This idea was discussed in more depth with members of my private investing community on January 4, 2018. Below are excerpts from that note.
This is a $34b market cap integrated oil & gas company headquartered in Bogotá, Colombia. The ADR represents 20 common shares that trade on the Colombia Stock Exchange (Bolsa de Valores de Colombia) as “ECOPETROL.” The company reports financials quarterly in Colombian pesos. The company last paid an annual dividend of 23 Colombian pesos per share in April 2017, which would equate to a current yield of 0.9%.
According to a 2014 PWC report on the Colombia Oil & Gas Industry, "Ecopetrol S.A. is among the top 50 oil & gas companies in the world and the fourth-largest in Latin America. In terms of revenue, profit, EBITDA, assets and equity, Ecopetrol S.A. ranks first in Colombia and has presence in Brazil, Peru and the U.S. (Gulf of Mexico)."
The Colombian government owns 88.49% of the Ecopetrol shares. The next largest shareholder, Ancora Advisors LLC, owns 2.10%.
Solid quantitative rankings
EC was added to our Base High Quality Long Model on December 29 because it ranked highly for relative value, operating momentum, consensus estimate revisions, and fundamental quality. While our Core and Opportunistic Models are derived from these larger Base Model portfolios they did not contain EC this month.
Benefiting from rising oil prices and oil discoveries
EC is benefiting from a combination of rising oil prices and oil discoveries. It appears the stock started moving higher October 27, around the same time that WTI crude prices spiked above September’s high of $53.25. Currently WTI crude is at $61.92, 24% above the October low of $49.94. Since that October 6 low in oil prices, the price of EC has increased 78% from $9.50 to $16.92.
The company has $3.6b of cash and short-term investments on its balance sheet (10,602b Colombian pesos). Capital spending over the last 12 months was only $1.9b, yet the company expects to invest $3.5-4b in 2018, largely in production and exploration projects.
On December 17, Reuters reported that Ecopetrol made its fourth discovery in 2017 during a joint exploration with Parex Resources (OTCPK:PARXF), a $2.9b market cap company headquartered in Calgary, Canada.
On December 6, in the latest analyst action that we are aware of, Citi upgraded EC to Neutral from Sell and increased its price target to $12 from $6. Over the last three months, consensus estimates for FY2018 EBITDA and EPS have increased 5% and 13%, respectively.
This upgrade, made prior to the Reuters article mentioning EC’s fourth oil discovery of 2017, makes sense given its growing reserves and rising oil prices.
A Note on Parex Resources
We do not incorporate many pink sheet ADRs into our rankings, and the light transaction volume shown by PARXF is one indication why. The shares on the Toronto Stock Exchange trade as PXT, with an enterprise value of 5.1x NTM EBITDA. Capital efficiency ratios for the company have improved consistently since last December which could support multiple expansion, though we would have to learn more. The Parex investor relations website may contain some useful detail on EC reserves.
Quick Multiple Valuation
Right now (January 4, 2018) Ecopetrol is trading at 5.3x the consensus EBITDA estimate for the next 12 months, a small discount to a 5.6x peer average that includes Ultrapar Participações S.A. (UGP) at 10.7x and Petrobras (PBR) at 5.5x. If the stock were to get to the 5.6x level, the ADRs could move to $18.
While the stock is not in our Core Long Model portfolio, we note it would have reached its price target today, and the position would have been assumed closed tomorrow.
Quick DCF Valuation
The consensus 2020 EBITDA estimate for EC is $11.7b, representing a 13.4% compound annual growth rate from the 2017 consensus estimate of $8.9b.
With the Colombia Government Bond 10Y at 6.35% and the equity market risk premium estimated at 8.40% by NYU’s Aswath Damodaran, a generous discount rate might be 11.0%. A 5.6x multiple to 2020 EBITDA of $11.7b discounted back three years at 11.0% implies a prevent enterprise value of $47.9b. Subtracting out net debt of $11.6b supports an equity valuation of $37.3b, or $18.15 per ADR.
According to S&P Capital IQ, ADR price targets range $7 to $13.50 and average $10. While I suspect most of these price targets are stale (given that it is an ADR, oil prices have risen, and more oil reserves have been found since its last quarterly report), and even though price/fundamental momentum stocks can often surge past fair value, we don't recommend jumping in at the moment.
Keep an Eye on EC
As we have already noted, the stock is ranked very favorably yet the price has already moved well beyond its normal trading range and hit a price target that we would have used if this were part of our Core Model.
We suggest investors keep an eye on EC. Learn about its ongoing exploration activities, expected production volume, capital spending, free cash flow growth potential, and consider a position in the stock next month when the recently positive volatility may have subsided a bit.
To support a significantly higher valuation, investors might have to assume EC continues to make new oil field discoveries or upside to whatever production volumes and prices are embedded in the 2020 consensus EBITDA estimate of $11.7b. I do not know what these assumptions are, though a prudent guess may be near November 7 levels when it reported its 3Q17.
EC is definitely worth keeping an eye on. Instead of chasing it today, it makes better sense to revisit the idea next month.
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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. I have no business relationship with any company whose stock is mentioned in this article.
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