Canadian Natural Resources: A Heavy Crude Oil Titan

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Oct 16, 2014
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Since Barron's recommendation in December 2013, Canadian Natural Resources (CNQ), one of the top 10 favorite stocks for 2014, currently performs in line with the S&P 500 index. However, most of the supporting rational behind the buy thesis still remains intact. I believe that the performance of CNQ will be outstanding given its significant free cash flow generation capacities. Sometimes an investment thesis will take more than a year for the potential of a stock to be fully reflected in the stock price. For long-term investors, one year is too short to measure the investment performance. With a longer time investment horizon in 2018 and beyond, CNQ should be able to fully unleash its potential.

Business Overview

CNQ explores for, develops, produces, markets, and sells crude oil, natural gas liquids, and natural gas in North America. It has a balanced production mix, including 35% heavy crude oil, 30% light crude oil and NGLs/SCO, and 35% natural gas. CNQ was founded in 1973 and is headquartered in Calgary, Canada.

(click to enlarge)03May20171327591493836079.png

Source: Company Presentation

Valuation

(click to enlarge)03May20171327591493836079.pngSource: Company Presentation

Based on the historical financial statement, investors would not notice the potential of growing free cash flow expected in 2018. As CNQ will achieve its $8 free cash flow target in 2018, its current enterprise value $51 billion will appear to be significantly undervalued relative to the future free cash flow generation capacities. The street consensus is to value companies, like CNQ, around 6x free cash flow. With a solid dividend yield and a strong management team, CNQ can trade at least 6x free cash flow, and my target price is around $47. This implies more than 30% upside potential.

According to various popular valuation matrices, CNQ appears to be undervalued:

(click to enlarge)03May20171327591493836079.png

Source: Gurufocus.com

In regards to the P/E multiple, CNQ is currently trading around 12.8x and close to the trough.

(click to enlarge)03May20171328011493836081.png

Source: Gurufocus.com

In regards to the P/S ratio, other than the financial crisis in 2009, CNQ is currently trading near 2x P/S. Again, the current P/S ratio is near the trough, too.

Financial Strengths

CNQ obtained BBB+ credit rating with stable outlook from S&P and Baa1 credit rating with stable outlook from Moody's. The debt/EBITDA ratio is expected to be 1.2x, which indicates a healthy financial profile. In addition, CNQ not only has financial disciplines in regards to handling debt, but also increases quarterly dividend to $0.225 per share resulting in 2.2% dividend yield. In fact, CNQ has grown its dividend by 34% CAGR since 2009.

(click to enlarge)03May20171328021493836082.png

Source: Company Presentation

As illustrated by the chart above, CNQ has recently increased its capital return to shareholders through both share repurchases and dividends. As CNQ expects to have a consistent stream of free cash flow in 2018 and beyond, prospective shareholders of CNQ can expect more capital returns in the future.

Catalysts

(click to enlarge)03May20171328021493836082.png

Source: Company Presentation

One of the catalysts to propel the stock price of CNQ higher is the narrowing in price difference between the heavy crude oil produced by CNQ and the WTI crude oil. As we might know, the price difference will change based on many factors. One of the key factors is transportation to deliver the Canadian heavy crude oil to the refiners. As the transportation costs decrease with the increasing in rail as illustrated by the chart above, the price difference will shrink. As a result, this will benefit the Canadian heavy crude oil price obtained by CNQ and make CNQ more profitable.

One major wild card for CNQ to appreciate significantly is the Keystone XL pipeline. Due to the political sensitivity of Keystone pipepline, most analysts expect that there won't be any decision in regard to passing the bill for the Keystone XL pipeline until the November election is over. In 2015, I expect that the bill will be debated again. Although nobody knows whether the bill will be passed, prospective CNQ investors can view the passage of the bill as a free call option since the fundamental of CNQ can support the current share price with or without the bill.

Management Team

(click to enlarge)03May20171328021493836082.png

Source: Company Presentation

Compared to its competitors, the management team members of CNQ own significant wealth in their companies, and this will provide more incentives for management to perform. Not to mention that the interest of the management team is more in alignment with the shareholders.

Steve Laut has been the CEO of CNQ since April 2005. He first joined CNQ in 1991. This gives him more than 20 years of experience at CNQ. He held various positions as Reservoir Engineer and Production Engineer with Poco Petroleum, Adams Pearson, Petro-Canada, Dome Petroleum, and Unocal.

Risks

First, CNQ is subject to the fluctuation in oil price and the price spread between heavy Canadian oil and WTI oil. Second, CNQ can be impacted by government legislations. Environmental policy and royalty fees have impact on the profitability of CNQ, too. Third, the future free cash flow generation capacities might be lower than anticipated, and there is execution risk involved in the management team of CNQ to deliver their financial targets.

The Bottom Line

Recently, as oil price has declined significantly, it is no wonder that CNQ was pull down together with the energy peers. However, if Jim Rogers can shed some light in the future direction of oil, the recent decline in the price of crude can be "artificial." If that's the case, CNQ with great FCF prospective in the future should be a solid investment in our portfolio. If not, the fundamental strengths of CNQ and its 2.4% dividend yield should help CNQ to find a floor near the current price. As Mohnish Pabrai once said, "Head I win; Tails I don't lose much."

Disclosure: I am not a securities broker/dealer or an investment adviser. You are responsible for your own investment decisions. All information contained should be independently verified with the companies mentioned, and readers should always conduct their own research and due diligence and consider obtaining professional advice before making any investment decision.