EnCana (OP/A): Assets still attractive, concerns about returns overdone - Goldman Sachs - February 16, 2006
We continue to believe Encana has an attractive asset base, which should allow it to generate sustainable long-term production growth at increasingly attractive rates of return at both current and mid-cycle commodity prices. We believe the Street's concerns about EnCana's rising capital costs will prove to be overdone, and we believe that new CEO Randy Eresman can begin to receive credit from the Street if he can convincingly show that EnCana's cost structure is similar to smaller unconventional gas companies in similar areas. We believe recent underperformance -- due to a combination of weak near-term natural gas fundamentals, perceived uncertainty arising from the recent CEO transition, and concerns about EnCana's returns -- is overdone, creating a buying opportunity, though near- term volatility is always possible. We rate EnCana Outperform relative to an Attractive coverage view.
Key Company-specific catalysts:
(1) Drilling results from key resource plays and exploration opportunities. We believe EnCana's ability to ramp up production in its key resource plays as well as show some exploration success in new areas will be a key driver of share price performance. In particular, we believe investors will focus on results from the Piceance Basin from both EnCana and other industry players such as Williams and XTO Energy (OP/A), the latter of which is drilling its first high-potential well with results expected later in 1Q 2006.
Rising costs have impacted EnCana in the Piceance - evidenced by the company's decision to reduce its 2006 well-drilling program there. This should create controversy as to whether the Piceance has seen such significant cost inflation over the last year as drilling activity has increased that infrastructure building should be delayed until a less frothy environment retuns, or whether the Piceance secularly only can be successful in a $7.50 or higher per MMBtu Henry Hub natural gas environment. We believe for now that costs have temporarily increased, and whether the company can slow or reverse unfavorable cost trends will be an important driver throughout 2006.
In addition, we do not believe much upside from EnCana's various exploration opportunities is currently being credited in the shares. Key among these are the Deep Bossier in East Texas, the Maverick Basin in Texas, the Columbia River Basin, West Texas and coal-bed methane in the Piceance Basin. EnCana also has a new resource play exploration opportunity in France, constituting a $20 million commitment and initial drilling program of 2-4 wells (though we do not expect companies pursuing international unconventional gas ventures to receive credit until closer to full-scale development).
(2) Ability to negotiate a favorable supply agreement for incremental oil sands production. At its November 2005 analyst meeting, EnCana announced plans to significantly accelerate its production growth from its oil sands assets. EnCana highlighted upside to 150,000 b/d from its Foster Creek project (currently producing about 35,000 b/d) and 250,000 b/d from Christina Lake (currently producing about 7,000 b/d). The remainder of the 500,000 b/d planned for 2015 will come from a third project, Borealis, which is not yet producing. Given our relatively bearish view of the prospects for bitumen prices versus lighter crudes, we believe that for credit to be given to EnCana's oil sands projects, it will be necessary for EnCana to show that it has plans to capture some of the value created by the upgrading and/or refining process. Currently EnCana has shortlisted a group of potential downstream partners, though no specific details of what a potential sales contract might look like have yet been disclosed.
(3) Cost control.
We attribute a large portion of the relatively bearish sentiment on EnCana in recent months to investor concerns about EnCana's ability to realize the economic benefit of its impressive asset base due to above-average cost inflation. Given recent volatility in natural gas prices, we believe scrutiny of EnCana's capital and operating costs is likely to become even more intense. However, it increasingly appears that the Street is discounting almost a worst-case scenario, and as such we believe there is upside in EnCana's shares if it can show even average cost results in 2006. We view it favorably that EnCana recently lowered its 2006 E&P capital expenditures guidance by about 8%, while only lowering production guidance by 2%.
Valuation Weakness in EnCana's shares has eroded the valuation premium the company enjoyed for most of 2005 and still, in our view, deserves. EnCana now trades at 4.3X 2007E EV/DACF, at a slight discount to the large-cap North America gas-focused E&P average of 4.4X. We continue to believe a premium is warranted given EnCana's superior asset base, and at current levels we estimate 47% upside to a "traditional" peak value of $60 versus 33% upside for the peer group. XTO Energy remains our favorite among Outperform-rated gas E&Ps.
4Q 2005 RESULTS GENERALLY IN LINE WITH EXPECTATIONS
EnCana reported 4Q 2005 operating and financial results generally in line with expectations. Adjusted EPS was $1.55, slightly below our estimate of $1.64 but above First Call consensus of $1.27. Operating cash flow of $2.51 billion was in line with our estimate of $2.53 billion. Production excluding discontinued operations in Ecuador was 4.28 Bcfe/d, generally in line with our estimate of 4.35 Bcf/d. Commodity price realizations were $34.41 per barrel for oil and $10.29 per Mcf for natural gas. Net debt/tangible capital was 33% at year-end.
INTRODUCING AND UPDATING ESTIMATES
We are introducing 2006 quarterly and updating 2006-2007 full-year EPS estimates to reflect revised assumptions for production and minor other adjustments.
Our 1Q, 2Q, 3Q, and 4Q 2006 EPS estimates are $1.01, $0.92, $0.99, and $1.29, and our full-year 2006 EPS estimate is now $4.20 versus $4.39 previously.
Our 2007 EPS estimate is now $5.74 ($5.84 previously). There are no changes to our 2008-2010 EPS estimates.
Please see exhibit 1 for our EnCana summary financial model.
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. |
