October 14, 2010 - 4:55pm EST by
2010 2011
Price: 21.00 EPS $1.29 $1.40
Shares Out. (in M): 585 P/E 16.5x 15.0x
Market Cap (in $M): 12,500 P/FCF N/A N/A
Net Debt (in $M): 1,500 EBIT 1,600 2,100
TEV ($): 14,000 TEV/EBIT 8.8x 6.8x

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I believe Williams presents a highly attractive situation for value investors looking for a catalyst.  Williams has been a sum of the parts story in the energy space for some time, but has not received the appropriate market valuation.  Its stock has significantly underperformed the market and peer group YTD in large part due to its complicated organizational structure.  While it is difficult to make such a prediction, I believe the board is likely to evaluate the potential spin-off of its E&P business sometime next year.


Williams has two major businesses: 1) natural gas focused E&P and 2) Midstream & Pipeline MLP, which is publicly traded.  Earlier this year (Jan 19,2010) in an effort to "unlock value" the board decided to structurally separate the E&P business from the Midstream business via the creation of a large cap MLP (WPZ).  In doing so, Williams created one of the largest MLPs in the public markets while retaining 80% of the stock and 100% of the GP interest.  While the board was successful in structuring the transaction, it has not resulted in equity appreciation for the parent (WMB).  Today, Williams Partners (WPZ), the MLP is a $12.5B market cap company that has appreciated close to 45% YTD while the parent, Williams Companies (WMB), is flat.  Usually these sum of the part stories carry certain shortfalls;  either they do not provide enough upside to merit investment (market does not recognizing value for one asset but if fully valued, only adds 20% to the value of the equity) or the discount will remain as mgt has no interest in taking action.  Williams is different in the fact that 1) The MLP it created now carries a greater market cap than the parent yet only represents 2/3rds of the business (significant upside) and 2) management has already taken action and has suggested to the street that further action may be taken to the extent the market does not appropriately value the equity.

I will first run through the quick math on the stock before diving into the qualitative merits of the investment (it is also worth noting that you can read more about the name as it was written up in February).  As of today, WPZ's market cap is $12.5B roughly the same as its parent.  Williams owns close to 80% of the publicly traded equity or 215mm shares, a value of $9.5B.  Additionally, Williams owns 100% of the GP interest in WPZ which brings the economic interest close to 90%.  When you value the publicly traded MLP & GP interest, you are paying practically nothing for the equity.  See below.

WMB Market Cap    $12,624.9
     WPZ Equity         9,460.0
    WPZ  GP           3,472.0
     Less Cash Taxes on WPZ       (2,558.5)
Adj Value of E&P    $2,251.4

 I believe the E&P business should be valued at roughly $9.6B, well above the $2.5B in value implied above.  Williams is currently the 10th largest gas producer in the US and 5th largest independent producer.  The company has 4.8T's of proved reserves and the ability to significantly ramp up production over the next number of years.  Additionally, Williams has some acreage in the Marcellus shale and plans to expand its presence in the region. 


Company Reserves EV EV/P1
NBL          4,920        12,185  $2.48
EQT          4,068          6,913  $1.70
UPL          3,912          7,920  $2.02
SWN          3,657        14,547  $3.98
NFX          3,619          8,575  $2.37
RRC          3,129          8,109  $2.59
Hk          2,750          7,288  $2.65
COG          2,060          4,222  $2.05
Ave          3,514          8,720  $2.48
WMB          4,800          9,600  $2.00
(Data from CHK's 9/10 Presentation)  

 This valuation represents $2/proved Mcf, well below comparable companies in the public equity markets in the $2.25-$2.50/Mcf range. This translates to roughly $5.6B of additional equity ($10/share) after factoring in corporate net debt of $1.5B & would value the consolidated company at $30/share.


Additionally, I believe the WPZ business is undervalued as well.  The restructuring created one of the largest MLP's in the public equity markets with over $12 billion in assets, 14,000 miles of pipeline and processing capacity of close to 2.4 trillion cubic feet annually. To simplify the structure, the company has contributed its entire midstream and pipeline assets representing roughly $2B of EBITDA to WPZ. By increasing the size of the MLP operation, WPZ was able to dramatically lower its financing costs. The company issued $3.5B of debt out to 2040 at a blended rate of 5.3%, something that would not have possible under the previous structure.  The pro-forma WPZ MLP business has been structured in a very conservative manner and will likely outperform the market over the coming years.  While WPZ's distribution yield is currently trading in line (6.3% yield) with the broad integrated MLP space, it has one of the highest FCF yields in the space.  The distribution coverage ratio, defined as the available cash flow/annual distribution, is currently 1.30 (average is 1.1) giving WPZ the ability to increase its dividend by 30% without running into any coverage issues. 

Another factor that will help the MLP business in the near term is its presence in the gas processing market.  When gas is pulled out of the ground it often contains impurities that can make the gas unfit for transport into the interstate pipelines, as well as natural gas liquids (NGLs) which can be sold for higher prices than natural gas. Midstream manufacturers are contracted to separate the NGLs and impurities from the natural gas in a process called fractionation. While many processors are paid a set fee (helps MLPs provide stable cash flow), 35% of Williams contracts are keep-whole based meaning the processor retains the NGLs removed and replaces the lost content with natural gas. Because NGLs have a high price correlation with oil (competes against naptha as a feedstock for ethylene) & and the main variable expense is natural gas, profitability on these contracts is dependent on a high oil/gas ratio. The midstream fractionation business is not well understood by the street and should be the key driver towards earnings beats for MLP business over time.  While there is skepticism about oversupply in the NGL space, I believe the risk only applies to a portion of the product stream and will remain very profitable even if ethane is sold at a 0% margin.  Lastly, it is worth noting NGL margins have recently spiked up and are near the highs for the year following production declines in the ethane space (type Frac GO into Bloomberg & select #3).  Overall, I believe WPZ should be valued at $50/share translating to another $1.5B or $2.5/share to WMB's valuation.

Spin-Off as Catalyst:

Despite management's best efforts, the "restructuring" at the beginning of the year has not translated into any level of equity appreciation for WMB.  In fact, the shares have declined since the transaction while the MLP stock has soared.  Management is disappointed in the performance of the stock and has begun to discuss the possibility of other options to unlock value.  When asked about the possibilities (monetize MLP stake, buyback, etc.) the company suggests that of all the available options spinning off the E&P business makes the most sense.  While it is difficult to make any predictions on timing, I believe the board is coming to the realization that the integrated model (even with a public market valuation - WPZ) is not likely in the best interest of shareholders.  Many investors are not aware of the significant presence Williams has in the gas business and such a strategic action would likely help to unlock the severe valuation discount in the stock.  

Addl Data: Yesterday after the close, the CEO announced his resignation at the end of the year.  I view this event to be a significant positive as the CEO was one of the biggest proponents of the integrated model.  With the new CEO coming from the Midstream business and the CEO of the E&P business still intact, the organizational expertise is there to make such a transition.




Spin of E&P business
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