EnCana is a Great Value
After comprehensive research, I’d like to recommend EnCana (ticker: ECA on both New York and Toronto Exchanges) as an excellent value prospect. While I can’t guarantee market success, EnCana has all of the elements of a great company and great value stock that should make this a profitable choice for a long-term purchase.
Detailed analysis follows:
Company Overview
EnCana, based in Calgary, Alberta, Canada, is the largest producer of natural gas in North America, producing 3.8 billion cubic feet per day in 2008. While the company also has some oil and shale oil operations, natural gas accounts for more than 80% of production. With a current market capitalization of 38 billion based on today’s share price of 50.81 (US), EnCana is one of the largest natural gas companies in the world. EnCana also enjoys considerable dormant potential with a land portfolio of 23 million acres and proven reserves of 19.7 trillion cubic feet. To understand the enormous swaths of land that the company controls, it is best to see a map of EnCana’s land holdings (PDF).
Value
EnCana is currently an excellent value. Everywhere one looks there are good things to be found with EnCana, so I will just list them:
Measures of Value
- EnCana is currently trading at a very cheap Price-to-Earnings (P/E) ratio of 5.6 and a price/book ratio of 1.63. Taken together, this provides a P/E and price/book multiple (I call this a PEB) of 9.13. Value-investing founding father Benjamin Graham believed that any PEB under 22.5 provided a margin of safety — in this case, the margin of safety is very large.
- EnCana is also trading at a low price/sales ratio of 1.30.
- The company is trading at an ultra-low P/E to growth (PEG) of 0.27 when dividends are included in the calculation (P/E divided by earnings-per-share growth plus current dividend yield). Current dividend yield is 3.15%.
- Current price/cash flow is a low 3.50, or about 31% less than the industry average of 5.10.
High Growth and Superb Margins
- EnCana boasts a superb 16.2% return on invested capital (ROIC), a measure of management’s savvy at wisely putting assets to their best use. Management has been consistent in keeping this figure above their target of 15% for the last several years.
- Other measurements of return are equally glowing — with a return on equity (ROE) of 31.5%, a five-year average ROE of 22.1%, and a return on assets of 14.3%.
- EnCana also enjoys the excellent margins necessary to profit considerably from its excellent returns — with a net profit margin of 23.23%, pre-tax margin of 32.20% and impressive gross margin of 64.84%.
Low Debt
- EnCana enjoys a low debt-to-equity ratio of 0.40 and debt-to-earnings-before-interest-tax-depreciation-and-amortization (EBITDA) of 0.70. This means that if the company dedicated its after-operations cash flow towards debt repayment, it could repay all of its debts in just eight months.
So Why is it So Cheap?
I know most people are cautious about the central premise of value investing — if I can buy a dollar for forty cents, then what is wrong with the dollar? I think this is a healthy question, and all value picks must be carefully analyzed to make sure that it is not a value trap – a company that is cheap for a very good reason.
EnCana is cheap because it has been punished with the rest of the natural gas producers. Natural gas prices are currently at an inflation-adjusted all-time low. Natural gas prices in 2009 have drifted in the $3 and $4 range, down from a high above $13. This shift obviously has profound impact on the earnings of natural gas producers like EnCana. EnCana, however, will be able to easily weather this storm.
The company’s conservative financial management has put it in a stronger position than its competitors. With its low-debt and strong cash flow ($2.3 billion net cash flow last year), EnCana has a substantially stronger balance sheet than its competitors. EnCana has wisely engaged in heavy price hedging — two-thirds of its 2009 production is hedged at contract prices above $9 for natural gas, despite current prices below $4, and over half of 2010 production is hedged at prices above $6. With contract prices more than twice current market price, EnCana is not feeling the pain of low gas prices that is crushing many of its debt-laden competitors. In fact, EnCana’s guidance predicts 2009 net cash flow similar to last year — between $2 and $3 billion. Should low gas prices persist through 2011, EnCana will have the cash flow and large cash reserves to continue healthy operations for some time while out-investing its competition for when prices return to higher levels. The company also wisely avoids guaranteed supply contracts — giving it the flexibility to shut down a majority of its operations should continued low gas prices force the need to do so. This allows EnCana to maintain high margins when prices are down.
Innovation and Culture
A poor corporate culture can stagnate a company and drive it into uncompetitiveness. EnCana is not one of those companies.
By all accounts I could find, EnCana seems to pride itself on a robustly innovative corporate culture. The company spends considerable resources on enhancing collaboration, communication, and innovation within its workforce. The best evidence for this, besides its own claims, is in its technological developments.
