Northern Oil and Gas, Inc. (NYSE: NOG) expects a dramatic increase in its free cash flow from 2022 to 2025. Management also announced that new acquisitions will likely increase future production while reducing its leverage. In my view, most investors haven’t had enough time to consider management’s expectations, as the current stock price looks quite undervalued. In my opinion, if management reports in 2025 what they expect, the stock price will likely be above $83. Finally, even taking into account the risks, in my view, the stock price cannot deviate much further from its current price.
Northern Oil and Gas, Inc.
Northern Oil and Gas, Inc. markets itself as a non-operated direct equity franchise across the United States.
With 287,000 million boe (barrel of oil equivalent), the company’s production is divided between the Williston Basin, the Permian Basin and the Appalachian Basin.
If I can cut to the chase, note that we are evaluating a company that expects a dramatic increase in FCF. Management estimates that FCF will grow from $375 million in 2022 to $1.3 billion in 2025. I’m not that optimistic in my calculations, but the company caught my attention because management claims to trade at 4, 2x 2022 earnings.
Northern Oil and Gas, Inc. has acquired a significant amount of assets in the past and expects to acquire many more in the near future. It is highly relevant that management is targeting transactions that will not reduce Northern’s return on capital employed (ROCE), which was over 20% in Q4 2021. If management truly achieves the promised CFO growth, I would expect significant increases in the stock price.
Other analysts’ expectations include debt reduction and significant FCF generation
Analysts expect sales growth of 52% in 2022, with an EBITDA margin close to 70% from 2022 to 2024. Their expectations also include an operating margin of around 51% and a positive net income in 2022. , 2023 and 2024.
Thankfully, analysts also expect strong financial numbers to likely help Northern Oil and Gas reduce debt. Free cash flow is also expected to increase from $460 million in 2022 to $508 million in 2024. In sum, the FCF margin would increase from 31% in 2022 to 37% in 2023. With these numbers, most analysts estimate that the business is worth between $29 and $57.
The advice given by Northern was also optimistic. The company expects 45 to 82 net wells to be added to production by 2022. Management estimates that future FCF would be sufficient to incur capital expenditures of $350 million to $415 million.
Debt reduction, more acquisitions and diversification could imply a fair price of $83
In my view, if Northern Oil continues to diversify its operations across multiple basins and the average working interest continues to be below 10%, future FCF is unlikely to be volatile.
As of December 31, 2021, we had participated in 7,436 gross (680.8 net) producing wells with an average working interest of 9.2% in each gross well, with more than 50 experienced operating partners. Source: 10-k
Also, if the company continues to acquire assets in different basins, sales growth and FCF will likely increase. Even without a significant amount of cash on hand, if the price of oil continues to trend north, future FCF will help the company acquire new assets. In the last annual report, the company noted that it intended to continue its diversification.
We also believe we can further diversify our risk with acquisitions across multiple basins, focusing on accretive acquisitions of top-tier assets with top-tier operators in major US basins.
Our “ground game” acquisition strategy is to establish a strong presence in our core basins and seek to acquire additional smaller concession positions at a price significantly below the contiguous acreage positions typically sought by larger producers and oil and gas well operators, focusing on future drilling opportunities. Source: 10-k
Also, in this scenario, I would expect a significant reduction in debt, so that the company’s leverage is 1.0x debt/adjusted EBITDA. If Northern Oil and Gas, Inc. reduces its debt, the cost of debt will likely go down. As a result, the weighted average cost of capital (WACC) could decrease, which could lead to an increase in the valuation of Northern Oil and Gas.
We intend to use a significant portion of our expected free cash flow in 2022 to further reduce our borrowings under our revolving credit facility with the aim of bringing our leverage closer to our target of 1.0x debt. / adjusted EBITDA. Source: 10-k
I used some of the numbers reported above. From 2025 to 2027, I assumed a sales growth of 3%, an EBITDA margin of 57%, an operating margin of 48% and a capex/sales ratio of 34%. The result is 2022 FCF of $415 million and 2027 FCF of $226 million. My median FCF margin would therefore be 21%.
With a WACC of 12.6%, the sum of free cash flow would imply a valuation of $1.497 billion. Furthermore, with an exit multiple of 7x, the terminal value discounted at 12.6% implies a valuation of $5.9 billion. Adjusted with net debt, the implied fair price should be close to $83.
Risks include depreciation of reserves, inability to predict future production and valuation of proved reserves
In 2020, Northern had to significantly write down the value of its oil and gas assets due to the decline in the price of crude oil. Management may write down the value of its assets again in the future, which would lower FCF’s expectations. Keep in mind that expectations for future oil production would decline. If stock researchers and financial analysts note the reduction in FCF, the stock price will likely fall.
In 2020, we had to write down the carrying value of some of our oil and gas properties, and further write-downs may be required in the future.
In addition to commodity prices, our production rates, proven reserve levels, future development costs, transfers of unevaluated properties and other factors will determine our actual cap test calculation and impairment analysis over the course of future periods. Source: 10-k
Northern may also miscalculate future oil production from future proved reserves. Engineers may not estimate future capital expenditures and oil and gas prices. In addition, government regulations or taxation could increase, which could result in a significant reduction in future free cash flow.
We base the estimated discounted future net cash flows of our proved reserves on specific price and cost assumptions. However, the actual future net cash flows from our oil and gas properties will be affected by factors such as the volume, price and duration of our oil and natural gas hedging contracts; the actual prices we receive for oil, natural gas and NGLs; our actual operating costs in the production of oil, natural gas and NGLs; the amount and timing of our capital expenditures; the quantity and timing of actual production; and changes in government regulations or taxation. Source: 10-k
Under the previous traumatic assumptions, I think 20% sales growth and an EBITDA margin close to 55% would be appropriate. I also included cautious changes in working capital and a capital expenditure to sales ratio of almost 35%. The results included 2027 FCF of approximately $105 million. If we add it all up with a 25% WACC and use an exit multiple of 5x, my implied enterprise value should be between $2.5 billion and $3 billion. Finally, the fair price should be close to $23.
With total assets of $1.52 billion and total liabilities of $1.3 billion, I believe the balance sheet is healthy. The company’s total net property, plant and equipment is $1.25 billion and cash on hand is $9 million.
Northern Oil reports long-term debt of $803 million, with derivatives worth $281 million. I expect an FCF of over $400 million in 2022, so I’m not really worried about future debt obligations.
With respect to Northern’s cash and bonds, I should add that management expects to receive cash from two recent acquisitions. Additionally, the company shared future plans for its revolver debt and senior notes.
With impressive FCF expectations through 2025, recent debt reduction, and promising M&A deals, Northern Oil and Gas looks quite attractive right now. With conservative assumptions on future EBITDA margin and FCF generation, I obtained a valuation significantly higher than the current share price. Even taking into account the risks associated with depreciating reserves and the inability to forecast future production, in my view the upside potential seems greater than the downside risks.