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|  | JANUARY 31, 2006
 FOCUS STOCK By Richard Tortoriello Cimarex's Deep Well of Good NewsIts disciplined drilling methods and the acquisition of a key independent have this energy exploration company poised to maximize production. That earns it S&P's highest ratingFrom Standard & Poor's Equity Research Services We view Cimarex Energy (XEC ; recent price, $45) as an oil and gas exploration and production company with a disciplined drilling strategy that effectively balances risk and return in order to maximize value creation. Cimarex should continue to maximize its return on invested capital through a disciplined drilling strategy that seeks to achieve high after-tax returns, while controlling risk, in our view. We believe that the Danver-based company's June, 2005, acquisition of independent E&P outfit Magnum Hunter Resources, which doubled production and tripled reserves, also provided Cimarex with an extensive portfolio of properties from which it can increase future production and reserves. (The acquisition also doubled Cimarex's market capitalization, which recently stood at nearly $4 billion.) We see reserves as increasingly valuable given an environment of rising energy prices. With the shares' current price-earnings ratio below the historical peer average, we believe investors are undervaluing the shares. Cimarex carries Standard & Poor's highest investment recommendation of 5 STARS, or strong buy. (The stock was recently added to Standard & Poor's Top Ten portfolio.) BALANCING RISKS. Cimarex's primary operations are in four geologic regions: the Mid-Continent, the Permian Basin, the Gulf Coast, and the Gulf of Mexico. By operating simultaneously in multiple basins, Cimarex seeks to diversify its geologic and geographic risk. Production is currently about 75% natural gas and 25% oil. Cimarex's strategy is to maximize growth in production and reserves by implementing an aggressive drilling program. To manage risk, it seeks a balanced portfolio of low- to medium-risk projects (those with historically high success rates) and higher-risk but potentially higher-return projects (those with lower success rates but greater reserve/production opportunities). Its sole criterion for determining a project's financial viability is the project's anticipated after-tax rate of return. We believe this approach to drilling, which is implemented by an integrated team of land personnel, geologists, geophysicists, and engineers using proprietary computer software, provides Cimarex with a discipline that leads to above-average results from its program. WIDER HORIZONS. Prior to the acquisition of Magnum, Cimarex's primary operations were in the Mid-Continent region of northern Texas and Oklahoma. Cimarex's success rates in this region have been near 90%, but returns are moderate. At the same time, it explored higher-risk projects along the Gulf Coast of Texas and Louisiana. Smaller projects were also underway in Kansas, the Permian Basin of west Texas, and other areas. The Magnum acquisition greatly expanded Cimarex's drilling opportunities in the Permian Basin, a geological area in west Texas and southeast New Mexico that offers a large number of moderate-risk projects. This complements Cimarex's existing Mid-Continent portfolio. By buying Magnum, the company's Permian Basin acreage (on a net-ownership basis) jumped to 281,000 acres, from 76,000. Cimarex now sees some 700 combined potential drilling locations in west Texas and southeast New Mexico, and has nine rigs operating in this region. In its core Mid-Continent region, it also operates nine rigs, and sees over 100 potential drilling locations in the Texas Panhandle alone. In the Gulf Coast of Texas and Louisiana, Cimarex currently has four rigs operating, with another two operating in the Gulf of Mexico. EXPLOITATION PLANS. The Magnum deal also added a large number of drilling blocks in the Gulf of Mexico, properties that Cimarex sees as higher risk and potentially higher return. The company partners with Remington Oil and Gas (REM ), Hunt Oil, and W&T Offshore (WTI ) for its offshore drilling and is currently ramping up its technical staff in this region. Cimarex plans to spend nearly $1 billion in capital on exploration and development in 2006, with about 75% for the Permian Basin and Mid-Continent region and the remaining 25% in the Gulf Coast/Gulf of Mexico and other high-risk/high-potential return areas. Historically, the company has funded its capital expenditures through operating cash flows. The decision to purchase Magnum was made at a time when crude-oil prices were significantly lower than today's prices, the company notes. Given current energy prices, Cimarex has also identified a list of about 600 exploitation projects -- projects for which it will use specialized techniques to fully utilize reserves from existing wells in which recovery had previously been deemed economically unfeasible. Cimarex has put together two teams devoted to exploitation only. It plans to spend nearly $500 million on such projects over the next few years. PRICE EFFECTS. Prior to the Magnum acquisition, Cimarex did not enter into derivative contracts to lock in future energy prices (i.e., to hedge its production) but sold gas and oil at market rates. Although the Magnum acquisition brought with it some hedges on oil and gas production, most of these hedges expired in 2005 and the remainder expire this year. We thus consider Cimarex leveraged to energy prices. Given the company's significant capital-spending budget, low energy prices would mean negative free cash flow. On the other hand, if energy prices were in the range of $9 per million British thermal units (MMbtu) for natural gas and $55 per barrel of oil, we would expect Cimarex to generate substantial free cash flows, with cash flows increasing sharply above these price levels. With the Magnum acquisition, we estimate that Cimarex produced 128.5 billion cubic feet equivalent (Bcfe) of natural gas in 2005, up almost 60% from 