For well over a decade, EnCana has been the pioneer of a major technological shift in oil and gas development. EnCana (under a different name at the time) first began pilot projects for shale oil and gas extraction in the early 90’s. While these technologies did not become in vogue until 2008, EnCana was well ahead of the curve with large-scale projects as early as 2003. As a result of its considerable dedication to innovative new extraction methods, EnCana holds or is in the process of obtaining patents for a number of critical technologies that it developed for cheaply extracting oil and gas from shale, as well as other technologies for minimizing the number of rigs that need to be drilled to extract a resource.
Thanks to its early investments and research, EnCana is the world leader in shale oil and gas extraction. This is supremely important given that EnCana has managed to reduce costs to where shale extraction is economical. It is estimated that there is up to 2.8 to 3.3 trillion barrels of shale oil globally that were previously too expensive to extract, and shale gas is expected to account for as much as half of North American natural gas production by 2020.
Financial Statements
After examing EnCana’s financial statements, I found no red flags. In fact, I was impressed by the high level of above-and-beyond financial detail that EnCana provided. In my mind, this is one sign of a good company that understands its duty to the shareholders by providing all possible information to make informed decisions.
Leadership
I’m a big fan of EnCana’s leadership, which is largely grown internally (yet another indicator of a strong corporate culture). CEO Randy Eresman has been a strong leader, and has guided the company to a smart model focused on its strengths in nonconventional extraction and on its home territory in North America. Eresman has guided the company into the sale of its overseas properties — which included fields in Qatar, Brazil, and France — in favor of Canada and U.S. development. This is a very smart play given the politically stable, natural gas rich environment in North America, and the lower costs of operating on a single continent. Mr. Eresman is also fairly young, and is likely to remain in charge for the foreseeable future.
CFO Brian Ferguson has also shown incredible savvy in his management of EnCana’s finances. While his very-conservative management may have made him look like a dinosaur next to free-wheeling natural gas companies like Chesapeake Energy when gas prices were high, Mr. Ferguson has the last laugh. His fiscal conservativism has left the company in a position to substantially best its competition in this difficult credit and low-gas-price environment.
Executive compensation has also been kept to reasonable levels, which shows strong corporate governance. Mr. Eresman’s total compensation package of salary, grants, and stock options of about $10 million is reasonable given the large size of EnCana and his successful management. Other senior executives’ compensation is also reasonable — in the one to four million range. I am particularly impressed with EnCana’s judicious issuance of stock options, with only 3 million options issued out of 750 million shares outstanding. I also like that none of EnCana’s executives have sold stock recently, indicating that they, too, believe in the company’s long-term potential.
Key Future Developments
One impending development of note is a proposed split of EnCana into two companies. The proposed split would split the company into EnCana, comprised of all of EnCana’s current natural gas assets, and Cenovus, comprised of all of EnCana’s current oil assets. Under the plan, shareholders would get one share of each company. The proposal was originally slated for vote in May 2009, but has been taken off the table indefinitely until stability returns to the markets (corporate speak for higher prices for the Cenovus initial public stock offering (IPO)). I am undecided about how I feel about the proposed split — it makes sense to allow the two areas of the company to truly focus on their core businesses, but I like the flexibility, and economies of scale provided by the current structure. I am also hesitant about the division of a winning management team — Eresman would remain head of EnCana, but CFO Ferguson would become the CEO of Cenovus. Given EnCana’s strong culture and leadership development, any leadership changes will probably be neutral.
Natural Gas Prospects
I like natural gas’ long-term prospects. Not only is it incredibly abundant, and cheap to extract, it offers significant advantages over oil. Natural gas burns much cleaner than oil-based fuels, with significantly less greenhouse gas emissions. I believe that given its abundance and competitive pricing, natural gas will continue to be a growing source of energy well into the future. Natural gas is positioned to be a key transition fuel, with the technology in place to easily switch from oil and coal burning to natural gas burning power, and combined with low carbon output, natural gas is a logical clean alternative to oil and coal. Continued global focus on lower greenhouse gas emissions and taxing carbon output will be greatly in natural gas’ favor.
Summary and Additional Information
In short, EnCana’s stock is currently very cheap and offers excellent prospects. Given that the company is Canadian, it also offers some diversification from US dollars and the US economy, which I would encourage all investors to strive for. I intend to open a position, and intend to continue buying and renvesting dividends as the stock remains cheap. I will also be proud to own such a fine company.
Additional Information:
