Canadian Oil Sands: Analyzing And Valuing The Oil Sands Operator - Part II

| About: Canadian Oil (COSWF)
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In Part I we took a look at Canadian Oil Sands Ltd. (COS.TO, OTCQX:COSWF) and determined that they have strong historical EPS growth and cash-flow generation, and a dividend that should be sustainable (assuming a relatively stable economic outlook). On the other hand, they do have a high amount of impending Capital Expenditures over the next 2-3 years which will likely have to be partially funded with debt if they wish to maintain their dividend. The good news is that COS can comfortably support a moderate increase in debt. In the second half of this article, we'll take a look at COS's valuation on both a relative and absolute basis.

Normalized Earnings

Looking at normalized earnings and the associated P/E provides a more comprehensive picture as to how a company's earnings respond to the vicissitudes of the business cycle. On a 5-year normalized basis, COS appears very attractively valued at between 10.11 and 10.84 times average earnings, depending on methodology.

Comparative Valuation

To get an idea of COS's valuation relative to the broader TSX energy sector, I compared COS's P/E, Price to Sales, Price to Book, and Price to Operating Cash Flow ratios to the average of 10 of the larger oil companies on the TSX, on a trailing-twelve months basis. The share price used for Nexen (NXY.TO, NXY) was taken on July 20, 2012, directly preceding their acquisition announcement. All other share prices were taken on Jan 4, 2013.

(Note: this table is condensed)

COS trades at a P/E which is more than 1 standard deviation below average, giving them an attractive valuation based on this metric. On the other hand, P/S is slightly above average, but only by about half a standard deviation. The fact that they trade at a low P/E and high P/S is mostly due to COS's high profit margins.

P/B and P/CF are marginally above average, but not notably so when considering that they are both well below 1 standard deviation above.

On a relative basis, COS appears to be moderately attractive, with a very low P/E, and a P/B and P/CF which are roughly in line with the industry average. P/S is slightly on the high side, but again, this is due to COS's high profit margins. Although COS appears somewhat attractively valued, it is worth noting that a couple other companies stand out as being even more attractive, and therefore warrant closer examination (Suncor (NYSE:SU) in particular, which trades well below average on all multiples).

Justified Multiples Valuation

Justified multiples combine several fundamental inputs to determine the multiple that a stock should theoretically trade at. That multiple can then be used to determine an estimate of fair value.

(click to enlarge)

The required rate of return was derived via CAPM. The beta was calculated using a data set consisting of 10 years of weekly price data for COS.TO and the S&P/TSX Composite index. Similarly, the market return is based on weekly compounded returns for the S&P/TSX Composite. The risk-free rate used is the current 10-year Government of Canada bond yield.

The growth rate of 3.69% was derived using the above two normalized P/Es and the TTM P/E.

Note: There is some circularity involved in using the P/E to derive a growth rate and then using that growth rate to determine an appropriate P/E. Invariably, this process results in a per-share value close to the current price. I included this number nevertheless both to make the value more conservative and also in case it represents an accurate valuation.

The justified P/B results in the highest valuation due to COS's strong ROE. Taking an average of the values from each multiple results in a share price of 25.95.

Dividend Discount Valuation

Dividend payments were modeled based on the assumption that the current quarterly dividend of 0.35 per share will be maintained, but not raised until the projected completion of major-project CapEx midway through 2015. After the conclusion of these projects, demands on cash flow should lighten, allowing for potential dividend increases. From mid 2015 until the end of 2018, payouts were assumed to increase at an annualized pace of 10%. From that point onward, payments were assumed to increase at the growth rate calculated above of 3.69% per year in perpetuity. Discounting all dividend cash flows results in a current value per share of 31.17, suggesting that COS is currently undervalued.

This model is very sensitive to growth rate estimates; however, even if a long-run growth rate of 2% is applied (which is in line with very modest economic growth), this results in a value per share of 25.07, meaning that even with a conservative growth estimate, COS still appears undervalued.

Discounted Cash Flow Valuation and Projected Income Statement

This is the most comprehensive valuation metric used; however, since it is based on future estimates for a number of variables, it is also the most subjective and discretionary. Some important assumptions:

- WTI oil prices were assumed to be 95 in 2012 and increase at an inflation rate of 2% per annum.

- Production volume is estimated by COS to be 39.3 mmbbl in 2012. Future year production volumes were assumed to increase at the 10-year historical production CAGR of 2.4% per annum.

- Operating expenses were estimated using a fixed-cost component plus a variable component related to production volumes and revenue.

- Depreciation expense was estimated based on the current expense, increased accordingly as CapEx projects are completed.

