Sometimes, some really large and successful companies just don't appear to attract that much attention. They quietly go about doing their thing year in and year out, producing good results yet the market always seems to pay attention to other companies. One of those companies may be ARC Resources (OTCPK:AETUF).
Source: ARC Resources First Quarter, 2016, Report Slides
The company is a Canadian gas producer, with some oil production that operates primarily in Western Canada. The roughly 20-year history is fairly impressive when one considers current gas and oil prices. It should be noted that the long-term return for investors would be less, but still good if the investor chose to not invest the dividend. With the dividend recently reduced, this may be the time to look at the company as the long-term debt level is fairly low, the business itself appears to be in good shape, and the challenges are very manageable.
In fact, this is just the kind of company that investors should consider at the bottom of the market. Long-term debt is low enough to be easily covered by the latest quarter cash flow that was reduced by lower commodity pricing. While cash flow is also low and was considerably aided by a hedging program, investors in a cyclical industry can expect that cash flow to return to normal levels over time. That bounce back of cash flow levels should provide an above average return (with the dividend being icing on the cake) with far less risk than average.
Source: ARC Resources First Quarter, 2016, Presentation Slides
That C$6.10 operating expense is one of the better figures out there for the industry, even when considering that the company is primarily a gas producer. The finding and development costs are also excellent. With the cost reductions shown, the company is clearly keeping pace with the rest of the industry, and can be expected to expand operations as industry conditions improve from gas price rallies sooner than many operators.
Source: ARC Resources First Quarter, 2016, Earnings Presentation Slides
The first slide shows the operating cost when the company is producing solely gas. This play is the company's main asset and those are industry-leading costs. BOE costs can be expected to vary as liquids are introduced because liquids can be more valuable, higher operating costs are allowed and can still have very efficient costs. But clearly, when solely natural gas is produced, this company is focused on very low, excellent costs. This agrees with the above average profitability claim on the very first sets of slides in the article.
With the replacement ratio being above 100% in the second slide, production growth is reasonably assured for the future even as the capital budget has shrunk to accommodate lower commodity pricing. The company has a moderate hedging program that returned the company to profitability in the first quarter and that hedging program extends five years out. Many companies are not close to showing profits (let alone a gas producer) even with their hedging program helping.
Source: ARC Resources, First Quarter, 2016, Earnings Presentation
The company can always move to its better acreage during hostile industry conditions to wait out the lower pricing. It has plenty to drill for years on its best acreage. The company is also building plants and expanding infrastructure to accommodate more growth once commodity prices improve. Then the company can expand the drilling knowing that the infrastructure is in place to support more production.
The Dawson slide above represents about a quarter of the company's total production and gives the company its best return for the company. So at times like this that part of the acreage gets an outsized amount of the capital budget and management attention. But the others are reasonably profitable in this environment also. Plus the company has the option of drilling in areas of increased liquids production to increase profitability.
So between the cost cutting and the product mix optimization, this company will claw its way back to profitability whether or not commodity prices rally. There would have to be a fairly significant and sustained drop in commodity prices to keep this company reporting losses.
In the first quarter, the company showed a sales prices of C$28.20 BOE with a netback before hedging of C$15.91 after operating expenses, transportation charges, and royalties. A netback that is more than 50% of the selling price at what is probably an industry bottom is excellent. With commodity pricing rallying somewhat in the second quarter, that netback can only improve. One would think that would pique the market interest in the company. The hedging program added another C$4.12 BOE.
One of the things that caused the company to report a loss in the first quarter is the depreciation charges of C$11.87 BOE. With costs to drill and produce dropping so rapidly, it takes a few years for allocated costs such as depreciation and other non-cash charges to "catch-up" to the actual future costs of drilling wells and producing the resources. Those non-cash charges like depreciation are heavily weighted to the higher cost wells and production infrastructure of the previous years.
As those older cost projects depreciate and become worthless, the non-cash charges will reflect the forward costs of the business when costs stabilize. But it has been some time in the industry since costs have stopped dropping. Right now, they appear to be dropping quite rapidly and the end to these drops is not yet in sight. So depreciation will continue to be an inaccurately high measure of drilling new wells, and building the supporting infrastructure going forward for the foreseeable future. So company reporting will continue to understate significantly the profitability of new projects in its reporting unless they are reported separately.
