Encana Corp – Undervalued Oily Duckling

In Autumn of 2016, I asked my friend: name at least one listed Canada company. We could not come up with anything. I had no idea three years later I would be investing in one.

Encana Corporation – Company Profile

Encana Corporation works in the Exploration & Production sector. Encana’s roots date back to late 1800s, when Canadian Pacific Railway workers discovered gas. Today corporation is a leading North American energy producer focused on oil, natural gas liquids and natural gas commodities.

Encana employs 2065 people. Market capitalization at the time of writing is 5.7 B USD. The company is dual-listed on Toronto’s Stock Exchange TSX and in NYSE under the same ECA ticker, which is about to change, but more on that later.

Before we dig into Encana itself, some groundwork needs to be done first. Let’s look at the Energy (primarily E&P) sector first.

Hated Energy Sector

Here’s the annual sector performance for S&P500, going few years back, you would see the same thing. Energy sector has been underperforming for quite some time, but why?

Overview of Recent Years in Oil Industry

Game changer in global oil supply (and the need for policing Middle East) was the boom in U.S. shale gas production efficiency. This has put America from net oil importer to top 5 exporters in the world and has contributed significantly to oil price plunge to 30 USD in 2016.

Such a drop in product (oil) prices has put plenty of producers at insolvency risk. Capital in this sector is vital, some issued capital, some went into debt and others did both.

While oil prices recovered, share prices did not keep up. Currently, shale oil producers have troubles with well density that decreases efficiency, cash flow issues, we already hear of some bankruptcies in the sector and as debt wall approaches, we may see even more.

Frenzy of Climate Change

While climate change is no joke, puppets like Greta Thunberg are creating a frenzy that is really emotion-driven. Climate activist movement is although ideologically acceptable, bears unwanted fruits that threaten the bigger picture.

Oil giants face shareholder pressure on climate emissions, greenhouse gas targets. Major oil company investors are starting to use their voting rights to speak out against a lack of climate action. Shareholders in Shell and Equinor have already had their say, now BP is in the spotlight.

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But investors have had enough. They’re demanding companies spend less and pay more dividends. Activists are forcing companies to put themselves up for sale. Bank funding is getting tighter, too, according to a Federal Reserve Bank of Dallas survey.

Bloomberg: Peak Shale: How U.S. Oil Output Went From Explosive to Sluggish

There’s one wonderful law in nature called inertia. And Energy sector is still very very slow in terms of current information age. Cut on investments now, will bite hard in upcoming years with decreased supply.

The point here is this: the energy sector is being bitten from all sides: creditors, operational activity, volatile oil prices, climate activists, even shareholders. And then there are global oil demand concerns.

Oil Demand

US-China trade war escalated concerns for China’s oil demand that accounts for around 15% of global oil consumption. But I believe this is an over-reaction. Oil is much more ingrained into our lives than we would like to think.

While renewable energy production is growing, it does not significantly impact global share of the rest of the fuels – it only offsets the growing global energy demand.

I could not get my hands on IEA (International Energy Agency) demand projections, but the second best choice was U.S. Energy Information Administration. In their outlook for 2019, projections are clear, at least for the horizon I’m concerned about.

The current trend is clear. IEA chart:

More charts at IEA statistics page.

Building blocks for Encana’s Perfect Storm

Encana’s current CEO and Transformation

Doug Suttles holds Mechanical Engineering BSc from University of Texas. He worked in BP (British Petroleum) for nearly 20 years. He gained public attention when leading BP’s reaction to the Deepwater Horizon Oil Spill in 2010.

When Suttles joined the company in 2013 it began selling off assets and narrowed its focus to what it called its “core four” areas, which were the Permian and Eagle Ford formations in Texas and the Montney and Duvernay formations in Alberta and British Columbia.

Financial Post: Doug Suttles transforms ‘headquarter-less’ Encana with $7.7-billion deal to buy Newfield

With a deep understanding of the industry, Doug started divesting and focusing company of high yield fields and rich oil liquids plays.

Encana Corporation (Ovinvit) Financial Analysis

Recent developments in Income and Cash Flow Statements are looking solid. Trailing 12-month revenue compared to 2018 is up +27%.

Net Income over the same period is up +19%.

EBITDA shows even stronger growth of +27.5%.

Encana’s Cash Flow Development also have seen huge turnarounds.

Several extra notes on Cash flow statement in table format for 2015 – 2019 Q3 ttm years.

Note, that these are key, not all sections from cash flow statement, so don’t bother with sums not adding up.

• The company generates solid, growing operating cash flow, while some peers in E&P are struggling with this line;
• Encana’s latest acquisition of Newfield Exploration closed in 2019 Q1 was financed by issuing new stock and is not evident in Investing Cash Flows;
• In 2019 over 1B was allocated to pick up beaten-down stock in the market via share buyback program, which accounts for ~10% of shares outstanding.
• Increased dividend by 25% over the last year;
• All this done with free cash flow remaining.

Encana Corporation Valuation

It’s cheap in all classic valuation ratios. It trades at 3.6 EV/EBITDA, 4.5 P/E and 0.78 price to tangible book value. Below are recent historic ratios developments:

Financial Leverage of Encana

One thing that stands out is the current debt level, which, compared to its peers is higher. From going through summaries of major players in E&P sector I got the picture, everyone was playing in the safe zone and in Q3 results webcast, executives were promising further deleveraging.

