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Canadian Natural Resources Ltd.: Lock In This 4.5% Dividend Yield

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About: Canadian Natural Resources Limited (CNQ)
by: Steve Brodrick
Steve Brodrick
Value, dividend investing, long-term horizon
Summary

Canadian Natural Resources boasts a 19-year record of dividend growth at compound annual rate of 21%.

The company's current cheap valuation means that investors can lock in a 4.5% dividend yield; a 61% premium over the company's long-term average yield.

Recent Q3 2019 earnings reported record quarterly adjusted funds flow of CAD $2.9B and free cash flow of CAD $1.9B.

This surplus free cash will be used to buy back shares, strengthen the balance sheet and increase the dividend.

Investment Thesis

On November 7th, 2019 Canadian Natural Resources Ltd. (CNQ) reported a great 3rd quarter, sending shares over 8% higher. In this earnings report, CNQ achieved record quarterly adjusted funds flow of approximately CAD $2.9B and free cash flow of CAD $1.9B. Despite this move in share price, Canadian Natural Resources remains undervalued and offers investors a compelling opportunity to lock in a great dividend yield with a company that has a 19-year record of 21% compound annual dividend growth. Canadian Natural Resources benefits from low decline-rate assets that don't require significant capital to maintain volumes. This asset structure enables the firm to generate significant free cash flow which has been used to grow the dividend, buy back shares and strengthen the balance sheet.

Image result for canadian natural resources

Source: Canadian Natural Resources

Company Profile

Canadian Natural Resources Ltd. was founded in 1973 in Calgary, Canada and has grown to become Canada's largest producer of oil. With a market capitalization of CAD $44B or USD $33B, Canadian Natural trades on both the TSX and NYSE. The company has its core operations located in Western Canada, the North Sea, and offshore Africa. CNQ has a mix of offshore, conventional, and oil sands mining assets. Its production mix as of Q3 2019 is 21% gas, 48% of light crude oil, and 31% heavy oil. Canadian Natural Resources is also the owner of massive undeveloped land reserves and boasts the largest reserve base of any Canadian producer. CNQ has built up a substantial portfolio of high quality, long life, low decline rate assets with a 10% composite corporate decline rate.

BOE Production Mix Oil Sands Mining & Upgrading -0% Decline Pelican & Thermal -13% Decline Conventional Assets -19% Decline Pro forma Maintenance Capital of -$3.4 billion required annually u Long Life LOW Decline Production -60% -10% Corporate Decline Rate LOW Capital Exposure Production -40%

Source: Canadian Natural Resources Investor Presentation

Canadian Natural Resources has proven itself to be a shrewd acquirer of assets picked up at below market prices. These contrarian purchases have complemented organic growth and new asset development. The firm has been able to grow production and cash flow regardless of commodity prices. Equally, Canadian Natural Resources has driven down production costs, significantly reduced carbon emissions and steadily produced free cash flow. For a deeper look at CNQ's business model please see For Oil Bulls, Canadian Natural Resources' Valuation Is Too Cheap To Ignore and Canadian Natural Resources: A Free Cash Flow Generation Machine.

Free Cash Flow

Canadian Natural has a significant portion of its asset base in long life, low decline production assets which require far less capital to maintain than other firms. This low decline rate on producing facilities results in a significant degree of free cash flow proportional to production which allows for greater dividend increases and share buybacks. This model allows CNQ to decouple its growing returns of capital to shareholders from short-term commodity price fluctuations in a way that most producers cannot achieve.

Based on Canadian Natural's Free Cash Flow Allocation policy, shareholders can expect that the free cash flow generated in 2020 will be used to buy back shares, pay down debt and increase the dividend. In Q3 2019 alone, CNQ paid down over CAD $1B in gross debt through free cash flow. Through this successful debt reduction policy, Canadian Natural is on track to finish 2019 with levels of debt to adjusted EBITDA; debt to cash flow; and debt to book capital below those of year-end 2018. This is especially impressive as the May 2019 Devon Energy (DVN) acquisition was completed in cash through a CAD $3.25B debt facility.

