Value Line Institutional Services

 

November 2016

Our digital Institutional Small & Mid-Cap Bulletin for professional subscribers offers powerful content featuring a pair of companies not often covered by sell-side analysts. Two stock highlights, one geared toward momentum investors and the other for buy-and-hold accounts, offer readers current, unbiased recommendations with in-depth analysis. These monthly featured stocks are among the approximately 1,800 that appear in The Value Line Investment Survey® — Small & Mid-Cap. Tap into Value Line's equity coverage, where you'll have access to complete content, and the ability to create watchlists and alerts based on the featured companies offered in this exclusive bulletin.


Momentum Investment

RSP Permian (RSPP)

By Jeremy Butler, Editorial Analyst

RSP Permian (RSPP) is an independent oil and gas company engaged in the acquisition, exploration, development, and production of oil and gas in the Permian Basin of west Texas. The vast majority of the company’s acreage is located in the core of the Midland Basin, a sub-section of the Permian. The company was formed in October, 2010 by RSP, LLC and an affiliate of Natural Gas Partners, a family of private-equity funds. In September, 2013, the company was incorporated in Delaware, and it went public in January, 2014 with 280 million shares at $21.75 a share.

An Opportunistic Survivor
RSP Permian has persevered throughout the toughest part of the oil price decline of the last two years. Many of the company’s contemporaries went bankrupt or were acquired by larger oil and gas conglomerates. Indeed, since the start of 2015, 102 American and Canadian oil and gas companies have filed for Chapter 11 bankruptcy. RSP Permian has always run a tight ship, but the fact that it operated in a rich oil and gas region (the Permian) was a major reason why the company managed to survive the worst of the low energy-price environment. Specifically, commodities here were relatively inexpensive to extract compared with many other fields in the United States. Moreover, the company’s Permian holdings contained high-grade oil and gas, which were in greater demand than other companies’ products, since they were easier (and thus cheaper) to refine due to their high quality. Also, RSP Permian was one of the first operators to engage in efficient multizone horizontal drilling, specifically in its Wolfcamp fields (a subset of the Permian). RSP is also a big proponent of “fracking”, also known as hydraulic fracturing. This drilling technique is designed to capture as much oil and gas as possible with one well. A well is drilled either vertically or horizontally across multiple bands of rock, tapping into numerous pockets of oil and gas as it goes. This technique, made all the more efficient by state-of-the-art equipment and powerful chemicals, allowed RSP to keep its cost per barrel very low and its head above water as oil prices plummeted from over $100 a barrel in June, 2014 to less than $40 a barrel in the early part of this year.

In addition, RSP Permian capitalized on the struggles of smaller companies that owned acreage in the Permian. It did this by obtaining working interests in these operators in exchange for RSPP common stock.  By doing this, RSP didn’t have to use much (if any) debt to expand its holdings. RSP has had offers of its own from suitors wishing to obtain its oil- and gas-rich acreage. No deals have been struck, but the interest increases the stock’s appeal as a speculative merger/acquisition play. 

A Game-Changing Acquisition
RSP recently announced plans to acquire the much sought-after exploration and production (E&P) entity Silver Hill Energy Partners for about $2.4 billion ($1.2 billion in cash and 30 million newly issued shares). The deal is set to close in stages between the fourth quarter of this year and the first quarter of 2017. Silver Hill is a big player in the Delaware Basin, another subsector of the Permian. The purchase would increase RSP’s production by at least 50%.  Silver Hill has control of 68,000 acres in the Delaware Basin, and would thus push RSP’s total holdings to well over 100,000 acres. The company expects the acquisition to add an average of at least 15,000 barrels of oil equivalent per day (boe/d) in the first couple of months after completion. Silver Hill Energy owns 58 wells, 49 of which are horizontal.  A closed-door bidding war had been going on to acquire Silver Hill, though it appears that RSP investors aren’t particularly worried about the premium management plans to pay for Silver Hill, since the stock price has held up fairly well since the announcement. Presumably, investors are looking further down the road and see the purchase as a feather in RSP’s cap, since it places the company in a bigger league, one with more operating leverage. This operating leverage would certainly benefit earnings and cash flow once oil and gas prices recuperate.

