Monday, December 21, 2009

XTO Energy: Liquidity and Solvency Analysis

Anyone who has been even remotely cognizant of financial market events over the past week should be aware that Exxon (XOM) has agreed to purchase XTO Energy (XTO) in an all stock deal worth $31B (or $41B, depending upon whether you choose to categorize debt assumption as a direct cost to Exxon). At first glance, the deal looks like a pure-play home run bet on the natural gas industry. After all, XTO's revenue has risen from less than $400M in 1999, to over $8B over the trailing twelve month period. Net Income has risen from $46M to $2B over the same time period. 

The question though, is whether XTO has managed to achieve this level of growth with a debt level that is manageable in the long term. I'll begin an attempt to answer this question by looking at XTO's debt maturity profile, as stated in its most recent 10-Q. All figures are in $MM:
 The schedule above lets us know that XTO has several billion dollars worth of debt maturing in the next 6 years; however, it may be more instructive to observe just how this debt has affected the firm's balance sheet. To do so, I prepared a 10 year look at XTO's debt to equity ratio:

The trend displayed by the chart above is encouraging; XTO's debt-to-equity ratio has declined throughout the past decade, and the company is now financed by roughly a 1 to 1 mixture of debt and equity. Yet another way of examining XTO's use of leverage is to take a look at its Times Interest Earned (TIE) ratio, which measures EBIT as a multiple of interest expense:
In 2006, XTO's TIE ratio peaked at just over 14X, meaning that the company reported earnings before interest and taxes that could have covered its annual interest expense 14 times. That multiple has since decreased to ~6X, as interest has comprised an ever larger share of XTO's EBIT. A possible explanation for this trend lies in TIE's numerator: EBIT. A rapidly growing company like XTO will have large amounts of depletion expense that will adversely affect EBIT, but not cash flow. To see whether this idea holds water, I'll look at operating cash flow as a multiple of interest expense:

Once again, we see this measure trending downwards. Obviously, 3 data points doesn't create an irreversible trend. However, its worth noting from a standpoint of how XTO's financial performance is likely to affect Exxon in the coming years. Of course, Exxon may be able to refinance XTO's debt at a far lower weighted average cost of capital.

Next, I think that XTO's liquidity should be examined using the current and quick ratio's:
Although you'd generally like to see both of these ratios at a level above 1, its worth noting that over the past decade, XTO's current and quick ratios have stayed within a relatively stable band (1.4-0.8). If you look at XTO's balance sheet, you'll notice a relatively large current asset labeled "Derivative Fair Value". According to XTO management, these derivatives are cash flow hedges used to protect the company from major price swings in the natural gas market. Ultimately, the hedges should be viewed as a prudent move that allows XTO to focus on the acquisition, exploitation etc of new properties, and ignore short term noise in the price of natural gas. 

In the end, XTO has to be considered a pretty remarkable growth story. There's clearly a strong performance oriented culture at the company that has allowed it to expand as rapidly as it has. My feeling is that post-merger, Exxon would do best by allowing the XTO culture to remain in place, at least in its core business operations. Exxon's true contribution to the marriage will be in the economies of scale created by the combined venture; perhaps XOM should handle the financing and hedging activities that XTO requires, and simply place some guard rails on the acquisition strategy. XTO is definitely structured for growth; the problem is, it needs to be managed properly, and with manageable levels of debt.
My last comment on the XOM-XTO merger is it represents the potential for a brilliant strategy. Exxon has poured too much money into share buybacks over the past decade, probably because hostile foreign government run oil companies have kept Exxon from exploiting their natural resources. The XTO purchase though, could provide a useful outlet for XOM's excess cash. If XTO's acquisitions can be funded through Exxon's internally generated cash flow, and the debt agglomeration trend can be halted, then Exxon could wind up being the largest owner of natural gas property in the country - and the US has plenty of natural gas.

*no positions

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