Annual Adjusted Funds Flow Less: Budgeted Capital Expenditures Less: Dividends Free Cash Flow Balance Sheet Strength Share Purchases

Source: Canadian Natural Resources Investor Presentation

Based on current production forecasts, Canadian Natural Resources should deliver CAD $7.75 of cash flow per share in 2019 and CAD $6.95 in 2020. An illustration of 2020 free cash flow allocation based on current production forecasts would result in CAD $1.61B allocated to balance sheet strengthening and CAD $1.61B allocated to share repurchases.

CN 2020 Free Cash Flow Production estimates of 1,320,000 boe/d Less Allocation: 50% 50% 59.00B $1.98B $3.80B $3.22B Cash Flow Dividends (current dividend payout + 20% increase, less 2019 NCIB) Planned Capital Expenditures Free Cash Flow $1.61B to Balance Sheet Strengthening $1.61B to Share Bu ks

Source: Author

Canadian Natural Resources is making significant progress on repurchasing the 5% of outstanding shares it is approved for in its current NCIB. In the first nine months of 2019, Canadian Natural has repurchased CAD $801M in shares. In the latest quarter these buybacks occurred at prices averaging between CAD $33.45 - $33.70. With shares prices at this low level, share repurchases continue to be an excellent use of free cash. This buyback program has been accelerated due to the implementation of the Free Cash Flow Allocation Policy adopted in 2018. From 2014 to August 2019, the firm has returned the equivalent of 27% of market capitalization to shareholders through dividends and share buybacks.

Dividend Growth

There is no greater signal of confidence that a firm's management can offer to its investors than declaring a dividend increase. This measure communicates to investors that the firm sees a sustainable path towards long-term earnings growth. A strong dividend growth record underscores the long-term commitment that a firm makes to its shareholders to return capital. A company like Canadian Natural Resources, where insiders hold a significant stake, inherently communicated that management has a long-term view aligned with shareholders. Canadian Natural Resources' dividend growth record is part of the corporate culture and has spanned recessions, oil price crashes, natural disasters, and multiple executives at the helm.

Canadian Natural Resources boasts a best in class dividend record of 19 years of consecutive dividend growth at a CAGR of 21%. There are only 12 other publicly listed firms on the TSX that have a dividend growth streak longer than that of CNQ. Only one of these, Enbridge (ENB) has a higher yield, but none of them have a better 10-year dividend growth rate. Even comparing internationally, only 2 out of 6 super major energy companies have been able to achieve a dividend growth streak of this duration.

CNQ Dividend Growth Rates

Source: Author

Canadian Natural Resources offers investors an opportunity to lock in a growing dividend with great yield on cost. The current yield of ~4.5% is superior to most of the Canadian Banks and offers a much greater dividend growth profile. In the last 12 months, Canadian Natural Resources has maintained an EPS payout ratio of 37.57%, giving the firm lots of room to run with future dividend increases. The current dividend of CAD $0.375 equates to CAD $1.50 per share annually, which is double the company's dividend at the beginning of 2014 as the global price of oil collapsed.

Compelling Valuation

On a relative and historic basis, Canadian Natural Resources is cheap at today's levels. At 12.85X forward earnings, CNQ is trading at half its 5-year average P/E. On a price to cash flow basis, Canadian Natural Resources is currently trading at 4.63X; 2/3 of the company's average since 2014. As a result of sluggish share price performance and healthy dividend increases, CNQ's current dividend yield is now ~4.50%; which is a 61% premium over the firm's 5-year average yield of 2.80%. Morningstar Senior Equity Analyst Joe Gemino has a fair value estimate of CAD $41 based on an EV/EBITDA multiples of 7 times and 8.5 times for 2019 and 2020, respectively. The current EV/EBITDA multiple of 6.74 is a 25% discount to the CNQ's 5-year average of 9.03.

Morningstar assigns Canadian Natural Resources a 4-star rating, putting the company in the top 5.7% of companies in the rating agency's 16,000+ stock universe. Analyst price targets average CAD $44.68, suggesting a 31% upside from current levels. This price level in the mid-40s is attainable for the stock, which traded into the high 40s for much of 2017 -2018. The analyst sentiment for CNQ is overwhelmingly positive. Of the 26 analysts who cover Canadian Natural Resources there is 1 "underperform", 4 "hold", 11 "buy", and 10 "outperform".

