Valuentum Exclusive Analysis for the Discerning Investor

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Image Source: Value Trap: Theory of Universal Valuation

From Value Trap: “The banking sector was not the only sector that faced considerable selling pressure during the Financial Crisis of the late 2000s, of course. Other companies that required funding to maintain their business operations faced severe liquidity risk, or a situation where refinancing, or rolling over debt, might be difficult to do on fair terms, making such financing prohibitive in some cases. Those that faced outsize debt maturities during the most severe months of the credit crunch faced a real threat of Chapter 11 restructuring had the lending environment completely seized. In thinking about share prices as a range of probable fair value outcomes, equity prices tend to face pressure as downside probabilities such as a liquidity event are baked into the market price and at a higher probability. Because debtholders are higher up on the capital structure than equity holders, shareholders can sometimes get nothing in the event of a bankruptcy filing. Entities that are extremely capital-market dependent, or those that require ongoing access to new capital to fund operations, often face the greatest risk of the worst equity price declines during deteriorating credit market conditions.” Value Trap: Theory of Universal Valuation, published 2018

By Valuentum Analysts

One of the key sources of intrinsic value within the discounted cash-flow construct is a net cash position. After all, a company with $1 billion in net cash is worth more than a company with $1 billion in net debt, all else equal. There’s another reason why we generally only prefer companies with fortress-like balance sheets (i.e. large net cash positions), and that’s because when the going gets tough in the credit markets, the equity prices of these companies tend to be much less sensitive to baking in a probability of a credit event than their more-leveraged counterparts.

This critically important dynamic tends to fly under the radar during the best of times, but it rears its ugly head during the worst of times. Last week, we just started to witness some cracks in the credit markets, and we’re not just talking about small businesses in China. According to Bloomberg, “bonds of American Airlines Group dropped to near distressed levels…Debt of rental-car companies and cruise lines came under increasing pressure. And energy company bonds and loans fell further into distress as crude oil prices slumped.” We’d expect these leveraged industries, including the midstream MLP arena, to continue to get pummeled as downside probabilities of liquidity events are baked into their share prices. Last Friday, for example, the Alerian MLP ETF (AMLP) dropped to $6.05 per share, an all-time low, down from north of $16 per share in June 2015, when we warned investors about the impending collapse.

Overleveraged Energy Names

The independent upstream producer space (XOP) is careening off a cliff, and that was before the OPEC+ cartel was unable to reach an agreement during their joint meeting (OPEC and non-OPEC members) on March 6. Due to the inability for the oil cartel to reach a deal, largely because Russia (RSX) wouldn’t get onboard with additional Gulf state-backed supply curtailments, Saudi Arabia (KSA) instead decided to embark on a full on price war.

The massive oil exporter reduced what it known as its official selling price (‘OSP’) for April to key markets around the world, including those in Europe and Asia, effectively attempting to steal market share from Russia, the US, and other exporters. In addition to that, Saudi Arabia is also getting ready to ramp up its oil production levels, possibly adding 1+ million barrels per day to global supply over the coming months.

Brent tanked ~20% according to trading action as of late Sunday, March 8, and the futures curve points towards realizations for the upstream space (firms that produce and sell raw energy resources) below $40 per barrel of oil for some time. Demand destruction from the ongoing novel coronavirus (‘COVID-19’) epidemic combined with a potentially prolonged oil price war could see Brent march below $30 per barrel in the near term (currently Brent deliveries for May 2020 are trading near $35-$36 per barrel as of this writing).

Whiting Petroleum

For an independent unconventional upstream player like Whiting Petroleum (WLL), these events could tip the firm into restructuring. Whiting Petroleum was free cash flow negative in 2019, and during the past three years (2017-2019), was only free cash flow positive in 2018 on a full-year basis. Furthermore, Whiting Petroleum carried a net debt load of $2.8 billion at the end of 2019 and had a negligible cash position on hand. Whiting Petroleum can’t cut its capital expenditures without sacrificing its production base given the extremely steep production decline rates (which run around 45-80% during the first year alone) seen at wells that are “fracked” (meaning horizontal wells that are hydraulically fractured to stimulate oil, natural gas liquids, and natural gas production). If Whiting Petroleum sharply cuts its capital expenditures, its cash flows will fall off a cliff regardless of where raw energy resources pricing goes (short of oil hitting $100+ per barrel, which we view as highly unlikely at this stage). Whiting Petroleum’s revolving credit line and the generosity of its creditors may be the only thing really keeping the company afloat, but how long that dynamic will last remains to be seen.

Devon Energy

Pivoting to Devon Energy (DVN), this independent upstream producer was modestly free cash flow positive in 2019 (however, the firm generated negative free cash flows in both 2017 and 2018), generating a little over $0.1 billion in free cash flows last year which still fell short of its modest dividend obligations. While Devon Energy carried a nice cash balance, its net debt load (not including ‘restricted cash for discounted operations’) still stood at over $2.8 billion at the end of 2019 (the firm did not have any short-term debt at the end of last year). Devon Energy exited 2019 with a current ratio ~2.0x.

