2 Gas Stocks with Plenty of Potential

By MoneyShow.com | March 20, 2012 AAA

When resource prices are down, smart companies look for acquisitions and new expansion possibilities on both sides of the border, observes Roger Conrad of Canadian Edge.

Successful southward expansion is the hallmark of both AltaGas Ltd (Toronto: ALA) and PHX Energy Services Corp (Toronto: PHX).

Added to the Canadian Edge Portfolio in February 2005, AltaGas has steadily accumulated power, gas, and regulated utility assets throughout Canada ever since.

Its latest and greatest move, however, is in the US, with the $1.135 billion acquisition of privately held natural gas distribution and storage company SEMCO Energy.

PHX was first recommended as an Aggressive Holding in September 2010. Since then it’s taken advantage of escalating global demand for equipment and services used in horizontal drilling to carve out a global empire stretching from Eastern Europe to South America, but with an especially large presence in the US.

Of the pair, AltaGas is the more conservative, relying heavily on fee-generating and regulated assets, as well as power generation locked up under long-term contracts. PHX’s appeal is it’s tapped into surging global demand for horizontal drilling to get at previously inaccessible oil and natural gas liquids, which is accelerating growth.

Both were able to convert from income trusts to corporations without cutting distributions. Both have since returned to dividend growth, PHX with a 50% increase accompanying the announcement of a 79% increase in overall 2011 cash flow. AltaGas management, meanwhile, forecast 3% to 5% annual dividend growth for the near term, reaching an upper single-digit rate later in the decade.

Dividend growth promises to be a major upside catalyst for both companies in 2012 and beyond. Meanwhile, payout ratios for both companies are low—29% for PHX after the dividend increase, and in the low 60% range for AltaGas. And neither company has any maturing debt over the next two years.

That’s a formula for robust long-term returns at both companies. PHX Energy Services’ buy target remains $14. AltaGas, meanwhile, is now a buy up to my raised target of $32.

AltaGas’ purchase of SEMCO adds cash flow of approximately $130 million, 99% of which is regulated. Gas distribution assets serve 286,000 customers in Michigan and approximately 132,000 in Alaska. The balance comes from gas storage assets held through a 65% interest in Cook Inlet Natural Gas Storage Alaska.

These storage assets will have capacity to hold 11 billion cubic feet of natural gas when they enter operation in the second quarter of 2012. And they can be expanded to 18 billion cubic feet going forward. These assets dovetail nicely with gas systems already acquired by AltaGas on the Pacific Coast.

All of them could find themselves in heavy demand if and when North American natural gas is exported to Asia. In the meantime, they generate fees that are unaffected by commodity-price swings.

The SEMCO deal is expected to close in the third quarter of 2012. It requires approvals by regulators in Alaska and Michigan, as well as antitrust review in the US, and possibly the Federal Energy Regulatory Commission will weigh in.

Given the deal’s relatively small size—barely $1 billion, including assumed debt—it should sail through, handing the company another prime asset with upside from expansion.

AltaGas expects this deal to be immediately accretive to cash flow and earnings per share by about 10%. That’s in part due to the low-cost financing of this deal, including C$403 million from a recent equity offering.

Continued…

The merger is also expected to be positive for the company’s credit quality, in part because of business security.

Utility operations also offer growth, both through capital spending on system improvements and customer growth. The Alaska business, for example, has added customers at a 2.5% annual rate for the past ten years. Return on equity is robust at 12%-plus in both jurisdictions, including 12.55% in Alaska.

Both are beneficiaries of the boom in natural resources that’s spurring the state’s economy, a trend set to continue based on strong global demand.

As has consistently been the case in recent years, AltaGas posted more solid results in the fourth quarter of 2011, with power, natural gas, and regulated utilities all contributing. Acquisitions and asset expansion once again played a major role, as the company continued to execute on its formula of low-risk, cheaply financed investment boosting revenue, earnings, and dividends.

That’s a strategy set to succeed for a long time to come, given the shortage of high-performance energy infrastructure in North America. And the larger AltaGas becomes, the more able it is to take advantage and the more reliable and robust its long-run growth.

Operations in the US contributed just 36% of revenue for PHX in 2011, down from 43% in 2010. Revenue from operations outside North America rose slightly to 9% from 7% a year earlier. The latter include expansion of operations in Albania to five rigs, as well as deployment to Colombia and Russia. The balance was from Canada, where operations are thriving as more producers turn to horizontal drilling techniques.

But US operations are a primary focus of future growth in all regions. Those include the Rocky Mountains and Gulf Coast as well as the Marcellus Shale and the Utica Shale, though management expects activity in the latter to possibly slow a bit.

US horizontal and directional drilling remained consistent during the fourth-quarter and full-year 2011 reporting periods. And the company continues to increase its market share as that happens, particularly in liquids-rich areas.

Directional drilling activity in the US rose by 20%, to 1,384 rigs in the fourth quarter of 2011 from 1,155 a year ago, according to data from Baker Hughes (BHI) quoted in PHX’s fourth-quarter earnings report.

PHX USA was active in the Permian Basin, Barnett, Eagle Ford, and Bakken regions in 2011, with rigs running on a daily basis rising 25%. That’s a rate of growth that looks set to continue in 2012 and beyond.

Worries about a dropoff in drilling, particularly for gas, and the company’s cost increases over the past year have kept PHX shares from blasting off, despite management continuing to report robust profits. That’s kept the stock less expensive than many in its industry, even after the 50% dividend increase announced in late February.

Cash flow as a percentage of revenue rose to 18% in the fourth quarter, up from 6% a year ago. Full-year cash flow margins, meanwhile, were 17% in 2011, versus 13% in 2010. This is clear evidence the company has overcome the challenges that hurt profit a year ago, even as it continues to expand revenue at one of the highest rates in its industry. Fourth-quarter sales, for example, rose 39%, while full-year revenue surged 47%.

That’s a formula for powerful long-term growth at PHX, despite the fact that it operates in an intensely competitive and volatile business.

And with the company continuing to grow rapidly, we haven’t seen the last dividend increase by a long shot. PHX Energy Services is a buy under $14.

What can go wrong at these companies? In PHX’s case, the key vulnerability is energy prices and the potential impact on drilling activity. At this point, drilling activity for oil and natural gas liquids remains robust. Dry gas production in North America is dropping due to the crash in prices, but it remains strong elsewhere in the world.

A real global relapse would hurt PHX revenue, as it would every energy services company. And investors would likely treat the stock even more harshly, given the trend now of chasing performance.

The good news is the company’s financial position and payout ratio are quite conservative and should enable it to weather even the most severe reversal of market conditions. And at this point, such a scenario appears quite unlikely, in any case.

As for AltaGas, the conservative nature of its assets and operations means the primary risk to the health of the company is execution of its strategy. And such deterioration should be identifiable in the numbers long before it becomes critical.

That leaves valuation, and the fact that all stocks sell off in downturns as key risks to returns. The company’s recent moves, however, are worthy of a raise in buy target.

I’ve set $32 as the next level. AltaGas is a solid buy for anyone who doesn’t already own it up to that price.

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