The quarterly earnings cycle is behind us. Here are some quick notes:
1. There is a lot more stress in the exchange-traded debenture market. Many more companies (ones which had dubious histories to start with) are trading well below par value. I’ve also noticed a lack of new issues over the past six months (compared to the previous 12 months) and issues that are approaching imminent maturity are not getting rolled over – clearly unsecured credit in this domain is tightening. There’s a few entities on the list which clearly are on the “anytime expect the CCAA announcement” list.
Despite this increasing stress in the exchange traded debenture space, when carefully examining the list, I do not find anything too compelling at present.
2. Commodity-land is no longer a one-way trade, or perhaps “costs matter”. I look at companies like Pipestone Energy (TSX: PIPE) and how they got hammered 20% after their quarterly release. Also many gold mining companies are having huge struggles with keeping capital costs under control. Even majors like Teck are having over-runs on their developments, but this especially affects junior companies that have significantly less pools of financial resources to work with (e.g. Copper Mountain).
3. This is why smaller capitalization commodity companies are disproportionately risky at this point in the market cycle – we are well beyond the point where throwing money at the entire space will yield returns. As a result, larger, established players are likely the sweet spot on the efficient frontier for capital and I am positioned accordingly. I note that Cenovus (TSX: CVE) appears to have a very well regulated capital return policy, namely that I noticed that they suspended their share buybacks above CAD$25/share. The cash they do not spend on the buyback will get dumped to shareholders in the form of a variable dividend. While they did not explicitly state that CAD$25 is their price threshold, it is very apparent to me their buyback is price-sensitive. This is great capital management as most managements I see, when they perform share buybacks, are price insensitive!
4. Last week on Thursday, the Nasdaq had a huge up-day, going up about 7.3% for the day. The amount of negative sentiment baked into the market over the past couple months has been extreme, and it should be noted that upward volatility in bear markets can be extreme. This is quite common – the process is almost ecological in nature to flush out negative sentiment in the market – stress gets added on to put buyers and short sellers and their conviction is tested. Simply put, when the sentiment supports one side of a trade, it creates a vacuum on the other side and when there is a trigger point, it is like the water coming out of a dam that has burst and last Thursday resembled one of these days. In the short-term it will look like that the markets are recovering and we are entering into some sort of trading range, but always keep in mind that the overall monetary policy environment is not supportive and continues to be like a vice that tightens harder and harder on asset values – and demands a relatively higher return on capital.
I suspect we are nowhere close to being finished to this liquidity purge and hence remain very cautiously positioned. My previous posting about how to survive a high interest rate environment is still salient.
“While they did not explicitly state that CAD$25 is their price threshold, it is very apparent to me their buyback is price-sensitive. This is great capital management as most managements I see, when they perform share buybacks, are price insensitive!”
CVE’s latest financials indicate book value is just over $14/share. A large chunk of book value is the value of their resources, which is marked to strip pricing shown in their AIF. Major moves in prices from there will move book up or down, depending.
I think it is dubious to buy commodity companies at prices above book value. There is some cognitive dissonance in doing so since the present value of future reserves is already reflected in book value. Therefore, paying more than book implies that the buyer thinks that the company’s own valuation of future profits is too conservative. This applies to buy backs.
Any commodity company buying back its own shares above book is probably destroying shareholder value.
“A large chunk of book value is the value of their resources, which is marked to strip pricing shown in their AIF.”
This comment, if true, would have been a significant altering of how I believe such things are accounted for. If this is correct, repurchases above book would be throwing away money as you stated and it would be good for a post on providing corrections on my prior postings on buybacks.
The accounting rules do not change that often but sometimes there are changes that require some mental re-modelling (e.g. IFRS 16/Leases which inflates apparent profitability on an EBITDA basis compared to the prior measure).
Going back to oil/gas accounting…
Inventories (i.e. stuff already pulled out of the ground) is subject to write-downs (in the event it cannot be sold at net realizable value) and in some cases, write-ups. No argument there.
The value of the resources is not reflected in book value. The property, plant and equipment assets are “stated at cost less accumulated DD&A, and net of any impairment losses.” (from the audited financials, note 3n).
The oil and gas assets are: “Development and production assets are capitalized on an area-by-area basis and include all costs associated with the development and production of crude oil and natural gas properties and related infrastructure facilities, as well as any E&E expenditures incurred in finding reserves of crude oil, NGLs or natural gas transferred from E&E assets.”
In other words, it is historical cost and not marked-to-market as crude and gas goes up and down. The expenses incurred with exploration are capitalized and written off if they are a bust, or they are transferred to PP&E if successful and amortized “using a unit-of-production method based on estimated proved reserves determined using forward prices and costs and considering any estimated future costs to be incurred in developing the proved reserves.”
The base amount that is amortized is a reflection of historical cost spent to develop the resource, not the resource value itself.
There is other evidence to show this is not the case, for instance, the statements of comprehensive income (page 9) show relatively little movement over the past three years despite a wildly changing price environment.
These companies are not like REITs which have to revalue their assets every few years or so. A mechanism of re-valuation of the oil/gas PP&E asset is an impairment test if the commodity price environment tanks, or if the company decides to abandon future production (and even then, it can be reversed, such as what Whitecap did a year back, which wildly inflated their book value).
However, your point is taken in that the proven and probable after income taxes net revenue at a 10% discount is currently $48 billion, less than the current market cap of $54 billion – probably one reason why they are putting a $25/share ceiling on the buyback (implied market cap of $48 billion!).
Great answer Sacha.