Continental Resources (NYSE:CLR) has seen its share price come under a great deal of pressure again, as investors fear the impact of the coronavirus on oil prices. Shares hit a high of $80 during the 2014 peak to fall to levels in the teens in 2016. A big recovery pushed shares up to $70 late 2018 again, yet amidst a corona-inspired sell-off, shares fell to just $15 last week.
With the company reporting its 2019 results, this is a perfect opportunity to gauge how the company is performing in a challenging environment. So let's look at these numbers to see how the company is positioned and what the prospects look like for the shares.
The Numbers
If you look at the headline numbers reported for 2019, you wonder why shares are off about 80% from their recent peak, little over a year ago. After all, Continental reported 2019 GAAP earnings of $775 million and adjusted earnings of $839 million, with both earnings metric surpassing $2 per share. With shares ending the trading week at $19, that suggests that something is at hand.
With both earnings metrics being quite close to each other and minor impairments and hedge results explaining the discrepancy, we do not really have to focus on the numbers and can safely assume an $800 million number is about accurate.
Total production was up 14% in 2019 to more than 340,000 barrels of oil-equivalent per day, with oil production up 18% to nearly 198,000 barrels. So with the business trading at a single-digit earnings multiple, what are investors so concerned about?
For starters are concerns about pricing as the company realised about $52 per barrel for its oil and about $1.80 per Mcf in natural gas last year. After all, WTI pricing comes in at $45 per barrel at the moment as natural gas prices have shed some 10 cents as well. Obviously this is a major detractor with the company producing about 75 million of barrels of oil a year. Hence a $7 shortfall works down to half a billion headwind, which after tax works down to about $400 million. This means that earnings could be cut in half this year if current prices remain where they are, as lower natural gas prices have another impact on the earnings as well.
While this is certainly discouraging with earnings per share set to fall about $1 per share given the current pricing, a 80% fall in the share price in relation to a roughly 50% cut in earnings seems quite an overreaction.
The worry of investors might be related to leverage and this is a double-edge sword. The company ended 2019 with $5.3 billion in net debt, actually down about $200 million from the year before. With full-year EBITDAX of $3.45 billion, that makes for a modest 1.5 times leverage ratio, and while it will increase this year, the move seems a bit like an overreaction.
So we have to look at the cash flow conversion to see why investors might be worried, as after all the company continues to grow at quite a decent clip. For 2019 the total depreciation expenses totalled $2.0 billion and this is where the catch is, with capital spending totalling $2.65 billion in 2019. This implies that about three quarter of the $800 million profit number was earmarked to grow production, leaving free cash flows of just $200 million to pay out to investors or reduce leverage.
With the company guiding for flattish capital spending in 2020, the company might see negative cash flow this year. Even as depreciation expenses are seen up, net capital spending in 2020 might surpass the lower profits anticipated in 2020. Somewhat worrisome is that these net cash outflows might only result in flattish or very modest production growth.
Some Thoughts
The accounting of Continental is quite "clean" compared to many of its competitors, and I am impressed with the level of profitability and relative modest leverage ratio. With 369 million shares outstanding, we have seen a huge shift in the enterprise value recently. Trading at $70 quite recently, this presented a $26 billion equity valuation and about $31 billion enterprise value. At $15 per share, the equity value came in at just over $5 billion, or around an $11 billion enterprise valuation.
That seems a bit like an overreaction as this is a best-in-class player, and while leverage is a concern on top of the pricing effects, shares look a bit cheap. Very important to realise is that the long-term potential of the firm might really be challenged, of course driven by the increased environmental consciousness.
Nonetheless, the company has the same mantra as most of its peers have and that is focus on production growth while arguably capital allocation strategy should prefer share repurchases over drilling budgets during these times, although the reduced earnings flow limits the potential to do so with leverage ratios increasing quite rapidly.
Given this discussion, it is noteworthy that $700 million of the 2020 capital spending budget will not benefit production this year, as this number alone would allow the company to buy back nearly 15% of its shares at these depressed levels.
Somewhat disappointing is the quality of the inventory, discussed by many contributors here on Seeking Alpha. Capital spending on current projects for 2020 is essentially set to fall from $2.65 billion to about $2 billion, and this level could result in a roughly flat production for 2020. While flattish production might be disappointing, note that annualised depreciation expenses already came in at $2.2 billion in the fourth quarter, making it perhaps not so surprising and disappointing.
While I am not expecting great capital allocation skills from energy companies, although savvy capital allocation has a great potential, I would prefer share buybacks over production growth, certainly if capital spending is geared to long-term production growth. A small speculative position might be warranted, although I generally have very low exposure to the energy sector given the long-term dismal outlook.
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