Got a question on natural gas stock--Williams Companies Inc. (WMB)
Williams Companies WMB
by Catharina Milostan
Thesis 08-23-2006
With turnaround efforts winding down, Williams is now focused on rebuilding its Rockies and Mid-Continent-based exploration, pipeline, and midstream businesses. Williams has made good progress with its nearly completed asset sale and debt-reduction programs. However, we'd like to see more debt reduction and remain concerned over potential earnings volatility from its still-too-large power-trading portfolio.
Williams has come a long way from its post-Enron liquidity troubles earlier this decade and can now generate cash flow to fund growth plans. We like how Williams is strategically well-positioned in several fast-growing natural-gas producing basins in the Rockies, Mid-Continent, and Gulf Coast with multiple avenues for earnings growth from its integrated natural-gas business. In contrast to many natural-gas producers, Williams can generate earnings by not only selling its natural-gas production, but also by earning fees for gathering, processing, and transporting natural gas via its midstream systems and interstate pipelines.
While a lot of management's attention was focused on restructuring efforts, it still maintained interests in major producing basins with several years of growth potential. Williams now plans to invest more than $1.5-$2 billion in each of the next three years to ramp up natural-gas drilling and to expand midstream and pipeline transportation capacity. In each of these businesses, Williams is well-positioned to reap the benefits of new investments.
Williams' exploration and production (E&P) operation should merit greater attention as it compares favorably with many E&P peers, attaining a top-25 ranking (in terms of U.S. natural-gas production) among U.S. natural-gas producers in 2004, and above-average drilling success and reserve replacement results in 2005. Williams' properties are in highly desirable, lower-risk, and longer-lived "resource type" basins, including large positions in the Powder River Basin in Wyoming and Piceance Basin in Colorado. We look for several years of drilling-driven production gains in these basins.
Williams' midstream operations are well-placed to take advantage of rising demand for gas gathering and processing as drilling activity increases in Rockies and Mid-Continent basins. The company is also set up to add gas gathering tie-ins to new deepwater Gulf of Mexico discoveries. Williams plans to build or expand pipeline transportation capacity to draw more natural gas eastward to markets in the Midwest and Northeast.
Despite the success of its turnaround to date, Williams still faces some hurdles. We'd like to see further debt reduction and remain concerned over its large derivatives portfolio. The company paid down 44% of its debt from 2002 highs and received credit-rating upgrades. However, its debt levels--the firm has a net debt/total capitalization of 49%--are still high compared with peers. The trading business will probably be a drag on earnings and a source of earnings volatility for at least a few more years.
Valuation
We're keeping our fair value estimate at $22 per share as Williams remains on track for drilling and expansion-driven earnings gains expected over the next few years. First-half 2006 results gave us greater visibility into how Williams' investment program is netting gains in production and midstream volumes and margins. Successful drilling results plus price-supported robust cash flows during the first half of 2006 encouraged Williams to boost capital spending plans by another $250 million to a range of $2.2-$2.4 billion for 2006. Most of this increase will be to support drilling and field development at the E&P unit, bringing spending in this segment to over $1 billion. Williams is allocating another $750 million to fund several pipeline projects, and $300 million to expand gathering and processing units. In early 2006, Williams also took another step away from its troubles in 2000-02 with a $175 million aftertax charge for a securities litigation settlement and jury rulings. Williams plans to add drilling rigs, particularly in the Piceance Basin, which should drive production gains later this year and well into 2007-10. We also look for gathering and pipeline expansion projects scheduled for completion in 2007 to drive earnings growth to the end of this decade.
Our model includes assumed benchmark natural-gas prices of $6.90 in 2006, $6.40 in 2007, $6.15 in 2008, and $6.30 in 2009, which were then adjusted for hedging, and the quality and location of Williams natural-gas production. In contrast to E&P-only companies, Williams is less sensitive to natural-gas price changes due to its hedging program and pipeline and midstream businesses, which are less affected by natural-gas price swings. In fact, a 10% upward or downward adjustment in our natural-gas price assumptions changes our fair value estimate by only $1 per share. Our fair value estimate assumes Williams remains a stand-alone firm. Given the price paid for Western Gas WGR, another Rockies-based natural-gas producer with midstream operations, Williams could fetch a handsome price.