Source: ARC Resources, First Quarter, 2016, Earnings Presentations
This is where management summarizes the results and really, the money is there. Management beat its own production forecast to show production growth in the first quarter and followed up by beating the operating costs. So that growth was not at the expense of operating costs, instead, it was superior operating performance. General and administrative is running a little above budget in the first quarter, but there could be some lower cost quarters in the future that will average those costs to budget. In any event, investors can believe that management is closely monitoring those costs and will either bring the costs in line with the guidance or change the guidance and explain why.
Source: ARC Resources First Quarter, 2016, Earnings Presentation
The company has a balance sheet with very low debt. Much of the debt is in notes, which is far more stable than a bank loan because those notes do not have periodic redetermination clauses. The company has several bank lines with more than C$1 billion in liquidity and has the credit rating to deal with any credit issues that will appear in the future. The reduced cash flow can easily handle the outstanding debt and would enable the company to make an acquisition if it chooses to acquire another company or a substantial lease position.
The company has some capital projects underway to enable it to handle more liquids in the future. However, the gas projects that are currently available are also very profitable in the current environment. Some of that new profitability is hidden by the older production. This company, like many in the industry, needs more of the new wells and less of the ones already drilled to change its profits. But it has the balance sheet strength and available credit to proceed to the new era at its own pace. Right now, management is choosing to live within its cash flow. Should commodity prices improve, expect this company to be one of the first (with its low costs) to profitably increase its activity levels.
This management is brutally honest and provides a lot of detail of the progress made by major project area. That is always a desirable goal for any investor. While the stock value plus the long-term debt total divided by the cash flow ratio is definitely high (at more than fifteen). Cyclical companies typically look very expensive at market bottoms and fairly cheap at market tops. Since cyclical stocks tend to rally early and provide much of the capital gains early in the recovery cycle, this stock is probably worth investigating for a long-term investment now.
The first quarter commodity prices were terrible, and gas prices probably will not strengthen until there is a reasonable winter (though commodity prices have rallied somewhat). Last winter, the weather was unseasonably warm due to El Nino, and this year, the weather is predicted to be cold due to La Nina, but forecasts are not usually all that reliable. In the meantime, terminals are being built to export gas to markets with higher pricing and electric utilities are building gas run plants. With industry competitors going bankrupt and cutting back production due to financial constraints, the end of low natural gas pricing may be near.
A return to average prices and the cost cutting could easily triple the cash flow of the company over the next two years (from the annualized first quarter results) making this stock a bargain that could easily double in price. Many of the company's costs do not directly vary with industry activity levels (though if the activity level changes enough, there could be a varying response over time with some costs), so more than half of any price increase will go to the bottom line.
Costs have dropped so much that the company will start the industry recovery with lower (and dropping) costs than when the last cycle ended: Those lower costs will lead to increased margins. With the infrastructure built, the company will have the ability to drill, hook-up the wells, and produce without having to worry about infrastructure expansion for a while. Depending upon the extent of a price rally, the company can choose to hedge and expand drilling considerably to take advantage of more favorable pricing. So in a recovery, this management has the basics in place to expand production by 20% annually if there is enough of a recovery.
This company has a 20-year average of returning 15% to investors when the dividends are reinvested. The last few years have been below that average but management is clearly taking the necessary steps to return the company to that growth path. Above average management will have great years to balance out the last few years. But typically, those results come without warning and the market focus happens when the results are history. Right now, the market appears to be focused on some very miserable results, so the risk of a sustained price decline is probably very low. In any industry recovery, this company could very quickly be earning C$1 per share every quarter or more which makes the stock look very cheap right now.
Disclaimer: I am not a registered investment advisor, and this article is not to be construed as an offer to purchase or sell stock. All investors are recommended to read all the filings of the company and the press releases to assess for themselves whether or not this company fits their investment risk profile.
Disclosure: I/we 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.
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