Description
Every once in a while, a value investor has the opportunity to purchase shares in a large and strong company at a bargain price because the company and its fundamentals have become materially miss-understood. El Paso Corporation appears to be such a company. Over the past few years, the company’s shares have declined from $75 to $11 – and yet the company has particularly strong and well-positioned businesses, has a $16 hard book value, a $.87 dividend (the yield is 7.9%), and a high level of earnings (it is projected to earn $2.30 per share next year, given natural gas prices at $3.50 per MCF). We believe that, two years from now, El Paso’s shares should be selling in the low $30s – or higher if natural gas prices are materially above $3.50 or if the company is acquired by another firm. There is a theory that Mr. William Wise (Chairman of El Paso), who controls over 4 million shares, will be interested in realizing shareholder values and that a large petroleum company could be interested in acquiring El Paso for its very attractive assets, particularly its natural gas business, which includes roughly six trillion cubic feet of reserves, substantial undeveloped acreage, and valuable technologies for finding and producing gas from tight formations.
El Paso is miss-understood because it is associated with Enron and other energy trading and power companies. In fact, El Paso’s is mainly a gas pipeline and natural gas production company – and its trading and power activities together are projected to provide only 25% of the company’s 2003 EBIT. Furthermore, while Enron and several other companies have come under criticism for their business practices, El Paso appears to have been a reasonably good corporate citizen. For example, Standard & Poor’s, as part of a credit report that affirmed a BBB+/Stable rating on El Paso’s debt, appeared satisfied that any “paired trades” executed by El Paso’s traders had a business purpose and that the company did not make an unjustified profits by withholding natural gas from the California market (other energy companies have been accused of making wash sales and of manipulating gas and power sales made to California during that state’s energy crises). From all our research, if El Paso violated any rules, the violations were minor.
Of importance, the backbone of El Paso is two businesses (the gas pipeline system and the natural gas reserves and production facilities) that are particularly strong and valuable. A brief description of these businesses and of El Paso’s four smaller business lines are:
1. El Paso owns the largest and one of the strongest system of gas pipelines in the country. Its five key pipeline subsidiaries are: (a) Southern Natural Gas; (b) Tennessee Gas; (c) El Paso Natural Gas; (d) Colorado Interstate; and (e) ANR. These pipelines are very profitable and currently are earning moderately above their “allowed rate of return”. Profits largely are a function of demand charges that vary little with volumes – and thus earnings are relatively stable. A negative is that growth is modest – only a projected 3-5% per year. I project that El Paso’s pipeline business should earn close to $1.5 billion (EBIT) next year.
2. El Paso is among the largest and best-positioned producers of natural gas. Its key assets are: (a) software and know how that give the company an important advantage when exploring for gas in tight formations; (b) about 6.5 trillion cubic feet equivalents (85% gas and 15% liquids) of reserves; and (c) a large and highly prospective acreage position in southern Texas and in the Gulf of Mexico. This year, reserve additions should be large – and the company believes that its production will increase by 20% next year to about 730 billion cubic feet equivalents per day (increases after 2003 likely will be smaller). Furthermore, production costs are very low – and thus profits are high. Given a $3.50 price for natural gas, El Paso’s gas and liquids production should earn close to $950 million (EBIT) next year. In my opinion, after EnCana and Shell, El Paso is the best positioned of the large North American producers of natural gas.
3. The company has a smaller, but well postured, “mid-stream” business that gathers, processes, and stores natural gas. This business is projected to earn about $190 million (EBIT) in 2003.
4. El Paso owns several oil refineries and chemical plants. These facilities (which are a small part of the company) are relatively unattractive and likely will be sold within the next year or two. Collectively, they are budgeted to earn $60-70 million (EBIT) next year.
5. The company has a very profitable trading operation that is projected to earn $400-425 million (EBIT) next year on invested capital (all working capital) of $1,000 million or less. Earlier this year, El Paso pared down its trading subsidiary – reducing the number of employees by 50% to 300, reducing the capital employed, and eliminating riskier activities. Currently, El Paso’s trading operations are similar to those of Royal Dutch Shell and the other large integrated petroleum companies. The traders take advantage of physical assets and unusual dislocations in the markets. For example, during a cold-snap in the northeast, the traders might be able to earn a profit by selling gas at a high price in New York and by simultaneously purchasing gas at a low price in Texas and arranging for the transportation of the gas via the company’s pipeline system. Another example is that the traders might earn a profit by buying gas at a low price in summer, arranging to store the gas until demand increases during the winter, and simultaneously purchasing a contract to sell the gas during the winter at a relatively high price.