Current main debt ratios:

• Debt/Equity – 1.15;
• Financial Debt to Total Liabilities – 70%;
• Net Debt / EBITDA – 2.99
• Current Ratio – 0.82

Key Takeaways From Q3 Results Webcast

Encana Corporation recently had Q3 results presentation, I suggest you listen for your self if you are interested in the stock. Event link. Main points, I noted:

• Newfield Integration – better synergies than expected; raised guidance for cost savings;
• In Q3 company announced it would change its domicile to US to get better access to passive capital pools (more on this later!);
• Redomicile costs are negligible, will not affect anything inside (no employee relocation etc.);
• Raised dividend +25%, positive future outlook (current dividend yield stands at 1.6%);
• Timely 1.25B USD buyback program of 197M shares, accounting for ~13% of shares outstanding (mentioned already);
• U.S. move to unlock share value (management sees shares as undervalued compared to peers);
• Cube development model leads to increased well completion efficiency. +21% pump time; x2 pumped fluid 2019 Q3 vs 2018 (don’t ask…), but company positions itself as an innovator in the industry, long history, and margins prove it;
• 35% reduced cycle times;
• “World-class assets”
• Strong balance sheet and deleveraging profile (I would argue, but solid cash flow backs them up);
• 2020 priorities: FCF over growth if oil prices were to go down again.
• Principles: driving returns, strong Balance Sheet, constant innovation (yada yada…)
• if oil prices stay in same level or improve – everything goes to balance sheet (shareholder);
• Encana operates everything they do. (in house know-how) (again supported by margins, in few minutes);
• Extraction quantity vs employee count ratio leading in industry (did not proof check);

Business Environment in Canada

Justin Trudeau, Canada’s Prime Minister is a far-left politician whose policies have been really unfriendly to classical businesses like Encana’s.

Here’s an interview with former Encana CEO Gwyn Morgan about the recent political environment and local communities. I suggest two things: put video at 1.25-1.5 speed to save time and read comments. Common Canadians sharing their woes. Gives good insight. There are plenty of related interviews, if you are interested.

If you look at the economy, why it’s still doing well. It is because the government has been pouring huge amounts of debt funded spending into the economy which has replaced a lot of private sector investment, that’s leaving the country.

Gwyn Morgan

So Encana is not really loved by Trudeau’s Government, business environment got worse over the years, management got fed up with low market valuation and decided to change its domicile to United States under new name Ovintiv.

Encana’s Redomicile to States & Name change to Ovintiv

Passive investing continues to rise (ETF investing) and Encana Corporation aims to tap into some of this passive capital stream. US equity market is almost x15 the size of Canada’s and most of US ETF funds can not invest in companies, that are based in other counties. Change of domicile will elevate this barrier of capital inflows.

At the same time, Encana Corporation is shedding its name and rebranding to Ovintiv (new ticker on both TSX and NYSE exchanges: OVV). Redomicile and brand name changes are due to regulatory processes and are about to be completed in early 2020.

While U.S. E&P peers have passive shareholder (index funds) presence of ~30%, Encana’s passive ownership is only 10%. Executives estimate this move will close the disconnect between intrinsic company value and share price and bring around 1B USD additional demand from index funds.

We firmly believe the move to U.S. domicile will be positive for our shareholders. Very few times in a company’s existence can it easily act on such a clear value disconnect. This time next year, subject to the discretion of the indices, we would expect to be eligible for inclusion in the S&P 400 & 1500 indices, Russell 1000 & 3000 indices, CRSP Total Market & Small-Cap indices and numerous applicable secondary indices such as the S&P XOP.

From Presentation for Investors

Quick peek at Energy ETF’s and Peers

I looked at the three largest Energy ETF funds by Market Cap. Top 5 and Bottom 5 members of each fund. Their Market Cap as of last Monday, Debt/Equity ratios and Operating Margins. Note, that Encana’s Operating Margin today stands at competitive 26.3%.

Even in conservative scenarios (not including S&P500 membership, which Encana has good chances being included) capital inflows should be substantial.

Technical Analysis for Encana Corporation

I’m a lousy technician and carried skills from my teens and first experiences in Forex, so nothing fancy here, just main trend lines. First long term perspective:

Looking closer, we can see a clear 3 times tested support line at 4 USD.

What seems to be happening, is the backtest of trendline, making a new support out of previous resistance. And of course, that’s part of wishful thinking.

Favorable Insider Trading Activity

As you can see, the stock is trading at near all time-lows and executives are using this as an opportunity to acquire equity at discount (subjective) while in management words: “there’s disconnect between stock price and intrinsic value”.

The table below shows management trading activity from 2019 H1, which cumulatively accounts for more than a million USD of insiders funds one-way investments.

Extremely Quick Take on Macroeconomics

• Macroeconomy according to the latest data is quite solid: slowing industrial production is offset by retail spending;
• Trump will finish trade-war just before the election;
• FED is scared to scare market participants and Trump will can not allow a crash. Cheap capital ensures it;
• Recently it was addmited FED’s not QE is actually QE;
• Across the Ocean: Germany’s GDP just avoided recession in Q3;
• New ECB head Lagarde is a very diplomatic woman with strong fiscal policy push.

Conclusions

Energy Sector is been beaten down for quite a while. Demand for oil is strong and renewables in short term can not replace it. Encana financial performance looks solid, management sees a huge disconnect between share price and intrinsic value and has made personal as well as corporate move (redomicile to US to access US ETF capital) to close this gap and create value for shareholders.

A lot of puzzles pieces paint the picture of the perfect storm for Encana Corporation (future name: Ovintiv, with ticker OVV) share price with asymmetric risk-reward ratio. We will see how this turns out.

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Updated Portfolio

Don’t forget my limited responsibility (disclaimer). I have entered this position on Monday at $4.68. I set no target price, but we are talking multiples here. Downside case: huge warning would be a break of 4 USD support line, but that must coincide with weakening macro / financial situation of the company.

Target holding time: at least half year from redomicile change.

Updated portfolio structure: