Large Cap Canadian Energy

A briefing note. I do not think any of this thinking below is original by any means, but it needs to be said.

On May 26, Suncor (TSX: SU) guided at WTIC US$60 in 2021 and US$55 in 2022 (which is presently US$68 and US$62 for the year-end contracts, respectively) a free cash flow of $7 billion. This is after a $3 billion capital expenditure in 2021.

The guidance was notable in that the 9 megabyte slide deck they provided went through great pains to downplay the amount of cash they actually were going to generate (in typical Canadian fashion, it is like they are embarrassed to admit they are making this much money), but let’s play along.

Suncor’s enterprise value is about CAD$60 billion, about $45 billion market value and $15 billion debt.

Let’s do some basic math. This is grade school finance.

It means if the company can produce cash at the present rate (which, in general, they can given the nature of what they are mining at the present capital expenditure rate), if directed to debt and equity, they will be able to pay off all their debt and repurchase their entire share stack (at current prices – it will rise over time) in 8.5 years.

This doesn’t include changes in the selling price of oil, which the above figure is currently below market.

This is a little more complicated to calculate the sensitivity to commodity pricing. Companies give out sensitivities and for every dollar on Brent (not quite WTIC, but deeply correlated), Suncor changes its funds flow through operations by about CAD$300 million. Very roughly, subtract royalties and taxes (no more tax shield, they made too much money already) and it is about CAD$200 million leftover.

I note that at current pricing, an $8 positive oil price difference over the model (note: do not confuse with the Canada/USA differential) changes the 8.5 years alluded to above into about 7 years.

You just need to make the assumption that oil pricing will stay steady.

If this is the case (or heaven forbid, oil rises even further), Suncor is ridiculously undervalued.

This doesn’t even factor in the WCS/WTIC differential, which is likely to close once Line 3 is completed (end of the year) and TMX is finished (2022?). This will be the freest money for all stakeholders involved. An extra US$5 off the differential (it is now about US$15) on Suncor’s capacity is about US$1.5 billion a year – suddenly 7 years now becomes 6 years.

Not surprisingly, the company is buying back stock like mad, probably because there isn’t anything else they can really do with the excess cash flow.

In the past couple months, they’ve bought back US$375 million in stock, 17.2 million shares (about 1.1% of the outstanding). They should aim to buy back the maximum they can at current pricing.

As this continues, the stock price will rise and make future buybacks less attractive. After the appreciation, they should jack up the dividend.

Normally businesses would also invest in capital expenditures, but in Canada, we are closed for business for any significant natural resource projects. We mine what we have left, which makes the decisions easy – harvest cash.

What is the thesis against this?

The obvious elephant in the room is the sustainability of oil pricing.

I have no doubt in 100 years from today that fossil fuel consumption, one way or another, will be seriously curtailed. It will likely be too expensive to use in most applications that we see today.

But in 8.5 years? Get real. Oil sands reserves are measured in decades.

The other obvious component of “Why are they letting me have it so cheap?” is political correctness in the form of ESG. Much demand is sapped because of this. Many institutions cannot touch oil and gas, including Berkshire Hathaway.

Eventually through buybacks and dividend payments, the market will adjust this.

The margin of safety here is extremely high and nothing comes close in the Canadian marketplace, at least to anything with over a billion dollar market cap.

The same reasoning above also applies to Canadian Natural Resources (TSX: CNQ) and Cenovus (TSX: CVE). They are also in the same boat in terms of their FCF/EV valuation, and also with similarities in their operations. Once they reduce leverage, they will be buying back stock like crazy if it is still at the current price. I don’t know how long this will last.

Sometimes things are so obvious in the markets you really wonder what the trick is, but with this, it is the closest thing I can think of picking up polymer cash notes on the street. Efficient market theory would tell me that those cash notes wouldn’t be there. Perhaps traditional finance theorists might be right, we will see. At least I can take some solace when I am at the gas station and seeing record-high prices.

Verticalscope IPO

I’ve got it give it to the people that bought the Toronto Star back in May of 2020, they got a very low valuation which assumed the residual business was relatively worthless (the company had a lot of cash on the balance sheet and the pension debts weren’t too onerous). They really cashed in the middle of the COVID-19 crisis.

However, never in my mind did I anticipate that they’d be able to bring public their Verticalscope subsidiary (TSX: FORA) for triple the value that they bought Torstar for.

