2023-11-06 13:46:23 ET
Summary
- Cenovus Energy is one of Canada's best energy stocks, with deep reserves, a strong balance sheet, and a plan to distribute 100% of its free cash flow to shareholders.
- The company's focus on buybacks is driven by its belief that the stock is undervalued, benefiting shareholders with potential for significant appreciation.
- Despite the volatility of energy stocks, accumulating Cenovus shares during dips could be a wise long-term investment strategy.
All financial numbers in this article are in Canadian dollars unless noted otherwise. Please note that oil and gas prices are always in US$.
Introduction
While I discuss a wide range of other investment opportunities, early November is shaping up to have a special focus on Canadian energy companies. A few days ago, I covered what has become my favorite Canadian oil stock, Canadian Natural Resources ( CNQ ).
Now, I'm covering one of its largest peers, Cenovus Energy ( CVE ) , a highly efficient energy producer with both upstream and refining exposure.
The reason why Cenovus isn't my favorite play is mainly based on its refinery exposure and its focus on buybacks. However, that's personal, as I'm very specific when it comes to investments that fit my portfolio.
This is what I wrote in my Canadian Natural article (emphasis added):
- I want producers with very deep inventories/reserves , which will prevent forced M&A to maintain production rates.
- I want producers with healthy balance sheets . In general, that's a good thing. However, companies with healthy balance sheets can focus on shareholder distributions.
- I want drillers who commit to distributing most of their free cash flow to shareholders, not just drillers who have the ability to do that but focus on other issues instead.
- I want companies that emphasize dividends over buybacks . As much as I like buybacks, in the energy sector, I prefer dividends, as I see energy stocks as income tools. This is a personal preference. There is nothing wrong with buyback-focused stocks like Marathon Oil ( MRO ).
As the title of this article suggests, I believe Cenovus is one of Canada's best energy stocks. Not only does it have deep reserves and an increasingly strong balance sheet, but it also has a plan to distribute 100% of its free cash flow to shareholders.
Although most returns will consist of buybacks, there's a reason for that. The company believes its stock price is significantly undervalued, which makes buying back stock more attractive than distributing dividends - technically speaking.
That's great for shareholders.
If we assume that my oil price thesis (as explained in articles like this one) is correct, investors get to buy undervalued CVE shares at current levels. The stock price rises, fueled by higher energy costs.
Once the stock is fairly valued, the company will likely switch from buybacks to special dividends, allowing investors who bought low to benefit from a very high yield on costs!
On August 31, I wrote my most recent article on CVE. In this article, I'll get to update my bull case using the company's just-released quarterly earnings, which show that the company's operations are back on track.
We're also very close to the aforementioned 100% distribution plan.
So, let's get to it!
Cenovus - Truly One Of The Best
Cenovus is great. That hasn't always been the case.
If you bought NY-listed CVE shares ten years ago, you would be down 19%, including reinvested dividends. The Energy ETF ( XLE ) is up 48% during this period, which isn't that great, either.
Nobody really cared for Canadian upstream companies. U.S. shale production output was so strong that it kept a lid on oil prices before the pandemic. On top of that, it seemed that most investors didn't care for refining exposure, as it came with more operating risks.
Now, that has changed.
- The U.S. shale boom is over. Production growth is quickly declining and is likely to peak in 2024.
- OPEC has gained pricing power, which it is using by cutting production to maintain elevated oil prices. There's also a geopolitical aspect to it, which I often ignore, as it would involve too much speculation.
- Now, Canadian producers are the place to be! They have deep reserves and low breakeven prices and are dedicated to distributing most of their cash to shareholders. Additionally, projects like the Trans Mountain Pipeline are expected to provide Canada with better access to export markets, which comes with pricing benefits.
Hence, CVE is now outperforming.
Over the past three years, it has returned 446%, beating the XLE ETF by more than 200 points!
With that in mind, CVE is in a good spot to continue outperforming most peers.
The company, which expects to produce 785 thousand barrels of oil equivalent per day this year - 75% of this coming from highly efficient oil sands - has a reserve life index of roughly 31 years, giving it one of the highest reserves in North America.
It also owns and co-owns a number of strategic refineries in Canada and the U.S., where it turns a big part of its own production into value-adding products like gasoline, diesel, and related products. This internal supply chain allows the company to capture benefits that refineries that rely on external supply do not have.
On a side note, if you're new to CVE, please note that it refers to refinery operations as manufacturing . You'll encounter this if you do your own due diligence.
Cenovus Energy
These refinery/manufacturing operations were a huge benefit in the third quarter, as the upstream business saw an increase in production to nearly 800,000 barrels of oil equivalent per day.
Combined with higher commodity prices, the company generated an operating margin of about $3.4 billion.
Although production volumes in the conventional business were impacted by wildfire activity in the second quarter, they returned to normal rates in the third quarter.
Production increased significantly compared to the second quarter.
Cenovus Energy
The company's crown jewels, the oil sands assets, are performing exceptionally well, supported by redevelopment programs and new well pads.
Production increased substantially compared to the second quarter. Sunrise oil sands production also showed positive growth in the third quarter.
The company expects this positive performance to continue, focusing on operational reliability and growth capital projects.
The same goes for its offshore assets.
- In the offshore segment, the Asia Pacific assets performed well, achieving the first gas from the MAC Field in Indonesia.
- In the Atlantic, the Terra Nova FPSO has returned to offshore Newfoundland and is expected to produce its first oil in the fourth quarter.
- The West White Rose project is progressing as planned, with regulatory dry dock preparations underway.
Adding to that, the downstream business saw healthier operating margins from refining and upgrading assets.
The U.S. manufacturing segment successfully got all refining assets online and running reliably, leading to increased crude utilization and reduced operating costs.
