Cenovus Energy:  Misplaced Market Fears About A Bargain Acquisition

| About: Cenovus Energy, (CVE)


Market acquisition worries may be overstated.

178,000 Oil Sands Production gained without expanding operations through the acquisition. Personnel and knowledge already in place from operating these assets for the partnership.

120,000 BOE of Deep Basin Production with infrastructure at 40% of capacity and expansion self-financing. Can high grade for more liquids than the current 26%.

Key Deep Basin personnel will keep their jobs and now work for Cenovus to further minimize acquisition risk.

Property sales will be the slowest process and try market patience the most.  But management appears to have a reasonable plan with specific goals.

Cenovus Energy (CVE) made what looked like a really good acquisition from ConocoPhillips (COP)

(Canadian Dollars Unless Otherwise Specified)

Source: Cenovus Energy Acquisition Presentation

Reviewing all that good news shown above makes it hard to believe that the stock did not just go through the roof. But the market rarely rewards shareholders quite that easily. In fact, sometimes investing can be a real pain in some anatomically-sensitive parts. In this case, the stock headed south not long after the acquisition was announced and continued that way.

It did not help that oil prices have declined since the acquisition. Mr. Market tends to worry a lot anyway. So are these worries based upon a solid foundation? Or will they vanish quickly as the results roll in? While predicting the future is always tricky, what worries the market may be easier to discern, and then the investor can decide if it is worth the risk.

(Canadian Dollars Unless Otherwise Specified)

Source: Cenovus Energy Corporate Update, May 2017

The market has become very debt-averse lately. Management clearly stated during the conference call that they got a high level of feedback about the debt taken on for this acquisition. Judging from the stock price reaction, one can safely state the feedback was not good.

However, management has a plan to deal with the bridge financing. There are already two tracts on the market and more will come on the market as management assimilates the new acquisition. It is true that if commodity prices decline, then maybe more properties will need to be sold to pay the bridge loan. If management got the deal it states, then the risk of more property sales is already factored into the purchase price. Short of a catastrophe, management should have and probably did cover this possibility.

For as much as the market worries, to expect a multi-billion dollar bridge loan to disappear is not realistic. Management has taken the step of adding more hedging to protect the revenue stream. But the market probably will not be happy until management states that the bridge loan will be paid down significantly on a certain day.

Management did sell stock and also pay for part of the acquisition with stock. So the acquisition was not made for all debt. The company can bring the debt ratios in line relatively easy. But the market needs to give the company time to explore its options. Now admittedly if the commodity prices go through the floor and stay there, the worst fears of the market will be realized. But that is highly unlikely.

Management did state that it expects to have a meaningful update sometime in the third quarter. That type of communication is definitely a step in the right direction. Management needs to build a track record of clear goals, deadlines, and meeting those deadlines. That will cure some of the nervousness of the market in the long term.

The market also appears to be nervous about the prospect of stock sales by ConocoPhillips. ConocoPhillips has contracted constraints on selling that stock. Plus investors have to believe that ConocoPhillips will do what it can to maximize the proceeds of those sales. Large holders don't just dump shares and destroy the market for those shares because it also hurts their profits. So while the contract is there to reassure the market, it is also there to maximize ConocoPhillips's profits on the deal.

(Canadian Dollars Unless Otherwise Specified)

Source: Cenovus Energy Corporate Update, May 2017

The market may get rightfully nervous about the first slide. The oil price forecast shown above is a little on the aggressive side and oil prices are unfortunately heading in the other direction at the current time.

But the second slide along with continuing operational improvements predicted by management should ensure a more reasonable first slide in the future. Even more importantly, management no longer has to worry about a partner. So operational improvements could speed up considerably.

ConocoPhillips had a lot of debt. So management may have had to rein in spending more so than Cenovus management. ConocoPhillips did agree to reinvest a fair amount of profits into the partnership, but it is unclear whether or not that agreement allowed the partnership to operate at maximum profitability. ConocoPhillips's management told its shareholders that this investment generated insufficient cash flow for the value of the partnership interest. ConocoPhillips only had enough cash from the partnership to service the debt. So management was very happy to receive the cash and redeploy that cash to higher cash generating activities.

As a rule, joint ventures, partnerships, and other groups can be unwieldy when both partners have different priorities. Since different priorities occur a lot, there is every chance that Cenovus management alone can operate the joint venture properties far more efficiently.

It may take awhile for that efficiency to become apparent. So the market will sweat about the outcome until the results become apparent. But the odds of considerable improvement in the properties are in the favor of Cenovus Energy management.

An even larger factor is that the oil sands part of the acquisition only expanded the ownership interest. Cenovus Energy management already operated the properties and probably knew them better than ConocoPhillips management. So this part of the acquisition, which may have been the majority of the value received, did not represent an expansion. It only increased the ownership interest of Cenovus Energy. So many market worries about managing a larger company are not valid in this case. If anything, this part of the acquisition is very likely to succeed in showing positive results quickly.

