Summary
- Cenovus is a quality company that has been deleveraging rapidly.
- This positions the company well for much higher shareholder returns next year.
- The company could triple its dividend next year and has share price appreciation potential on top of that.
Article Thesis
Cenovus Energy ( CVE ) ( CVE:CA ) is a high-quality Canadian oil sands player with strong cash generation that is rapidly improving its balance sheet. This will position the company for much higher shareholder returns in 2023, once the net debt target is reached, with higher buybacks and higher dividends being a likely scenario. At the same time, the inexpensive valuation and upside potential for global oil prices also could allow for considerable share price appreciation over the next year.
Cenovus Energy: Getting Closer To Its Debt Target And Offering A Hefty Shareholder Yield In 2023
Like other quality energy names, Cenovus Energy put a capital return framework in place a while ago. The company seeks to return a set portion of its free cash flows to its owners, depending on where it stands when it comes to reaching its deleveraging goals. The following slide shows this framework:
Cenovus presentation
Cenovus has a net debt goal of C$4 billion or less. Until that debt level is hit, the company will divert some of its free cash flows towards deleveraging, while Cenovus plans to return 100% of its free cash flow to the company's owners once the net debt target has been reached.
At the end of the third quarter, Cenovus had a net debt position of C$5.3 billion, as showcased here in Cenovus' earnings release:
Cenovus earnings release
This represents a reduction of C$2.2 billion versus the end of the second quarter when Cenovus' net debt position still totaled C$7.5 billion. In other words, Cenovus has reduced its net debt position by around C$700 million per month during the third quarter. If the company has kept that pace up during the fourth quarter, the C$4 billion net debt target has already been hit.
That being said, it is likely that the debt reduction pace was somewhat lower in October, November, and the first half of December, as energy prices have pulled back from the levels seen during the summer months:
In July-September, the average price for Brent and WTI was higher than during the quarter-to-date period, which is why Cenovus was more profitable in Q3, all else equal. Still, Cenovus likely has generated a compelling profit in Q4 so far, and deleveraging will have progressed further over the last two and a half months. In order to be conservative, let's assume that the debt reduction pace has been just half as high in Q4 relative to Q3. That would mean a monthly debt reduction of C$350 million, which would indicate that Cenovus' net debt would be around C$4.3 billion by the end of December. By the end of January, Cenovus should thus hit its C$4 billion net debt goal.
In order to be extra conservative, let's assume that it will take two additional months to get there, which would mean that Cenovus would end the first quarter of the upcoming year with a C$4 billion net debt position. For the remainder of 2023, i.e. for Q2-Q4, Cenovus would thus be able to return 100% of its free cash flows to the company's owners via buybacks and dividends.
Cenovus has generated US$8.2 billion of cash from its operations over the last four quarters, Q4 2021 to Q3 2022, which is equal to around C$11.2 billion. It is not clear how high cash flows will be next year, due to several factors. First, oil prices naturally move upwards and downwards. I believe that there's a good chance for higher oil prices a year from now (more on that later), but that's not guaranteed, of course. Cenovus will produce more oil next year, which should be positive for its cash flows. Lower interest expenses due to CVE's debt reduction efforts should also have a positive impact on Cenovus' cash flows. Let's still be conservative and assume that cash flows will be lower next year, at C$11 billion. A significant portion of that, around C$4 billion to C$4.5 billion, will be spent on capital expenditures, according to a recent update by management. That would imply free cash flows of around C$6.5 billion to C$7 billion in 2023. Assuming the net debt target will not be hit by the end of this year, some of that will be used for debt reduction, so let's say Cenovus will generate after-debt-reduction free cash flows of C$6 billion next year.
We made rather conservative assumptions several times when calculating this number, thus actual results could be significantly stronger, I believe, especially when oil prices increase meaningfully due to factors such as China's economic reopening. But even the C$6 billion number would be quite attractive for investors.
