Seeking Alpha

Whitecap Resources Q3: Falling Oil Creates Less Room For Error

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About: Whitecap Resources Inc. (SPGYF)
by: Zach Zubac
Zach Zubac
Value, macro, dividend investing, long/short equity
Summary

Company makes modest improvements to financial position with a reduction in long-term debt.

No near-term liabilities and ample credit facilities leave Whitecap able to handle poor industry conditions.

With capital scarce for industry, Whitecap's focus on balance sheet improvements is a positive sign for investors.

Reduced production levels create narrower margins for cash flow.

Whitecap should be able to handle dividends moving forward, providing investors with 8% return, and the prospects of 25-30% capital appreciation.

Canadian Oil stocks

Note: All figures discussed are in Canadian Dollars unless stated otherwise.

Canadian oil stocks have continued their downward trend through 2019 as any catalyst for sustained improvements has yet to emerge. WTI crude prices have been relatively flat on a year-to-date basis, after gains made through the first half of the year had been largely whipped out during the summer months. Prices for Canadian crude have mirrored that of WTI, after making some improvements to narrow the disparity between the two through 2018, recent months have seen a slight increase in the difference emerging again.

These prices changes, along with the recent Canadian election, do not bring about much hope for improved industry conditions. With the Liberal minority government likely to be backed by the NDP, risks of increased regulatory burden have been amplified as both parties made reducing dependency on oil a main theme of their campaigns. Whether this government will be worse than the previous Liberal majority is difficult to determine.

Though Whitecap Resources (OTCPK:SPGYF) has taken its fair share of lumps along with the industry at large, its conservative approach to 2019 has proved moderately effective in managing the environment. Although reduced production volumes and lower oil prices led to an expected drop in profitability, Whitecap has been able to make improvements to its financial position due to strong free funds flow given and reduced capital expenditure. Moving forward, the company’s ample liquidity and lack of near-term obligations should allow management to maintain until more positive market conditions emerge.

At current valuations, a price appreciation of 25% is possible, but likely only from a long-term perspective. For investors seeking oil exposure, the 8% dividend provides an immediate return on investment in the near term.

Strong Liquidity and Modest Improvements to Debt

Whitecap’s management continued to make good on previous guidance, reducing the long-term debt outstanding on the balance sheet through in third quarter. Although the overall reduction was relatively modest, it comes off as a positive for investors that the company has continued to make inroads in its financial position on a consistent basis even during less than ideal market conditions.

Sept 30 2019 vs Dec 31 2018 Liabilities

Whitecap Resources Debt(Source: Whitecap Resources Q3 Financial Statements)

One area of the balance sheet that did not see an improvement was the working capital accounts. As currently liabilities spiked, Whitecap witnessed deterioration in its working capital ratio. This draws into question the company’s short-term liquidity capacity.

Whitecap Resources balance sheet(Source: Whitecap Resources Q3 Presentation)

With over $500 million available of its total $1.7 billion credit facilities, this should prove more than enough to manage operations moving forward, even if an unforeseen drop in cash flow emerges. With a current lack of capital available for the Canadian oil & gas industry, it is imperative that Whitecap maintain enough capital on hand for the foreseeable future, as the company’s ability to raise capital in the market would prove very difficult and would likely come at a high cost.

Ideally, investors would like to see these conditions reversed, but it is unlikely that an abundance, or even small amounts, of capital will begin flowing back into the region until there appears to be a continued commitment by policy makers to encourage investments. Until then companies such as Whitecap will be forced to make due with what is available. Strengthening the balance sheet and ensuring sufficient capital on hand is a step in the right direction.

Financial Obligations

whitecap resources debt obligations

(Source: Whitecap Resources Q3 Presentation)

With a weighted average maturity of 2024, and no obligations coming due prior to 2022, Whitecap has enough breathing room for at least the short to medium term. While this could change if industry conditions do not improve through 2020 or 2021, management continued its efforts to make improvements to the balance sheet and the long-term debt should free up enough capital to protect Whitecap.

The general lack of capital for firms within the industry makes capital allocation decisions extremely important. Whitecap's aim to reduce production, and thus capital expenditures, in order to make improvements to its debt position is likely the best play given the circumstances. With oil prices relatively low, the return on capital provided by further increases in production would likely erode the balance sheet instead of improving it. This does, however, create a problem due to the fact that it creates narrower cash flow margins, and thus less room for flexibility on cash flow that may come in below expectations.

Lower Cash Flow Still Maintains Dividend

Cash flow expectations for 2019 have come in slightly down from managements' previous guidance by approximately 3.4%. With boe/d for the year expected to come in right on target around 70,000-72,000, the drop can largely be attributed to falling crude oil prices through the third quarter.

Free funds flow was largely whipped out due to the significant jump in capital expenditures for the period, but on a year-to-date basis, it has proved sufficient to make the improvements to the balance sheet previously discussed.

whitecap resources forecast (Source: Whitecap Resources Q3 Presentation)

The spike in capital expenditure for the second half of 2019 was expected as management’s 2018 guidance indicated the second half of the year would be taking the lion’s share of expenditures. Looking at 2019 on a whole, the company was able to come in under its previous estimate by a substantial margin, reducing the full year expected capex from $450 million to $400 million. With $300 million already on the books for 2019, this should create a nice boost to free funds flow for the fourth quarter that will likely go back into improving the balance sheet.

