Matador Resources: Downgraded To Sell; 50% Downside Possible (NYSE:MTDR)

It’s been ten months since we covered Matador Resources’ (NYSE:MTDR) stock. Although the security has garnered total returns of nearly 5% since our initial strong buy rating, it has underperformed our expectations. Today’s article provides an updated outlook amid a changing economic environment, which could lead to cyclical shifts in the stock market.

Operational Update

Hard Operations

Matador Resources released its third-quarter financial results in October last year, revealing a robust quarter that saw it amplify its revenue by 78.03% year-over-year. Moreover, the company beat analysts’ earnings-per-share target by four cents, indicating good management during a period of increased input costs.

Let’s break down Matador’s recent operational highlights.

Upstream operations remain robust, with the Delaware Basin paying dividends. In addition to Wolf Jackson turning to sales in the company’s first quarter, Matador’s Stateline site turned to sales in the third quarter. Furthermore, the company has successfully drilled eight Rodney Robinson wells and anticipates four additional Antelope Ridge wells to turn to sales in its fourth quarter. Also, Matador expects 12 wells to turn to sales in Ranger during its fourth quarter.

Midstream operations are picking up. As mentioned in our previous article, we believe the company’s San Mateo midstream venture will add significant leverage as it might allow Matador to exercise more competitive pricing via a vertically integrated strategy.

In September, the firm transitioned the Pronto Midstream project, which it acquired around mid-year. The asset has 50 million cubic feet per day of takeaway capacity and 60 million cubic feet of processing capacity. Thus, providing Matador with valuable synergies.

After releasing its earnings, the company’s CEO, Founder, and Chairman, Joseph Wm. Foran declared an upgraded outlook. According to Foran: “Due to the better-than-expected well performance across our Delaware Basin asset areas in the third quarter of 2022, we are increasing the midpoints of our 2022 total oil and natural gas production guidance from 21.7 million barrels to 21.85 million barrels for oil and from 95.5 billion cubic feet to 97.0 billion cubic feet for natural gas,”

Whether Foran’s outlook materializes or not, it’s evident that Matador is expanding rapidly as a nimble up-to-midstream enterprise.

Financial Statement Talking Points

The company has successfully executed cost-cutting since 2018. However, its CapEx surged during its third quarter. Yet, I don’t see this as structural because the cost basis for asset-heavy businesses, in general, has increased significantly during the past year due to broad-based inflation growth. In addition, Matador is expanding exponentially, requiring significant capital commitments.

A notable achievement is the company’s reduction in revolving loans and its transition to a longer-term debt profile, which earned it a credit rating upgrade. Moreover, the firm’s $105 million bond repurchase suggests it is more than capable of restructuring its cost of capital in the future.

Unfortunately, Energy Prices Are No Longer Supportive

Oil and gas prices are highly cyclical. In the long run, you’ll experience various sharp fluctuations of fossil commodities as they’re not only inextricably linked to industrial production (and reproduction); but the supply of oil and gas is closely controlled by a select few decision-makers, which leads to abrupt changes in the supply/demand landscape.

As the diagram above shows, oil and gas prices have fallen off a cliff during the past six months, which should’ve been expected, given that supply and demand were eventually going to level out to a more realistic level. In addition, slowing global economies have compressed implied demand for core commodities such as oil and gas.

Looking ahead, it’s unlikely we’ll experience a similar surge in oil and gas prices as we experienced in 2022. My explanation is that re-openings have commenced in most parts of the world (including China), producers have ramped up production after the Russia-Ukraine shock, and global economies are running at a lower velocity than they did during the low-interest rate/expansionary economic environments, we experienced in the past three years.

The implied supply surplus has clearly affected energy stocks since the turn of the year. Whether investors have cashed out profits or whether they are betting on a cyclical industry downturn remains unclear; however, both are possible.

As an investor, you need to ask yourself whether less supportive commodity prices will deter Matador’s profitability. Sure, broad-based inflation is tapering. However, I believe the firm’s revenue is more elastic than some of its variable costs and definitely more elastic than its fixed costs. Thus, I would prefer to avoid onboarding risk with an investment that might suffer from cyclical price pressure.

Valuation

Model Output

I decided to value the stock with a residual income model (the model is explained in one of our previous articles) as it is a natural resource company that requires an emphasis on book value. Based on my model, Matador Resources is severely overvalued and could recede to $24.95 per share if we assume an efficient financial market.

In large, the stock’s poor valuation is likely due to a potential cyclical downturn of its earnings-per-share, which is systemically driven. In addition, I believe the market has priced a significant asset base expansion because Matador’s price-to-book ratio is at a 2.27x premium. If earnings expectations had been brighter, I think the firm could’ve expanded its asset base. However, high-interest rates, uncertain asset cost bases, and a looming recession make exponential acquisitions and expansion projects highly unlikely.

Note: The RI model is an objective indicator. Yet, it doesn’t guarantee that its price target will realize in the marketplace.

Model Inputs

Here are the input variables that I utilized for the RI model.

1. Book Value: I divided the stock’s price by its price-to-book ratio to discover Matador’s initial benchmark book value per share.
2. Earnings-per-share: I utilized Seeking Alpha’s database to sample Matador’s analyst EPS estimates. Additionally, the terminal year’s estimate is a normalized average of the preceding years’ values.
3. Dividends: Seeking Alpha’s database was leveraged once more to discover the company’s dividend estimates. Due to the firm’s thin dividend history, estimates were limited. Thus, I assumed dividends to grow in line with earnings-per-share.
4. Equity Charge: I employed the CAPM formula to calculate the equity charge, which was multiplied by the “beginning book value” figure to obtain an absolute value. The current U.S. market risk premiums were used; however, I compressed the stock’s beta coefficient to its pre-pandemic figure of 2.4 to normalize the risk environment.

Concluding Thoughts

Despite Matador’s rapid expansion within both its upstream and midstream segments, the company is likely to suffer from less supportive oil and gas prices during 2023 amid a shift in global supply versus demand dynamics; in addition, a potential recession looms.

Despite its rapidly increasing asset base, near-term acquisitions and expansion projects will be arduous in an environment with unfavorable capital structures and uncertain asset cost bases. Thus, the stock’s price-to-book ratio spells trouble, especially when incorporated into a residual income valuation model.

I/we downgrade Matador Resources’ stock to sell with a six-month horizon.