The Canadian manufacturing segment achieved a 98% crude utilization rate.
When combining all assets, the company is expected to boost output by 80 thousand barrels per day through 2025-2027, with at least $1.2 billion in investments in sands, offshore, and downstream/manufacturing.
Cenovus Energy
With that in mind, the good news continues, as CVE is also highly efficient and capable of boosting shareholder distributions soon.
CVE Shareholders Are In A Great Spot
In the third quarter, the company reported roughly $3.4 billion in adjusted funds flow, with both its upstream and downstream businesses contributing significantly to the operating margin.
Its net debt at the end of the third quarter came in at $6 billion.
Notably, Cenovus successfully reduced its long-term debt to $7.2 billion by purchasing $1 billion worth of notes that were due between 2029 and 2047.
Additionally, the company has no debt maturities in 2023 and 2024 and barely any maturities until 2027. It has a BBB- credit rating from S&P, which I expect to be boosted to BBB over the next 12 to 24 months.
Cenovus Energy
As a result, Cenovus distributed over $1.2 billion to shareholders during this period. This distribution was made through actions like dividends, share buybacks, and partial payment of common share warrant obligations.
The company currently pays a $0.14 per share quarterly dividend. The dividend was hiked by 33% in April. This payout translates to a yield of 2.1%.
2.1% is nothing to write home about. And I doubt that will change anytime soon.
Yet, it's still not bad news.
Looking ahead, Cenovus is committed to achieving its $4 billion net debt target and delivering 100% of excess free funds flow to shareholders.
- CVE has the capacity to sustain and grow its base dividend (yielding 2%) at $45 WTI, making it one of the most efficient energy companies in the world.
- With a net debt load between $4 and $9 billion, CVE is committed to spending 50% of its post-base-dividend free cash flow on debt reduction. The other half is spent on either buybacks or variable dividends.
- Below $4 billion, the company aims to return every penny of free cash flow to shareholders. After all, below $4 billion in net debt, there's no point in lowering debt any further.
Analysts believe that CVE can end this year with $4.2 billion in net debt, meaning that it could start aggressive buybacks in the first half of 2024!
Cenovus Energy
These buybacks will likely be the key source of distributions until the company believes that its stock price reflects higher oil prices.
Next year, CVE is expected to generate $6.4 billion in free cash flow, which would translate to 13% of its market cap. That's how aggressive buybacks can be, even at current oil prices.
This is what the company said in its second-quarter earnings call (these assumptions were unchanged in the third quarter):
We screen our buybacks at 60%. We still think those are sort of the right low cycle and mid-cycle prices. I think I'm looking at Kam and he's nodding his head. I'm looking at Jeff and he's nodding his head. But I think with where our share price is today, we're still more inclined to return capital to shareholders in the form of buybacks and at the share price today, in our view, doesn't reflect the net asset value at $60 .
So I think you're going to continue to see that until we continue to see shareholder returns come back in the form of largely buybacks until we get there. But we've been pretty clear on the framework. If we get to the point where we think it's in excess of mid-cycle pricing or the discounted value of the shares are in the excess of mid-cycle pricing. I think you'll see a greater majority of the returns come back in the form of special dividends . - CVE 2Q23 Earnings Call
Speaking of the valuation, I agree with the company's management and believe that CVE is significantly undervalued.
Using the chart below:
- CVE is trading at just 5.2x operating cash flow.
- Going back to the Great Financial Crisis, the normalized multiple was 7.6x OCF.
- This year, OCF is expected to decline by 14%, followed by a potential 27% surge in 2024 and a 7% decline in 2025. Although I believe that higher oil prices will cause the actual results to be higher, I'm using these expectations in the "fair" value calculation.
- If the stock were to return to its fair valuation, the stock could return 29% per year through 2025, which includes its dividend and buybacks.
FAST Graphs
Needless to say, I'm not promising these returns. Economic headwinds could easily derail these plans. This includes currency headwinds for non-Canadian shareholders.
However, based on reasonable assumptions, the case for significant outperformance can be made. Based on current estimates, the stock has a fair stock price value of $45 (in Toronto), which is 70% above the current price.
There are a few reasons why the stock may not have reached its fair value yet.
- Firstly, there is a general sense of distrust towards oil and gas companies, especially given the current economic climate.
- Additionally, we are now dealing with a new environment in which there is a higher potential for free cash flow. It may take some time for the market to fully incorporate this information.
This also goes for other companies, not just CVE.
While I believe that recession fears will keep a lid on energy stocks for the time being, the downside is limited due to changed supply dynamics.
As I have said in multiple articles, the moment economic growth expectations bottom, I expect oil prices to enter the triple-digit dollar range, which should unlock a lot of value.
The way I'm dealing with oil and gas stocks is to accumulate them on weakness.
So, while I have a very bullish target on CVE, I think it's reasonable. It just takes time to unlock value, which is why CVE is so focused on buybacks.
Needless to say, if you believe that CVE is right for you, please be aware that energy stocks are volatile. They are not your average blue-chip dividend growth stocks.
Takeaway
With deep reserves, a strong balance sheet, and a commitment to distributing 100% of its free cash flow to shareholders, CVE offers a compelling investment opportunity.
While some may prefer dividends, CVE's focus on buybacks is driven by its belief that the stock is undervalued.
This strategy benefits shareholders, as undervalued shares have the potential for significant appreciation.
The company's dedication to reducing debt and returning capital to shareholders, combined with a favorable valuation, makes CVE an attractive option for investors looking to tap into the energy sector's potential.
Despite the volatility that comes with energy stocks, accumulating CVE shares during dips could prove to be a wise long-term investment strategy.
For further details see:
Canada's Best - Cenovus Is A Significantly Undervalued Buyback Powerhouse