Stone Energy: High Potential, High Risk

Louisiana-based Stone Energy (NYS: SGY) has been looking good recently. The company's stock has skyrocketed 192% in the past 12 months, leading to a general sense of optimism about the company. While this perception may be true over a shorter period, the question Fools should ask is: Is the company well placed for growth over the long run?

The problem
The Gulf of Mexico has seen a natural decline in production, and this should be a major cause of worry for Stone. Not surprisingly, total production in 2010 fell from a year ago. With approximately 83% of proved reserves and more than 99% of production for 2010 coming from this region, it's time the company increases its production activity in a more geographically diverse way.

While diversity is definitely an issue, another worrisome one is the top line. Revenues have dropped by 7% in the last 12 months. Correcting a drop in sales is of fundamental importance, which I believe may not be too difficult for Stone.

Fortunately, reservoirs in the Gulf of Mexico are easily recoverable, unlike other regions. So, it shouldn't be too tough for Stone to stage a turnaround in terms of production. Proved reserves, in fact, grew 15% year-on-year, and this includes a 27% increase in natural gas reserves.

Need for cash
Short-term concerns still remain. For one, Stone needs to sustain its operating cash flows through increased oil production. Its 43% oil reserves definitely have the potential to script a comeback (read: growth in revenues and cash flows) in the near future.

Operationally speaking, the company's return on equity stands at a fantastic 27%. But I'm not impressed. Stone has been gradually leveraging itself and reducing equity over the last three years. This has the artificial effect of driving up a business' ROE number.

Plus, a debt-to-equity of 131% is not at all enviable. Foolish investors should sit up and take note. The unavoidable need to prop up production and sales is only too clear. With free cash flows turning negative, capital expenditure programs may take a hit as well.

How is the stock valued?
Here's how Stone stacks up when compared with its peers:

Source: Capital IQ, a Standard & Poor's company. TTM = Trailing 12 months. NM = not meaningful.

Current numbers for Stone look reasonably good, particularly the company's enterprise value-to-EBITDA. The stock looks undervalued in that respect. But investors should keep a close watch on the company's operational growth in the future as this could considerably impact prices.

The last five years have seen ROA range between -51.4% and 7%. The fluctuation is a bit too much to get a grasp on the real value of the company's assets.

The Foolish bottom line
Overall, Stone Energy looks like it's doing OK. But it may not in the long run if it fails to address some of these short-term issues. Management needs to look into core problems and rectify production drops and the subsequent losses in revenues. While this isn't too difficult, investors must take note of the company's progress every quarter.

Do you agree with the issues Stone's management is facing? Share your comments below.

At the time thisarticle was published Fool contributor Isac Simon does not own shares of any of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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