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Morningstar | Laredo Fair Value Estimate Sinks After Incorporating New Type Curve and Slower Development. See Updated Analyst Note from 18 Feb 2019

We are reducing our fair value estimate to $2.50 per share after incorporating Laredo Petroleum's updated capital plan, which calls for a sharp slowdown in spending. We have also further moderated our well performance expectations given further color from management on unexpectedly high oil decline rates.

The firm currently has three active rigs but will release two during 2019. The goal is to ensure that spending will not exceed cash flows. We think this is achievable--our model suggests sustainable free cash flows and gradually improving leverage ratios with one rig. However, the firm’s growth outlook is tepid in that scenario. It is capable of adding a second rig in 2020 without putting undue pressure on the balance sheet, and by bringing cash flows forward this would lift our fair value estimate to about $4 per share. But this cannot be done without outspending, unless oil prices rally beyond our current expectations. Our midcycle forecast is still $55/bbl (WTI), and we believe management is committed to living within cash flows, so adding a rig seems unlikely.

The disappointing well performance that the firm has been coping with recently was initially addressed by management after the previous quarter. But the downward adjustment we made initially looks insufficient now that the firm has updated its type curve. This factors in a typical oil cut of just 30% after five years, compared with our most recent estimate of 35%. The firm’s previous type curve baked in 40%. By incorporating this guidance we are effectively assuming that the firm can replicate its success in 2016, when the separation between adjacent wells was higher (16-24 wells per section). This seems reasonable, based on the solid track record that the firm established in that period (with about 50 wells averaging 100 boe/d over the first 90 days).

Laredo's operating leverage is well above the peer average due to its low oil cut and the resulting drag on unit revenue. It also has above-average financial leverage. As such, its equity value is very sensitive to commodity price fluctuations (reflected by our extreme uncertainty rating). Therefore, the adjustments described above weigh heavily on our valuation, explaining the large spread between between our current and previous fair value estimates ($2.50 and $5.50 respectively).