Devon Energy is in a better position than Whiting Petroleum, but the road ahead indicates there’s a good chance its dividend will be slashed (as its operating cash flows will likely plummet alongside raw energy resources prices) and that might really pressure its share price going forward—its Dividend Cushion ratio stands at -0.6. Should oil and other raw energy resources pricing stay subdued for some time, things could get a lot worse at Devon Energy as it contends with a declining well inventory at its core plays in the US (forcing the firm to shift capital towards less lucrative regions within its portfolio).

While Devon Energy may be better positioned that Whiting Petroleum, the firm’s inability to generate meaningful free cash flows and the chance for significantly negative free cash flow generation in the current raw energy resources pricing environment (which could further weaken its balance sheet), on top of its existing net debt load are quite concerning.

The “shale treadmill” (the continuous need to run hefty capital expenditure budgets to offset steep production decline rates at fracked wells) makes free cash flow generation a nearly impossible if not downright impossible task for Whiting Petroleum, Devon Energy, and the unconventional independent upstream industry at-large.

A Looming Credit Crunch?

Valuentum's Financials and Economics contributor Matthew Warren, former head of Global Financials at Morningstar during the Great Financial Crisis, has explained how the coronavirus outbreak can turn into a global crisis, “2,350-2,750 on the S&P? Could the Coronavirus Catalyze a Financial Crisis,” and this is something that we’ve been monitoring closely as COVID-19 continues to spread around the world, with Italy being the latest hotspot to face a proliferation of new cases, “Coronavirus Crisis Deepens, Italy on Lockdown.”

Matthew Warren had the following to add: “Declining oil prices are going to further pressure credit quality in the U.S. oil patch. Cocooning will put pressure on travel and leisure industries and the credit quality of the over-leveraged players. A blowout of high-yield spreads will catalyze defaults as some companies struggle to refinance. The associated bank loans could go bad. Beyond that, there is also a self-fulfilling-prophesy effect as extremely volatile markets cause bank lenders to pull back on the reigns and reduce credit availability more broadly. Smaller and more leveraged companies will be the worst affected. If large-scale quarantines eventually come into play, expect a loss of earnings as people stay home from work with their kids. Over leveraged personal balance sheets could also come under pressure.”

We believe the lending environment is likely to become much tighter in the coming months, and businesses will have to hunker down for what could be a prolonged period of reduced demand. Here’s what Moody’s had to say:

Like it or not, the Treasury yield curve and fed funds futures now assign an uncomfortably high implied probability to a painful contraction of corporate earnings and a pronounced worsening of the corporate default outlook arriving by the end of 2020. In turn, the high-yield bond market is now susceptible to a 500 bp ballooning of the average spread over Treasuries. These dangers may persist until COVID-19 risks subside convincingly.

A contraction of corporate earnings by a modest 10% from expected February 14 levels for 2020 may be a good base-scenario. Applying an optimistic 16x forward multiple to those adjusted earnings puts a fair value of the S&P 500 (SPY) between 2,350-2,750, our target range. We assign a comparatively higher multiple than historical forward measures given accommodative Fed policy and the ultra-low interest rate environment [10-year average forward P/E (14.9), 15-year (14.6), and 20-year (15.5)].

Concluding Thoughts

We believe that the probability of the impact of COVID-19 to catalyze into an all-out financial crisis has increased in light of recent developments. We’re starting to see cracks in the credit markets, energy prices have collapsed, and investors should expect some of the most highly-leveraged entities to face some of the most intense selling pressure, as credit conditions tighten and businesses hunker down for reduced demand. We continue to expect conditions to worsen before they get better, and our target range on the S&P 500 of 2,350-2,750 remains unchanged at this time.

Aerospace & Defense - Prime: BA, FLIR, GD, LMT, NOC, RTN

Aerospace Suppliers: ATRO, HEI, HXL, SPR, TDY, TXT

Energy Equipment & Services (Large): BKR, FTI, HAL, NBR, NOV, SLB, TS

Energy Equipment & Services: CLB, DRQ, FI, HLX, HP, OII, OIS, PTEN

Gaming & Hotels: HLT, LVS, MAR, MGM, WYNN, CHDN

Leisure: AOBC, CCL, CLCT, FUN, HAS, IGT, MAT, RCL, SIX, WWE

Metals & Mining - Aluminum: AA, ACH, ATI, CENX, KALU

Metals & Mining - Diversified: BHP, FCX, NEM, RIO, SCCO, VALE, WPM

Metals & Mining - Steel: AKS, GGB, MT, NUE, PKX, STLD, X

Oil & Gas - Independent: APA, CLR, COG, DVN, EOG, MRO, OXY, PXD

Oil & Gas - Major: BP, COP, CVX, RDS, TOT, XOM

Pipelines - Oil & Gas: ENB, EPD, ET, KMI, MMP

Rental & Leasing: CAR, PSA, R, UHAL, URI

Telecom Services: BCE, CTL, EQIX, S, T, TMUS, VOD, VZ

Related: AAL, ALK, DAL, DVN, HA, JBLU, LUV, SAVE, UAL, JETS, WLL