2024-01-18 16:15:17 ET
Summary
- Baytex Energy is a Canadian driller with a dual listing in Toronto and New York, focusing on oil production and transitioning to a healthier state.
- The company has improved its business in recent years, achieving operational efficiency and productivity, increasing shareholder returns, and introducing a dividend.
- Baytex Energy has a clear plan for debt reduction, distribution of free cash flow to shareholders, and aims to generate significant free cash flow in the future as oil prices increase.
All financial numbers in this article are in Canadian dollars unless noted otherwise.
Introduction
In the past few quarters, I started to expand my coverage more rapidly, including new healthcare companies, industrialists, and energy stocks.
For example, during the Holidays, I covered ARC Resources ( ARX:CA ), a Canadian natural gas driller with deep reserves, a healthy balance sheet, and a focus on shareholder distributions.
In this article, I'm covering a company I found a few months ago. That company is the Baytex Energy Corp. ( BTE ) , another Canadian driller.
However, unlike ARC Resources, the company has a dual listing in both Toronto and New York, a production mix focused on oil, and a business that is currently transitioning to a healthier state, increasingly capable of distributing massive amounts of free cash flow to shareholders.
Although I would not put BTE In the same category as my favorite oil play , Canadian Natural Resources ( CNQ ), I believe the company is a fascinating small-cap play with tremendous upside potential once oil prices start a meaningful uptrend, backed by recovering economic growth.
So, let's dive into the details!
A Significantly Undervalued Turnaround Story
Founded in 1993, Baytex Energy is a Calgary, Canada-based upstream company engaged in the production of heavy oil, light oil, natural gas liquids ("NGLs"), and natural gas.
To give you a short chemistry lecture, heavy oil is oil consisting of heavier hydrocarbons that have longer carbon-plus-hydrogen molecule chains.
It is a denser form of oil, which flows slower. Generally speaking, it is cheaper to buy for refineries (who turn it into value-added products) but more expensive to refine.
Furthermore, with a market cap of $3.5 billion, the company is certainly not a small player. However, it dwarfs in comparison to the "big guys" up north, including Canadian Natural, Suncor ( SU ), and Cenovus ( CVE ).
Baytex Energy
Over the past two decades, the company has executed several deals to expand its drilling inventory, including the 2014 acquisition of Aurora Oil & Gas, which led to a significant new position in the Eagle Ford shale play in Texas.
In 2018, it bought its Canadian peer, Raging River, to expand its Canadian assets.
Last year, on June 30, the company announced the closing of its Ranger acquisition, which added more Eagle Ford exposure to its portfolio.
Unfortunately, due to overly opportunistic deals with questionable timing (in hindsight) and significant oil and gas price headwinds before 2021, the company's stock price history looks horrible.
The company's stock price looks like a banking stock during the Great Financial Crisis, with the 2014/2015 period of imploding oil and gas prices comparing to the downfall of Lehman, Bear Stearns, and others in the previous decade.
In other words, for long-term investors, BTE has not been a great pick, to put it mildly.
Luckily, like most oil and gas companies, BTE has improved its business in recent years.
We're now dealing with a much healthier and more focused company.
As we can see in the business overview above, the company currently produces more than 150 thousand barrels of oil equivalent ("BOE") per day. 84% of this consists of liquids.
While I do like the long-term outlook for natural gas, I do like to keep a focus on oil and liquids, as I believe that the supply situation in that area is more bullish than for natural gas.
For example, the quality of U.S. shale oil, which was the driver of supply growth after the Great Financial Crisis, is quickly deteriorating, which is boding very well for oil prices and players with deep reserves.
International Energy Forum
Baytex currently has close to 700 million BOE worth of reserves, which translates to roughly 13 years of production at its current run rate of 150,000-156,000 BOE per day.
Baytex Energy
Needless to say, this excludes any new discoveries.
The company has hedged roughly 40% of its production for the first half of this year with a floor of US$60 and a ceiling of US$100. After 2Q24, the company's hedges drop to 20% by the end of the year.
It is also increasingly efficient.
During the third quarter, Baytex achieved notable success in various operational aspects.
For example:
- The company delivered top-quartile results from its operated Eagle Ford assets, showing operational efficiency and productivity.
- The Clearwater results at Peavine were exceptional, with Baytex holding the top 30 wells drilled across the entire Clearwater Fairway.
- Additionally, the Pembina Duvernay play witnessed significant progress, with six wells drilled and completed, meeting performance expectations and contributing to the company's overall operational success.
Baytex Energy
Even better, following the aforementioned Ranger acquisition, Baytex increased its direct shareholder return to 50% of free cash flow, resulting in a strengthened share buyback program and the introduction of a dividend.
BTE shares currently pay $0.0225 per quarter, which translates to a 2.2% yield.
Through October 31, 2023, the company repurchased 28.1 million shares for $155 million, which translates to 4.4% of its current market cap.
