Suncor still cheap, even as smart money slides into oil patch

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In this more mature, responsible stage of oil patch development, Suncor Energy Inc. is doing all the right things.

The market isn't quite ready to embrace the new Suncor though, still somewhat put off by the memory of the old Suncor. Its valuation, it could be argued, is a blend of the two.

But institutional investors are starting to side with the company's future over its past, a trade preceded by Warren Buffett's stake in Suncor first disclosed last August.

"The real smart money is moving into Suncor and it's going to take people a while to realize it was an opportunity that maybe they missed," said David McColl, a Morningstar equity analyst.

The pre-recession era in the oil sands was one of growth for its own sake. Companies pushed bold new projects, fought to get them online quickly and get the cash flowing. Suncor for years pumped billions into project expansions.

The recession brought a cold sobriety to the sector. The exuberance faded and projects were shelved. The oil patch was further stricken by the interrelated adversities of limited pipeline capacity, market share competition with U.S. shale oil, and a price discount on Canadian oil products.

While those challenges persist, they have eased this year upon the acceleration of oil by rail and the increasing confidence that demand for Canadian oil remains strong.

U.S. investors are coming back to Canadian large-cap energy stocks. And Suncor is the cheapest of the integrated oil firms, with an enterprise value of less than five times forward EBITDA, compared to its peers, which average about 6.5 times, according to Bloomberg.

"We believe this is a valuation proposition that is unlikely to last given the strength of the company's revised business strategy," said Raymond James analyst Chris Cox. He rates the stock the equivalent of a "buy" with a $51 price target. "We believe Suncor is successfully transitioning into a premier growth and income model."

Under new leadership since mid-2012, Suncor is no longer explicitly targeting aggressive growth, but is instead prioritizing execution.

"They're really focus\ed on growth through execution, through cost control," Mr. McColl said, noting that the company is trying to cast off its reputation for operational problems and delays. "Profitable growth" is the company's new mission.

While production was lower than expected in the first quarter, earnings handily beat analyst estimates, largely as a result of increased volumes of oil by rail to Suncor's Montreal refinery.

"In our view, the value of Suncor's integrated business model can't be overemphasized," Mr. Cox said. "With the market increasingly focused on the free cash flow potential of the company, we believe the improved stability of cash flow … will continue to be a key part of the Suncor value proposition that investors gravitate toward."

Suncor is beginning to reward those investors with a dividend payout that has increased by almost 80 per cent from the beginning of 2013 and an increasingly aggressive share buyback program.

Still, the stock has underperformed the sector year to date. Over that time, Suncor generated a total return of 16 per cent, while the TSX capped energy index has returned 19 per cent.

"Now you have a pretty shareholder-friendly management and you could see a valuation premium creep into Suncor if the operational issues they've had in the past don't reoccur," said Todd Johnson, portfolio manager at BCV Asset Management, which owns Suncor shares.

Suncor, of course, remains vulnerable to economic deterioration and a slide in global and Canadian oil prices. But a reasonably stable oil price and even just a mediocre economy should be enough for Suncor's stock to produce decent returns, Mr. Johnson said.

Mr. McColl estimates that the stock is trading at a 20-per-cent discount to fair value.

"For a long term investor, you need to be patient," he said. "Suncor is a good company, a good stock, its trading at a discount, and their dividend program should slowly rise over the next few years."