Encana: Terrific buy at current levels – with cash, margins and profits poised to takeoff following significant restructuring
Encana Corporation (ECA) focuses on the exploration, development and production of natural gas, crude oil and natural gas liquids in the United States and Canada, and is the second largest gas producer in North America.
With shares at $20.23 (market close on 3/14/2014), Encana has a market capitalization of about $15 billion and offers an annualized dividend of $0.28 per share (1.4% dividend yield). Dividends are expected to ramp-up steadily as cash flow improves – so this is also a dividend growth play.
Shares trade at a substantial discount to projected 2014 net asset value and could rise significantly after management completes bold restructuring actions that were initiated in November 2013. Shares trade at about 6x projected 2014 cash flow.
FastGraphs estimates that Encana shares could rise to $36 by 2019, delivering a 14% annual total return – that’s up about 80% from current levels of $20 per share.
Encana Restructuring to Unlock Shareholder Value, Grow Cash Flow 10% Annually
In November 2013, Encana announced a dramatic restructuring of its business with renewed focus on
five high-return oil and NGL plays where Encana will invest 75% of its $2.5 billion capital, the spinoff of its Clearwater mineral rights portfolio in southern Alberta (Canada) through an IPO (with Encana retaining significant ownership; Clearwater is valued at about $2 billion), the divestment of certain assets, a 20% reduction in its workforce and a cut in quarterly dividend to $0.07 per share (from $0.20 per share). To reduce cost duplication, the company will consolidate offices in Calgary and Denver and close its office in Plano, Texas.
The Clearwater spinoff involves the transfer of 5 million acres – and associated royalty interests – to a new company in which Encana will continue to hold a significant stake and manage leasing activities. Management believes these royalties offer strong long-term cash flow potential and are currently not fully reflected in the company’s valuation. Under an unusual concession made by the Canadian government, Encana is not required to pay royalties to the government on Clearwater lands and will retain all leasing fees, bonuses and royalties. Encana expects to pass on most of this cash flow to shareholders in the new company.
Through these steps, the company plans to lower its cost structure by focusing operations to improve productivity, increase liquids production to add commodity diversification to its portfolio and unlock shareholder value through asset divestments and the Clearwater spinoff. With this focused strategy, management expects to grow cash flow at 10% annually through 2017.
While Encana is big on natural gas production, its new focus on five liquids-rich plays should increase liquids production, diversify revenues against fickle natural gas prices and deliver higher returns.
As the image above shows, management goals are solidly focused on increasing cash flow per share and paying out dividends under the company’s new structure.
New CEO Instrumental in Bold Shakeup
Doug Suttles joined Encana in June 2013 (from BP) as President and Chief Executive Officer, and has since been instrumental in restructuring the company to unleash hidden value, improve core focus, diversify into liquids production and spinoff or divest non-core or undervalued assets. Suttles has over 30 years of experience in the oil and natural gas industry.
Sherri Brillon serves as Chief Financial Officer. David Hill is Executive VP – Exploration & Business Development and has been with the company since 2002. Michael McAllister serves as Chief Operating Officer and President of the Canadian Division.
Under Suttles leadership, shareholders should see a significant return to value and significant share price appreciation from current lows that are below 2014 net asset value.
Five High-Growth NGL and Liquids Plays
Encana plans to invest 75% of its $2.5 billion capital into high-return resource plays in Montney, Duvernay, DJ Basin, San Juan Basin and Tuscaloosa Marine Shale (TMS). Montney is liquids rich, Duvernay has high value condensates, DJ Basin is oil and liquids rich, and San Juan and Tuscaloosa are oil rich. Clearly, Encana is re-focusing on higher margin liquids plays going forward.
Over the next three years, Encana plans to quintuple oil production, grow NGL production to 2.5x current levels and double natural gas production. The core focus on all five plays is to accelerate liquids growth and improve capital efficiency. By 2017, 75% of Encana’s upstream operating cash flow will be from liquids.
With its focus on just five plays, Encana will more than double its cash flow from $1.90/Mcfe to $4.20/Mcfe once the transition is complete because of a stronger focus on higher margin liquids production.
And these five plays are expected to generate about 45% of Encana’s total pre-hedge upstream operating cash flow, up from 25%.
