March 28, 2009 - 6:21am EST by
2009 2010
Price: 33.06 EPS $2.26 $1.75
Shares Out. (in M): 131 P/E 14.6x 18.9x
Market Cap (in $M): 4,330 P/FCF 9.9x 11.2x
Net Debt (in $M): 1,570 EBIT 501 420
TEV ($): 5,900 TEV/EBIT 11.8x 14.0x

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 Over the past several years, there has been considerable investor interest in companies that produce natural gas from shale formations, especially from the Barnett, Fayetteville, and Haynesville.  EQT (previously named Equitable Resources) is a relatively undiscovered company that has particularly large exposure to the new Marcellus shale play in Appalachia.   EQT already has large reserves and production from the Huron shale, which is in the vicinity of the Marcellus.  (note - just as I was ready to submit this idea, I noticed that EQT was selected in the April 6th edition of Business Week as the 34th "best performing" company in the country;  Google was # 35.)

 More specifically, for years EQT has controlled over 3.3 million acres in the Appalachian basin, most of which is held in fee or by existing production.  Production on this acreage was relatively unexciting until recent years, when a combination of higher gas prices and break-through technologies made the underlying gas reserves highly profitable.  The break-through technologies include horizontal drilling and multi-stage fracturing, both of which permit higher levels of production from larger areas of the gas bearing formation.  In addition, EQT has pioneered the use of air in horizontal wells, which materially reduces drilling costs.  Over time, EQT, which has been considered a technological leader in drilling in low pressure shale, has been able to reduce drilling costs and increase well productivity.  As a result, EQT has among the lowest finding and development cost in the U.S. - and, in addition, has among the lowest production costs.

 Currently, EQT is producing gas at about a 90 billion cubic foot ("BCF") annual rate.  The company's stated proved reserves are 3.1 trillion cubic feet ("TCF"), or a 30+ year reserve life.  However, the 3.1 TCF of proved reserves does not begin to tell the full story.  Much of the company's 3.3 million acres lies over blanket shale formations.  The company publicly estimates that its probable reserves are an additional 3.3 TCF and that its possible reserves a further 3.1 TCF.  To date, most of the company's production is from the Huron formation.  As of year-end 2008, only 23 wells had been drilled by EQT in the Marcellus and therefore little of the Marcellus reserves are included in EQT's stated reserve position.  Of the 9.5 TCF of P3 (proved, probable, and possible) reserves, 6.0 TCF were in the Huron, only .9 TCF in the Marcellus, and 2.6 TCF in other formations.  The company says that less than 10% of its Marcellus acreage is included in the P3 figures and that the "additional potential" of the Marcellus is 6.0-9.0 TCF.  Obviously, these are huge numbers.

 I encourage those possibly interested in EQT's shares to visit the web-site of Range Resources (RRC), which has been an early and large player in the Marcellus.

 I note that George P. Mitchell, the founder of Mitchell Energy and Development, which was the pioneer in the Barnett shale formation, recently made a large personal investment in the Marcellus (through a company named Alta Resources).  In a recent (March 12th) Bloomberg interview, Mr. Mitchell talked about the size and potential of the Marcellus, which, he said, will be a giant, partially because it covers a larger area than the Barnett.  Others in the E&P industry say that the Marcellus will be among the most important gas fields in the United States.

 EQT has 400,000 acres in the Marcellus trend.  The company is slowly but steadily experimenting with Marcellus wells, learning how to extract the most gas at the lowest cost.  The number of Marcellus wells drilled by EQT is expected to increase sharply over the next several years.

 Because of its reserve position, infrastructure, and low costs, EQT has the physical resources to increase its production at a 20% annual rate, although I would expect long-term growth to be in the 12-15% range.  Gas prices and cash flows currently are low, so growth next year likely will lag, although the company is projecting 15% production growth for 2009.

 When valuing EQT, we look ahead two years and we assume that the benchmark gas price in that year is $7.50 per thousand cubic feet ("MCF"), which we consider a "normal" price given the economics of drilling and production around the country.  EQT's production in 2011 is estimated at 119 BCF.  If the benchmark price for gas is $7.50, we estimate that EQT's well head price (before hedges) will be about $6.90.  After lease operating costs of $.40 per MCF, DD&A of $1.05, overhead of about $.45 per MCF, and production taxes at 6.8% of the benchmark price, pre-tax profits per MCF would be close to $4.50 per MCF, or about $535 million on the 119 BCF of production.

 In addition to its E&P operations, EQT has an extensive gathering (mid-stream) network that gathers, processes, and transports gas for itself and for others.  EQT also owns a highly regarded, but small, gas distribution company that serves residences and businesses in parts of Pennsylvania, West Virginia, and Kentucky.  The profits of the gathering system largely grow in parallel with EQT's rate of production.  The system earned $145 million pre-tax last year - and our estimate for 2011 is $200 million (an 11% CAGR).  The distribution business is estimated to earn about $75 million pre-tax in 2011.

 All in all, after an estimated $100+ million of interest and corporate expenses and after income taxes at a 38% rate, our 2011 EPS projection for EQT is roughly $3.25 per share, based on 132 million shares outstanding, assuming that natural gas sells at $7.50 per MCF, and before consideration of hedges.

 In my opinion, EQT is almost everything that anybody could want in an E&P company:  very low finding and development costs, very low production costs, very large proved and future reserves, leading edge technology, and, by all reputation, an excellent management team.

 Furthermore, we are optimistic about the future of natural gas. Our new Government's policies include energy self-sufficiency and reductions in carbon emissions.  Natural gas helps accomplish these goals.  Gas is produced in the United States and is relatively friendly to the environment, especially when compared to coal.  We anticipate that an increasing percentage of our nation's electrical power will be generated from combined cycle turbines that are fueled by natural gas.

 Given its expected EPS growth rate (10-15%), its quality, and the long term attractiveness of natural gas, I value EQT at 20 X its earnings power.  Therefore, I believe that, two years from now, the shares will be worth about $65.  I note that in 2008 the shares sold as high as $76.  Furthermore, should the price of gas spike to a high level (gas sold as high as $13 in both 2005 and 2008) or should the attractiveness of natural gas create abnormal interest in the investment community, the price of the shares could sell for substantially more than its appraised 2011 value.

 Finally, a comparison with Range Resources is interesting.  There has been excitement about Range because of its strong position in the Marcellus.   Range's enterprise value is about $8.4 billion (market value of the equity of $6.6 billion plus $1.8 billion of net debt) and Range has 2.6 TCFE of proved reserves.  I estimate that the enterprise value attributable to EQT's E&P operations is $3.6 billion (market value of equity of $4.3 billion, plus net debt of $1.6 billion, less the estimated book value of the gathering and distribution businesses of $2.3 billion) and EQT has 3.1 TCF of proved reserves.  I realize that there are other considerations when making a valuation comparison, but based on the above data and estimates, if EQT's enterprise value per MCF of proved reserves were the same as Range's, EQT's shares would sell at $81.

 I note that the above estimates and opinions are my own and might change from time to time.  The firm I work for owns shares of EQT.  For various reasons, we might buy additional shares, or sell the shares we currently own.






EQT's huge natural gas reserves in Appalachia are yet to be recognized by investors -- and the reserves should provide the foundation for a high growth rate for EQT for years to come.  Furthermore, I believe that the natural gas marekt will tighten within a few years -- and that natural gas will be a valuable, sought after commodity.

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