EnCana Corp. (OP/A): Superior resource base with potential returns upside
Goldman Sachs July 28, 2005
We continue to believe that EnCana Corp. has a superior resource base to large-cap E&P peers and that with production growth expected during 2H 2005 the company should be able to easily grow production by at least 10% in 2006. While large-cap E&P stocks are trading closer to traditional peak values than other oil and gas companies, we still see value in owning resource-advantaged companies such as EnCana and XTO Energy, both rated Outperform relative to an Attractive coverage view. We believe that there is upside to our traditional peak values if EnCana can show improvements in relative returns and freecash flow as its whirlwind restructuring begins to calm. Additionally, we believe there are regions such as the Piceance Basin where EnCana's recoverable resource is significantly greater than management's guidance.
KEY COMPANY-SPECIFIC CATALYSTS
(1) Second half production and 2006 production growth. EnCana's 2Q 2005 production was slightly weak due to a combination of bad weather and infrastructure/service delays. Despite this, the company expects strong production growth during the second half, with an estimated 150 MMcf/d of potential gas production behind pipe awaiting hookup (representing 5% of 2Q 2005 natural gas volumes). EnCana believes it can exit the year producing 3.6-3.7 Bcf/d of natural gas, versus 3.2 Bcf/d in 2Q 2005. Expected 4Q/exit rates would be about 7% above average production for 2005, meaning that the company would likely not have to invest significant capital to grow absolute production 10% in 2006. We are assuming that the company does invest capital, with production growth above the 10% rate, made even greater considering expected share buybacks. Most unconventional gas basins, due to weather/environmental drilling seasonality, show greater growth in 3Q and 4Q relative to 1Q and 2Q.
(2) Cash flow and relative cost structure. While EnCana has, in our view, a superior resource base, it has not yet shown superior returns or free cash flow. While there are reasonable arguments that suggest that returns are somewhat in flux because of the company's restructuring and depressed as a result of historic purchase from the Pan-Canadian/Alberta Energy merger and other transactions, EnCana does not have as strong a returns and free cash flow profile as XTO Energy. Other large caps also have lower returns and free cash flow, but EnCana's powerful resource base combined with top-tier returns would justify a higher premium for the stock. We believe that EnCana's relative returns will rise over time, given that the company has attractive drilling inventory on its acreage versus other companies which may have to look to the acquisition market.
(3) Further resource base upside. As highlighted in our June 23 report, "Piceance Basin: Potential material upside for super- and small-caps", we believe EnCana has far greater recoverable resource on its Piceance acreage than its guidance suggests. EnCana's 4.6 Tcfe in company-estimated unbooked resource potential comes from having delineated about 15% of its acreage. Assuming 25% of remaining undeveloped acreage is prospective, we see 13 Tcfe in unbooked potential. Piceance potential has been overlooked by the Street in our view because, unlike most other unconventional gas basins, there is no pure-play company there. Given EnCana's dominant acreage position in other basins, there could be upside beyond the Piceance to unbooked resource.
VALUATION
EnCana trades at 6.2x 2006 EV/debt-adjusted cash flow, above the large-cap E&P average of 5.5x though below XTO Energy and EOG Resources. We believe that XTO deserves a premium to EnCana, though we see room for both stocks to move up due to strong production growth, exposure to the Piceance Basin at attractive rates of return and, in the case of XTO, superior returns and free cash flow. Both are rated OP/A, and for EnCana we see 7% upside to a $45 traditional peak value and 48% upside to a $62 super-spike peak value.
2Q 2005 RESULTS IN-LINE WITH EXPECTATIONS
EnCana reported 2Q 2005 operating and financial results generally in line with expectations. Adjusted EPS of $0.76 was slightly below our estimate of $0.78, while reported EPS, including special items, was $0.94. Operating cash flow of $1.57 billion was slightly above our estimate of $1.54 billion, while production of 4.45 Bcfe/d was slightly below our estimate of 4.53 Bcfe/d. In-line DD&A expense was offset by higher than anticipated lifting costs and royalties, as all-in unit costs were $19.25 per BOE versus our estimate of $18.94 per BOE. Commodity price realizations were $32.08 per barrel for oil and $6.25 per Mcf for natural gas versus our estimates of $33.23 per barrel and $6.03 per Mcf, respectively. Midstream EBITDA of $25 million was below our estimate of $28 million. Net debt/tangible capital was 38% at quarter-end.
UPDATING ESTIMATES
We are adjusting our quarterly 2005 and full-year 2006 EPS estimates to incorporate changes to our forecasts for production, realized prices, unit costs, and minor other adjustments. Our 3Q 2005 EPS estimate is now $0.87 ($0.85 previously), our 4Q 2005 EPS estimate is now $1.01 ($0.97 previously), and our full-year 2005 EPS adjusted estimate is now $2.75 versus $2.54 previously ($3.31 versus $3.27 previously for reported EPS). We now estimate full-year 2006 EPS of $3.70 versus $3.65 previously. There are no changes to our 2007-2010 (normalized) EPS estimates.
Each of the analysts named below hereby certifies that, with respect to each subject company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Brian Singer, Arjun Murti. |