Source: Cenovus Energy Corporate Update, May 2017

Most agree that ConocoPhillips neglected this part of the portfolio for a long time. So some infrastructure improvements and some newer drilling techniques will probably work miracles.

Two things here really bug the market. First, the market wants to know what the company is going to sell. Then Mr. Market can value the remaining company to determine a proper future for the company and a reasonable stock value.

But management wisely decided it needed two years to figure this part out. Management already has two properties on the market for sale. So there is no need to rush other properties onto the market to sell just to make Mr. Market happy. That would be one of those short-term victories with potential long-term payback. Management has a reasonable plan, so Mr. Market probably needs a sedative until this part of the deal becomes clearer within a year or so.

Second, management really has no experience in this area. So Mr. Market worries that this part of the acquisition will be run into the ground. Red ink will be in the future as far as the eyes can see. But management has publicly stated that it intends to keep the current management in place. It will probably hire someone from either outside or maybe inside to run the division. Management still has to execute the prevention of wholesale personnel turnover. But Cenovus management appears to understand the issues enough to minimize acquisition risk.

(Canadian Dollars Unless Otherwise Specified)

Source: Cenovus Energy Corporate Update, May 2017

Best of all, a fair chunk of the acquisition appears to be able to self-fund its expansion. That is a really professional way of saying that management believes it got quite a bargain in this deal. A part of the acquisition that can self-finance its own expansion is a very powerful tool to ensure company growth while the debt gets paid down. By the time the debt is paid, this part of the company could be a lot larger.

Mr. Market thinks this could be an allocation trick to make another part of the acquisition look bad. That could certainly be the case. Shareholders will know for sure in the future. But the IRRs shown on the first slide are very attractive. They are also not out of line with the rest of the industry. Plus management intends to review the infrastructure for possible cheap connections that would enable the oil from the oil sands to either travel more cheaply or travel to more profitable markets. There are other possible synergies under review. So the Deep Basin may allow synergies between existing company operations and the acquisition not anticipated by the market.

Compare this to a company such as Chesapeake Energy (CHK) that does not even show IRRs. Chesapeake Energy management is forecasting at most single digit growth, whereas Cenovus management intends to grow faster.

More to the point, Cenovus Energy made sure the acquisition was accretive from the start by using enough stock to free up enough cash flow. Fiscal Year 2017 will have a lot of acquisition charges and other one-time charges. But management is already on record for demonstrable improvements next year. That includes key shareholder concerns such as more cash flow and earnings. Chesapeake Energy management is still showing some significant losses even after more than one year of trying to improve company results.


Source: Seeking Alpha Website

The largest concern by far is long-term performance. Even taking into account the commodity price crash a little while back, this long-term performance is nothing to write home about.

Management has presented a reasonable plan with tangible goals and deadlines. Cenovus Energy management had always been significantly tied to the ConocoPhillips partnership. Now Cenovus Energy management can run things completely on its own and be accountable for those actions to shareholders. This is what every leader should want. Decision making will be much simpler as will accountability. Many things will become much more streamlined.

Investors will have to decide if the partnership held back the progress of the company. They will also have to decide about the advantages of keeping keep ConocoPhillips personnel around after the acquisition of the Deep Basin properties. To some extent, the acquisition provides some new diversification. But to a far greater extent, the acquisition consolidates some very known properties under one entity.

That entity had better do what it has so far promised because Mr. Market already has doubts. So it would not take much of a misstep to send the stock crashing. Right now, the odds appear to favor Cenovus Energy management for a very favorable outcome. Many very reasonable measures have been taken to minimize the risk of the acquisition. The acquisition of additional oil sands interest should not be all that risky because management should know the business from operating it all these years. The risk of acquiring the Deep Basin properties should be minimized by allowing key ConocoPhillips workers to remain employed after the acquisition. The additional hedging to increase revenue visibility reduces risks more.

Clearly, management has thought the whole thing through quite well. So the worry that Mr. Market is dithering over a catastrophe that will not happen is very reasonable. The recent decrease in commodity prices will decrease projected cash flow and benefits. But management is hard at work continuing to decrease costs. Plus about 25% of the oil sands exposure can be eliminated by the refinery capacity. That is an existing, pre-acquisition benefit that will aid cash flow during times of low commodity pricing. It may also represent an area for future growth if the company benefits from more refining capacity.

As management recovers the confidence of the market by carrying out the stated goals on schedule and meeting some reasonable profitability goals, this stock should appreciate considerably. A double over the next year from current levels is reasonable. There could be considerably more growth in store after that as oil sands production expansion proceeds and the self-financing expansion of Deep Basin operations also progresses. So from current levels, a five-year goal of quadrupling the current stock price appears reasonable. The current risk appears to be much less than average.

Disclaimer: I am not an investment advisor, and this is not a recommendation to buy or sell a security. Investors are recommended to read all of the company's filings and press releases as well as do their own research to determine if the company fits their own investment objectives and risk portfolios.

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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