Encana Has A Bright Future

| About: Encana Corporation (ECA)

Summary

Long term debt is more than $5 billion. But the long term debt-to-cash flow ratio is comfortable.

Operating Costs should be reduced by 20% over the next two years.

The company was profitable before the non-cost charges (ceiling cost calculation and hedging).

The company has liquidity of nearly $4 billion, no real covenant restrictions, and no long term debt due for a few years.

The company still pays a dividend. With its low costs, this should be one of the first companies to rally in any energy rally.

Production exceeded 274,400 BOED. Encana (NYSE:ECA) also managed to increase its cash flow to $383 million from the third quarter even though commodity prices dropped. Annualized, that fourth quarter cash flow is higher than the $1,430 million cash flow reported for the year. With the very aggressive cost cutting program the company has for the year, there is every possibility that cash flow could increase again, despite hedging factors and commodity prices drops. With total debt of $5.4 billion, the company has a very comfortable ratio of total debt to cash flow of 3.8-to-1. Despite the massive cost ceiling writedowns, the long term debt remains slightly less than the shareholders equity. Having any shareholders equity left after those writedowns is a major accomplishment. The fact that long term debt is less than shareholders equity is a feat that very few companies in the industry have achieved.

Yet the market appears focused on the writedown, even though those asset revaluations will end. Last year the company issued nearly 100 million shares for which it received more than a billion dollars. So Mr. Market is grumbling about the dilution ever since. Then at the beginning of this year, the company, in the annual report noted that it again cut the dividend for the second time since the end of 2013. Even though the fall of commodity prices has been nothing short of extraordinary, and probably the largest change in commodity pricing since the end of the 1970's, Mr. Market appears to worry that a company like this is in no better shape than companies such as Halcon Resources (NYSE:HK), Energy XXI (NASDAQ:EXXI), and Sandridge Energy (OTCPK:SDOC) that are truly on life support. Such market inefficiencies can be exploited by the astute investor for above average profits in the long term. Of course the assumption that goes without saying is that oil and gas prices are at or near their historical bottoms and will stabilize from here forward, rather than continue their free falling ways.

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Source: Encana March, 2016, Corporate Presentation

The company has been managing (click on corporate presentation) through the business cycle by proactively cutting back. There have been several layoffs in addition to a current layoff in process. The company has sold non-essential business and paid down $2 billion in debt. Now there is no debt due for several years. The company management actually managed to increase the credit facilities and extend the maturity of the credit line. The one covenant that the credit line has is easily met, so there are no covenant worries. This could be a sign that the company will be on the prowl for acquisitions that fit its key operating areas.

Another key figure is the operating expense reductions. This company already had low operating costs to start with, but the drive to continue to reduce costs is obviously still very strong. The main point is that this company has done what it needed to do to survive the latest downturn, and while shareholders may not be thrilled about the dividend cuts, workers may not like the layoffs, and shareholders the dilution from the stock sale, the fact is that the company ratios and liquidity are more than adequate going forward for the most probable scenarios. At times like this a reduction in financial leverage is indicated, and that is just what happened.

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Source: Encana March, 2016, Corporate Presentation

The company has been managing (click on corporate presentation)to project further cost reductions, and it has enough of a hedging program to provide some protection in case the commodity pricing drops too fast before some of the cost cutting programs take effect. The company has a heavy dependence on gas. Gas prices have done worse then oil in the past, however, the reduction in activity of drilling is a positive development for gas, as is the construction of several export facilities. Go gas should have at least as positive a future as oil. The cost cutting and the hedging should enable the company to get to that future. In the meantime, the focus on the best four operating areas practically guarantees that the company's costs will drop further in the current fiscal year. The company has some hefty processing and transportation costs that it needs to focus on, and management has indicated they will reduce those costs, but its operating costs are among the best out there.

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Source: Encana March, 2016, Corporate Presentation

The company management demonstrates (click on corporate presentation) exactly how the company leads in costs. Several of those well costs are industry leading costs. In addition, management is targeting production rates, and other operational areas for more improvement. In the Permian, for example, the latest well costs comes with a second highest EUR in the industry comparison given by the company. While management can pick its competition often enough, that EUR rate is definitely above average. These kinds of moves will drive down depreciation as well as finding and development costs going forward.

In the Eagleford, the company can drill and complete a well in less than four days. Plus the cost of the wells has decreased by a third over the last few years. That is before the company talks about the large increases in the first thirty days of flow rates and the reduction of the decline rate.

This company, like most, was stuck with the high cost wells on the books from prior years before the latest round of operational improvements. So the writeoffs taken really reflect the costs of those older wells being adjusted going forward. But accounting costs are different from the company's own profitability measures. Many of these companies calculate their own breakeven costs, and make sure they are hedged enough to guarantee that breakeven. Then the "pure profit" part of the production often runs for years with little or no hedging. The only worry at this point is cash production costs because supposedly the rest is paid for. The accounting department, on the other hand, spreads the costs over the life of the wells, so shareholders really don't know the profitability of the wells until the end of the well's life. With the titanic change in pricing and operating procedures, those old wells are not nearly as profitable as projected, and the old cost assumptions are invalid, so extremely large writeoffs were the result.

The company actually reported earnings before impairments (cost ceiling adjustments), and some hedging losses. Even though it was about eight to nine cents a share, and nowhere near the earnings of a few years ago, the positive earnings before the non-cash charges are a major milestone that few in the industry can claim.

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Source: Encana March, 2016, Corporate Presentation

The company managment (click on corporate presentation) guides to a slight reduction from the 2015 ending production. However, if the company exceeds its cost cutting goals, or commodity prices begin a sustained rise, this could very easily change. The company has a very large unused line of credit that could very easily finance a fast increase in activity. On the other hand, with its low level of debt, the company could hunker down and collect the money from the wells that are producing until things get better. In any event, near the bottom of the market, this company has an ideal financial position, with a steadily improving cost structure. A lot of other companies dream to be in this position at this point in the market cycle.

The company stock closed under $6 per share (March 25, 2016) giving the company a market cap of about $5 billion. Operations were above breakeven in the latest fiscal year before the non-cash charges, so this company will probably be one of the first to swing to a profit as the non-cash charges decline in each succeeding quarter. Stable pricing combined with the hedges and cost cutting could easily mean earnings of $.50 a share this year. If prices simply stabilize, this company has the low costs and the means to lower operating costs more so that it could increase earnings 20% a year at a minimum. If prices rally a little, the company will probably quadruple its earnings over the next five year period and earn $2 per share. When combined with the current dividend yield of more than 3%, this stock offers a very attractive rate of return. At ten times the projected fifth year earnings rate, the stock could easily be a $20 stock.

Disclaimer: I am not an investment advisor and this article is not an investment recommendation. Investors are urged to read all of the company's filings and press releases to determine for themselves if this company fits their investment profile.

Disclosure: I am/we are long EXIXF, SDRXP.

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.