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Morningstar | Laredo Sell-Off Is Way Overdone. See Updated Analyst Note from 02 May 2019

After a first look at Laredo’s first-quarter operating and financial results we are raising our fair value to estimate to $5 per share, which reflects a 68% premium to the last close. That makes it one of the most compelling ideas in the upstream oil and gas segment. Only a year ago the stock was trading above $10, before the firm announced a midstream dispute with Shell that left it vulnerable to Permian Basin basis differentials right before a major pipeline capacity shortage took hold in the region (the first-quarter news release hints at a favorable settlement of the resulting litigation). But the subsequent failure of the firm’s downspacing initiative was a bigger driver. This compromised well performance, leading to weaker initial production rates, and unexpectedly high oil declines.

We were spooked, too (eventually cutting our fair value to $2.50, $0.30 below the early 2019 bottom). But in hindsight that looks like a severe overreaction. The firm has now completed the last of its downspaced wells, paving the way for a resurgence in well productivity during 2019 now that the firm has reverted to 4-8 wells per drilling spacing unit in each reservoir layer. The incremental performance under this configuration was established back in 2016-17, with about 75 wells averaging over 100 barrels of oil equivalent per day per thousand lateral feet in the first 90 days of production. And though wider spacing means fewer potential drilling opportunities, the firm still has around 1,600 locations to work through, translating to more than 20 years of runway at the current pace. The firm has also made considerable progress cutting costs since the change in strategy was announced, and has shaved off over $1.50 per barrel in operating expenses. Given the firm’s relatively high operating leverage this improvement is highly accretive to our valuation.

To be clear, the unfavorable location of Laredo’s acreage on the eastern fringe of the Permian Basin will always prevent it from earning the same returns as its peers in the more profitable core of the basin. It is also growing at a more modest clip than most Permian operators. So it certainly deserves to trade at a discount. However, at just 3.3 times consensus EBITDA in 2020 that discount is overdone. For reference, the other Permian pure plays in our coverage are trading at about 6 times 2020 EBITDA on average, while our current fair value for Laredo shares – two thirds higher than the market price – translates to a multiple of only 4 times. We do not juice our valuation with incremental rigs, and we model a type well performing below the aforementioned standard set back in 2016-17 (when in reality the company and industry have advanced along the learning curve since then, and are more likely to outperform this reference curve, if anything). Our production and capital forecasts are roughly aligned with updated guidance from management, and our valuation assumes a midcycle crude price of $55/bbl (West Texas Intermediate).