Description

Last December, Cenovus (CVE) held an investor day where it outlined its capital allocation framework. Under this framework, prior to reducing net debt to $8 bn, CVE will allocate 50% of FCF after dividends to debt reduction and the balance to repurchases. Once net debt is below $8 bn, it will allocate 75% of FCF after dividends to repurchases. Once net debt is below $6 bn, CVE will stop debt reduction and return all FCF to shareholders. 

CVE closed its acquisition of Husky Energy 13 months ago with a combined net debt of $13 bn.  In its Q3 2021 earnings report (Nov 3, 2021), CVE said it had reached net debt of $10 bn. In Dec 2021, it also announced the divestiture of its Tucker asset (a higher cost oil sands asset inherited from Husky; just 2% of total production) for $800 mm, as well as its Husky retail fields network and Wembley assets for $660 mm. These transactions should close in Q1/Q2 2022 respectively. 

At US$75 WTI, CVE should be generating $500 mm FCF per month, and allocating 50% of it to debt paydown. At the end of Q1 2022, 5 months would have passed from the Nov 2021 update and CVE would have paid down $1.25 bn of debt (possibly more given the run up in oil prices YTD). In addition, it would have received the $800 mm Tucker proceeds. So I think CVE would reach its $6 bn net debt target at the end of Q1 2022, at which point it would allocate 75% FCF to buybacks. 

After the $6 bn net debt milestone, using the $75 WTI assumption, it would pay down $125 mm of debt per month. With another $660 mm proceeds expected from Husky/Wembley, it would only take another 11 months to reduce net debt to $6 bn, at which point 100% FCF would be allocated to buybacks. 

$6 bn net debt represents 1x net leverage ratio at $45 WTI, and $8 bn net debt represents 1.5x. This low leverage will give CVE a lot of flexibility in capital allocation in a lower commodity price environment. CVE said its dividend capacity at $45 WTI is $1.2 bn/year vs current $280 mm. 

CVE also provided FCF sensitivity at $45, $60 and $75 WTI. At these prices, the company will generate $11 bn, $23 bn, and $33 bn FCF from 2021 to 2025 respectively. Currently, CVE has a market capitalization of $40 bn. Given the imminence of reaching $8 bn/$6 bn net debt and the resulting shift of majority of FCF towards share repurchases, CVE is set to reduce its share count by half in the next 5 years. In fact, a comparison of CVE to its largest Canadian peers/energy majors shows CVE has the highest “buyback” yield at $70 WTI. 

Below I show several price scenarios in which CVE buys back shares at $20 using FCF allocated as per its framework. For simplicity, I reduced Nov 2021 net debt $10 bn by $1.5 bn (Tucker/Husky proceeds) but in reality the divestitures would close in the first half of 2022.

CVE management has also signaled the desire to materially increase dividends if repurchase opportunities diminish. CVE expects to generate $2 bn of FCF at $45 WTI, so its $1.2 bn dividend capacity represents a modest 60% payout ratio (considering the 1x net leverage ratio). Slap a 5% dividend yield, the equity should be worth $24 bn. But as the analysis above shows, CVE should be able to retire at least half of its ~2 bn shares in the next 5 years if it’s able to buy back shares at $20. If CVE has 1 bn shares left in 5 years, the stock would be worth $24. In other words, CVE’s future dividend capacity, thanks to strong current oil prices and rapid deleveraging, will provide a “backstop” even if WTI drops to $45, not to mention that if WTI does drop $45, CVE would likely be able to buyback shares much cheaper than $20. 

The table below shows where CVE would trade assuming 5% dividend yield/60% FCF payout at various oil prices and ending share counts.

CVE has a reserve life index of more than 30 years, and its low decline, low capital intensity oil sands assets represent ~80% of its EBITDA. In its 2020 reserve report, reservoir engineers valued the CVE+HSE’s combined reserves at $34 bn using a 10% discount rate. The valuation assumed $47 WTI in 2021, going up to $63 in 2031. Today’s pricing is much higher and will be reflected in the 2021 reserve report which will come out this month. A recent Credit Suisse report shows US oil weighted E&Ps trade at 30% premium to 1P NAV. At current price, one could argue that CVE trades at the same 1P NAV multiple using dated price assumptions and gets zero value for its vast downstream business. I think buybacks and/or dividend increases should help correct this mispricing. 

Catalyst

Capital return