CA - Yangarra Resources: Profitability Increase Through Cost Reductions

2023-08-28 12:15:36 ET

Summary

• Yangarra Resources Ltd. management has announced major cost reductions.
• The company was already very profitable before those cost reductions were announced.
• Depreciation expenses will decrease over time as more wells come online at the new costs.
• Lease Operating Expense is likely to show a cost reduction much faster.
• The benefits of the stock sale were not immediately apparent due to a severe winter followed by wildfires and Spring Breakup.

Yangarra Resources Ltd. ( YGRAF ) has gotten production past that important 10K BOED level of production. This often allows management to become more efficient and reduce costs. Therefore, it should come as no surprise that management announced major cost reductions during the quarter while continuing to grow production. The company was already very profitable before the announcement. The announcement is likely to increase that profitability and lead to greater cash flow generation.

(Note: This company reports in Canadian dollars unless otherwise noted.)

As the company grows production, more can be done internally to increase the profitability of each well drilled. Now, the older production with those wells drilled using more expensive outside services is still there. But as more new wells are drilled at the new pricing structure, company profitability should increase as the number of lower-cost wells becomes more significant. As investors, it should become significant to the quarterly reporting, probably within a fiscal year (or two at the latest).

The costs do not immediately come down because there is a startup process. That process was likely influenced by the wildfires and winter weather (among other things) that were largely beyond the control of management. Therefore, it is not all that unusual to see the costs shown above despite the cost reduction announcement.

Depreciation, in particular, is unlikely to change quickly because there are a lot of costs with various ages in that depreciation amount. Therefore, seeing the reduction in drilling and completion costs will take time.

Operating costs, on the other hand, will more likely decline faster as they are current costs, and therefore cost reductions often appear in the near future (like next quarter).

In summary, management often has a handle on cost reduction before the reports show the impact of those reductions. The time to show the impact will vary with the particular cost.

Forward Valuation Just Got Cheaper

If the cost reductions reported by management flow through to the balance sheets as they should, then the forward valuation of the company becomes even better.

As cost drop along the lines that management expects, the reported corporate valuation will increase because cash flow, EBITDA, and reported earnings will all grow over time.

The measurements shown above are based upon past results (and are already a good deal). Now management expects to report more profitability throughout the business cycle at various commodity prices before taking into account that management also intends to grow production more.

Small companies can remain a bargain for a long time. But the intention to grow production by management should mean that at some point, this management will attract enough attention that valuation should improve.

Debt

This is that rare company that was able to dig itself out of the perceived debt hole while still growing production.

Management expects to reduce debt in the current fiscal year. Now, it is also true that some stock was sold in the current year to raise cash. But the company has also had to deal with a very harsh winter that restricted operations and wildfire issues that temporarily reduced production. Otherwise, that sale of stock would have had a more apparent effect.

The original game plan appeared to be to use the stock sale to increase production during the important winter months. That would have led to a lot more cash flow throughout the fiscal year. But mother nature had other ideas that really cancelled the original plan out in a big way.

What appears to have happened instead is that production is growing, even if later than planned, and management purchased more items while expanding some internal departments to reduce costs, even if that also is lagging plans.

But then again, when you have to deal with the weather, then delays like this happen.

What is likely important to the lenders is that debt was reduced. Lenders usually do not care how that happens. So, the debt reduction priority continues. Management is also showing the lenders growth, even if that growth is on the tardy side. Then there is also the cost reduction (again, even if that is a little later than expected).

One thing about debt is that debt has to be serviced no matter what happens. The debt market has really changed considerably over the last few years. This management appears to be accommodating that change while growing production. Most companies in the industry did accretive acquisitions to accomplish the same thing. Here that was not necessary.

Profitability

Management has built an unusually profitable small company. That profitability appears set to increase with the announcement of more cost reductions.

This company made money in fiscal year 2020. That is an accomplishment that few companies can boast of. Most upstream companies in fiscal year 2020 "lost their shirt." They were not close to anything remotely profitable.

Management followed up that fiscal year 2020 with some leading profitability reports after that. The profit margin remains unusually wide. The fact that management repaid debt while growing production also points to unusual profitability along with large amounts of cash flow for the size of the company.

Return on capital employed likewise appears to be among the highest of any company I follow.

Summary

This management and the board have considerable experience building and selling companies. That experience shows itself as one very profitable low-cost operator.

This company is likely to remain a growth story for the time being. Therefore, income investors can look elsewhere.

The company is a strong buy consideration for those willing to forego current dividends in exchange for a capital appreciation story. The company profitability, management experience and low debt all lower that small company risk. The low stock price valuation shown above also lowers the risk of principal loss long term.

Low price-earnings ratio strategies have long been shown to outperform the market. However, at the micro-cap level, such a strategy can take a while to perform as expected. This is why it's important for small companies to be growing before you invest. Small companies otherwise can remain a bargain for a very long time, whereas a growing company should eventually become large enough to attract institutional attention.

Most likely management will sell this company at the right price when the time comes. But until that time arrives, investors can expect management to continue to grow the company.

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