Equity – Page 13

Whitecap’s acquisition of XTO Energy’s Canadian assets

Whitecap Energy (TSX: WCP) yesterday announced a $1.9 billion cash ($1.7 billion net of working capital) acquisition of XTO Energy’s Canadian operations, which involves a huge chunk of land and operating assets in the northwestern portion of Alberta, in addition to a gas processing plant. This deal is much more gas-weighted than liquid-weighted.

This deal works for Whitecap if we are in a “higher for longer” commodity price environment. They are acquiring an immediate 32 kboe/d asset at a relatively expensive price, but the lands they are acquiring have very good expansion potential, which they are targeting in 2023. In 2023, they intend to ramping up Capex from $600 million to approximately $1 billion, which means that they will be generating less free cash flow that year than they otherwise would have had they not made this acquisition. However, that would pay off in 2024 and beyond (perhaps when TMX is actually finished, and the SPR drawdown concludes and thus the WCS differential closes???)

However, this flies in the face of the general thesis for most oil and gas companies that they are generally in “maintenance” mode and they will be distributing the bulk of their cash flows to shareholders. In this particular case, Whitecap will be busy paying off the debt from the acquisition and will need the better part of 2023 to get back down to their end of Q1-2022 debt level ($1.07 billion). Specifically they will not be in the open market buying back stock over the next year. They do provide some clear milestones for shareholder returns (at a $1.8 billion debt, they will increase their dividend and at $1.3 billion, they will increase it to a projected 73 cents/share/year – projected at Q2-2023) – which would put them at an approximate 8% yield.

There is now a clear differentiation between companies that are in maintenance mode (spend the capital to maintain production, and then pay down debt and distribute proceeds to shareholders) and expansion mode. WCP is now clearly in the latter category. It works until the commodity price environment goes adverse.

The market has also soured on the deal – Whitecap traded down 6% for the day after trading initially higher. This is probably going to be a disincentive for other companies contemplating expansionary policies.

That said, if the “higher for longer” environment continues, the stock is looking cheap, along with the rest of the sector. But there is this ominous feel of the winds of recession coming, coupled with the potential end of the cycle of the industry.

In terms of valuations, it increasingly looks like that free cash flow multiples aren’t going to get much higher than present values, which suggests that the mechanism of returns for these companies will be in the form of total returns (the cash they will distribute to shareholders, coupled with the impact of open market buyback operations). It will also be very rocky.

The nature of risk has finally returned into the fossil fuel market.

Cenovus / Sunrise Oil Sand Acquisition – Analysis

Cenovus (TSX: CVE) today announced they are purchasing the remaining 50% interest in the Sunrise oil sands assets for C$600 million plus another C$600 million in contingent consideration, plus a 35% interest in the “Bay du Nord” project in Quebec, a currently undeveloped offshore project.

The contingent consideration is quarterly payments of $2.8 million for every dollar that Western Canadian Select is above CAD$52/barrel, for up to 2 years, and a maximum of C$600 million. Considering that WCS is currently at about CAD$130, this will work out to $220 a quarter. Barring a complete disaster in the oil sands, it is a virtual certainty the entire C$600 million will get paid out.

I have no idea how to value the 35% Bay du Nord project stake and will zero this out for the purposes of the following calculations.

Cenovus made a $56.20 netback in their Q1-2022 oil sands productions. Sunrise, not being the best asset on the planet, is about $15/barrel more expensive to operate and transport, so we will calculate a $41/barrel netback. However, the royalty structure is in pre-payout, compared to post-payout and hence netback will be higher by about $10/barrel. Very crudely (pun intended!) I estimate around $51 netback (estimated to last 7-8 years before the full post-payout rate kicks in). CVE will acquire 25k boe/d, so they are acquiring about $465 million of netback with $1.2 billion spent, or about a 39% return.

This does not assume that CVE will be able to scale up the operation to 60k boe/d as stated in the release, which would add another $186 million/year, or about 15% extra, ignoring the incremental capital costs of the project.

Tax-wise, CVE still has a $17.6 billion shield at the end of 2021, so the impact of income taxes will not kick in for at least a couple years. Even assuming full income taxes and ignoring the extra 10kboe/d production, CVE is purchasing something for a 30% after-tax return in today’s commodity environment. That’s pretty good for shareholders!

