Markets & Finance

Evergreen Steps on the Gas


By Markos Kaminis With new domestic reserves of natural gas increasingly difficult to identify, Standard & Poor's Equity Research believes the U.S. will have to get an increasing share of its supply of this vital fuel from some unconventional places. Like coal beds. S&P views Evergreen Resources (EVG

; recent price $33), a leading developer of coal-bed methane gas, as well positioned to benefit from growing U.S. energy demand. Evergreen carries S&P's highest investment ranking of 5-STARS, or buy.

We expect Evergreen's gas to find attractive pricing over the next few years, given the limited supplies of natural gas, which is mostly sourced within the continent. Because Evergreen's cost structure is one of the industry's lowest, we believe it should enjoy better relative economics than its peers in good times, while gaining a larger share of the available production base in lean times, when it may not be feasible for its rivals to explore for new reserves.

We believe Evergreen's historical performance is evidence of this dynamic. The stock's five-year chart reflects operations throughout a wide range of commodity prices but still depicts 30% average annual capital appreciation through yearend 2003.

DRILLING OPPORTUNITIES. Almost all of Evergreen's current production is generated from coal-bed-methane (CBM) properties in Colorado. Methane gas trapped within the molecular structure of the coal can be recovered through various methods. CBM is usually free of other hydrocarbons typically found in natural gas reserves and, thus, is often pipeline-quality.

Evergreen has recently complemented its Colorado reserves with acquired properties in Utah, Canada, and eastern Kansas. In doing so, it hopes to exploit its skill in coal-bed-methane mining across a greater span of the country, and thereby benefit from better pricing in various regions outside of the Rockies. Significant drilling opportunities remain within the Raton Basin in Colorado, but with positive results at new properties, we think Evergreen can reassure investors of a continuous growth opportunity for the long term.

Growing demand for energy has led to intensified efforts to tap the wealth of America's embedded CBM reserves. CBM accounted for 10% of all U.S. dry natural gas reserves in 2002, as reported by the Energy Information Administration (EIA), and 8% of U.S. dry-gas production by the end of 2002. We believe CBM will grow in importance as a critical national source of energy.

NEW FIELDS TO CONQUER? Evergreen is one of the largest holders of oil and gas leases in the Raton Basin, with interests in approximately 385,000 gross acres of coal-bed-methane properties. At the end of 2003, it had estimated net proven reserves of 1.495 trillion cubic feet equivalent (Tcfe). Evergreen believes it can increase reserves to 1.7 Tcfe to 1.75 Tcfe by yearend 2004.

Evergreen's net average daily gas sales for the fourth quarter of 2003 were approximately 139 million cubic feet equivalent (including acquired Carbon Energy), vs. 114 Mmcfe in the fourth quarter of 2002. It had 973 net producing wells at yearend 2003, and Evergreen has identified approximately 1,000 more drilling locations in the Raton Basin.

Estimated finding and development costs (excluding acquisitions) during the three-year period 2000 through 2002 was $3.05 per barrel of oil equivalent (boe), well below its peer-group (large U.S. exploration and production outfits) average of $7.97 per boe, as calculated by industry data provider John S. Herold.

With plenty of drilling opportunities left in the Raton Basin, Evergreen, in our view, will not be pressured over the next few years to find another property to spur continued growth. However, we think that investor sentiment would strengthen substantially should a new field be discovered -- and be proven a suitable replacement for Raton. We have been pleased to see Evergreen pursue that goal.

BIG GULP. Evergreen scoured North America in recent years for prospective coal-bed properties -- and added several. In 2002 and 2003, it acquired in excess of 700,000 gross acres of prospective unconventional CBM natural gas properties in the Forest City Basin in eastern Kansas. With the October, 2003, acquisition of Carbon Energy, it established positions encompassing 150,000 acres and 59 Bcfe of reserves in the U.S. and 130,000 acres and 38 Bcfe of reserves in Canada. Evergreen also holds approximately 300,000 gross acres of prospective coal-bed-methane acreage in south-central Alaska's Cook Inlet-Susitna Basin.