Risk
Williams' greatest risk remains potential earnings volatility from its power trading business. After Williams could not find a buyer for this trading unit, it decided to keep the unit and find ways to restructure contracts and reduce risk. The power segment owns derivatives and has contractual obligations extending past 2020. Adding uncertainty, some of Williams' counterparties have below-investment-grade credit ratings. In addition to credit risk, its trading business has market risk. Williams also incurs the typical industry risks such as environmental liability, mechanical failure, and volatile commodity prices.
See Previous Analyst Reports
Close Competitors TTM Sales $Mil Market Cap $Mil
Williams Companies 12,501 14,109
* El Paso 4,505 9,207
* Kinder Morgan 7,227 14,059
* Western Gas Resources 4,114 4,636
* Morningstar Analyst Report Available | Compare These Stocks
Data as of 12-31-2005
Strategy
After restructuring to restore liquidity and reduce debt through asset sales, Williams is now a smaller, integrated natural-gas company. Management can take advantage of strong and steady cash flow generation at its pipeline and midstream units to fund pipeline and gathering expansion projects and greater drilling at its exploration and production unit.
Management & Stewardship
Chairman, president, and CEO Steven Malcolm has remained at the helm throughout Williams' turnaround and can now refocus on Williams' core businesses. Malcolm was promoted to president and CEO in late 2001 and became chairman in early 2002, at the time when the energy trading markets began their post-Enron collapse. Malcolm and the majority of his senior operating team have 15-20 or more years of experience at Williams, including its turnaround years. We give management some credit for its turnaround efforts, as Williams was among the earlier companies (with energy trading units) to forge settlements for the California power crisis and other litigation, and to restructure its debt and balance sheet. After forgoing a bonus in 2002, Malcolm received cash bonuses of $1.6 million in 2003, $2.7 million in 2004, and $2.3 million in 2005. Instead of cash bonuses, we think Malcolm's restricted-stock and option awards, which totaled over $3 million in 2004 and 2005, will serve as better long-term incentives. Overall, Malcolm's pay package looks relatively high but justified given the turnaround he helped orchestrate at Williams. We applaud Williams' effort to boost transparency by holding seminars to discuss its trading business and exploration and development efforts. However, we would like to eventually see a separate chairman and CEO at the helm of Williams.
Profile
Tulsa-based Williams is an integrated natural-gas firm with four business segments: power (formerly energy trading and marketing), exploration and production, gas pipelines, and midstream. Together, the segments produce, gather, process, and transport natural gas. At the end of 2005, Williams had proved natural-gas reserves of 3.4 trillion cubic feet, 14,700 miles of long-haul pipelines, 8,100 miles of gathering pipes, and six gas-processing and -treating facilities.
Growth
Williams' exploration and production, midstream, and pipeline segments have above-average sales growth potential relative to segment peers due to the firm's proximity to growing Rockies and Mid-Continent producing basins and access to end-user markets. Williams' power unit, with its derivatives trading portfolio, could periodically be a drag on earnings.
Profitability
Williams' gas pipeline and midstream segments have fairly stable profits. Its upstream business can be volatile but offers the largest margins over time. The trading business still casts a shadow over firmwide profitability.
Financial Health
Williams has worked hard to reduce its debt, but it still carries a heavy debt load with an above-average 47% debt (net of cash)/capitalization ratio. While the risk of insolvency has diminished, debt-service costs continue to hold back earnings potential. We look for continued efforts to pay down debt over the next few years.
Morningstar Rating
10-05-2006
3*
Stock Price
As of 08-23-2006
$24.61
Fair Value Estimate
$22.00
Consider Buying
$17.00
Consider Selling
$27.60
Business Risk
Avg
Economic Moat
Narrow
Stewardship Grade
B
