News Analysis date published New: 
Wednesday, September 29, 2010 - 15:25

An Unknown Energy Play That Could Deliver +365%

Although the energy sector has underperformed in the wake of the Gulf oil spill disaster, it will likely be a plentiful source of profitable stocks as the economic recovery grinds ahead. While investors ought to do nicely during the next few years with household names like Chevron (NYSE: CVX), ConocoPhilips (NYSE: COP) and Exxon (NYSE: XOM), I'm anticipating much larger returns from some of the sector's small- and mid-caps.

One mid-cap oil and gas producer I've found could more than quadruple your money by 2015 or even sooner.

Projections call for a share price of $45 to $70 in three to five years from the current price of about $15. Assuming five years, the annual return would be +25% to +35%. At three years, you'd be looking at something more in the +45% to +65% range annually. All told, the stock could jump roughly +200% to +365% from current levels.

The company I'm referring to is called Petrohawk (NYSE: HK).

Such ambitious return projections for the stock are feasible, mainly because of its plans to keep ramping up production at its profitable Haynesville Shale and other natural gas fields. The company churned out an average of 625 million cubic feet of natural gas per day in the second quarter of this year, for example, and is expected to produce 650 to 660 million cubic feet daily in the third quarter. That's more than twice the 283 million cubic feet per day it was putting out in the second quarter of 2008. The company anticipates production growth of +30% to +40% in 2011 and +15 to +25% in 2012.

The dramatic upward productivity trend should profoundly increase Petrohawk's earnings. Excluding a nonrecurring loss of -$0.39 per share, the company is expected to earn $0.65 a share this year. That's +67% more than in 2009, when earnings were $0.39 a share, excluding a nonrecurring loss of -$4.05. The 2011 projection of $1.20 a share is an +85% spike from 2010's forecasted earnings.

Obviously, a growing enterprise needs cash and Petrohawk has been raising plenty through divestiture and cost cutting. The company recently collected a total of $1.4 billion when it sold its WEHLU and Terryville fields and some other smaller properties and entered into a joint venture allowing Kinder Morgan (NYSE: KMP) access to some of its Haynesville acreage. To reduce expenditures, Petrohawk is testing a new wellbore design that could shave up to a million dollars off drilling costs per well starting in 2011.

A recent debt refinance should also help shore up Petrohawk's cash position by reducing interest expense. In early August, the company issued $825 million in 7.25% senior notes due in 2018. The proceeds will be used mainly to pay off $769 million in 9.125% notes due in 2013.

High P/E isn't an issue
With an industry average P/E ratio of about 15, Petrohawk's P/E of 28 may seem too pricey. However, the stock is only trading at about 14 times forecasted 2010 earnings. And the stock is more than -46% off its one-year high, about -72% below its five-year high and almost -50% shy of Morningstar's current fair value estimate of $30 a share.

Although I'm not worried about Petrohawk's P/E, its total debt-to-equity ratio of nearly 70 reflects a large debt burden, and there's no sign of that load lightening in the near future. While heavy leverage is common for young, equipment-intensive companies like Petrohawk, it greatly increases your risk as an investor.

For one thing, as its beta of 1.35 suggests, this stock comes with added volatility. And if revenue shrank enough for some reason (like a drop in energy demand or worse-than-expected well output), there is a real risk of the company defaulting on its bonds. That certainly wouldn't help its stock price any.

Such a scenario seems a bit less likely, however, since Moody's recently upgraded Petrohawk's credit status from "negative" to "stable." The company's debt is still considered junk, though, as indicated by Moody's ratings, which are in the B2 to B3 range.

Action to Take --> See Petrohawk for what it is: a volatile mid-cap stock with potential for serious outperformance -- but also a considerable amount of risk. Don't buy it if you're risk averse. If you do buy the stock, keep the amount reasonable -- no more than, say, 2% to 4% of your total portfolio. That way, you'll get a benefit if it performs as projected, but you won't suffer terribly if it doesn't meet expectations or the worst case materializes.

A final note on one of the intangibles at play here: Petrohawk is the third major oil and gas startup of founder and CEO Floyd C. Wilson. His plan for Petrohawk is to accomplish what he did with the prior two -- sell when the time is right at a nice profit for shareholders.

Tim Begany does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of HK in one or more of its “real money” portfolios.

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