2019  2020  
Price:  5.15  EPS  0  0  
Shares Out. (in M):  297  P/E  0  0  
Market Cap (in $M):  1,529  P/FCF  3.7  3.3  
Net Debt (in $M):  3,522  EBIT  0  0  
TEV ($):  5,051  TEV/EBIT  0  0 
Overview
MEG is an upstream oil producer in the Athabasca region of Alberta (the “oil sands”), the largest oil deposit in the world outside of Saudi Arabia. Its main asset is the Christina Lake project which has an estimated proven reserve life of 40 years based on MEG’s current production rate.
MEG’s share price has declined ~35% since the start of the year following a failed takeover from Husky Energy. MEG’s management claims the bid grossly undervalued its business. Despite significantly improving fundamentals since this failed bid, MEG’s share price has not recovered. Today, based on all observable inputs (e.g. WTI price, USDCAD rate, WCS differentials, etc.), I see MEG trading at a 27% levered FCF yield. Under current market conditions, MEG has significant financial flexibility with no mandatory debt repayments until 2023 and all outstanding debt covenants are incurrencebased. Management anticipates to be under 3.0x of leverage by the end of 2019.
Why did the Husky deal unravel?
Husky launched an unsolicited offer to MEG shareholders on September 30, 2018 for $11 per share, valuing MEG at $6.4 billion (debt outstanding plus $1.0 billion in cash and 107.2 million shares of Husky for MEG shareholders). Husky’s bid implied a mix of $3.21 in cash plus 0.344 shares of Husky for each MEG share. However, during the transaction tender period, market conditions weakened with WTI declining and heavy oil differentials blowing out, resulting in Husky’s share price dropping over 30%. MEG’s management did not support the deal and believed the bid significantly undervalued the company. As a result, Husky failed to take up the required 66% from MEG shareholders and on January 16, 2019, Husky’s hostile bid for MEG expired.
Following the failed takeover, MEG’s share price experienced a 37% oneday drawdown as mergerarb funds rotated out of the story. Despite strong improvements in the underlying fundamental drivers of MEG’s business, MEG’s share price has failed to recover as there has been very little capital flows into the energy space.
Valuation?
MEG extracts bitumen from its oil sands reserves. For 2019, MEG’s management is forecasting to produce 91,000 barrels of bitumen per day. This is a 5% increase versus MEG’s production last year. Based on MEG’s current production rate at its Christina Lake project, MEG has a 40year proven reserve life.
The bitumen produced is blended with a lighter, sweeter diluent and is sold to various refiners. This diluent is purchased externally. While there is no direct benchmark for this diluent, costs can be approximated using Edmonton light oil pricing and the Canadian C5 condensate index. I estimate the current diluent cost to be C$90.00 / bbl.
MEG’s final product is a blended barrel which is comprised of 70% bitumen and 30% diluent. The blend is priced as a differential against Western Canadian Select (WCS), which currently and historically has traded at a discount to WTI. WTI is currently US$63.00 / bbl, the WTIWCS differential is US$15.75 / bbl and the USDCAD rate is currently 1.34, which equates to a WCS price C$63.50 / bbl. MEG’s blend trades at a small premium to WCS which is currently estimated to be $3.00. Therefore, I estimate MEG will receive C$66.50 / blend bbl and produce 131,000 blended bbls / day. On a net basis after blend costs, this implies MEG will receive $55.85 per BOE and produce 33.2mm BOEs in 2019.
The remaining assumptions required to derive a value for MEG are mechanical and the risks assumed are largely operational. I see the net back build as follows:
Unit Economics 
2019e 
Comment 
Net Revenue after Blend, $/boe 
55.86 
Calculated from the above (+54% YoY) 
Royalties, $/boe 
3.38 
Prescribed Alberta formula (+181% YoY) 
Transport, $/boe 
8.50 
Estimate (+1% YoY) 
Opex, nonenergy, $/boe 
5.00 
Management provided (+8% YoY) 
Opex, energy, $/boe 
2.00 
Estimate (+1% YoY) 
G+A, $/boe 
2.05 
Management provided (+21% YoY) 
R+D, $/boe 
0.17 
Estimate (unchanged) 
EBITDA (field netback), $/boe 
34.76 
+102% YoY 
EBITDA: The above unit economics implies C$920mm in EBITDA for 2019.
Capex: Management has outlined $200mm of capex in 2019, $160mm of which it claims is sustaining / maintenance. I’m including but giving them no return credit for the incremental $40mm.
Taxes: Using a 26.5% tax rate, I see total taxes of $75mm. I’ve assumed no deferral.
Bringing the above together, I see $445mm in 2019 FCF versus a 2019 fully diluted market cap of $1,670mm ($5.20 share price), equivalent to a 27% FCF yield. Assuming all FCF is used to repay debt, I see MEG getting to 3.2x of leverage by the end of 2019. With assumptions unchanged, I see MEG deleveraging 0.6x per year.
Worth noting, even using current observable inputs this base case scenario may prove to be conservative. Case in point, in management’s most recent May 2019 investor presentation, management is guiding to leverage closer to 2.75x3.0x. In turn, if management hits its guidance, this would suggest MEG is trading at a 2019e FCF yield of >30%.
Sensitivities?
The tables below outline the various sensitivities to MEG’s FY1 P/FCF and leverage assuming all other drivers unchanged from what I have previously outlined.
WTI
WTI (US$) 

45 
50 
55 
60 
65 
70 

P / FCF 
25.9x 
21.4x 
7.7x 
4.7x 
3.3x 
2.6x 
Net Debt / EBITDA 
3.8x 
3.6x 
3.5x 
3.3x 
3.2x 
3.0x 
WTIWCS Differentials
WCS  WTI Differential (C$) 

35 
30 
25 
20 
15 
10 

P / FCF 
132.1x 
11.0x 
5.3x 
3.5x 
2.6x 
2.1x 
Net Debt / EBITDA 
3.7x 
3.6x 
3.4x 
3.2x 
3.0x 
2.8x 
USDCAD
USDCAD 

1.15 
1.20 
1.25 
1.30 
1.35 
1.40 

P / FCF 
7.7x 
5.9x 
4.8x 
4.2x 
3.6x 
3.3x 
Net Debt / EBITDA 
3.5x 
3.4x 
3.3x 
3.3x 
3.2x 
3.2x 
Allinall, I believe MEG is an attractive opportunity that the market is not currently discounting correctly due to a rotation in the investor base and lack of capital flows into the energy sector. Under a reasonable array of outcomes, MEG is FCF positive and under the current observable outcome, MEG is trading towards a 30% FCF yield. As MEG delevers, this value should accrue to shareholders. Moreover, once MEG proves to the market its FCF generating and deleveraging ability, I believe a rerating is in order. Even if MEG’s share price was >$10 (~100% above current levels), I don’t think anyone would consider MEG expensive as it would still be trading at a ~15% cost of equity. MEG’s current valuation is extremely compelling and offers a significant margin of safety against various macro factors that can be argued and debated either way.
 Deleveraging