenants.

A reduction in oil prices below this level, particularly in light of the company's planned $875 million capital budget, will stress both operating performance, as capital expenditures are reduced, and cash flows. Although EXXI's covenants provide significant wiggle room for the company, it is this risk, along with execution risk, that most notably weighs on the stock at this time.

The median price target of the 14 analysts that cover the stock is $26 a share; more than double the current price of the stock.

A Possible Takeover Target:

EXXI has working relationships for exploratory work with Apache (NYSE:APA) and ExxonMobil (NYSE:XOM), among others. These two majors have a respect for the company, its management, and their ability to utilize new technologies to increase opportunities in old wells. Both Apache and ExxonMobil have vast resources of aged wells and EXXI's knowledge base and comparative advantage in harvesting these old properties has their attention.

Additionally, the technical teams of both EXXI and EPL have complementary strengths and expertise. Per a recent comment on The Street, "While most of the majors are largely focused on exploiting the deep water areas, with advancements in exploration and production technologies, such as higher quality seismic analysis and horizontal drilling, the big boys of the industry might consider revisiting the shallow waters".

As EXXI integrates the EPL deal and executes on its robust horizontal drilling inventory, ExxonMobil, Chevron (NYSE:CVX), and other energy majors with a presence in the Gulf could take notice. EXXI's core horizontal drilling competency and low valuation even in upside cases, sets it up as a likely acquisition target for these majors. It will take a year of operating performance before the majors take note, however, but EXXI remains a possible target for acquisition in my opinion.

Outlook:

Even without a possible buyout, the shares are attractive. Assuming a conservative 5.5x enterprise value to 2015 estimated EBITDA multiple, as compared to the average mid and large-cap EBITDA multiples of 8.5x and 9.6x, respectively, provides for an EV of $6.0 billion. Assuming no reduction in leverage, EXXI will have a $2.3 billion market cap by fiscal year ending June 2015. EXXI should generate approximately $100 million to $200 million in free cash flow, excluding planned asset divestitures, which will reduce debt and further increase EXXI's market cap. At 5.5x estimated 2015 EBITDA, EXXI's stock would trade at $31.60 per share.

The company has grown successfully in the past via acquisition and by organic growth and I expect the EPL acquisition to be no different over the longer term.

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In addition, the company has expertise in making the oil fields it acquires bigger producers over time.

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EXXI is a good speculative buy for patient investors that believe the company will be able pay down its debt and believe oil is closer to a floor than a ceiling at around $92 a barrel. If both of these conditions are met, I believe this stock has considerable upside. I believe that the company will successfully integrate its recent acquisition, reduced leverage and benefit as sentiment on the sector and the company improves. It has become one of the larger positions in my portfolio as I have averaged down during the recent decline in the stock and believe this patience will be rewarded. SPECULATIVE BUY
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http://seekingalpha.com/article/2533945-energy-exxi-a-major-opportunity-for-patient-investors?uprof=46

EXXI