We think some investors may have questions about the environmental impact of extracted water used to release the gas. Some environmental organizations assert that risks are associated with water removed from coal seams. Water quality may vary, and Evergreen's experience is that in many instances it may even meet federal drinking standards. In 2000, Evergreen received a new five-year water-discharge permit from the state of Colorado. When water does not meet these discharge standards, the company drills additional disposal wells to reinject the produced water into deeper sandstone layers.

Evergreen plans to spend $220 million in 2004, with approximately $110 million targeted to the Raton Basin, a portion of which will be spent to drill 200 wells there. It plans to spend $34 million in the Piceance/Uintah Basins (55 wells), $34 million in Alberta Canada (65 wells), and $33 million for the development of the Forest City Basin in Kansas (61 wells). A total of 381 wells are planned, compared to the 160 drilled in the Raton Basin and 185 net producing wells acquired during 2003.

FUTURE EARNINGS. We see the drilling of 381 wells and the acquisition of Carbon Energy and properties in Kansas driving up production 37% in 2004, vs. production growth of 19% in 2003. For 2005, we forecast production growth of 40%, driven by drilling activity across Evergreen's various properties. Based on our forecast for a fractional increase in realized natural gas prices, at $4.69 per thousand cubic feet equivalent, or Mcfe (including hedge positions), we estimate revenues to climb 38% in 2004. With increased transmission and compression capacity needed, especially at acquired properties, production costs should rise to 56 cents per Mcf, which still compares well to peer averages.

We see Evergreen's earnings before interest, taxes, depreciation, and amortization (EBITDA) margin near 72% in 2004, as we expect higher production costs to be offset by improved general and administrative spending. With our expectation of higher interest expense on acquisition-related assumed debt, we see net margins narrowing by 320 basis points.

Based on 18% more average shares outstanding vs. 2003, reflecting acquisition financing and dilution of convertible debt, we estimate 2004 operating EPS at $1.98, up from EPS of $1.88 (excluding charges) in 2003. For 2005, we forecast operating EPS of $2.15.

M&A PAYOFF. Our Standard & Poor's Core Earnings estimates are $1.94 per share for 2004 and $2.11 for 2005, which fall 2% below our operating forecasts for both periods. The difference reflects our projections for stock-option expense.

The acquisitions of peers Barrett Resources and Pennaco in recent years provided evidence of interest in coal-bed methane producers, in our view. Comparing Evergreen's reserves to the multiple offered for Barrett Resources, we would value the stock at about $44. With a p-e multiple-to-growth ratio of 1, based on our EPS estimate for 2004 and our 16% five-year earnings-growth projection, the stock is trading at a discount to the industry average multiple of 1.3.

Our

discounted cash-flow analysis estimates intrinsic value 12 months from now at $52. The model forecasts Evergreen to first generate positive free cash flow in 2009 due to the costs of reserve development. Valuing the shares based upon peer acquisition multiples (to reserves and enterprise value), we find implied values for Evergreen ranging from $39 to $45. Applying the median of the above metrics, our 12-month target price is $44.

WORRY WATCH. Risks to our investment opinion, earnings forecasts, and target price, in our view, include: an extended decline in the price of natural gas in the U.S., especially in the Rocky Mountain region; large capital requirements for Evergreen in its development schedule; unsuccessful results from projects in the Raton, Piceance, Uintah, and Western Canada Sedimentary Basins; the availability of pipeline capacity; U.S. economic conditions; the supply and demand for natural gas; lack of success in locating and producing new reserves; estimates of proved reserves not reflecting actual reserves; changes in governmental regulations or taxation; and equipment failures or accidents.

Other risks, in our view, include the ability to hire and train personnel for drilling and completion services; acquisitions that provide integration problems, distract management, or hurt current business standards, controls, and procedures; unanticipated water disposal costs; the adverse impact of hedging; and/or the loss of key personnel. Analyst Kaminis follows emerging growth stocks for Standard & Poor's Equity Research


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