Operating Metrics
In the second quarter, production grew 33%, to 26,407 boe/d, from the year-earlier tally and increased 7% from the first-quarter figure. Sales rose $3 million, to $81.5 million ($74.8 million of which was oil revenue), and the bottom line came in at a deficit of $0.10 a share, compared with the year-earlier loss of $0.07 a share. The company participated in the drilling of 20 horizontal wells. Cash on the books tallied $142.7 million, compared with $56.3 million in last year’s second period, and the long-term debt-to-total capital ratio was 27%, the same as at December 31, 2015.

RSP is due to release its third-quarter results in early November. We are looking for the company to report a very marginal per-share deficit of two pennies, on $93 million in revenue. Third-quarter production should average 29,800 boe/d. For full-year 2016, we look for a per-share loss of $0.25 on sales of $340 million. Production for the whole of 2016 should average about 29,000 boe/d.

Conclusion
The Silver Hill acquisition ought to considerably enhance RSP’s earnings potential. Many of the more lucrative fields expected to be obtained from the deal lie adjacent to RSP’s core properties. This means that it can easily and inexpensively extend its wells horizontally into these newly acquired fields. This fact, in conjunction with RSP’s ability to extract oil and gas at a considerably lower cost than its competitors operating in other parts of the nation, should provide it robust operating leverage. At present, based on the possibility that OPEC may reduce its production, potentially elevating oil prices, we think RSP can generate a bottom-line profit in 2017.

All told, we think this little-known, top-ranked (Performance: 1) oil and gas stock has considerable short-term momentum.

 

At the time of the above article’s writing, the author did not have positions in any of the companies mentioned.
 


 


Long-Term Investment

XPO Logistics, Inc. (XPO)

By Kevin Downing, Editorial Analyst

XPO Logistics, Inc. (XPO) is a global transportation and logistics company. Since 2011, it has developed from a predominately domestic outfit with $177 million in annual revenue to an end-to-end supply chain leader that’s expected to generate around $15 billion in revenue this year (last year, management spent $5 billion to acquire four businesses with aggregate revenues of $11 billion). The company is asset light, with three quarters of free cash flow originating from nonasset businesses. Too, capital spending is just 3% of sales, versus 8%-13% for typical freight companies. Asset-light business models typically have higher returns on capital, lower profit volatility, increased flexibility, and greater potential for cost savings when the business grows. Approximately 60% of 2015 revenues were generated in the United States; 12% in France; 12% in the United Kingdom; 4% in Spain; and 12% in other countries. Last year, 6.6% of revenue came from the company’s five largest clients, and the total customer base topped 50,000.

The company operates two reporting segments, Transportation (64% of 2015 revenue and 39% of operating income) and Logistics (36% and 61%). The Transportation segment consists of seven subdivisions. The first, freight brokerage, assigns customers’ freight to third-party trucking companies, provides or outsources intermodal capacity (containers compatible with various forms of transport), contracts with railroads, negotiates prices, transports goods short distances (drayage), and executes billing/payment. Second, the last-mile business employs contractors that move heavy goods from retail stores or distribution centers to end-consumers’ homes or offices. Additional “white glove” services include unpacking, assembly, and installation of merchandise, as well as removal of old products. Third, the expedite department arranges the transport of urgent freight shipments via independently owned trucks/vans or air carrier partners. Fourth, the less-than-truckload (LTL) unit is asset-based (meaning that XPO owns the trucks and equipment instead of relying on contractors and their independently owned equipment) and uses employees, trucks, and terminals to pick up, consolidate, deconsolidate, and deliver relatively small freight bundles. The fifth subdivision, full truckload, is also asset-based and uses XPO employees and company-owned equipment to provide short- and long-haul transportation of a single customer’s goods. Sixth, managed transportation assists shippers who want to outsource various services. Lastly, global forwarding uses logistical expertise to facilitate complex domestic, cross-border, and international shipments, some of which involve processing customs documentation, etc.