Encana’s Tuscaloosa Marine Shale (TMS) offers significant upside from higher liquids production, and could be a game changer for the company’s fortunes. Encana owns over 300,000 net acres of TMS land in Mississippi and Louisiana, with about 60% liquids-rich, with large quantities of oil condensate (8 billion barrels of oil equivalent for production of over 50,000 barrels per day).
TMS produces ultra-light oil condensates that reduce the viscosity and enable pipeline transportation of heavy oils including oil from oil-sands. Oil-sands production is expected to increase from 1.8 million barrels per day (bpd) to about 3 million bpd by 2015, and this is expected to increase condensate demand for transportation to about 350,000 bpd, well above 2013 production of 145,000 bpd. So the gap in demand and supply should boost condensate revenues from TMS.
TMS condensate will also benefit from a price advantage because it is pegged to the price of Light Louisiana Sweet (LLS) crude which trades at about a $10 premium to West Texas Intermediate (WTI) crude. Higher condensate production should deliver higher margins for Encana.
Spinoff of Clearwater Royalty Business
Encana will spinoff its Clearwater mineral rights portfolio – 5.2 million net acres in Southern Alberta – on which the new entity can keep 100% of all profits and royalties. This new company will be independently managed and a sizable portion of its cash flow will be paid out as dividends. Revenues will largely consist of royalties from oil and gas companies leasing land in Clearwater, of which Encana has already received a C$16 million lease issuance bonus on 97,000 acres and a C$106 million minimum drilling commitment over three years with royalties received on all production.
In 2012, Clearwater produced 374 MMcf of natural gas per day and 8.6 Mbbls of oil and natural gas liquids per day. Encana will transfer the fee title and associated royalty interests associated with Clearwater to a new entity which will subsequently go public. Encana plans to hold a significant stake in the new entity after the IPO, and will oversee leasing and other operational details. Clearwater assets are valued at between $1.80 billion – $2.25 billion based on annual revenues of over $200 million.
Competitively Well Positioned
Encana’s main competitors in the natural gas and oil industry include Apache Corp. (APA), Anadarko Petroleum Corp. (APC), Chesapeake Energy Corp. (CHK), Devon Energy Corp. (DVN), EOG Resources Inc. (EOG), Southwestern Energy Co. (SWN) and Talisman Energy Inc. (TLM). Despite being smaller than its competitors, Encana offers the third highest dividend yield of the group. The company also has the highest current ratio of 1.45; current ratio tracks a company’s ability to pay off its debt over the next 12 months. Management’s new strategy for the company should help improve operating margins and profit margins, where Encana ranks sixth relative to its peers.
Ukraine Crisis May Boost Gas Exports from North America
The political crisis in Ukraine and Russia’s standoff with Europe and the U.S. may lead to economic sanctions on Russia which could restrict natural gas supplies by Russia’s Gazprom, or Russia may unilaterally cut off gas exports to Ukraine and Europe. Moreover, Ukraine owes Russia almost $2 billion for natural gas already delivered and the crisis may cause Gazprom to shutoff supplies.
To fend off a blackout in supply, the U.S. Department of Energy (DOE) may approve exports to Ukraine and Europe, and companies such as Encana would greatly benefit from natural gas exports at higher prices.
Antitrust Charges Could Hurt Shares Near-Term
Encana and Chesapeake Energy (CHK) face charges of colluding to manipulate oil and gas lease prices in Michigan. Attorney General Bill Schuette began investigating both companies during the oil and gas leasing boom in the Collingwood Shale region of Michigan in 2010. An investigation found that executives from each firm met to discuss dividing bidding responsibilities for nine private landowners in Michigan. Encana and Chesapeake management deny any accusations of collusion and acknowledged a meeting about a possible joint venture in Michigan in 2010. Both companies are reported to be working on a settlement with Schuette and are expected to be arraigned on March 19, 2014.
If the companies are found to have violated the Sherman Antitrust Act, penalties could go as high as $100 million or more – which is an overhang on future cash flow though not significant over the long run.
For 2014, management expects total cash flow to be $2.4 billion – $2.5 billion, or $3.24 – $3.37 per diluted common share. In line with the company’s restructuring plan, 2014 capital investment is expected to be between $2.4 billion and $2.5 billion, with dividend cash outflow of $2 million.
