While I remain optimistic on the energy sector at large, few companies attract me as much as integrated oil & gas plays. In this article, I will run you through my DCF model on Suncor (SU) and then triangulate the result with a review of the fundamentals against Marathon Oil (MRO) and Encana (ECA). I find Marathon to be substantially undervalued while Suncor and Encana have more speculative upside.
First, let's begin with an assumption about the top-line. Suncor finished FY2011 with $39.8B in revenue, which represented a 22% gain off of the preceding year. The year before that, growth registered at 31.2%. Over the next half decade or so, I model per annum growth at 13%.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 46% of revenue versus 25% for SG&A, 0.5% for R&D, and 17% for capex. Taxes are estimated at 30% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to get free cash flow. I estimate this figure hovering around 0.5% of revenue over the explicitly projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 9% yields a fair value figure of $32.85 for north of 8% upside.
All of this falls within the context of a growing commitment to returning free cash flow back to shareholders:
[I]n February, we announced a $1 billion extension to our normal course issuer bid, and that brings the total of that bid up to $1.5 billion. In addition to the $500 million that we purchased last year, we're now up to just over $300 million purchased in just over the past 2 months and canceling almost 10 million more of our common shares…
Now of course, our share buybacks are an event, and -- whereas dividends are a long-term commitment to our shareholders…. Suncor board yesterday approved an 18% increase to our quarterly dividend. And that brings our 5-year compound annual growth rate for our dividend up to 21%, which is one of the best in the business.
From a multiples perspective, Suncor also appears attractively priced. It trades at a respective 11.1x and 8.1x past and forward earnings versus 11.4x and 6.4x for Marathon and 139.3x and 122.9x for Encana.
Consensus estimates for Marathon's EPS forecast that it will grow by 10.6% to $3.55 in 2012,, grow by 19.4% in 2013, and then decline by 9.4% in 2014. Assuming a multiple of 11x and a conservative 2013 EPS of $4.20, the stock would head skyward by 72.4%. The base has been set low for the company that, at this point, the downside is exceptionally low. And this favorable risk/reward comes on top of a 2.3% dividend yield. Given that the stock has a beta of 1.4, I expect the discount to intrinsic value to be cleared off quicker relative to the market at large.
The story is much rockier at Encana. Consensus estimates forecast that company's EPS growing 44.4% to $0.78 in 2012, then plummeting to $0.18, and returning to $0.68 in 2014. Investors who feel confident in predicting E&P trends can substantially profit off of exploiting the "ups" and "downs". Speculation will be substantially greater at Encana and Suncor than at Marathon due to the greater uncertainty over growth.
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