As we can see in the overview below, BTE has a clear capital spending plan:
- As long as its total debt load is above $1.5 billion, it will distribute 50% of its free cash flow to shareholders through its base dividend and buybacks.
- Once net debt is below $1.5 billion, it will boost distributions to 75% of free cash flow, which lets it compete with some American peers like Diamondback Energy ( FANG ), who have similar plans. The larger Canadian peers I mentioned earlier in this article have distribution plans of up to 100% of FCF.
Baytex Energy
As of September 30, 2023, Baytex's total debt stood at $2.7 billion, translating to a total debt-to-EBITDA ratio of 1.1x, which is a stable financial leverage position.
Despite a temporary increase in total debt relative to the previous quarter, attributed to currency exchange effects and working capital adjustments, Baytex anticipates exiting 2023 with approximately $2.5 billion in total debt.
Baytex Energy
It also has no maturities until 2027, which buys the company a lot of time. By the time it has to refinance, it will likely be in a much healthier situation.
Analysts expect net debt to fall to $2.0 billion at the end of 2024. Free cash flow is expected to be roughly $700 million this year. This translates to a 20% free cash flow yield, meaning even under its current distribution plan, the company could buy back roughly 10% of its shares (depending on the price of oil).
Unless oil prices implode, I believe BTE could reach its leverage target in 2025, especially when adding that production growth could average 1-4% per year.
Baytex Energy
On a longer-term basis:
- Although highly dependent on pricing, by 2028, the company aims to reduce total debt to 0.5x EBITDA.
- By 2028, the company aims to generate $1.11 in free cash flow per share. That would translate to 27% of its current share price.
With that in mind, speaking of distributions and the impact of the oil price, Baytex estimates that at US$70 WTI, it can generate close to $500 million in free cash flow. That would translate to 14% of its current market cap.
- At US$80 WTI, the company's free cash flow can exceed $800 million (23% of its market cap).
- In a US$90 WTI scenario, the company could generate $1.2 billion in FCF, more than a third of its market cap!
Baytex Energy
Currently, WTI crude oil is trading close to US$70. It has been close to this level since early 2023, as weak global economic growth is not providing much upside.
TradingView (NYMEX Crude Oil)
However, as I have written in countless prior articles, I believe that if it weren't for subdued supply growth and OPEC production cuts, oil would be trading up to US$20 per barrel lower.
Hence, my thesis is that once economic growth indicators improve, oil will work its way to US$100 and beyond, potentially causing massive inflows into oil and gas stocks.
On a side note, this is what the comparison between Toronto-listed BTE shares and crude oil looks like:
TradingView (BTE.TO, NYMEX Crude Oil)
Valuation & The Verdict
Earlier in this article, I mentioned that BTE is not as large, stable, nor as able to distribute cash to its shareholders as its larger peers.
It also does not have a history that comes with confidence.
To me, BTE is not a reliable income play. For that, I invest in Canadian Natural and others.
However, what makes BTE so special is the fact that it is turning things around.
- The company is rapidly lowering its financial debt.
- It has decided that it wants to focus on aggressive shareholder distributions.
- While growing its output, it is sticking to capital discipline.
Moreover, because of its poor (long-term) performance, it is very attractively valued.
Using the data in the chart below:
- BTE has a normal price/operating cash flow ("OCF") ratio of 5.2x. That's well below the 9-10x multiple many of its larger peers like Canadian Natural and Exxon Mobil ( XOM ) enjoy.
- Currently, BTE is trading at a blended P/OCF ratio of just 2.2x!
- Even a return to 5.2x OCF could give the stock a fair price target of $11, which is roughly 170% above its current price and based on a gradual decline in OCF expectations.
- Higher oil prices would make BTE even more attractive, as it would "force" analysts to increase their OCF expectations.
FAST Graphs
Hence, while I will stick to the "big guys" when it comes to buying potentially elevated oil income, I believe that BTE is a very attractive long-term recovery play that has more upside potential than the other stocks I mentioned in this article.
If I am right and we get a long-term uptrend in oil prices, BTE will not only be able to buy back loads of stock and grow its dividend but also enjoy the benefits of trading at a very low multiple.
While I would not recommend BTE to conservative investors who want to avoid stocks with elevated volatility, BTE has become one of my favorite recovery plays for the next few years.
Now, I'm figuring out how BTE fits into my trading portfolio, as I want to initiate a position due to the favorable risk/reward.
As I own a number of energy names in my trading portfolio, I'll have to potentially make some changes to prevent overlap.
Takeaway
Baytex Energy is a captivating small-cap play with significant potential.
The company's strategic turnaround involves aggressive debt reduction, robust shareholder distributions, and disciplined capital allocation.
Despite past challenges, BTE's commitment to financial health and operational efficiency positions it as an attractive long-term recovery play.
With a focus on oil and liquids, impressive drilling assets, and a clear distribution plan, BTE's current undervaluation presents an opportunity for investors eyeing substantial upside, especially in a bullish oil market.
For further details see:
Baytex Energy May Be The Most Undervalued Energy Stock On My Radar