The dividend coverage has eroded slightly for the year with the jump in capital expenditures, but still remains largely in line with management’s guidance of 80-85%. Whitecap historically has paid out the majority of its capital, opting to maintain a relatively high payout ratio. Some investors have made the point that a reduction in the dividend would be optimal for making greater improvements to the balance sheet. While this is true, as more capital available could lead to greater reductions in debt, whether it will be of benefit to the shareholders is not as certain.

With management currently aiming to reduce its debt by $100 million for the year, it’s difficult to argue this should be increased at the expense of the dividend. Considering the company has revised its production volume down from previous years, if it can maintain the same level of debt reduction with a reduced production level, it would not be necessary to accelerate this further with a divided cut.

Management has not indicated any expectations for a dividend cut, and was not prompted to give their opinion on the matter by analysts during the third-quarter call. Some, however, did bring up the topic of share buybacks, as Whitecap has seen a slight increase in repurchase over the previous quarters.

Share Buybacks

whitecap resources share buy backs (Source: Whitecap Resources Q3 MD&A)

Although current valuations may seem make this an opportune time to for repurchases, management indicated that their first priority will remain on improving the balance sheet through a reduction in debt. While they did not rule out the possibility, it would largely come on the back of higher than expected free funds flow. With capex expected to come in at $100 million for the fourth quarter, investors should not expect to see any repurchases beyond the previous levels unless a sustained rally in crude prices develops. The transcripts from the shareholders call provide some insight into management's thinking on the issue.

If we have more free cash flow, we’ll look at considering a more aggressive buyback at that particular time. Our objective similar to this year was to keep our share count flat to slightly declining. It won’t be a huge component of our free cash flow allocation unless we have, you know, much more free funds flow in excess of what we’re currently forecasting here

(Source: Whitecap Resources Q3 Call Seeking Alpha Transcripts)

Decline in Profitability

Along with the firm's drop in cash flow, its profitability has declined again largely on the back of dropping oil prices. On a year-over-year basis, WTI prices witnessed a 19% drop, with the impact on full display in the firm’s net income. The decline also had an impact on operating netbacks for Whitecap which came in below previous expectations.

Operating Netbacks

whitecap resources netbacks (Source: Whitecap Resources Q3 MD&A)

Although there were some other areas which added to the dropping income, such as operating expenses, it is relatively clear that the majority of the drop can be attributed to a steep reduction in Petroleum and natural gas revenues. Although stronger cash flow measures through the fourth quarter could provide a bump to Whitecap's earnings, the possibility for asset impairments does leave some cause for concern.

An issue that we have touched on in a previous article, which can be found here, concerns asset impairments effect on net income. Dropping expectations for oil prices have led to fairly substantial asset impairments in the past with a $219 million writedown occurring on Dec. 31, 2018. As prices have fallen through the year, it could be expected that further impairments will take place for YE 2019. Having eaten away at a substantial portion of income in the past, this area does cause concern for investors, and should be monitored by analysts through the remainder of the year.

Management did touch on this issue when prompted in the call indicating:

"...we’ll have to take a look at what that environment looks like at this particular time on the price forecast. Certainly, I think when you look at the price deck at December 31, 2018, compared to where our strip is at this particular time, it is lower, but we’ll have to see what that pricing environment looks like relative to what our reserves are as well at the end of the year."

(Source: Whitecap Resources Q3 Call Seeking Alpha Transcripts)

Valuation and Conclusion

Canadian oil investors may have been hoping for a different turn out at the recently passed federal election. A NDP backed Liberal minority government could definitely pose a threat to the industry as both parties had made climate change and carbon pollution a central point of their campaigns. Whether either party will follow through on the claims is an entirely different story. Politicians can often have their hands forced, as unforeseen economic circumstances take their toll. Still, a vital part of Canada’s economy, the talks of fading out oil production are likely more theatrical than anything, but the risks they pose should still be monitored closely by analysts.

From a valuation standpoint, we have opted to lean on an EV/EBITDA ratio of 5.5x. One main difference is the use of EBITDA instead of an adjusted EBITDA, which added back asset impairments. With no impairment charges for 2019 year to date, the adjustment does not effective the outcome.

whitecap resources value(Source: Author's Own Calculation)

As can be seen, a hypothetical fair value for Whitecap produces a share price of approximately $5.3/share, providing a modest gain from levels seen in previous weeks, although the gains through the start of November have eaten away at this slightly. Over the long term, we believe Whitecap will produce strong gains for investors, as they continue to collect a solid monthly dividend. The 5.5x multiple used falls largely in line with the industry average, which is typically somewhere between 5.5 and 6x.

Risks are still present for the company and any investors interested in entering a position with Whitecap would be wise to do so patiently. With no near-term catalyst and guidance for 2020 largely flat, it is possible the firm will trade sideways if not slightly down through the next 6-8 months. With the dividend comfortably covered, however, investors wishing to enter a position sooner do have some incentive to do so.

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Disclosure: I am/we are long SPGYF. 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.