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Morningstar | Continental FVE Up on Bakken Outperformance and Growth Outlook - Shares Slightly Undervalued. See Updated Analyst Note from 08 Aug 2018

Narrow-moat-rated Continental delivered production of 284 mboe/d in the second quarter, which was 1% lower sequentially and below the low end of guidance. The disappointment was attributed to Bakken weather issues (for the second consecutive quarter) and voluntary curtailments in Oklahoma related to the startup of the Project Wildcat pipeline that should enable the firm to capitalize on premium out-of-basin natural gas prices for its Oklahoma production in future periods. Regardless, the company's financial results were close to Street estimates (with adjusted EBITDA and adjusted earnings per share coming in at $878 million and $0.73, respectively). In addition, management noted that full production was restored in early July, and full-year guidance was tightened to 290-300 mboe/d (1% higher at the midpoint, and consistent with 20-24% year-on-year production growth). The firm's projected 2018 exit rate was also raised by 10 mboe/d at the midpoint.

The firm's updated outlook for growth in the second half also incorporates accelerating activity in Oklahoma. 3 rigs will be added at Project Springboard (a massive development consisting of several hundred Springer and Woodford wells), and 16 additional net wells are now expected online during 2018 (pushing up the drilling and completion budget by $125 million).

These guidance increases were also underpinned by better-than-expected well performance in the Bakken. Management has now increased its type curve to 1.2 mmboe (from 1.1 mmboe), and was able to demonstrate that the 70 operated wells drilled thus far with its 60-stage completion methodology are, on average, outperforming the updated curve. Within this group, four of the top 10 producers were brought online during the second quarter. Incorporating this outperformance in our model supports a fair value increase to $67 per share, which reflects a premium of about 6% to the current price.

Our updated valuation also reflects stronger realized prices going forward, as the marketing cost at Project Springboard is very low--netbacks are projected to come in at less than $2 below WTI, which is much better than the current differential of over $4/bbl (management commented that Project Springboard could account for 10% of firmwide volumes by the end of 2019).

And finally, we note the announced mineral rights partnership with Franco Nevada. This effectively enables the firm to recoup royalties related to its upstream activities. When this subsidiary is formed in the fourth quarter, the firm will: 1) purchase mineral rights for $275 million; 2) drop them into the new entity; and 3) receive $220 million in compensation from Franco (resulting in a net outflow of just $55 million). A further $375 million will be spent on mineral rights in the next three years, of which Continental is on the hook for 20%. Going forward, the partnership will receive royalties when the minerals it owns are developed (equivalent to about 19% of revenue from production). Continental's share will range from 25%-50%, and management believes it can hit the necessary thresholds to earn the full 50%. How much that actually translates to is unclear, as the specific rights to be purchased have not been disclosed. The goal is to grow the subsidiary into a multibillion valuation, according to commentary on the conference call. For now, we assign a value of $500 million ($1.30/share).