Playing an Undervalued Energy Name

 | Oct 18, 2012 | 11:30 AM EDT
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Myriad strategies can be used to make money in equities. Aggressive growth investors are always on the lookout for the next Apple (AAPL) or Amazon (AMZN). Dividend investors bet on companies that have a good yield and consistently grow their dividend payouts. Turnaround investors look for companies with good assets, solid cash flow, and a known brand that will benefit from new management. One of my favorite strategies is to find a company that is more than the sum of its parts and is undervalued by the majority of the market.

A perfect example of this is eBay (EBAY). At the start of the year, it trading at just $30 a share. At that valuation, investors were assigning little to no value to the company's fast growing Paypal service. As the value of that portion of the business became more apparent, the market has more properly assessed the earnings power of eBay and the stock now sells for just under $50 a share. It has been one of the best performers in my portfolio so far in 2012. Another stock in my portfolio that I believe has more unrealized value than the market is currently assigning to it is Hess (HES). The company has been rightly accused of having "unfocused" management at times but has a couple of catalysts that I think could unlock substantial shareholder value over the medium to longer term.

Hess is an integrated energy company that operates in two segments: exploration and production as well as marketing and refining.

Two possible catalysts for Hess:

  1. Following in the footsteps of Conoco Phillips (COP) and Marathon Petroleum (MPC), Murphy Oil (MUR) just announced that it is splitting its refining business from its core exploration-and-production units. This strategy has been successful in unlocking a significant amount of shareholder value and Murphy has had a nice run since its announcement that it would take this action. Hess owns and/or has ownership interests of several refineries and more than 1,300 gas stations. Given the continuing movement to split off marketing and refining businesses among integrated oil firms, I think this is a positive catalyst that has a good probability of occurring in the near to medium future.
  2. The company is already a substantial player in the Bakken and recently added substantial acreage in the promising Utica shale region. It has increased its capital budget substantially this year and plans to devote 35% of it to the Bakken, up from around 10% in past years. Given the continuing improvements in fracking technology and the explosive production growth from these two regions, this has the potential to be very positive for the company's production growth over the longer term. Hess more than doubled its production from the Bakken in 2011 and replaced more than 140% of its production overall in its last completed fiscal year. The company is disposing of some non-core assets to help fund these additional capital outlays so cash flow is likely to be lumpy in the near term. It also has promising finds in the Gulf of Mexico and Ghana among other areas in the world.

Given the company's longer-term prospects, the stock is cheap as it is trading just below 5x operating cash flow and just above 8x forward earnings. In addition, consensus earnings estimates for both fiscal 2012 and fiscal 2013 have risen nicely over the last two months. HES is a buy at $55 a share.



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