Professional fund managers are growing wary of the torrent of investor support for PrairieSky Royalty Ltd.
Since Encana Corp. spun off its royalty business in late May, shares of PrairieSky have leapt 45 per cent higher than the initial public offering price of $28, closing at a fresh high of $40.83 on Friday.
According to some buy side veterans, that valuation defies underlying financial forecasts and underappreciates the company’s risks.
“They are not immune to the laws of economics that hold all others to seemingly more reasonable valuations,” said John O’Connell, CEO of Davis Rea.
Last week, a number of bank analysts initiated coverage of PrairieSky, but shares are quickly approaching their one-year average price target of $42.61.
The appeal of PrairieSky is understandable. The new entity holds Encana’s vast expanses of oil-and-gas-rich lands on which other energy producers pay royalties to drill.
PrairieSky can offer third-party producers access to Encana’s seismic data, as well as the opportunity to establish a position quickly from a 5.2 million acre land base, rather than build acreage piecemeal over a period of months or years.
“That could defer some of the cost, accelerate the drilling, and increase the potential success rate,” said Eric Nuttall, portfolio manager at Sprott Asset Management.
Once those leases are in place, PrairieSky’s work is pretty much done. The company has no capital expenditures and little operating expenses.
“It’s all top line,” said Mason Granger, a fund manager at Sentry Investments. “So it should, in theory, be a less volatile cash flow stream. And the market will ascribe a higher valuation multiple for less volatile cash flow streams.”
The market did just that, and then some.
The stock is currently trading at a forward enterprise value (EV) to discounted annual cash flow (DACF) of about 22 times, compared to its peer group average of about 8 times, according to RBC Dominion Securities.
“It’s obviously being priced for a lot of growth, but I don’t think even the company itself can give you an accurate representation of how quickly that growth can take place,” Mr. Granger said.
Freehold Royalties Ltd., which represents a more direct comparison to PrairieSky, trades at about 13 times EV/DACF. Some premium for PrairieSky is warranted, given its superior land holdings, but its stock appears expensive by any measure.
“We currently own Freehold, which trades at a much lower valuation and double the dividend yield, making us feel more comfortable,” said Ryan Bushell, portfolio manager at Leon Frazer.
He sees limited upside from here, unless PrairieSky was to substantially increase its cash flow forecasts or aggressively raise its dividend.
It’s easier to imagine the ways in which the stock might drop off in the short term.
“The biggest risk is that their business model is contingent on access to third-party capital,” said Mr. Nuttall. PrairieSky’s success is predicated on the spending plans of the companies drilling on its land. And that activity is subject to the whims of energy prices.
Combining the oil sands, dividends and the biggest Canadian IPO in 14 years was bound to spark an investor frenzy.
“People are looking for income these days and they’ll pay ridiculous prices for it,” Mr. O’Connell said.
But at the current share price the stock will yield about just 3 per cent, while further big capital gains look unlikely, he added. “Investors shouldn’t think you can make those kinds of returns again. So you’ve got to think, is 3 per cent good enough for you?”
It may not be good enough for shareholders who decide to take profits on a richly valued stock.
“Everybody knows it’s expensive,” Mr. Nuttall said. “It really is a spectacular company, it’s just a question of what you’re willing to pay for it.”