), and think the shares offer speculative appeal as management works to transform the company's fortunes. Williams originally was upgraded in late April to S&P's highest investment recommendation of 5 STARS, or strong buy.
Williams' top brass is currently in the process of transforming its capital structure and business operations through a series of divestitures. In 2002, Williams closed on 17 different asset sales for $3.8 billion in cash, $835 million in assumed debt, and $570 million in other consideration. In late February, management detailed a deleveraging campaign intended to return the company to investment-grade credit status by 2005. The linchpin of this restructuring effort: another $4 billion in aggregate divestitures projected for 2003 and 2004.
Given prospects for lower capital expenditures and increasing operating cash flow, we believe the ultimately delevered Williams should post nearly $1 billion of free cash flow to equity by 2005.
ASSETS FOR SALE. Standard & Poor's has been impressed by Williams' execution since the unveiling of its February deleveraging initiative. Since the plan was announced, the company has closed on or announced asset sales totaling approximately $2.1 billion in cash. Importantly, included within these asset sales has been the sale of three positions from the book of the company's Energy Marketing & Trading (EM&T) unit for $256 million in cash. The successful divestment of EM&T positions reduces the collateral requirements for the company's capital-strained energy merchant operation.
Williams has been among the most successful of the energy merchants at liquidating its EM&T book and we believe its yearend 2002 settlement agreement with California and other western states bodes well for the marketability of additional EM&T contracts. Williams is the only leading energy marketer to resolve disputes over refund claims from the California energy crisis and long-term power supply contracts.
In May, 2003, Williams' senior unsecured debt was upgraded to B+ by both Standard & Poor's Ratings Services (which had previously rated it B) and Fitch Ratings Services (B-). To our knowledge, only one other energy merchant (Reliant Resources [RRI
]) has received a credit upgrade since the beginning of 2002. Also in May, Williams boosted its capital position by selling to institutional investors $300 million of 5.5% coupon notes convertible into common stock at $10.89 a share.
BACK TO BASICS. As a result of these asset sales, Williams will be left with three core business units -- Exploration & Production (E&P), Pipelines, and Midstream Gas & Liquids. Given the strained supply/demand relationship within the natural-gas sector, S&P views Williams' presence across the natural-gas value chain as very encouraging.
A number of highly profitable expansion projects for Williams' core operations are expected to be completed in 2003 and 2004. We see the conclusion of these projects contributing to both increasing operating cash flow and declining capital expenditures. During 2003, the company expects to complete about $540 million of pipeline-expansion projects (increasing capacity by 828 million dekatherms per day on its remaining wholly owned Transco and Northwest pipelines). This will replace nearly half the capacity lost by the company's May, 2003, divestiture of its Texas Gas Pipeline system for $1.045 billion (including $250 million in assumed debt).
S&P believes Williams will also be finishing significant Midstream deepwater gas and oil production projects, including the Devil's Tower project in the eastern Gulf of Mexico (which may come online in the first quarter of 2004). Williams has stated that the $462 million Devil's Tower project could yield about $57 million in first year operating profit. With the completion of these Midstream projects, Williams sees capital expenditures for this segment dropping from over $200 million in 2003 to under $50 million in both 2004 and 2005.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