|From SMH report on KCS dated 5/9/03, raising target to $6.|
• The involuntary “belt-tightening” in 2002 left KCS with a high-grade drilling prospect inventory for 2003. While most of
the wells will be targeting traps in the 1 bcfe to 3 bcfe range, KCS has 5 to 7 wells in South Texas looking for big targets in
the 20 bcfe to 50 bcfe range. If KCS is reasonably successful with the drill bit, 2003 could be significant in terms of reserve
additions and value creation.
• We have revised our forecast and estimates to reflect guidance, plus an expected $4.7 million gain in the second quarter
related to the sale of emission credits. We are raising our 12-month price target to $6.00, which is based on 3.6 times our
2003 CFPS estimate of $1.65. We think KCS could generate cash flow of $67 million, assuming $28.75/bbl oil and
$5.00/mmbtu gas, and thereby finance its $55-million capital-spending program, in addition to further reducing debt. We
reiterate our Buy recommendation
Sanders Morris Harris: KCS 2
KCS’s primary focus areas are the Mid-Continent region and onshore Gulf Coast. The company has key operations in the
Anadarko and Arkoma basins, North Louisiana, West Texas and Michigan. Along the Gulf Coast, the focus properties are in
South Texas, Coastal Louisiana and the Mississippi Salt Basin. KCS Energy devoted most of 2002 toward the redemption of
the $61.274 million Senior Notes that were due January 15, 2003. The company sold assets and slashed its budget to conserve
cash in order to meet this obligation. KCS was able to negotiate the financing to pay off the notes. With the financing behind
it, KCS is finally able to devote 100% of its attention on drilling, with some encouraging early results.
First Quarter Performance
KCS reported first-quarter 2003 EPS/CFPS of $0.36/$0.47, netting out the effect of an accounting change (SFAS 143), beating
our estimate of $0.30/$0.42. The variance was largely driven by better-than-expected commodity prices after adjusting for
hedges. The company paid down more debt and ended the quarter with long-term debt of $185.5 million, and a debt-to-cap
ratio of 109%. KCS will likely continue to pay down debt even with an expanded capital budget of $55 million. If commodity
prices hold up, KCS could have positive equity by year-end.
Table 1: First Quarter Results
KCS Energy Inc. 1Q02 1Q03 03-02 % Change
Production (bcfe) 10.35 7.55 -2.80 -27%
Gas Production (Bcf) 8.31 5.98 -2.34 -28%
Oil Production (mmbbl) 0.27 0.22 -0.05 -20%
NGL Production (mmbbl) 0.07 0.05 -0.02 -32%
Oil/Gas Revenue ($ million) 28.82 40.44 11.62 40%
EPS ($/diluted share) -0.15 0.36 0.51 NM
CFPS ($/diluted share) 0.07 0.47 0.41 616%
Gas Realization ($/mcf) 2.88 5.51 2.63 91%
Oil Realization ($/boe) 17.70 27.48 9.78 55%
NGL Realization ($/boe) 9.03 17.27 8.24 91%
Cash Cost ($/mcfe) 1.46 2.01 0.55 38%
DD&A ($/mcfe) 1.26 1.45 0.18 14%
All-in Cost ($/mcfe) 2.72 3.45 0.74 27%
Debt-to-Book Cap 113% 109% -0.04 -4%
EBIT -0.72 18.94 19.66 NM
KCS will be drilling aggressively in 2003. The focus will be on development wells during the first half of the year, in order to
generate more cash in this high commodity price environment. Toward the second half of the year, KCS will drill more
exploration wells to grow its reserves. The involuntary “belt-tightening” in 2002 left KCS with a high-grade drilling prospect
inventory for 2003. During the first quarter, KCS drilled fourteen wells, with a 93% success rate, and drilling during the
second quarter thus far has yielded a 100% success rate. Currently, KCS has six rigs drilling: one in Sutton County Texas, two
in south Texas and three in Louisiana and East Texas.