Total production after royalties is expected to be 3,020 MMcfe/d – 3,250 MMcfe/d with natural gas accounting for roughly 86% of total production. Operating costs are expected to be $3.7 billion, of which $2.8 billion is for transportation and processing, and depreciation, depletion and amortization.
Joint Ventures Deliver Investment Capital, Royalties
In December 2013, Encana inked an agreement with marine services provider, SBM Offshore whereby SBM will operate Encana’s Deep Panuke platform in the natural gas fields off Nova Scotia, Canada. Deep Panuke has the capacity to produce approximately 300 million cubic feet of natural gas per day, with production likely to be sold to Spanish oil and gas company, Repsol SA (REPYY).
Encana entered into a joint venture with KOGAS Canada Ltd (KOG) in 2010. KOGAS has since invested over $675 million in the Greater Sierra and Cutbank Ridge locations in British Columbia. In 2011, Encana Oil & Gas entered into a joint venture with Northwest Natural Gas Company, which invested approximately $250 million in the Jonah, Wyoming, natural gas fields. In 2012 Encana inked joint ventures with Exaro Energy III LLC, Mitsubishi, Nucor Corporation, PetroChina (PDR) and ToyotaTsusho. Encana received investments with an aggregate total of $5.49 billion for interest in operations in Wyoming, Alberta, Colorado, and British Columbia.
Guidance Can Be Trusted
As the table below shows, Encana delivers within the range of its guidance. In 2013, Encana beat or hit almost all of its guidance parameters, such as delivering $2.6 billion in cash flow versus guidance of $2.4 – $2.5 billion, and achieving total production of 3.1 Bcfe/d, right in the mid-range of prior guidance.
For FY 2013, Encana had cash flow of $2.58 billion, or $3.50 per diluted common share, down 27% from $3.54 billion in 2012, primarily on lower hedging gains of $544 million versus $2,161 million in FY12. Operating earnings were down 20% to $802 million, or $1.09 per diluted common share. The company reported net earnings of $236 million compared to a net loss of $2.79 billion in FY 2012 when natural gas prices tanked.
Recent Operating Results
For Q4 2013, Encana reported net revenues of $1,423 million and a net loss of $251 million which was 214% higher than the net loss in the year-ago quarter primarily due to higher tax expenses. For the full year, revenues were $5.86 billion, with net earnings of $236 million, up from a net loss of $2.8 billion in FY12.
In Q4 2013, Encana had cash flow of $677 million, or $0.91 per diluted share, down 16% from $809 million, or $1.10 per diluted common share, in the year-ago quarter. The drop in cash flow was due to significantly lower financial hedging gains of $174 million versus $420 million in Q4 2012. Operating earnings were down 24% to $226 million, or $0.31 per diluted common share, due to lower natural gas production, higher transportation and processing expense and restructuring-related costs.
In the quarter, Encana produced 2,744 MMcf/d of natural gas, down 7% from 2,948 MMcf/d in the year-ago quarter, and total liquids production of 66 Mbbls/d, up 82% from 36.2 Mbbls/d in 2012.
As of December 31, 2013 Encana had proven reserves of 7,852 Bcf in natural gas and 220.8 MMbbls in liquids, for a total of 9.2 Tcfe. Compared to 2012, natural gas reserves decreased 11% while liquid reserves increased 5%.
The company exited the year with cash of $2.6 billion, net property of $10 billion and total assets of $17.7 billion. Long-term debt declined to $6.1 billion (from $7.2 billion a year ago) while shareholders’ equity was down modestly to $5.15 billion.
The company is under pressure to, and plans to lower its debt, which was 1.1x equity and 0.34x total assets. Encana plans to payoff about $1 billion in debt (which matures in May 2014) using cash on its balance sheet, and maintain an investment grade credit rating.
Encana shares are under pressure on negative Q4 GAAP earnings, recent antitrust charges and a show-me posture, with critics unwilling to give shares a boost on the restructuring plan and related execution uncertainty following missteps in the past. However, Encana’s restructuring plan is very bold with minimal downside, and makes this a great time to establish positions for healthy share price appreciation and sizable dividends, particularly after the Clearwater IPO and higher cash flow from the five liquids-rich areas. While the fourth quarter ended with a net loss, higher margin liquids and tighter operating efficiencies should turn the company to profitability over the next few quarters, following which shares will ride strongly higher.