If C$6 billion will be returned to shareholders next year, that's equal to more than 13% of the company's current market capitalization. Some of that would be used for share repurchases, with the remainder going to dividends. Cenovus has recently applied for a 10% buyback authorization, relative to its public float -- that's 137 million shares . Note that the total share count, at 1.92 billion, is higher than the public float, at 1.37 billion. Buying back 137 million shares based on a current share price of C$25 will cost the company C$3.4 billion, meaning C$2.6 billion would be left over for dividends. Right now, Cenovus' market capitalization is C$47 billion, thus a C$2.6 billion would make for a 5.5% dividend yield. Note that the buybacks that will be done throughout 2023 will reduce the share count and thereby result in slightly higher per-share dividends, all else equal, thus the 5.5% dividend yield is, again, a conservative estimate.
No matter what, it looks pretty clear to me that Cenovus will offer a hefty shareholder payout next year. Not only will the company hit its debt reduction goal (assuming it has not already done so, which is possible, although not very likely), but Cenovus will also continue to buy back shares at a hefty pace and will offer a nice dividend yield on top of that. In 2022, the company paid out C$0.464 per share this year, including the variable dividend payment in Q4. That pencils out to a yield of 1.9% relative to the current share price of C$25. If the company pays out dividends yielding 5.5% next year, that's almost three times the dividend return investors have gotten this year -- which would be extremely attractive, I believe.
Dividend growth in 2024 and beyond would not be this high, of course. But between some organic cash flow growth thanks to growth and optimization investments and the impact of buybacks -- cash flow would be distributed over a smaller number of shares -- the company could increase its dividend further in 2024 and beyond. I believe that 10% annual dividend growth could be quite achievable in the long run, as long as oil prices do not pull back too much.
Oil Prices Could Climb Meaningfully
In recent weeks, oil prices pulled back meaningfully, mainly due to recession fears. But I do believe that there is a good chance that oil demand will grow over the next year instead of falling. China looks like it is now seriously opening up its economy again, which should add massively to global oil demand. International travel continues to recover, and gas-to-oil switching in markets such as Europe adds to oil demand as well. Add a likely production decline in Russia due to the impact of sanctions and a likely end to SPR releases, and oil markets could get tight over the next couple of months. In that case, all oil-related equities should benefit. The good news for CVE owners is that an oil price increase is not needed, the company should do pretty well with oil prices staying where they are now, too.
Risks To Consider
Cenovus looks like a compelling investment to me, but it's not risk-free, of course. A major pullback in oil prices would hurt profitability and would cause lower cash returns to investors next year. I do believe that a major oil price pullback is unlikely due to the factors laid out above, but it can't be ruled out. New COVID lockdowns in major markets could hurt oil demand, or OPEC might decide to increase production. I do not believe that such a production increase by OPEC is very likely, as they have cut their output this fall to protect prices, but one never knows. A potential end to sanctions against Russia and/or Iran could also bring additional supply to the market, although I personally believe that both are unlikely in the foreseeable future, due to the ongoing war in Ukraine and due to the regime's actions in Iran.
Valuation
Cenovus is currently trading at an enterprise value to EBITDA ratio of just 3.5x, which is extremely cheap relative to the valuation of many other integrated energy companies. One could argue that CVE's business model and low decline rates, coupled with low break-even prices, would justify a premium valuation versus companies such as Exxon Mobil ( XOM ) or Chevron ( CVX ) -- but Cenovus trades at a 20%-30% discount versus these two leading American integrated energy companies. Cenovus' shares offer a free cash flow yield in the low-teens range under conservative assumptions, which represents a pretty low valuation and a discount compared to many other integrated energy companies as well. Due to these factors, I believe that capital appreciation is also likely for someone buying CVE today -- relative to what can be expected from other energy companies, and in absolute terms. The high expected buyback yield -- much higher compared to many other energy names -- could also be positive for Cenovus' share price performance.
Takeaway
Cenovus is a compelling oil sand major that benefits from a long reserve life, low decline rates, strong cash flow per barrel, and it has been cleaning up its balance sheet rapidly in recent quarters. By the end of the first quarter, Cenovus will have hit its net debt target and will be well-positioned to return massive amounts of cash to the company's owners. Even under conservative assumptions, dividends could triple next year, while Cenovus will also continue to buy back shares at a meaningful pace. Between an inexpensive valuation and a substantially increased dividend next year, Cenovus should attract additional investor attention, especially by income investors. Overall, this makes Cenovus a compelling investment over the next year.
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Cenovus: Buy Now For A Likely Much Higher Dividend Yield In 2023