2004. For 2006, we expect a 40% rise, to 179.7 Bcfe, with 2006 comparisons benefiting from pre-Magnum production levels for the first two quarters of 2005. UPPING PRODUCTION. We estimate organic production growth for 2006 of about 10% if the effects of both the Magnum acquisition and Hurricanes Katrina and Rita are excluded. For 2007, we are projecting 7% production growth, to 192.9 Bcfe. We're assuming average realized energy prices of $7.59 for gas and $53.32 for oil in 2005, $7.28 for gas and $53.75 for oil in 2006, and $7.28 for gas and $51.25 for oil in 2007. In other words, we are assuming no rise in commodity prices from current levels. After factoring in projected expenses, we arrive at EBITDA (earnings before interest, taxes, depreciation, depletion, and amortization) estimates of $815 million for 2005 (up from $371 million in 2004), $1.063 billion for 2006, and $1.125 billion for 2007. Our earnings-per-share estimates are $5.02 for 2005 (up from $3.59 in 2004), $4.89 for 2006, and $5.15 for 2007. Our 2005 estimate excludes a $0.61 after-tax non-cash charge relating to mark-to-market accounting for derivative contracts acquired from Magnum. NO DEMAND LETUP. On an enterprise value-to-EBITDA basis, which takes into account a corporation's long-term debt and cash, as well as equity, Cimarex recently traded at multiple of 5 times, versus a recent peer average of 6 times and a five-year historical peer average of 5 times. Our 12-month target price of $60 is based on a multiple of 5 times enterprise value to our 2006 EBITDA estimate of $1.1 billion. On a p-e basis, Cimarex trades about in line with peers at a recent multiple of about 9 times our 2006 earnings estimate. This compares to a five-year historical average for peers of about 12 times. Thus, we believe that markets are currently pricing in declining energy prices and declining exploration and production earnings for Cimarex over the next couple of years, a view we disagree with. We believe that due to declines in large energy fields around the world, growth in energy supply is slowing at the same time that growth in demand from emerging economies, including China and India, is rising. As a result, we think that although there will certainly be short- to intermediate-term declines along the way, energy prices are in a long-term uptrend. And we expect earnings multiples to move toward the 12 times historical average as this trend becomes clear. Based on our estimate for 2006 earnings, this would imply a target price of $59 for Cimarex. SOUND GOVERNANCE. Our discounted free cash flow valuation assumes heavy capital expenditures in the next two years, and declining (but still high) capital expenditures as a percentage of sales thereafter. Our assumption is that Cimarex will derive long-term benefit from wells currently being drilled. Our DCF model yields a net present value per share of about $67. However, factoring in different risk assumptions suggests a range of $50 to $70. Because DCF analysis is built on a large number of assumptions about future risks and returns, we use this model as only one component of our overall valuation analysis. We believe that Cimarex applies sound corporate-governance practices and is run in the best interests of its shareholders. In our experience, management provides an unusual amount of detailed numerical analysis of its business operations to shareholders on a regular basis, providing transparency as to what business decisions are being made, why those decisions are being made, and most importantly, what results have accrued. We also note that 75% of the members of the board of directors are independent outsiders, and that the compensation and nominating committees are composed solely of outside directors. POTENTIAL RISKS. In our view, compensation levels are reasonable (CEO F. H. "Mick" Merelli earned $1.1 million in 2004, and all other officers earned less than $750,000). We also believe that stock-option grants are kept within reasonable bounds, with estimated after-tax stock option expense at less than 1% of net income in 2005. However, we're concerned that the same person holds the chairman and CEO positions. Cimarex faces a number of business risks including (but not limited to) rising costs for oilfield equipment and services; current industry shortages of experienced personnel; risks to Gulf Shore and Gulf Coast operations due to hurricanes; and geologic risk (i.e., the risk that drilling success rates in the future will decline versus rates experienced in the past). However, we believe that the major risk to our recommendation and target price is the possibility of a sustained decline in energy prices. In our view, supply/demand factors favor continued high energy prices, but substantial discoveries of large new oil and natural gas fields or decreased demand for energy, due to an economic slowdown, could have a negative impact on prices. We believe the more likely risk scenario of these would be an economic slowdown in the U.S., leading to declines in demand from export-led countries, such as China, and resulting in a marked decline in prices. We do not currently predict a significant decline in growth for 2006.  Analyst Tortoriello follows shares of emerging growth companies for Standard & Poor’s Equity Research Services All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is or will be, directly or indirectly related to the specific recommendations or views expressed in this research report. Standard & Poor's Regulatory Disclosure Any advice, analysis, or recommendations contained in articles labeled "Insight from Standard & Poor's" reflect the views of Standard & Poor's, which operates separately from and independently of BusinessWeek Online. It is possible that BWOL may from time to time publish information that is not consistent with advice, analysis, or recommendations that are published by Standard & Poor's. Standard & Poor's and BusinessWeek Online are each units of The McGraw-Hill Companies, Inc.
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