6. El Paso owns electrical power plants, both in the United States and abroad. In addition, the company has been successful in earning a spread by “restructuring” high price power contracts. El Paso purchases older and high cost power plants that have long-term contract to sell electricity at very high prices, arranges long-term contracts to purchase power from a third parties at lower prices, closes the high cost plants, and offers the purchasers of the power discounts for changing the sources of the power. El Paso then collateralizes its spread in order to receive the discounted value of the profit up front. Partially because the cash is received in the year that a contract is signed, El Paso recognizes the profits in the year the contract is signed. In 2003, El Paso expects to earn $450-475 million (EBIT) from its power business, of which $150 million (or $.15 per share after taxes) is expected to be “non-recurring” profits from restructuring power contracts.
In aggregate (given $3.50 natural gas), the above six business lines are projected to earn close to $3.6 billion in 2003 before interest expense, corporate expenses, and income taxes. After these three items, earnings are expected to be $1.4+ billion, or about $2.30 per share on 625 million diluted shares outstanding. I estimate that El Paso’s earnings (again, given $3.50 gas) could increase by roughly 8% in 2004 to $2.50 per share – and that the shares should then be worth 12-13x earnings, or in the low $30s.
When analyzing El Paso, there are a few other key considerations. In the 1998-2001 period, El Paso had many opportunities to grow – and borrowed heavily to finance the growth. Last fall, when the credit rating agencies materially tightened their rating standards, El Paso, to management’s credit, quickly moved to improve its balance sheet by selling less important assets and by selling common shares. Given current action, by the end of 2002, El Paso should have about $15 billion of debt, $4 billion of preferred, and $11 billion of common. On a very positive note, Moody’s recently re-confirmed its Baa2 credit rating on El Paso’s unsecured debt – and Standard & Poor’s complemented management for its “decisive actions and the progression of its initiatives since late 2001 to address the energy market’s desire for greater financial stability…”. El Paso plans to sell more assets over the next twelve months – and by the end of next year should have a reasonably solid balance sheet given the nature and value of its assets.
In the post-Enron era, accounting has become a major issue. El Paso’s books recently were audited by PriceWaterhouseCoopers – and the SEC carefully reviewed the company’s accounting in connection with a recent offering of common shares. Some criticize El Paso for reporting “non-cash” earnings. Current accounting conventions require companies to mark certain derivatives and other financial instruments to market – and we believe that the company currently is properly following conventions, including for the treatment of the complex power restructuring contracts. In any case, “non-cash” earnings in 2003 are expected to be less that $.15 per share vs. the company’s total projected earnings of $2.30.
Some have criticized El Paso for establishing a number of special purpose entities. These entities have a business purpose. By putting assets in a special purpose subsidiary, it is easier for a company to pledge the assets as collateral for a loan – and thus for the company to borrow at an advantageous rate. I note that all of the debt in El Paso’s special purpose subsidiaries is consolidated or otherwise disclosed and that the company’s Form 10K discloses the nature and purpose of each subsidiary. However, 10Ks normally are written by accountants and lawyers – and El Paso’s descriptions are difficult to read and understand. The New York Times and Fortune Magazine wrote articles criticizing El Paso for its disclosures – and I agree that the disclosures should be written in English that is more readily understandable. I note that both these articles appeared to have put pressure on the price of El Paso’s shares – which brings me back to my original point: El Paso’s shares are undeservedly depressed because investors temporarily have been judging the company superficially by its appearance and by its peers – and not by it values, strengths, management, and other fundamentals.
Catalyst
The company's shares are unusually and undeservedly depressed. When investors realize that El Paso is a very strong company that is incorrectly being compared with energy trading companies, its shares should rise sharply. Furthermore, the shares should benefit when natural gas prices turn strong or if management decides to offer the company for sale -- which,we believe, is a real possiblity in a few years.