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Introduction and Overview

Canadian Oil Sands Ltd. (COS.TO, OTCQX:COSWF) owns a 36.74% stake in the Syncrude Joint Venture, making them the largest partner involved in the project. This is also their sole producing asset.

The Syncrude operation involves the mining, extraction, and upgrading of bitumen into a light, sweet synthetic crude oil, which fetches a price roughly analogous to WTI crude. Net to Canadian Oil Sands, proved and probable reserves total 1.8 billion barrels, which is sufficient to last around 45 years at current production levels of ~40 million barrels per year.

Over the course of the next several years, until Q2 2015, COS will incur in a large amount of CapEx, totaling roughly 3 billion (a substantial amount when considered in relation to COS's asset base of 10 billion). 2 billion of this total will be devoted to mine train replacements and relocations, which will serve to enhance efficiency and reduce maintenance downtime. The remaining 1 billion will fund environmental sustainability projects, which are required in order to comply with impending legislation from the Alberta Government. While environmental projects are important from the perspective of maintaining government-granted operating leases and creating the potential for future leases, they offer no direct productive benefits.

In addition to annual maintenance CapEx of around 325 million, major project CapEx associated with these projects is estimated based on the following figure:

COS currently pays out a quarterly dividend of 0.35 per share, resulting in a yield of 6.83% (based on the January 4 closing price of 20.50). Although the yield appears attractive, high yields do not normally exist unless there is some degree of incremental risk associated with them. The dividend sustainability of COS is one of the things I will examine in this article.

At the end of 2010, COS reorganized from an income trust to a corporate structure, which led to dramatic changes in their tax situation. Prior to reorganization, distributions to trust holders were tax deductible, creating an incentive for the disbursement of excess cash. Under the income trust structure, a tax rate of 39% was applied to earnings, less payouts. Moving forward, income is taxed at a corporate rate of 26.50%, however, dividends are no longer deductible.

Due to the nature of oil sands operations, COS has a cost base which is largely fixed (i.e. it does not vary significantly with production). These costs are incurred regardless of how many barrels are produced or how much they are sold for. Consequently, the two most important profitability drivers are the price of WTI crude oil and production volumes. This essentially makes COS a leveraged play on the price of oil. A sustained increase in oil prices and steady production volumes would make COS more profitable than conventional oil plays. On the other hand, an operational interruption, unexpected downtime, or depressed WTI prices can result in a substantial hit to earnings.

To this end, COS has stated that until the end of the decade, their primary focus is on improving capacity utilization and operational efficiency. Around 2020, they plan on turning their attention towards the development of new fields. For this reason, growth opportunities will not be robust during the intervening time period.

Aside from WTI oil prices and production volumes, other important measures affecting profitability include:

1. The CDN:USD exchange rate. The synthetic crude oil (SCO) produced by COS is sold at prices based on WTI crude, which is denominated in USD. As such, the company will realize higher revenue when the US Dollar rises and vice versa. This effect is offset to some degree by interest and principal payments made on debt which is denominated in USD. These payments become more burdensome as the USD rises and less so as it falls.

2. WTI-to-SCO premium/discount. Due to refinery access, proximity, and pipeline capacity, SCO tends to sell at a small premium or discount, relative to WTI crude (historically, +/- $2 per bbl). Recently, due to refinery constraints and associated transportation costs, this spread has been larger, ranging from a premium of ~7/bbl in 2011 to a discount of ~4.5/bbl in 2012. As a result of supply and demand dynamics in North America, SCO could continue to sell at a discount for several years to come. Issues include: lack of pipeline access (exacerbated by the Keystone Pipeline issues), refinery, shale oil has increased the inland North American supply of crude oil, which will limit prices, all else equal.

3. Natural Gas prices. As an important input to the upgrading process, natural gas prices affect production expenses. Due the abundance of NG supply in North America, these costs should remain subdued for the foreseeable future.

Historical Growth

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Since 2001, the Syncrude project, as a whole, has increased production from 81.4 million barrels per year to 105.3 million barrels in 2011. This represents a compounded production growth rate of 2.4% annually. Allowing for reasonable maintenance downtime, the current theoretical maximum production capacity is 127.8 million barrels (or 46.9 mmbbl net to COS). Assuming management is successful in their attempts to improve capacity utilization, production could rise up to 21% from current levels (note: at the current CAGR of 2.4%, it would take just over 8 years to reach this target).

Canadian Oil Sands has also increased their ownership interest in the project from 21.74% to 36.74% over the last decade. There is the possibility of future ownership increases, should other partners be willing to sell all or part of their stake.

