Category: Equity

Corporate earnings for the quarter – Oil and Gas

The next couple weeks will be busy processing quarterly earnings reports.

Oil and gas, however, will be the most interesting. There will be a bonanza of cash flows.

MEG Energy (TSX: MEG) was the first off the bat.

I’ll spare the details and focus on the following line in their PR:

Based on the current commodity price environment, MEG anticipates generating approximately $275 million of free cash flow in the second half of 2021, which will be directed to further debt repayment.

Just below that they talk about one of the worst hedges I can think of, which was to hedge for oil prices in Q2-2020 in a US$39-46 WTIC band. They have about 1/3rd of their production hedged at this level (29k BOE/d) which has lost them a gigantic amount of money. Fortunately it is done after the year is over, but it will be another $125 million of damage (lost potential) at current prices. The hedges cost them nearly half a billion dollars in lost opportunity in the first half of the year.

Adjusting for their hedge disaster, the “true” projected free cash for the second half is closer to $400 million.

Considering the enterprise value of the company is around $5 billion, that’s trading slightly above 6x EV/FCF. This isn’t a case of some US shale driller with a 35% annual decline rate – MEG’s asset is much longer lasting.

MEG currently does not give out a dividend. They are pouring free cash into reducing their debt – they announced they are paying back US$100 million of their existing US$496 million 6.5% senior secured second lien notes (matures 2025). At the rate cash is being generated, they will be able to retire debt this sometime in 2022, and after they will be able to work on the US$1.2 billion 7.125% senior unsecured notes. This tranche matures in 2027.

If oil stays at current pricing, the debt gets removed pretty quickly (in addition to saving money on interest expenses).

Eventually there is a point where it becomes logical to buy back stock, assuming they stay at 6x EV/FCF. It’s a matter of whether management wants the sure 6.5 to 7.125% return, or whether they want to buy back stock at a 16% return on equity.

I speculated that somebody else might be happy to do that for them.

Virgin Galactic – Cool but economically challenged

I wrote back in 2019 about the original SPAC that took Virgin Galactic (NYSE: SPCE) public and my thoughts haven’t changed much from today.

Indeed, they had their hype – astute traders gamblers have seen their capital go from $10 up to $35, down to $15, up to $60, down to $15, up to now $50, in what is oddly like the trajectory the Virgin Galactic spaceship flies itself.

Today the main headline is Richard Branson flying out in one of those spaceships, in what was a massive marketing exercise – I bet Branson was jealous of all of the hype that Elon Musk was stealing over the past few years.

Much to their credit, the rocketship flight made it – they got their 70 seconds of propellant out and made it to the height of about 280,000 feet (or about 85 kilometers above the ground).

The marketing exercise is caused by the perverse anticipation of disaster, similar to how some people watch automobile racing to see car crashes.

This is all great and everything, and SPCE is likely going to trade up Monday morning, but I deeply suspect it will be a great time to short the stock. I will not be – I only mentally trade these sorts of situations with a million eyeballs and daytraders that will inevitably be crowding around the stock.

The issue is that the while the venture tries to do cool things, from an engineering perspective sending a craft out 85 kilometers over the surface is much, much more trivial than it is to send it to a practical altitude (low earth orbit) with the energy required to keep it there – Virgin Galactic’s ship just requires it to go up, and it glides to the bottom. A rocket ship going into low earth orbit requires it to go up (for example, the international space station is about 420 km above the surface), but also horizontally (about 28,000km/h) to keep it in perpetual free-fall. This requires a lot more energy to perform, and a lot more engineering with the design frame and engines which need to scale up disproportionately in order to haul these loads into orbit (mainly to handle the amount of fuel required to get there). This isn’t a matter of “extending the frame” to fit further usages – that design is hard-wired.

Amazon’s Jeff Bezos’ Blue Origin has a different system, the New Shepard rocket ship (which unlike Virgin Galactic, starts on the ground instead of on an airplane), which is designed to send people in a capsule up to around 105km – with a 110 second rocket burn. They will launch in just over a week. The same analysis applies to them as well. Scaling up to a point where you can do SpaceX-type activities requires a lot more engineering than slapping on a few extra engines and increasing the size of the fuel tank.

As such, the Virgin Galactic ship, as currently designed, has little use other than a tourism vessel. This was the intent of the design, the company was not meant to be other than an amusement factory. Cool but useless – and it’s a business model that almost guarantees there will be no repeat customers, similar to the skywalk at the Grand Canyon.

Briefing note on Arch Resources

For historical context, read my December 2019 post on Arch Coal where I give a primer on coal mining and discuss Arch Coal.

This is a short briefing update on the renamed company, Arch Resources (NYSE: ARCH).

My timing from the December 2019 post was a bit botched up – indeed, at one point I exited the entire position (during the Covid crisis) but later took a very healthy position at lower prices than they are trading at today. It is a large but not gigantic position currently. I am expecting it to get larger by virtue of appreciation.

Between then and now, other than Covid-19, the other major setback they hit was the regulatory blocking of the merging of their Powder River Basin thermal coal operation with Peabody Energy. This probably cost the company tens of millions of dollars a year in synergies.

It also turned out that they engaged in poor capital allocation. They bought back way too many shares in the 2017/2018 coal boom and were forced to tuck their tails behind their backs when doing some subsequent debt and convertible debt financings to fund the $390 million Leer South Project, but it appears that path is now clear and the need for future capital is gone.

The reason for this is that the Leer South project is due to be operating in Q3-2021 and this project, at current met coal pricing, is going to make a ton of money. The project is anticipated to generate 4 million tons of High-Vol-A coking coal a year for the next couple decades.

Right this very second (partially instigated by the trade war with Australia), prices to China are around US$300/ton. Indirectly, demand from China will continue to suck supply from other suppliers of the world.

Because shipping tens of thousands of tons of material is not an easy feat, transportation logistics became a ‘weighty’ issue. There is a limited capacity to transport from an eastern inland mining area (West Virginia) to the west coast (typically Long Beach, CA), and then onto a freighter across the Pacific Ocean. The opportunities for westward export are limited (indeed, Teck is making a fortune doing this from Elk River mines in southern British Columbia). As a result, the prices that ARCH will be receiving will be well less than US$300/ton, but it will be significantly higher than the averages received in 2019-2020.

High Vol-A, from what I can tell, is around US$190 spot currently. At that price, Leer South, once completed, will contribute an incremental US$500 million or so at existing pricing to the entity, in addition to the existing metallurgical operation. This is crazy amounts of money. Also, by virtue of the entire coal industry being decimated, competitors will have to take their time to open up more met operations (looking at Warrior Met Coal (NYSE: HCC) here), so Arch will eat up the lion’s share of marginal met coal dollars.

There is a lag effect between when coal is mined and when it is sold – contracts and deliveries have to be signed quarters and years in advance, so the pricing seen on GAAP statements will not be see until well after the economic substance of such transactions is actually performed. You can sort of see this being factored in the existing share price (which is the highest it has been since the Covid crisis) but my question will be what sort of valuation the market will ascribe to the company when they generate around $15-20/share next year (current analyst estimates are $7.63). Ultimately it depends on how much this boom for steel production (the primary driver of metallurgical coal consumption) continues world-wide.

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.