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Note: All dollar figures in Canadian dollars.

Background

Canadian Oil Sands is a Canadian oil and gas exploration and production company. Per the 2011 annual report, the company owns one producing asset, a 36.74% interest in the Syncrude Joint Venture. COS' operations are within the Athabasca oil sands region of Alberta, Canada.

At a current share price of $20.58, COS is undervalued. COS has significant oil reserves, strong cash flows and a healthy balance sheet to support operations.

Oil reserves

Per COS' annual information form, COS has net proved plus probable reserves of 1,522 million barrels, with an estimated value of $87.271 billion.

At 2012 estimated production of 42 million barrels, this represents over 36 years of reserves. Using this production rate and a discount rate of 5%, the oil is estimated to be worth $32.703 billion. Compared to COS' market cap of $10.020 billion, existing reserves are valued at more than three times the current price of the company.

A unique feature of COS is that it is largely immune to the Canadian heavy oil discount. COS upgrading facilities convert raw bitumen to synthetic crude oil (SCO). SCO is comparable to light sweet oil that is immune from the heavy oil discount. North American light sweet oil is typically measured at West Texas Intermediate (WTI) pricing, during 2011 SCO averaged a sales price $7.32 greater than WTI due to selling in certain US markets that price oil on other measures (such as Brent and Louisiana Light Sweet).

Cash flows

COS makes quarterly dividend payments of $0.30. Given Monday's closing price of $20.55, this represents a dividend yield of 5.80%. The dividend is easily covered by the cash flows of the company. For the year ended 12/31/2011, cash flows were as follows (in millions):

Operating cash flows$1,958
Investing cash flows(644)
Financing cash flows(676)
Total cash flows638

Source: Annual Report.

Note that the above figures include the following (in millions):

Net drawdown (repayment) of bank debt$145
Issuance of shares2
Dividends(533)
Capital expenditures(643)

Source: Annual Report.

Cash flows net of dividends were $1,171 million, easily covering dividend payments of $533 million. Cash flows net of capital expenditures were $1,281 million. Capital expenditures over the next three years are expected to be (in millions):

Year

Project Spending

Capitalized MaintenanceTotal
2012$900$405$1,305
20131,0004051,405
2014400405805

Estimated based on budgeted 2012 capitalized maintenance expenditures.

Sources: Annual Report and Annual Information Form.

Project spending is inflated in 2012 and 2013 as Syncrude works on replacing/upgrading four mining trains and two tailing ponds. Management expects spending on these two projects to taper off significantly after 2014. If we assume that aside from capital expenditures, 2012-2014 cash flows are identical to 2011, total cash flows for 2012-2014 would be (in millions):

2012$(24)
2013(124)
2014476

Given management expects increased production in 2012-2014, it is possible that operating cash flows will cover both dividend payments and capital expenditures. Regardless, oil prices are volatile, therefore COS increased their cash reserves to $718 million at year end so that debt or equity financing will not be required to fund investing or financing activities under any normal situations.

COS' cash base plus estimated future operating cash flows easily cover both dividend payments and estimated capital requirements for the foreseeable future. The dividend appears in no danger of cuts in the next two years, and will likely be increased in two years, once the current capital projects are completed.

Balance Sheet

COS is a well capitalized company. A current ratio of 2.37 implies it will have no problems in meeting current commitments. Long-term debt of $1.132 billion is healthy against assets of $8.620 billion. An interest coverage ratio of 7.70x indicates the debt is not burdensome.

Conclusion

COS is a well-capitalized business, with significant cash flows and years of reserves in the ground. One year ago, COS traded for more than $33/share. I find no reason for the subsequent 40% drop in share price, given COS cash flow generation in 2011 and future outlook. COS should return to the $33/share level within the next year. If you purchase COS today, you can collect a 5.83% dividend while you wait for the market to correct the share price.

Source: Canadian Oil Sands Is Undervalued