Sell Side Rating on CNQ Sell Side Rating . 4_15 Sell Underperform Hold Ou tpe rform Buy 26 Analysts in the Last 90 Days Buy: 10 Outperform: 11 Hold: 4 Underperform: 1 Sell: O

Source: Seeking Alpha

Market Access

The lack of market access in Western Canada continues to be the key driver of CNQ's depressed current share price. The slow progress on the Canadian government-owned Trans Mountain Pipeline expansion, continued regulatory delays on Enbridge's Line 3 replacement and a stalled US segment of the TC Energy's (TRP) Keystone XL pipeline have led to a difficult situation for crude exporters in Western Canada. As of September 2018, production in excess of pipeline capacity was approximately 200,000 b/d. Much of this excess has had to be moved by rail or held in storage. The Government of Alberta's Crude Oil Curtailment Program has been successful in drawing down storage quantities as well as narrowing the WCS discount to WTI.

Figure C.5: Pipeline Capacity and Crude Oil Available for Export from the WCSB 2.5 S 15 Express Trans Mountain -Crude Available for Export -Milk River -Keystone Enbridge Mainline 4.5 4.0 3.5 3.0 1.0 0.5 0.0 2010 2011 2012 2013 2014 2015 2016 2017 2018

Source: Canadian Energy Regulator

While the challenges of getting pipelines built have continued to be an overhang for the Canadian oil and gas sector, CNQ's President Timothy McKay contends that there is some reason for optimism:

As we move to December [2019], Enbridge will start to take an additional 85,000 barrels a day. We see improved Egress into 2020, both Express pipeline and Keystone Base, each adding 50,000 barrels a day. Additionally, the northwest upgrader is targeted to take incremental heavy oil at 40,000 barrels a day, so a total of 225,000 barrels a day of additional capacity.

Enhancements to the Enbridge mainline have added some incremental capacity to Western Canadian egress. Crude by rail shipments has also continued to grow helping to alleviate. In August, 2019 crude shipments by rail were 310,000 b/d, up 35% from the same period in 2018. Alberta Premier, Jason Kenney has stated that crude by rail shipments should be able to reach as high as 550,000 b/d which would allow producers to ramp up production.

Incremental WCSB Egress Capacity Market takeaway current production 03/19 04/19 QI/20 E N B ENB E T RP C VE Rai AB Rail IMO Rail SIGNIFICANT MARKET ACCESS OPPORTUNITY

Source: Canadian Natural Resources Investor Presentation

In addition to rail capacity, there is optimism that an additional 80,000 b/d of supply capacity will be absorbed when the North West Sturgeon Refinery comes on line in early 2020. This refinery is a joint venture between North West Refining and Canadian Natural, who will contribute 25% of bitumen feedstock. The long awaited project will refine 50,000 b/d and return some 30,000 b/d of diluent to the Alberta market. While a lack of pipeline capacity will continue to weigh on CNQ's share price and limit production growth, there are positive developments in the marketplace that will serve to mitigate part of the supply surplus in the near term.

Risk Analysis

Canadian Natural Resources is challenged by the limited available options for transporting its landlocked crude from Western Canada. The recent outage of TC Energy's Keystone pipeline and the subsequent expansion of the WCS/WTI differential is an example of how CNQ can be impacted by transportation interruptions. Canadian Natural is more exposed to the negative impact of discounted WCS pricing than some of its more integrated peers. Like all other energy producers, CNQ is subject to commodity price risk and share price volatility as a result of international supply conditions. Overall, Canadian Natural has de-risked much of its model by diversifying its production mix, owning and operating many of its own pipeline systems and by maintaining a strong balance sheet.

Investor Takeaways

Canadian Natural Resources Ltd. is a high-conviction top-ten holding for me. The company has an incredible dividend growth record and is committed to returning capital to shareholders. I have been taking advantage of the recent share price weakness to add to my position. While the Canadian energy sector continues to face egress challenges, Canadian Natural Resources provides an opportunity to buy a great company at a good price and lock in an attractive and growing dividend.

Disclosure: I am/we are long CNQ, TRP, ENB. 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.