I have been concerned about the outlook for Tullow Oil plc(LSE: TLW) for some time.
The former market darling has struggled with high levels of debt and a low oil price over the past three years, and there was a period where it looked as if the group wouldn't survive in its current form.
However, over the past 12 months, the business has made enormous progress, and I now believe that an investment in Tullow could mean considerable returns for investors.
Cleaning up the balance sheet
My biggest concern about Tullow in the past has been the group's highly leveraged balance sheet. In the middle of last year, net debt was four times operating profit, and the company was in the process of a multi-billion dollar refinancing with lenders.
Now this process is complete and according to the firm's full-year results, which were released last week, net debt had declined to $3.5bn at year-end, still a substantial amount but down around $1.3bn year-on-year.
And it looks as if the company can keep its creditors happy for the foreseeable future. For 2017 the group generated $543m of free cash flow, $100m more than previous guidance. Considering the fact that the price of oil is currently around $60 per barrel, more than $10 per barrel above the average of approximately $50 for 2017, it looks as if this cash flow generation is set to continue.
Management is certainly positive on the outlook for the group. In fact, alongside full-year results, the company announced that for the first time since the oil slump began in 2014, Tullow is planning to increase its capital expenditure in the year ahead. Specifically, capital spending is set to double to $460m to support exploration, development of a new project in Kenya and expansion of existing resources in Ghana.
As Tullow gets back on a growth footing, I believe that the stock has the potential to double from current levels.
A higher valuation
On current City estimates, the company is set to earn around 14p per share for 2018 giving a forward P/E of 12.5, hardly a demanding multiple. As the group reinvests free cash flow to pay debt down further, earnings growth should accelerate and I would not be surprised if, as debt is reduced and oil prices stabilise, City Expectations for growth are revised higher.
With this being the case, I believe a valuation based on the company's free cash flow generation might be more appropriate. The group's 2017 figure of $543m translates into free cash flow per share of approximately 50p meaning that the firm is trading at a price-to-free cash flow ratio of just 3.5. This is dirt cheap. In fact, the rest of the oil and gas sector is currently trading at a ratio of 15.3. If Tullow were to trade up to the average sector valuation, the shares could be worth as much as 765p, up 337% from current levels.
In other words, if Tullow can prove that its free cash flow generation is sustainable over the next 12 months, I see no reason why the shares cannot rise to 700p or higher.
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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.