The 3 Week Diet System

Thursday, May 7, 2015

Encana: Build A Position Slowly

May 07:


  • We believe it's a good idea to build a position in Encana over the next year in anticipation of the day (that may eventually arrive) when natural gas prices rise.
  • Encana has a decent return on assets track record and we believe the market isn't giving it credit for its profitable hedging strategy.
  • The concerns here is the debt level at the company. It has risen dramatically recently and any rise in interest rates may swamp cash flows.
The difficulty for investors is that they sometimes don't buy companies when they reach "screaming buy" territory. The reasons are at once varied and identical: there is always some specific reason that keeps them away when a good business is trading cheaply. The reasons for this fear are always different, but it's this gut wrenching fear that causes people to eschew good businesses trading at cheap prices. Many investors remember the opportunities missed and don't really learn the lesson. "I should have bought X when it was trading at this price", they say. Most remember, few learn from such events. When you present them with another great return potential at a cheap price, most people will find a specific excuse about why it's a terrible investment.
It's with that in mind that we want to talk about Encana (NYSE:ECA). They are going to report results in a week and it would be prudent for us to submit a report after they have their latest earnings announcement. We're sometimes not prudent and it sometimes pays to stick your neck out and offer an opinion from a more vulnerable position.

The Latest Available Financials and Issues With Encana

There is some "hair" on these shares (hence the low price). The first is the debt load and the second is the sense that the natural gas market has been on the verge of recovering for years. The natural gas market reminds me of a line from the movie "The Contender", where Jeff Bridges, as the President tells a hopeful: "you're the future of this party…and you always will be." Many of us have been waiting years for natural gas to have its day in the sun. There have been very plausible arguments made for years that natural gas was about to "explode" (forgive the pun) because of the impending LNG growth or because extraction costs were unsustainably low etc.
In spite of a host of optimistic forecasts we've heard over the years, prices have failed to pick up materially. This, in spite of the fact that everyone is aware of the potential proliferation of LNG facilities that will capture-eventually-the quasi arbitrage in the global natural gas market. It might also be the case that a well operator might be better off operating at a loss than they would be to shut off a well.
From our perspective this is problematic because there are a number of variables impacting price: economic and population growth, housing, appliance efficiency, cost of production efficiencies, the fact that this is a local market with global aspirations (witness the explosion of LNG facilities etc. etc.) It's hard to predict when the natural gas market will take off. We'd rather be cautious and assume that natural gas will remain relatively stable for at least two years. We're therefore going to assume that the future will look much like the (recent) past and ask whether the status quo represents a good entry point for Encana? If you're a patient investor, willing to spread your purchases over at least two years, we believe it is.

The Ugly: Debt

This is highly leveraged company. During the last three months of 2014, long term debt increased 34% from $6.7 billion to $9.01 billion. The company has been more indebted in its history (notably in the closing months of 2009), but this uptick in risk in the capital structure is noteworthy. Equity to assets at the firm are now ~39%. Given low natural gas prices and the fact that hedges can't last forever, if interest rates start to rise for the company, cash flow will be endangered. To us, this is the biggest risk here and it's something we'll be keeping a close eye on in the coming months.
Source: Gurufocus.

The Good: Great Combination Cheap Price, High Return on Assets, Great Producing Assets and Hedging

The mean return on assets over the past 10 years has been 6.5%, in spite of the terrible outlier year in 2012. (graph ROA ROC). To us, that's a reasonable return in a host of pricing environments. In addition, the company currently trades for a ridiculously cheap PE of 3.3 (trailing 12 month). Now the market is forecasting a collapse in earnings, but at 3.3 times we believe much of the bad news is already priced into the shares.
Source: Gurufocus.
We believe Encana's properties in Montney and Duvernay are an excellent source of growth in Canada. We also believe that their horn river asset will eventually give them access to the Kitimat LNG facility. In the United States, of course, the Permian Basin and Eagle Ford are also excellent assets for the company. The thing these five areas have in common are low production costs, access to markets (or eventual very profitable markets in the case of Horn River) and scale opportunities.
In spite of the relatively anemic price for natural gas, the company has realised about $9 billion of hedging gains since 2003. That's a sign that management knows what they're doing, but it does present risk in case natural gas does rise dramatically in price. We're less concerned about that happening in the near term, though.


We believe this is an excellent company, though we acknowledge that Mr. Market can be fickle and it's more about perception of quality than actual quality. For that reason, we would recommend minimizing risk when building a position in this name. Specifically, long dated call options would work, as they give an investor much of the upside with less downside. They obviously may evaporate if prices for natural gas don't recover robustly, but our view is that it's better to risk only 25% of the capital with these. If prices rise, all the better. If prices fall, the loss of capital is painful, but we believe that outcome superior to keeping all of the capital tied up in a name that's languishing, potentially waiting for years for a recovery. The alternative to calls is obviously to buy into a position over time. Taking a year to build a position would reduce the various risks that are present here. Finally, to reduce risk even further, consider taking a position in this name once we have some more visibility post earnings next week. We're bullish about Encana, but we need to be realistic and to engineer our position relative to the vagaries of a market that may not share our view.


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