My, oh my, are the founding shareholders of Torstar probably feeling like they got ripped off.

Skimming the Verticalscope June 14, 2021 prospectus, we see a corporation that is flat on revenues (approx. $57-58 million/year in 2020 and 2019) and capitalized with about $100 million in debt on the balance sheet. The net debt will be gone with proceeds from the public offering. The entity does generate cash (about $14 million in operating cash flow in 2020) but overall it isn’t exactly what one would consider to be a huge money-winner, especially given what has been invested in it.

The business itself is a collection of online properties. It is a faint resemblance of what the Yellow Pages (TSX: Y) was probably trying to originally execute on their “digital strategy” before management (rightly) corrected that course from 2017 onwards. And just like Yellow’s original digital strategy, it’s likely they’ll use their enhanced liquidity position and/or their stock to acquire more online properties.

Indeed, one of the businesses that Verticalscope owns, Red Flag Deals, was sold to them by none other than the Yellow Pages.

Verticalscope extensively uses the phrase “adjusted EBITDA” to justify valuation and it indeed appears that investors are happy to overlook all the adjustments. At least with the IPO, there won’t be much in the way of interest expenses anymore.

It won’t be myself buying shares of this offering. I really wonder what the thought process of the institutional managers that do, or people that bidded it up another 10% on the after-market trading today!

Late Night Finance with Sacha – Episode 13

Date: Thursday June 10, 2021
Time: 6:00pm, Pacific Time
Duration: Projected 60 minutes.
Where: Zoom (Registration)

Frequently Asked Questions:

Q: What are you doing?
A: It’s been about two months since the previous one, so I will be chipping off some rust, but also discuss various economic developments that have caught my eye in addition to other salient observations. There should be some time left for Q&A, so please feel free to ask them on the zoom registration.

Q: How do I register?
A: Zoom link is here. I’ll need your city/province or state and country, and if you have any questions in advance just add it to the “Questions and Comments” part of the form. You’ll instantly receive the login to the Zoom channel.

Q: Are you trying to spam me, try to sell me garbage, etc. if I register?
A: If you register for this, I will not harvest your email or send you any solicitations. Also I am not using this to pump and dump any securities to you, although I will certainly offer opinions on what I see.

Q: Why do I have to register? I just want to be anonymous.
A: I’m curious who you are as well.

Q: If I register and don’t show up, will you be mad at me?
A: No.

Q: Will you (Sacha) be on video (i.e. this isn’t just an audio-only stream)?
A: Yes. You’ll get to see me, but the majority will be on “screen share” mode with my web browser and PDFs from SEDAR as I explain what’s going on in my mind as I present.

Q: Will I need to be on video?
A: I’d prefer it, and you are more than welcome to be in your pajamas. No judgements!

Q: Can I be a silent participant?
A: Yes. I might pick on some of you though. Bonus points if you can get your cat on camera.

Q: Is there an archive of the video I can watch later if I can’t make it?
A: No.

Q: Will there be a summary of the video?
A: A short summary will get added to the comments of this posting after the video.

Q: Will there be some other video presentation in the future?
A: Most likely, yes.

Corvel Corp – Annual Report

Corvel (Nasdaq: CRVL) announced their year-end results (10-K). The company has such fanfare that it has precisely zero analysts following it, so the automated news generators couldn’t even tell you whether they ‘beat’ or ‘missed’ expectations. There are few (USA) domestic companies that have billion dollar market capitalizations that have zero analyst coverage.

Their fiscal year ends on March 31st, so this was their Covid year. Revenues dropped about 7%. Margins, however, remained consistent. They made reference in their last quarterly conference call to streamlining real estate leasing costs as they were able to seamlessly ‘go online’. This can also be seen in the recent dramatic drop in IFRS 16 asset/liability for leases vs. the previous quarter. Year-to-year, lease obligations are down by half, and this is explained by the company projecting that renewals will not be exercised.

The company has nearly doubled in share price since last year. Valuation-wise, they are at about 50 times the previous twelve months of earnings. Needless to say, this appears to be rather rich, but the earnings should accelerate in the upcoming fiscal year as employment in the USA continues to expand, especially as Covid supports terminate.

