Stockerati

It’s 6/29/2008 the current trading price of ARD is 51.66

I am writing this post in real-time, as I analyze ARD. So first things first, how do I do this? I usually start by answering these fundamental questions

1. What do I know about ARD?
2. What do I know and understand about the industry?
3. What do I know about ARD’s business and  customers?
4. What do the numbers say?
5. How do the numbers compare with the industry?

RESEARCH

Reuters provides an in depth description of the company here. The highlights are:

• It’s been around a while (8 years)
• It focuses on US domestic exploration. It’s engaged in oil and natural gas acquisition, exploration, development and production, with activities in Oklahoma, Texas, New Mexico and Kansas
• It has a decent sized portfolio of oil and natural gas reserves
  • 84% of its proved reserves consisting of oil
  • 16% consisting of natural gas
• Profile of Arena’s reserves:
  • 28% of Arena’s proved reserves are developed & producing
  • 5% of its proved reserves are developed and non-producing—this could be due to mechanical failures etc.
  • 5% are developed behind pipe— it means extra work is required to tap these
  • 62% are proved undeveloped— it means roughly 2/3rds of its known oil deposits haven’t been tapped yet.

According to Engineering Information Administration, US imports around 60% of its oil needs. The chart below from agmrc.org indicates that the domestic consumption of oil and natural gas will only continue to go up. US has less than 5% of the world’s known oil reserves—we’ll run these dry for sure before the rest of the world dries up.

I’m convinced that a US company engaged in oil exploration and production in top oil-producing states, with 3/4th’s of it proven reserves untapped, has anything to worry about. Unless driving on compressed air really takes off :)

Couple more interesting trends from the agmrc.org article.

1. Only half a barrel of crude oil gets converted into gasoline, the other half is consumed for industrial usage
2. The top two major consumers of oil/year are the transportation and industrial sectors

I am more confident of the domestic oil industry now than I was before starting this research.

ARD’s BUSINESS

The avg. selling price of oil is likely to remain above $140 for the rest of 2008 and if forecasts are accurate. then it’s likely to stay in the $150-200 range for times to come. Bloomberg carries a good round-up of this.

The major customers of ARD are Plains Marketing L.P, Sun Oil Company and Navajo Refining Company

The avg. selling price of Oil from the table above is expected to go up by 69% from 2007 to 2008. Even if the ARD’s net production remains the same during this period, the company’s revenues and profits are going to increase significantly. Natural gas prices in the same timeframe increased by 14.15%. Mind you, this is assuming the avg. price of Oil in 2008 stays at 122, which is conservative IMHO. So far, it seems like it’s good times ahead for ARD.

Let’s take a look at the company’s operations:

The ownership is as follows

• Shares Outstanding 37.00 Mil
• Institutional Ownership (%) 79.16
• Top 10 Institutions (%) 36.60
• Mutual Fund Ownership (%).82
• 5%/Insider Ownership (%) 6.29
• Float (%) 93.71

It’s top 5 institutional owners are Neuberger Berman, LLC. Barclays Global Investors, N.A., QVT Financial LP, Rainier Investment Management, Inc., TimesSquare Capital Management, LLC. It’s 6% insider owned—this is positive, as the management and employees also have skin in the game.

ARD recently increased  its CAPEX by $30 million for 2008, to $248 million. The additional funds were for increased activity at the Company’s Permian Basin properties in southeast New Mexico and west Texas. ARD received delivery and has started drilling operations with its second contract rig, making a total of four drilling rigs in operation at the Fuhrman Mascho. The additional funds will be used to increase the number of new development wells to be drilled on this property in 2008 from 222 to 257 and increase the number of re-fracs of existing wells from 40 to 50. In total, the Company has increased the number of new development wells to be drilled on all of its properties to 303 and re-fracs, including all workovers, to 129. However, it’s recent $10.2 million New Mexico acquisition (June 5, 2008) is not included in the 2008 CAPEX budget.

This article gives a great insight into ARD’s management philosophy and operations. My key take-aways

• the CEO is well experienced in the Oil sector. Used to be the CEO of Magnum Petroleum
• Company emphasizes operating efficiency—multi-tasking and employing contractors clearly indicate that
• Company’s philosophy is to maintain low-debt while expanding aggressively
• ARD was started with a 1.1M investment in 2000—today, its market-cap is 1.8B and it’s revenue in Q1 FY08 increased by 172% compared to the Q1 FY07

ARD gets full-points for management excellence, IMO.

ARD had 89 employees in 2007 (low-overhead), and the revenue/employee is 1.4M and profit/employee is 0.5M. I’ve highlighted data of interest in red, in the table below

Two things jump out:

1. The Operating margins of ARD are pretty good and much higher than the industry and the sector. OM is a measurement of what proportion of a company’s revenue is left over, before taxes, after paying for variable costs of production as wages, raw materials, etc. A good operating margin is needed for a company to be able to pay for its fixed costs, as interest on debt
2. The profit margin’s are very good (1/3 of its revenue), better than the industry and sector and have held been steady through the last 5 years

COMPUTING THE RIGHT PRICE

Assuming a 84-16 breakup in it’s oil and natural gas production and assuming a 69% increase in oil and 14% increase in gas prices, the income and profits for 2008 can be conservatively estimated as follows:

2007 revenue: 100M; Net profit margin: 36.5

2008 revenues = (84 + (0.69* 84)) + (16 + (0.14*16)) = 141.96 + 18.24 = 160M appx

A 60% OM gives a 96M operating income and factoring in the 10M investment and the 30M for the new rig, my program (I use a custom spreadsheet that I’ve created for analysis) tells me that a conservative estimate for 2008 income is 50M. The 2007 income was 34M. This means a 40% y-o-y increase in income—good work ARD. This estimate assumes no increase in production which is not the case as the total production increased by 54% year over year to 517,042 barrels of oil, YTD. I feel that my analysis is very conservative.

The Intrinsic Value of the stock per my calculations is $86. The current selling price of the stock has a 40% margin of safety

ARD has a relatively low P/E for the kind of growth it has seen in the past 5 years and especially during the past 12 months. Comparing ARD to it’s main competitors in the US domestic oil and natural gas production market, namely CXO, CHK and HK; I feel that ARD is poised for explosive growth. A custom algorithm I use tells me that it should easily reach the $100 level. Here’s how ARD has performed over the past 5 years

ARD’s market cap and low shares outstanding indicate that if it steadies around the 80-100$ level, we can expect a split.

The technical indicators show a mainly bullish trend. The 80-day resistance level is at 55.17, it’s bound to rally higher if it can break that level. Interestingly, ARD also displays a neutral trend—this means it’s neither been overbought or oversold. It’s a stabilizing indicator in today’s volatile and speculative market. MSN Money gives the beta as 0.82, implying that ARD is 18% less volatile than the market. Positive sign indeed

WHAT OTHERS ARE SAYING

SeekingAlpha’s post on ARD states all four analysts covering ARD have raised estimates in the past month, sending expectations for this year higher by 22% to $2.22 from $1.82.

ARD is also one of the 4 powerful BUY stocks according to Zacks—it’s been earmarked for aggressive growth in the report.

MY DECISION

I’m convinced it’s a strong buy for my portfolio, given all of the above.