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GAS HAUL. Given project completions in the Pipelines and Midstream segments, S&P projects the company's total capital expenditures to fall from $1.8 billion in 2002 to $1.0 billion in 2003, and to $500 million in 2004.
A key factor contributing to the profitability of these projects is Williams' competitive leadership in the markets in which it operates. Even after significant pipeline divestitures, Williams still transports nearly 14% of all the natural gas consumed in the U.S. The company's Midstream operations gather about 38% of the production in the San Juan basin, 25% of the production in the deep water Gulf Coast, and about a third of the volumes in the Western Gulf of Mexico. The company benefits from meaningful economies of scale as it adds to infrastructure in these regions.
The E&P unit is Williams' primary growth segment, however. With nearly 52% of its proved natural-gas and oil reserves undeveloped as of the end of 2002, the company sees over 10 years of low-risk, high-return drilling opportunities. We believe the company's expertise in Rockies tight sands and coal bed methane production has buttressed its low-cost, competitive position.
THE RIGHT METRIC. Excluding the effects of asset sales, the E&P segment believes it can sustain 10% to 15% annual production growth for years to come. During 2002, Williams drilled 1,357 wells and realized a 99% success rate. The E&P operations also benefit from integration with Williams' Midstream and Pipeline services. For example, 25% of William's proved reserves are in the San Juan basin (as noted above, the Midstream segment gathers about 38% of all production in this region).
Given Williams' restructured operations, asset sales and discontinued businesses, S&P believes that the most reliable valuation metric for the company is discounted cash-flow analysis. S&P believes that its DCF analysis is conservative because it has not attributed any value from asset sales, and it has incorporated sufficient risk into its 10% weighted average cost of capital used to discount projected free cash flows.
S&P thinks the inherent near-term challenges posed in evaluating Williams on anything other than a DCF basis may be one of the reasons the stock still trades at a discount to what S&P believes is its fair value. Assuming a continued convergence of positive cash flow, credit rating, and earnings trends, we look for the stock's discount to fair value to disappear in the coming year. For now, our DCF analysis suggests a target price of $10.50 per share (it was trading around $8 as of June 2).
STARS ON SPEC. We note that Williams' current earnings quality is poor. The company's operating earnings have varied sharply from Standard & Poor's Core Earnings calculations, which take into consideration factors such as stock-option expenses, restructuring costs, and defined pension costs. In 2002, Williams incurred an S&P Core Earnings loss of $1.35 per share, vs. an operating loss of 19 cents per share.
In 2003, we estimate a Standard & Poor's core earnings deficit of approximately 27 cents per share, vs. S&P's operating earnings estimate of 15 cents per share. Asset sales, restructuring charges, and asset writedowns make up the bulk of the differences between operating earnings and S&P core earnings in 2002 and 2003. It's also important to note that in recent periods Williams has experienced substantial losses from discontinued operations which are not reflected in operating earnings or S&P's Core Earnings calculations.
In sum, S&P views Williams' turnaround potential to be compelling enough to warrant a speculative 5-STAR ranking. Assuming an improving level and quality of earnings, and benefits achieved by management's renewed focus on its three sound core operations, the shares could recover significantly in the near-term, which supports our 12-month target price of $10.50.
Analyst Shere follows multi-utilities and unregulated power stocks for Standard & Poor's
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
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