Is a pristine balance sheet a means to an end, or the end onto itself?
It seems that many shareholders of Cenovus Energy Inc. felt the latter. Ever since the company announced its transformational deal to buy $17.7-billion worth of oil-sands assets from ConocoPhillips, the company's stockholders have headed for the exits. Thursday, Cenovus hit a 52-week low of $12.41, down nearly 30 per cent from pre-deal prices.
To use market jargon, it seems a fair number of investors have "rotated out" of Cenovus. But here's the good news: Not enough folks who'd be more comfortable with a risk-taking energy player with a slightly heavier debt load have rotated in. That means you have time to get in on Cenovus when the misplaced pessimism is quite likely at its highest point.
To review: My colleague Jeffrey Jones referred to Cenovus chief executive Brian Ferguson as "Mr. Steady-As-She-Goes," so the company's March 30 announcement caught investors badly off guard. To acquire the 50 per cent of the FCCL Partnership that Cenovus didn't already own (plus additional conventional energy assets), the company has issued nearly 400 million shares, to investors for cash in a "bought deal" and to ConocoPhillips; committed $3.7-billion in cash toward the deal; and will likely add about $7-billion of debt to its balance sheet, prior to any offsetting asset sales.
In the days after the deal, analysts at Macquarie Research met with 40 different investment funds in six different cities in Eastern Canada and the United States, and, wrote analyst Brian Bagnell, "We did not hear a single positive comment made from any investor with regards to the deal." The investors understood the strategic rationale for adding the oil sands assets, Mr. Bagnell said, but not so much the reasons for buying the "Deep Basin" natural gas also involved in the deal. And, he says, "essentially everyone believes that Cenovus overpaid."
Justin Bouchard of Desjardins Capital Markets says the deal "muddies the investment thesis" for the company, as the Deep Basin production gives Cenovus less relative upside to higher oil prices than it did before, and the additional debt reduces the company's ability to withstand lower oil prices.
Menno Hulshof of TD Securities Inc. notes that prior to any of the promised asset sales that would improve Cenovus's balance sheet, the company has increased its debt to cash flow to 4.6 times, from 1.0 times, and net debt as a proportion of the company's capitalization goes to 41 per cent from 13 per cent.
Mr. Hulshof, however, is not negative on the company: He maintains a "buy" rating and has an $18.50 target price for the shares, implying nearly 50 per cent upside. "The sharp underperformance of Cenovus shares since the announcement would suggest that the strategic rationale and long-term benefits are not readily apparent or fully appreciated by the market," he writes. "We would argue that Cenovus deserves the benefit of the doubt pending a better understanding of the full merits of the transaction."
Mr. Hulshof believes the company's June investor day, where the company will once again defend itself, may be a catalyst for an improvement in sentiment; many other analysts say the market wants to see Cenovus divest some assets at healthy prices and start paying its debt back down again, something that may not happen until the third quarter, at the earliest.
Investors who wait for such things may benefit from decreased risk once they occur, but they'll almost certainly pay a higher price to get in than those who wade in now.
Morningstar analyst Joe Gemino says that while most oil sands players' shares are fairly valued, Cenovus is, by contrast, "vastly undervalued," and "presents an attractive opportunity for long-term investors." Mr. Gemino, who estimates the fair value of Cenovus stock at $23, says Cenovus's "solvent-aided process" for extraction from the oil sands, while not ready to come online for several years, will provide meaningful value for the company. He estimates it will lower the break-even production price to $45 (U.S.) per barrel of West Texas intermediate crude. "We think the market is missing this long-term story."
Nima Billou of Veritas Investment Research disagrees with the idea Cenovus overpaid, arguing that the oil sands assets alone are worth $20-billion (Canadian), in excess of the purchase price, and the conventional Deep Basin assets are a $3.6-billion sweetener on top of that. He now estimates the fair value of Cenovus at $25 a share. "Ultimately, Cenovus has taken control of its destiny with a significant transaction that has greatly reduced the threat of a potential takeover … We are encouraged that Cenovus has taken a pro-active step to deploy its cash towards an asset with which it is intimately familiar."
And Michael Ruggirello of Accountability Research Corp. writes that the Deep Basin assets provide the company "tremendous flexibility to manage the business to whatever commodity price environment presents itself," with 1,500 new drilling locations "representing what could be a decade of growth there."
It's all very long-term thinking, certainly, and the next few weeks, or more, may see Cenovus shares muddle along the bottom. There may come a time in the near future, however, when investors look back on this period of deep skepticism and recognize that it was the best opportunity to buy.
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