Adjusted for inflation, diluted EPS has grown at an impressive annual rate of 10.32% since 2001. There has been some significant volatility in per-share earnings, particularly in 2008 when oil prices peaked near $150/bbl and in 2009 when they bottomed at around $40/bbl. This example highlights the earnings fluctuations that can result from COS's high fixed-cost base. Importantly though, COS did not experience a net loss during this period, even despite highly volatile oil prices amid the financial crisis.

Dividend History and Sustainability

As seen above, COS has had a somewhat volatile payout history. This was partially a result of their former income trust structure. Under this structure, the tax deductibility of disbursements meant that payout policy was closely tied to earnings, and varied accordingly.

Since reorganization in Q1 2011, COS has paid out a steadier quarterly dividend. Starting at 0.20 per share, it was raised to 0.30 per share in the following quarter, and then to where it stands now, at 0.35/share in Q2 2012. Although this stability is promising, it provides a limited picture due to COS's relatively short history under a corporate structure, as well as a lack of earnings fluctuation during the time period.

Quantitatively speaking, since the beginning of 2011, dividend coverage has been strong on both a Net-Income and a Free-Cash-Flow-to-Equity basis. Both ratios have been well above 1, indicating that COS should be able to maintain their current dividend. Their 2011 payout ratio was about 50%, which is not especially high considering their dividend yield. However, the 2012 payout ratio looks as though it will come in higher, at around 65%, depending on Q4 earnings.

Moving forward, COS has stated their intention to maintain a quarterly dividend of at least 0.35 per share. Despite strong coverage at present, COS will not be able to fund both their current dividend and impending CapEx unless: 1) operating cash flow turns out to be stronger than anticipated, or 2) they issue debt. Therefore, it is likely that COS will be increasing its debt over the next few years.

Barring some significant economic turmoil which adversely affects COS's earnings, I don't believe dividends will be cut. However, I also do not believe they will be raised until the conclusion of major-project capital expenditures in the first half of 2015.

Profitability

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In 2011, ROE, ROA and net/operating margins were all very robust and above their longer-term averages, suggesting that 2011 was a strong year for COS in terms of profitability. In addition, the long-term averages themselves also appear strong, with ROE and Net Margin both in the low 20's. Note: although record oil prices in 2008 skewed the averages upwards, this effect was mostly balanced out by a weak year in 2009.

Further examining ROE produces the following results:

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Over the past 6 years, taxes have been the most volatile component and have skewed ROE upwards on several occasions due to tax recoveries. Moving forward, COS is now subject to a corporate tax rate of 26.50%, however, it's possible that tax implications (on a cash basis) will be reduced both by applying available income tax deductions (which currently total roughly 953 million), and also by depreciation on new assets from impending CapEx.

If debt is increased over the next couple years, financial leverage will increase, boosting ROE. This will be partially offset by higher interest payments and by lower asset turnover (if the money from debt issuance does not result in higher sales). We can also see that Operating Margin was the major cause of the increase in ROE from 2010 to 2011. Once again, due to COS's high fixed-cost base, maintaining a high Operating Margin will depend on sustained high oil prices and stable production.

Cash Flow and Financial Stability

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Due to the accruals accounting system, it's possible for management to manipulate reported earnings. To ensure this is not the case, there should be a stable relationship between cash flow and earnings, with cash flow ideally exceeding earnings. COS's cash-flow generation has been consistently higher than its operating income. The quality of COS's earnings is further confirmed by a low balance sheet accruals ratio and cash flow accrual ratio (not included in figure).

Cash flow to reinvestment measures a firm's ability to fund expansions and ongoing capital expenditures from operating cash flow. A ratio below 1 would indicate that a company would need to deplete their cash reserves and/or seek debt or equity financing. Historically, COS has had strong coverage, however, it has been weaker in 2012 due to higher CapEx. This trend will likely continue for several years.

Cash Flow-to-Debt and Cash Flow-to-Interest measure a firm's ability to cover their existing debt burdens and also assesses whether they are able to pursue additional debt financing. COS has extremely strong interest coverage. Even during an extremely weak period in 2009, their cash flow covered interest almost 7 times. CF to Debt is also strong, with operating cash flow exceeding total debt in every year except 2009. These two measures suggest that COS will comfortably be able to support an increase in debt, if necessary.

In terms of working capital management, COS's Current Ratio has historically averaged 2, indicating strong liquidity. A ratio above 2 is preferable, but although the Current Ratio has slipped slightly relative to 2011, it is still quite strong at 1.93.

In Part II, we'll take a look at COS's earnings and attempt to estimate a value per share using several different methods (including discounted free cash flow, a discounted dividend model, and relative to other energy players with similar business profiles).

*All values are in Canadian Dollars unless otherwise specified

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Canadian Oil Sands: Analyzing And Valuing The Oil Sands Operator - Part I