Birchcliff Energy – hiding in plain sight

Sometimes an investment stares at you in the face and it is so obvious that it makes you wonder why others do not see it this way.

This is the case with Birchcliff Energy (TSX: BIR). Now that it has appreciated well beyond its Covid lows, I’ll write a little more about it in detail. I’ve been long shares of this (both common and preferred) for quite some time.

In 2022 it will produce about 79,000 boe/d equivalent (exit 2022 at approx. 82,000 boe/d), of which 80% of it is in the form of natural gas. All of this production is in the northwestern Alberta area, right up to the BC border.

Thus, the primary driver for this company is the state of the natural gas market. It has exposure to Dawn, Henry Hub and AECO.

Birchcliff is an unusual company in that they do not host quarterly conference calls. Instead, they issue information through large press releases and make it very easy to look at the assumptions. Although I have no problem sharpening my pencil and doing the leg works to do a proper pro-forma projection given various commodity price environments, Birchcliff expedites this process considerably.

There is some fine print to wade through, but the point is that BIR will generate $910 million in “excess free funds flow” (effectively cash flows after capex and projected dividend payments) with the average commodity prices as displayed in the release.

Notably, spot WTI and the spot Henry Hub price is well above their assumptions (US$114 and US$9.2 as I write this). Dawn typically tracks Henry Hub. Let’s ignore that spot is higher than modeled rates in the press release.

$910M of “excessive free funds” translates into $3.43/share.

At Wednesday’s closing price of $11.56, that is 3.4x or a yield of about 30%.

Normally companies are constrained with leverage and debt servicing. At the end of 2021, Birchcliff had $539 million in net debt (which includes BIR.PR.C) and another $50 million for the redemption of BIR.PR.A. The redemption of the preferred shares will result in a $6.8 million annualized savings on dividends (3 pennies a share, every bit counts!).

This will leave the company with a positive net cash amount of $270 million at the end of the year (the “Surplus”), unless they decide to blow some money on acquisitions and the like. Importantly, the math does not have to be adjusted for a leveraged return (indeed, it has to be corrected in the opposite direction).

The company will also be making enough money to eat through most of its tax shield ($1.9 billion at the end of 2021) and start paying income taxes in 2023, if the current price environment continues. Still, at US$88 oil, and US$5.50 Henry Hub for 2023 assumptions, the projection is for $535 million or about $2/share in free cash flow.

The stated policy on what to do with the cash surplus is to dividend it out beyond that which is to be used for strategic purposes. Management does not appear to be big on share repurchases other than to offset dilution that which has been issued from option plans (which is a real cash cost and will drag cash flows accordingly).

They will increase the dividend to $0.80/year in 2023, which is a $212 million outflow. This dividend can be maintained at price levels that are unlikely to be seen barring a great depression.

If they dividend the rest of their cash flows, when plugging in current commodity prices, they can give out far more than $0.80/year in dividends. It would be closer to around $2.80, or about $0.70 per quarter. Needless to say, if this is what they did, the market would find the yield (24%) tough to resist.

This is a very similar situation to Arch Resources (NYSE: ARCH), where the company will be giving out half of its free cash flow as a dividend and the other half to buy back shares. Considering its Q2 dividend will likely be around US$11/share, the obvious value of a share buyback is apparent. I wish Birchcliff would more actively consider it, at some cut-off threshold. For example, they can buy back shares until the price gets to a point where it is at 15% projected long-term free cash flows, a very conservative metric for a beneficial buyback. Right now that would imply that buying back below $15/share will clear that hurdle. At 12%, that number is about $19/share. There’s quite a way to go from current market prices.

None of this is a huge secret. It’s all in plain sight. It all relies on elevated commodity prices.

In a rising rate environment, cash flow talks – ARCH’s payout phase

“How much should I pay for the equity” is an easy question to ask, but computing all of the variables to come up with a range of prices is not so easy.

One of the components is the rate of interest. As interest rates rise, you want your cash flows today instead of tomorrow.

For instance, if your high tech company will give out a billion dollars in cash 10 years from today, the rate of interest has a significant effect on today’s capitalized value.

At 1% your billion dollars of cash 10 years out translates into $905 million.

However, at 3%, that same billion dollars turns into $744 million, or about an 18% difference from the above.

This is one reason why long term government debt has been decimated as of late. For instance, the TLT ETF (with an average term to maturity of 26 years) from the local peak at the beginning of December to present has rendered investors a 21% loss. The higher the long-term yield goes, the more damage that gets priced into the capital value. This is only mildly tempered by the 2.47% coupon and 3.01% yield to maturity – in other words, all things being equal, you would have to wait 7 years to recover the loss.

The converse is true for entities that will give out cash today instead of tomorrow.

Arch Resources reported their first quarter results today. There is a lot of details to digest, but the obvious headline is the declaration of a $8.11/share dividend, which is the result of their capital allocation policy to give out half of their free cash flow in dividends, while retaining the other half for other general purposes.

With the price of coal, both metallurgical and thermal, being sky-high as a result of a huge confluence of events (chronic under-investment, ESG, Russia/Ukraine, Australia/China, and overall demand for steel production), Arch and other coal producers that are still able to produce (this is the key – they need to have functional mines and not promises to build them) are making a fortune in free cash flow.

This quarter alone, operating cash flow minus capex was $271 million. This number was smaller than it otherwise would have been due to logistical constraints on the railway that serves the company.

In Q2, this number will be increasing because they will be able to further restore rail capacity, coupled with the average realized price to likely be higher.

My rough estimate for Q2’s dividend will be about $11.60/share, but this depends on certain variables being achieved. Barring a complete and total collapse of the commodity market, it will be around that figure.

However, to be “conservative”, let’s use the previous number – $8.11/share. Multiple this by four times and you get $32.44/share annualized. At Monday’s closing price of $131.32, that represents a yield of 24.7%.

Realize that the dividend represents half of the free cash flow available to the company before a reclamation (asset retirement obligation) reserve.

Obviously the stock market is going to find a 24.7% annualized yield to be very difficult to resist, no matter how vilified the sector of the company is. Pension funds, with both broad exposure in an equity market that is down about 12% year to date and a long bond market that is down 16%, have gotten murdered this year. They need an avenue for returns. The temptation is going to be too much for them to avoid.

Not surprisingly the stock market has decided it was too much to resist and Arch is up about 20% as I write this post. The yield at the implied $32.44/year dividend is now down to 20%.

The question is how much temptation there will continue to be going forward. Will yields compress to 18%? 15%? 10%? This really depends on how desperate the market is for a return, coupled with their impression on how durable the coal market is.

At the current pricing of coal, however, Arch will pay back its entire enterprise value to investors (either through dividends or share buybacks) in a couple years. Needless to say, this beats Microsoft equity which has a total return of 4%, based off of analyst estimates on their upcoming fiscal year ended June 2023.

Going back to my original topic of interest rates and cash flows – in a rising rate environment, present cash flows talk bigger than the promise of cash in the future. Arch (and other fossil fuel companies) is going to be a demonstration why.

A happy problem is to decide how to re-invest the cash flows. Internally for Arch, after building up a sufficient cash reserve, they will likely engage in some sort of equity buyback which will further juice up the stock price. So they are already making part of the decision for you with their cash flow, although there is a diminishing returns aspect to this decision (inevitably they will buy back too many shares at too high a price, like they did in 2019). It doesn’t mean that you have to re-invest your dividend into them – indeed, it would probably be a better time than to be stockpiling the cash for stormier days.

Atlantic Power – after the buyout

It’s always interesting to see what happens to companies after they get bought out. It makes you wonder whether the price you are receiving is well-deserved or not.

In the case of Atlantic Power, they were bought out for approximately US$270 million plus the assumption of debt (not a trivial amount, roughly US$560 million).

I was just doing some checking up and noticed that Innergex bought the Curtis Palmer hydroelectric project. They paid US$318 million, which implies an EBITDA multiple of about 7.5x.

This was the gem of Atlantic Power.

I also notice they inked a deal with New Jersey to decommission their only coal plant (a 40% economic interest) at Chambers effective May 2022, where they would have received a capitalized value of the remaining power purchase agreement. This PPA was set to expire in 2024. I’m not sure exactly how much the payout was, but I would estimate it would have been around US$80-90 million.

This leaves 19 projects remaining, consisting of biomass, natural gas and hydro generators.

Atlantic Power was a very interesting company to analyze, and run by top-grade management that I would follow in a heartbeat if they decided to manage another public company.