- Debt was presumed to have been issued to cover any dividend payments or CapEx which operating cash flow did not. This resulted in an estimated increase in total debt of ~900m from current levels. Interest expense was adjusted accordingly by applying the average rate on COS's outstanding debt to new issuance.

A firm value of 29.76 per share was calculated as the present value of FCFE from 2012-2018, plus a terminal value based on normalized 2018 earnings, times the industry-average trailing P/E of 15.24. However, given the subjective nature of the variables, this model is more useful for developing a better understanding of the effect different inputs and scenarios might have on COS's earnings and FCFE than it is as a straight valuation tool.

Potential Risks & Conclusion

Potential Risks:

· Highly leveraged to the price of oil, creating a risk to earnings if oil prices fall precipitously

· Large amount of CapEx over next several years leaves COS vulnerable to market turmoil and unforeseen events

· A large portion of this CapEx (1 billion) is required for environmental compliance and has little to no productive value. There is the potential for similar expenses in the future

· Strong balance sheet will be affected by potential debt increases (forecasted at ~900 million)

· Strong cash position will be largely eroded over next several years due to CapEx

· Pipeline capacity and refinery proximity issues may lead to a continued SCO discount relative to WTI for several years

· Volatile dividend payout history (primarily due to formerly being structured as an income trust rather than a corporation)

· Few growth prospects for foreseeable future, short of acquiring a larger stake in Syncrude (which would have to be funded)

· Therefore, returns will need to come from operational efficiency and/or sustained WTI price increases for the time being

These risks are likely reasons why COS’s share value is currently depressed. Although they are valid, I believe that they have been more than fully discounted in COS’s current market price.

Assuming pipeline and refinery issues persist for several years and lead to a SCO discount of $5 per barrel, this will result in an annual reduction of $0.09 in EPS (assuming 40mmbbl production volume and applying the average Net Profit Margin of 22.3%). Although not ideal, this will not cripple COS. Furthermore, these issues will not remain indefinitely. Increased rail shipments will alleviate some transportation pressure, while pipeline projects are underway to provide additional capacity (most notably the Keystone XL expansion). This will allow SCO to reach its preferred markets and reduce or eliminate any SCO discount.

In my opinion, the biggest risk facing COS is a deterioration in their cash position and the quality of their balance sheet due to large amounts of CapEx over the next 2-3 years. This risk is partially offset by a strong history of cash-flow generation, which should allow COS’s balance sheet to recover quickly following the conclusion of major-project CapEx. However during the intervening time, COS will be more vulnerable to fluctuating oil prices and market turmoil.

On the positive side, COS has demonstrated a high propensity toward paying out earnings in the form of dividends. This is a strong positive in terms of generating continued returns. Strong cash flow and the ability to raise debt in order to cover impending major project CapEx support dividend sustainability. Additionally, maintenance CapEx is not very high, at around 17% of 2011 Operating Cash Flow. This means that there will be ample cash flow available to fund dividend growth following the conclusion of major projects in early-mid 2015.

Although the fact that COS is highly leveraged to the price of WTI crude creates a downside risk if oil prices were to fall significantly, it also creates an opportunity to take advantage of high oil prices. With a high fixed-cost base, COS can realize incrementally stronger profits from high oil prices.

COS’s current share price also appears undervalued. Even using conservative estimates, several different valuation models suggest that COS is undervalued by anywhere from 25 to 50%. Combining this with EPS growth of over 10% per year for the last 10 years, a ROE which has averaged over 22% during the past 5 years, and a 5-year normalized P/E of only about 10.5, COS is an attractive company at a comfortable valuation.

Overall, I’d rate COS as a moderate buy. Although not without risks, it adds a strong yield component and good fundamentals to an energy portfolio.

Financial Statement Adjustments

In analyzing the company, I made several adjustments to recent financial statements:

  1. Due to their reorganization from an income trust to a corporation, COS was able to recognize a one-time deferred tax recovery in 2010. Upon reorganization, a corporate tax rate of 26.50% was applied to all outstanding deferred tax liabilities, reducing their value and leading to a non-cash gain of 289 million in the income statement. This gain is both unusual and infrequent, so it was removed from net income and added directly to equity.
  2. Capitalized interest. COS capitalizes and depreciates interest costs associated with major capital projects. These amounts were removed from assets and depreciation and added to interest expense for the period in which they were incurred.
  3. Foreign exchange gains and losses. COS's long-term debt is denominated in USD. This results in non-cash gains and losses from fluctuations in the CDN:USD exchange rate which are included in income. These amounts were removed from net income.

*All values are in Canadian Dollars unless otherwise specified

Disclosure: I 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.