Although it looks like that revenues and net income has flat-lined over the past three years, there will likely be an upward trajectory going forward. In addition, note the historical ROE numbers of 20%+. The ROE number next year will be down as the amount of cash on the balance sheet will serve to be a drag on the denominator, but this will likely be transitory.

I also believe the stock has been a positive recipient of automatic index buying. Trading of the stock is thin, with spreads typically a dollar or so. The company is currently on the S&P Smallcap 600 index, although it is well below the liquidity threshold for the index. Their market cap, over $2 billion, is creeping up to the point where they are getting into mid-cap territory.

Historically, the company has engaged in a capital allocation policy of repurchasing shares (they repurchased approximately 100,000 shares, or about half a percent of their shares outstanding in the past quarter at an average of US$104). Despite this, the company has been building up cash on the balance sheet, and the US$140 million they have at fiscal year end is an all-time high. I do not think management is of the type to suddenly declare a treasury policy of purchasing Bitcoins with spare US dollars. They also have little use for excess capital – they continue to engage in the usual R&D that software companies should be doing. In a paradoxical sense, this lack of capital reallocation is a negative in that the corporation cannot “snowball” retained earnings into more fruitful endeavours (unlike an acquisition machine like Constellation Software (TSX: CSU)). CRVL management is very happy to stay in their niche and only make the tiniest steps outwards from their strategic niche.

Operationally, they are in a dominant position, which explains the valuation. Indeed, when compared to companies like Constellation, they are trading at 85 times past earnings. On an absolute level they are expensive, but relatively speaking, it is in the ballpark. Another metric is price-to-sales, and also this makes Corvel cheaper than CSU. I would make the claim that CRVL’s niche has a much stronger competitive moat and justifies a premium valuation as a result. Their management is even more reclusive than CSU’s Mark Leonard. This is a trivial analysis, but a few of the factors swimming in my head when I look at this company in my portfolio and wonder if I should reallocate.

For many reasons, I will not be. I do not know what price the shares will rise to before I say enough is enough and seriously think about the sell button. I can easily see them staying where they are currently for a lengthy period of time, but I can also see reasons for them to head up to $200 and higher.

My only regret was not picking up a little bit more when I did, but at that time in the Covid crisis, there were many other things floating on my radar at the time. This is probably the least dramatic investment in my portfolio at present. They consume a disproportionately lower amount of attention in relation to their size in my portfolio, which is in the top 5.

When will Cenovus or CNQ buy out MEG Energy?

MEG Energy (TSX: MEG) is an oil sands producing company with a very good asset – it occupies a prime bitumen producing location at Christina Lake, Alberta. The type of mining is the typical steam-assisted gravity drainage project that, one you put in the required capital expenditures and intellectual prowess, has a relatively low rate of decay. It will produce for decades.

Geographically speaking, the company is out of options. There’s little in the way of synergies as they are surrounded by Cenovus and CNQ’s properties. There isn’t much of a choice beyond optimizing the primary asset they own (which is very valuable) and generate cash. The asset will be producing for decades.

They are properly capitalized – approximately US$2.3 billion in debt securities, with maturities on 2025, 2027 and 2029, in addition to an undrawn credit facility. They made some (retrospectively) stupid hedges on WTI which will cost them a few hundred million in lost opportunity costs in 2021 (approximately a third of their production is hedged at US$46 WTI), but they claim this was to fund the existing year’s capital budget in the event that crude crashed. CEO Derek Evans was formerly the CEO of Pengrowth Energy, and the only reason why Pengrowth lasted as long as it did before it was unceremoniously bought out for 5 cents a share was because they hedged a ton of production before oil prices tanked.

After Line 3 and TMX become operational, egress issues will likely subside and at current prices, they will be generating a significant amount of cash. While they do not give out dividends at present, it probably won’t make much difference in the end equation – they are likely to get consolidated by one of the two in the title of this post.

Notably, MEG rejected a hostile takeover from Husky in 2018 (which was offered at a higher price). From a strategic perspective, Cenovus (which took over Husky at the beginning of this year) would make the most amount of sense – they would own the majority of the bitmuen complex around Christina Lake. They have been busy digesting the Husky merger, but there’s probably ample room for a stock swap. MEG at the end of December 31, 2020 also had a $5.1 billion non-capital loss carryforward, so this would survive a merger and constitute a non-trivial tax asset for an acquirer.

This analysis is by no way a secret – they have been a logical target for ages. We will see.