The Logistics segment provides contracted logistics services such as custom engineered solutions, e-commerce fulfillment, reverse logistics, (any process or management that takes place after the sale of the product, such as organizing return shipping; testing defective products; repairing, recycling, or disposing of old products; etc.) packaging, labeling, distribution, transportation, warehousing, etc. The division enjoys high entry barriers as well as consistent revenue streams, since the average contract is five years and the renewal rate is 97%. Too, XPO’s substantial industry expertise and a cumulative $400 million investment in technology make its offerings differentiated. Further, the business is somewhat countercyclical since organizations tend to outsource supply chain operations more during economic downturns. 

Growth Prospects

Over the past four years, the company’s revenues have increased at a compound annual growth rate (CAGR) of more than 170%. Management expects to post EBITDA (earnings before interest, taxes, depreciation, and amortization) of $1.265 billion this year, and grow that number to $1.75 billion by 2018. Although the majority of that improvement should stem from company-specific initiatives, some prevailing industry trends are very likely to remain a tailwind for the foreseeable future. The most important is skyrocketing e-commerce demand. XPO’s business is structured to benefit from more online spending in general, but also consumers’ rising comfort with purchasing large items (mattress, furniture, refrigerators, etc.) over the Web. According to XPO, last-mile transportation is a $13 billion industry that’s growing at five to six times the rate of gross domestic product, or some 10% a year. The company is exceeding this pace, as it arranged 10 million deliveries of heavy items in 2015 and is on track to deliver about 12 million this year. Another favorable industry trend is businesses’ rising preference for just-in-time inventory strategies. Finally, Mexico presents an attractive growth arena as its government pushes deregulation and successfully encourages original equipment manufacturers to move operations there. Assuming current Mexico-U.S. trade relations remain favorable, this should benefit the freight brokering, expedite, and truckload businesses, as they have long-standing relationships in the country. 

Taking a look at internal earnings-growth drivers, there appears to be room for cost cuts. The business has grown rapidly of late, which has resulted in greater bargaining power with vendors. In turn, XPO looks to negotiate better prices on everything from tires to office supplies. Other priorities include building out the sales team, implementing cross-selling initiatives, and right-sizing the real estate portfolio. Perhaps the biggest opportunity lies with a plan to identify the most productive facilities, operating procedures, technology, and routes, and then implement best practices across the company. In total, over $300 million in profit improvement opportunities have already been identified, and they should be achievable regardless of the prevailing global macroeconomic environment.


Current Environment

Investors reacted very positively to excellent June-quarter results. The stock price jumped 27% following the announcement of record net income, EBITDA, and free cash flow. Still, revenue increased only 1.8% year over year (excluding acquisitions—Con-Way Inc. was acquired last year for $3 billion—and adjusted for fuel and currency). The strongest growth came from last-mile, truck brokerage, and European supply chain operations, but this was somewhat offset by soft industry trends in domestic intermodal and expedite services. Importantly, some restructuring initiatives (facility closures, headcount reductions, etc.) at the less-than-truckload business held back revenue. Excluding that unit, the top line grew 4.3%, a level XPO thinks it can maintain for the remainder of the year. (GAAP revenues, which include the Con-Way purchase, more than tripled year to year.) In response to the results, management raised its full-year EBITDA forecast by 1% and its free cash flow target from $100 million-$150 million to at least $150 million. (XPO is set to release September-quarter earnings at 8:30 A.M. EDT on November 3, 2016.) 

Notably, the Teamsters recently reported that a minority group of XPO’s warehouse workers and truck drivers has joined their union in an attempt to obtain job security, higher wages, and retirement benefits. Any resulting action will likely take years to develop, and the unionization was not on a large scale.

Conclusion

Recently, management has been fond of saying its business is “hitting an inflection point.” This means the $5 billion spent on acquisitions last year are really starting to bear fruit. Now, efforts will be focused on streamlining, expanding, and harvesting synergies from the diverse set of businesses. We find the management team more than capable of successfully executing its plans. Too, the shares still possess a reasonable forward P/E ratio. Nonetheless, we suggest conservative investors approach with caution, as there are inherent risks when investing in smaller shippers due to their sensitivity to fluctuating economic conditions.

 

At the time of the above article’s writing, the author did not have positions in any of the companies mentioned.

 

 

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