By: Bill Powers
Valuing public companies is a black art.
Analysts use many metrics, and when delivering a final price target on a stock, use the average of several methods—cash flow multiple, Net Asset Value and the esoteric “management premium”.
But I want to suggest to investors that right now, one of the main metrics is NOT WORKING in the US E&P sector—EBITDA multiples. Think of EBITDA as a fancy acronym for cash flow. They’re not quite equal, but the Street generally considers them close enough to be interchangeable.
Using EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) in company valuations has long been a favorite metric amongst the sell side exploration and production (E&P) analyst community. And why not? EBITDA is fairly easy to calculate and widely recognized. While everyone likes to use the familiar when diving into a company valuation, using it now can be a profoundly misleading metric in today’s debt-soaked E&P universe.
I caution any investor reading a sell side research report to understand that the main reason its author is using EBITDA to describe the financial health of an E&P company is to obfuscate its indebtedness.
For example, consider the EBITDA of heavily indebted, gas focused Range Resources (NYSE:RRC). Range had EBITDA of only $24.1million in Q2 2015, and is on track to generate slightly more than $100 million in EBITDA this year. However, considering the company had interest expense of $43.5 million along with $9.2 million with ad valorem taxes (taxes paid to states when oil and gas come out of the ground) in Q2 2015 it is easy to see that RRC is cash flow negative.
In other words, Range’s $247.5 million in Q2 revenue does not even cover the cost to pay operating, overhead and interest expense on its debt let alone drill new wells. Clearly, not a healthy financial picture.
After years of taking on debt to grow production at times of low natural gas prices, many companies’ interest expense is now a huge percentage of revenue and, as in the case of Range, is wiping out EBITDA. Range’s interest expense consumed a whopping 17.6% of revenue in Q2 2015 and is likely to eat up an even larger percentage in Q3.
Why should all of this matter to investors? Investors should care because history tells us that a company’s ability to generate EBITDA or cash flow is a very important factor in ensuring its survival as well as its eventual takeover valuation. I find Range Resources, with a market capitalization of $6.2 billion and an enterprise value of $9.6 billion, incredibly richly valued given its miniscule EBITDA and negative cash flow.
While RRC’s valuation may be extreme given its inability to generate EBITDA or cash flow, many of its peers have also been awarded valuations that are not justified by their (in-)ability to generate positive cash flow from operations.
Another instance where EBITDA does not reflect a company’s financial health is US-based Sandridge Energy (NYSE:SD). The troubled producer had Q2 2015 revenue of $230 million and $97 million in EBITDA in the quarter.
However, due to Sandridge’s massive debt load of $4.4 billion, the company paid a whopping $74 million in interest in the quarter. In other words, the company’s interest expense amounted to 31% of its revenues.
More importantly, SD generated only $18 million in cash in Q2 while incurring $168 million of capital expenditures. Given the extreme leverage of SD and its inability to generate enough cash to cover a meaningful portion of its capex budget it is easy to see why the company is actively restructuring its debt.
This issue can even impact larger companies, and oil-weighted ones. I would point to another company—a market favourite–where EBITDA does not reflect a company’s financial health—one of Canada’s favorite dividend payers, Crescent Point Energy (TSX: CPG, NYSE:CPG).
A cursory review of CPG’s Q2 2015 EBITDA of $433 million would suggest the company would easily be able to cover the $228 million of dividends it paid out in Q2 2015. However, a look below the surface of the EBITDA calculation tells a different story.
Due to Crescent Point’s interest expense of $33 million and its capex of $338 million Q2 2015, the company was cash flow negative for the quarter when factoring in its dividend payments. It was one of the factors that caused CPG announced a major reduction in its dividend in conjunction with announcement of quarterly results.
Taking a step back, the inability of Range and other gas-focused E&Ps to generate meaningful EBITDA or cash flow at today’s natural gas prices says a lot about the health of the industry. In years past, many companies simply borrowed or issued shares to grow their production despite an inability to pay for the required drilling or acquisition from current earnings.
More importantly, companies that followed this path were rewarded with higher share prices. Those days are—for the most part—over. Without access to outside capital expect North American E&P companies to further lower capex and production guidance for the remainder of 2015 and calendar year 2016. On a positive note, lower spending over the next 6 to 12 months should go a long way towards higher oil and gas prices.
In conclusion, while EBITDA may have been a useful valuation metric in days past, before E&P balance sheets became cesspools of debt, EBITDA has morphed into a commonly use metric to hide a company’s financial distress.