The company plans to drill a total of 60 to 80 wells in 2003:
• Louisiana and East Texas: 16 to 24
• Oklahoma: 5 to 10
• West Texas: 13 to 22
• South Texas: 14 to 20
• Other areas: 2 to 4.
Although most of the wells will be targeting traps in the 1 bcfe to 3 bcfe range, KCS has 5 to 7 wells looking for big targets in
the 20 bcfe to 50 bcfe range in South Texas. Most of these wells will be drilled during the second half. We like this portfolio—
KCS has an average 48% working interest, and a tally of the top six prospects could result in an unrisked net exposure of 131
bcfe to KCS, which is significant relative to KCS Energy’s year-end reserves of 196 bcfe.
Sanders Morris Harris: KCS 3
Table 2: South Texas Exploration Exposure
Prospects Gross-bcfe Working Int. Net Unrisked-Bcfe
Delhi 50 50% 25
5 Mile Creek 25 50% 13
E. Marshall 25 25% 6
Ray George 50 50% 25
Austin Deep 75 50% 38
Coquat Deep 50 50% 25
275 48% 131
The company is raising full-year production guidance to 32 bcfe to 36 bcfe versus the prior forecast of 31 bcfe to 35 bcfe.
KCS Energy is contemplating a mid-year reserve update—our interpretation is that KCS is confident. We revised our forecast
and estimates to reflect guidance, plus an expected $4.7 million gain in the second quarter related to the sale of emission
credits. We are increasing our 12-month price target to $6.00, which is based on 3.5 times our 2003 CFPS estimate of $1.65.
Our previous target was $5.00. We estimate that KCS could generate cash flow of $67 million, assuming $28.75/bbl oil and
$5.00/mmbtu gas, and thereby finance its $55 million capital spending program, in addition to further reducing debt. We
reiterate our Buy recommendation.
Table 3: Revised Estimates
2003E EPS $1.05 $0.85
2003E CFPS $1.65 $1.41
2004E EPS $0.89 $0.91
2004E EPS $1.72 $1.70
2003E Basic Share Base (million) 38.97 38.95
2003E WTI ($/bbl) $28.75 $28.75
2003E Henry Hub ($/mcf) $5.00 $5.00
2004E WTI ($/bbl) $26.00 $26.00
2004E Henry Hub ($/mcf) $4.50 $4.50
2003E Production (bcfe) 33.27 33.01
2004E Production (bcfe) 35.35 35.19
2003E Production Growth (11%) (12%)
2004E Production Growth 6% 7%
2003E All-in Cost ($/mcfe) $3.19 $3.15
2003E Cash Cost ($/mcfe) $1.77 $1.77
Valuation and Price Target
In valuing our E&P companies, we use a price-to-cash flow multiple. We establish a reasonable range based on historic
averages of a group of broad-based E&P companies, which includes twelve E&P companies with market capitalizations
ranging from $900 million to over $11 billion. Our 12-month price target of $6.00 is based on 3.6 times our 2003 cash flow
per share estimate of $1.65. We used a low multiple to reflect KCS’s high leverage, which is currently about 109%. We also
revised our net asset value (NAV) analysis for KCS. Using our 2003 price forecast of $28.75/bbl for oil and $5.00/mmbtu for
gas, we arrived at $8.52 per share, net of debt. Under a more modest assumption of $26.00/bbl oil and $4.50/mmbtu for gas,
KCS’s NAV is $7.28.
• KCS has a small market capitalization, a relatively thin float and light trading volume, which, under certain circumstances,
could make the stock more volatile.
• The company’s production mix is roughly 79% natural gas: with each $0.10/mmbtu change in Henry Hub natural gas prices,
both 2003E EPS and CFPS could be impacted by $0.04 each. Also, with each $1.00/bbl change in WTI oil price, the 2003E
EPS and CFPS could both be impacted by $0.02.
• In addition, the high debt level makes KCS more sensitive to positive or negative moves in U.S. natural gas prices.