Cardinal (OTC: OTC:CRLFF) is a Canadian junior producer located in Alberta with three core areas: Wainwright, Bantry and Slave Lake. The company is one of my favorite names in the Canadian E&P space for its disciplined management, low debt profile, low decline and acquisition prospects. Cardinal provides an excellent way for investors to secure an attractive yield (~5%) while waiting for acquisitions, both inbound and outbound as Cardinal has the balance sheet to acquire and at the same time appears as an attractive target to larger peers.
Source: August Corporate Presentation
Cardinal has a unique business model that pays meaningful dividends while completing accretive acquisitions financed with equity and debt. Cardinal is an ideal candidate to your portfolio if you are looking for safer names in the Canadian small-cap producer space with potential of significant capital appreciation due to prospective M&A activities.
Cardinal's success depends on three things: 1) low decline and low capital investment required, 2) pristine balance sheet with low leverage, 3) accretive acquisition financed with equity and limited debt.
To think about how Cardinal is able to achieve both sustainable dividends (~5% yield) and capital program to keep production flat at today's strip pricing, we need to understand that Cardinal's assets are low-decline assets. Most of Cardinal's wells are producing <10 boe/day and under waterflood. Small wells are expensive to operate as there are fixed costs associated with each well no matter what the production is. Waterflood is also expensive because of the need to dispose waste water. The situation becomes interesting as Cardinal manages to run a large number of low-producing wells and ended up with best-in-class decline rate at ~15% on a corporate level, and much higher operating expenses both due to waterflood and well counts. Cardinal's operating costs is ~$20, much higher than peers such as PWE at ~$10 (PF for Phase II completion) and RRX at $9. Cardinal currently produces ~15,000 boe/d, after applying 15% decline rate, we arrived at 2,250 boe/d that needs to be replaced. Cardinal has previously indicated that if capital budget is reduced by $15 million, production will fall between 5% and 10%. Using mid-point of 7.5% decline on total production of 14,600 boe/d, we are getting $13,700 boe/d replacement costs. In order to maintain production flat based on 15% decline rate, we are getting $25 - $30 million required maintenance capital spend.
Cardinal has increased its base capital spend by $10 million, partially to fund drilling of 4 wells in Bantry and 1 well in Slave Lake, further cost reduction and to increase abandonment and reclamation budget by $2 million. The increased drilling activity is positive for the company as a source of modest organic growth in the range of 5%, while spending within its means. Cardinal is expected to generate cash netbacks of $14 in 2016 at current strip pricing, and FFO of $62 million. The sensitivity table below shows that 2016 FFO is estimated to increase $12 million for each $5 increase in WTI.
Cardinal has a simple capital structure, with the right amount of equity to support a $10 - $20 share price. Debt is $75 million at end of Q2 2016 comprising of $25 million bank debt and $50 million convertible debentures. Cardinal could easily pay off its bank debt with FFO but growing production is more lucrative. Assuming $25 million is spent on growing production, based on $13,700 boe/d drilling costs, we are seeing an increase in production of 1,800 boe/d, which translates into $9 million in additional FFO based on $14 netbacks ($14 per boe x 1,800 boe/d x 365 days). Three year payback indicates a high ROI for additional capex, which is also why Cardinal should grow production instead of paying down debt since its leverage is already so low.
The future success of the company still predicates on future acquisitions. In order to execute successful acquisitions, several considerations need to take into account including access to capital markets, leverage, and the new Alberta LMR rule. Cardinal so far has had track record of access to capital markets, as it recently completed a $60 million equity offering. Leverage is under control and provides ample dry powder to fund future acquisitions.
Alberta regulators imposed an interim rule that requires all potential acquirers to possess a Liability Management Rating (LMR) of no less than 2.0, which is roughly calculated as asset / ARO. In Cardinal's case, management responded quickly to the rule change which is a good sign. Cardinal has assets of $942 million as of Q2 2016, and decommissioning liability of $555 million on an undiscounted and inflated basis, which translates into an LMR ratio of 1.69 at the end of Q2 2016. Cardinal indicates that it will increase its LMR to 1.75 in July without spending any money, and expects to reach 1.90 at the end of 2016. It means that Cardinal likely won't be making any acquisitions for the remainder of 2016. However, as Cardinal integrates its Slave Lake acquisition and, if oil prices recover, it will be in a position to pursue further acquisitions.
Cardinal is trading at fair level of ~$10, and presents an attractive dividend-paying investment for tax-free accounts. As mentioned above, a US$5 increase in US WTI would result in $12 million increase in FCF. Cardinal currently pays out $28 million in dividend net of DRIP each year, which means that at ~US$60 WTI, we could see an increase to dividend that will boost your effective yield.
Cardinal is one of the few names that still pay a dividend that is sustainable at current strip pricing. Cardinal's future catalysts include a rising oil price, dividend increase, accretive acquisition, or corporate takeout by large players. To me, Cardinal appears as an underappreciated stock that has solid fundamentals and clear path going forward: getting paid 5% while waiting for acquisitions, either accretive acquisition or sale to a bigger player.
Disclosure: I am/we are long CRLFF.
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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