(Seeking Alpha, Vasily Zyryanov, 24.May.2019) — Canacol Energy, Toronto-listed and Colombia-focused natural gas producer, has recently presented its Q1 results and impressed investors with robust revenue and a 42% funds from operations increase. Importantly, that surge in cash flow and sales is just the very beginning of a much more spectacular growth story. In June 2019, as it was promised in the corporate presentation, gas production of the company will surge 65% to ~215 mmcf/d (roughly 37,996 boepd) as a result of the Promigas pipeline expansion between Jobo and Cartagena. What is more, it has the potential to produce up to 330 mmcf/d in the medium term. The sell-side analysts in the cohort compiled by Seeking Alpha Essential predict share price to equal $4.62, which is nearly 1.5x higher than the current $2.95. But is the loss-making company with a heavy debt burden literally so brilliant that analysts express phenomenally bullish sentiment?
The top line
Canacol Energy is Colombia’s largest independent natural gas producer focused on the Llanos and Lower Magdalena Basins. Its current business strategy and capital allocation priorities were calibrated according to the hypothesis that gas demand in the country would inevitably gallop ahead, while supply from Canacol’s competitors would gradually come down, by around 12% yearly. At the moment, its key rival is Chevron, an integrated energy mammoth, which has been the largest supplier to the Caribbean coast for more than 30 years and provided nearly 50% of gas, according to Canacol’s data (see p. 4). However, its offshore Chuchupa field in the Guajira area is depleting, putting the sustainability of supply under question and providing opportunities to Canacol, which “is replacing Chevron as the largest supplier of gas to the Caribbean coast.” CNNEF projects an ~3% (YoY) natural gas demand growth in the coastal part of the country. According to the International Monetary Fund, Colombia’s 2019 Real GDP is expected to increase by 3.5%, which indicates that energy needs will likely mirror the overall economic development, and Canacol’s optimism has its rationale.
Here it is worth briefly noting that Colombia still shuns hydraulic fracturing, which could nearly triple the country’s oil & gas reserves and ease the gas supply concerns. In March 2019, Canacol’s and ConocoPhillips’ environmental licensing requests for fracking projects were shelved by the authorities. To rewind, the companies have two unconventional oil exploration licenses in the Magdalena Basin, VMM 2 and VMM 3. So, Colombia is not about to follow the path of the United Arab Emirates, which have decided to utilize colossal unconventional sour gas resources and attract IOCs to commercialize them in order to cut dependence on Qatar’s imports (I have touched upon that matter in the article “Total, ADNOC, And Unconventional Gas Play”). Hence, in the medium term, the country’s demand will likely be met solely through LNG and conventional piped gas. So, as a piped gas supplier, Canacol has all the chances to reap benefits from galloping demand.
To fully benefit from favorable market changes, the firm had to pour funds into capex to bolster reserves and develop the necessary infrastructure. It used different sources of funds to finance growth, both debt and equity. It is quite clear that the company used proceeds more than efficiently, as since 2013 its 2P reserves have been increased 7.2x. The flipside is a lofty net debt/EBITDA ratio (3.5x) and burdensome interest expense, which makes operations riskier and puts pressure on cash flow generation. Massive debt (Debt/Equity ratio of 1.7x) could easily ruin the growth story of any company, so, despite anticipated and secured production leap, potential investors probably stay on the sidelines. BB- grade from Fitch and B1 from Moody’s (see p. 15) perhaps make some investors avoid the company’s equity as too risky. Another matter worth emphasizing is that costly debt increases WACC (Weighted Average Cost of Capital) and thus pummels the intrinsic value. Hence, when a company manages to bring borrowings to the lowest level possible and reduce the cost of debt, its fair or hidden value based on discounted cash flows increases. I hope with production jump and EBITDAX surge, Canacol will manage to ameliorate capital structure and alleviate the debt burden. I reckon that when the firm ultimately unlocks the potential hidden in the asset base it amassed, the debt will come down quickly. That is essential to attract investors and prop up the share price.
A brief look at 1Q19
In 1Q19 Canacol’s realized contractual sales jumped 15%, bolstering FFO per share by 42%. The company not only increased the top line, but also enhanced operating efficiency, bringing opex down by 29% QoQ. As a result, EBITDAX rose 18% compared to 1Q18. Yet, negative FCFE is a clearly disenchanting matter. $25.2 million generated by operations were not enough to cover investments in PP&E of $25.15 million and expenditures on E&E of $2.49 million. Besides, the company paid $7.4 million as net financing expense, and $1.15 million were used to cover lease principal payments. In sum, levered FCF was profoundly negative, as in 2018, and $1.15 million share buyback in Q1 was not the best decision. However, despite uninspiring LTM cash flow, I expect that sales and EBITDAX growth will help Canacol to turn FCF positive in FY19.
As far as both the bottom line and FCF are negative, standard profitability measures as ROE and net margin are irrelevant. However, we could compute Return on Total Capital, the metric that utilizes EBIT or operating income in the nominator. It appears that ROTC is quite decent, 8.28%, while the sector median is 3.74%. What is more, I expect profitability to improve further in H2 2019 as a direct consequence of higher gas sales and low opex.
Valuation
Canacol is loss making and FCF negative at the moment, so standard valuation metrics as P/E, PEG, FCF yield are irrelevant and useless. Fortunately, despite massive leverage, its net worth is positive, and we could benchmark the Price/Book ratio against the Canadian and US market medians. It appears that compared to the US market, Canacol is substantially overpriced, as far as its P/B of 2.5x is well above the market median of 1.84x; at the same time, Canadian stocks’ median P/B is 1.44x. The only justification of such lofty valuation is anticipated stellar revenue growth.
Apart from comparison to the broad market, it is worth taking into account the valuation of comparables. Toronto-listed Frontera Energy and London-listed Amerisur Resources, in my view, are the closest peers of the company, because they are focused on E&P operations in Colombia (Frontera also has a footprint in Peru), though they produce primarily oil. Frontera has EV/Production ratio of ~18.2x, Amerisur’s ratio is ~30x. Contrarily, Canacol’s valuation is higher, 39.61x. So, it is relatively overpriced in the peer group due to stellar growth prospects.
I also reckon that Australian Cooper Energy, which I covered in October 2018, is akin to Canacol despite different regions of operations. Their prospects and natural gas-focused strategies are pivotal similarities. The Sole gas project is an apparent boon of Cooper, and it will propel revenue growth this year. Unfortunately, COPJF and CNNEF are loss making, so the P/B ratio might be used instead of earnings yield. Cooper currently trades at ~2.1x Price/Book, while CNNEF P/B is ~2.5x. So, as the natural gas stock with hefty growth prospects, Canacol looks reasonably priced.
Final thoughts
Canacol operates in a favorable environment with bright demand growth prospects. It has poured gargantuan funds into exploration, appraisal, and development, and now is poised to reap benefits utilizing amassed asset base. Though the stock’s Quant rating provided by Seeking Alpha Essential, which is exceptionally helpful in equity research routine, is close to “Neutral” now, I believe that sell-side analysts who express bullish sentiment are right. Yet, I suppose the market needs time to realize the hidden value of the company, while leverage should definitely go down, as Fitch’s BB- rating might hinder to attract new investors’ attention.
Unfortunately, Canacol is not a dividend payer, which is not coincidental, as capex coverage and debt servicing are the essential matters with the highest priority. Yet, if anticipated EBITDAX and cash flow surge comes true in 2019-2020, I suppose the firm might consider an option to reward shareowners.
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