(Public) MEG Energy - One Of My Favorite Names

Editor’s Note: This write-up was first published to subscribers on August 3, 2024. Please note that the stock price is reflective of the publication date.

Since the publication, MEG has sold off further. We find the valuation very attractive here and will be releasing another article at the end of this week on the name (paying subscriber post).

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MEG Energy’s (MEG:CA) second-quarter results were in line with analyst consensus—and our own—expectations. Adjusted funds from operations per share came in at $1.30, while free cash flow was $0.87 per share.

The company made two big announcements during the quarter. The first was MEG’s initiation of a $0.10 per share dividend, which will generate a 1.5% annual dividend yield on MEG shares at their current price of $26.

The second was management’s expectation that the company will reach its $600 million net debt target in the third quarter, at which point it intends to pivot to distributing 100% of free cash flow to shareholders through dividends and share repurchases.

The slide below details the company’s inflection to 100% free cash flow distribution. It also illustrates the outstanding capital allocation performance that has been a hallmark of this company for many years.

Source: MEG Energy June 2024 Corporate Presentation.

Management is currently guiding for long-term production growth of 3% to 5% per year. In light of the low growth trend and MEG’s operational prowess, capex is likely to be consistent and low relative to cash flow generation above $70s per barrel WTI over the coming years. Management plans to focus on pursuing low-risk, self-funded, and capital-efficient debottlenecking and project integration.

Another Steady Quarterly Performance

On the operating front, MEG’s production came in at 100,531 bbl/d in the second quarter, down from 104,088 bbls/d in the first quarter but up 17%, from 85,974 bbl/d, from the year-ago quarter. The difference between the previous quarter was due to cold weather and the timing of well start-ups. The difference between the year-ago results was due to a short turnaround at the company’s Christina Lake facility.

MEG’s steam-oil ratio climbed from 2.37 to 2.44. This ratio is a measure of the company’s oil sands asset quality and its operating efficiency. MEG is consistently among the best in the industry. We expect the steam-oil ratio to remain in the 2.4 range over the next few years.

Turning to second-quarter financial performance, results illustrate MEG’s operating leverage, which is one of the reasons why we like the name, particularly at lower oil prices such as today’s. High operating leverage allows free cash flow to grow at a high rate as oil prices increase. We don’t believe WTI in the low-$70s per barrel and Brent in the mid-$70s per barrel are sustainable over the long term, so they create attractive long-term buying opportunities among E&P stocks when they occur.

During the second quarter, revenue increased 9.3% over the previous quarter, for a $65.6 million increase. The positive top-line result was attributable to a 23.8% increase in bitumen realizations, from $73.58 to $91.11. Higher oil prices and a tighter differential between WTI and MEG’s AWB crude oil grade pricing benchmark drove the increase.

The top line got an additional boost in the second quarter from a 30.9% decline in diluent costs per barrel from $10.00 to $6.91. These were a temporary phenomenon caused by low condensate prices during the quarter. We expect MEG’s diluent costs to increase back to the $10.00 level over the long term.

Of the $360.8 million of cash flow generated by MEG during the quarter based on its corporate netback, the company spent a lower-than-expected $123 million on capex to generate $237.8 million of free cash flow. It allocated $169.7 million of free cash flow to debt reduction and $68.0 million to repurchase 2.1 million shares, representing 0.8% of shares outstanding. MEG ended the quarter with $868 million of net debt.

On the expense side, MEG entered a higher royalty regime around mid-year 2023 when its Christina Lake SAGD project reached post-payout status under Canada’s oil sands regulations. Royalties now represent the company’s largest expense item. In the second quarter, the company’s effective royalty rate increased from 7% in the year-ago quarter to 25.9% in the second quarter. It is likely to remain at approximately 25% at $80 per barrel WTI. MEG also saw its transportation and storage costs, as well as hedging losses increase costs relative to the previous quarter. These expenses were slightly offset by lower operating expenses to increase operating expenses by $50.1 million, or 15.5%.

These revenue and cost dynamics result in an annual free cash flow run-rate of approximately $940 million. At MEG's current $7.0 billion market cap, its share trade at an attractive 13.4% free cash flow yield. For MEG, we would consider a 10% yield an appropriate valuation benchmark, which results in a valuation of roughly $34.50 per share. Our valuation implies 33% upside from MEG’s current share price of $26.

Capital Allocation Set to Deliver Value Prudently

We’re particularly pleased by MEG’s initiation of a $0.10 per share base dividend. The dividend will be payable on October 15 to shareholders on record as of September 17. At the current share price, the dividend will result in a 1.5% dividend yield. It is small enough relative to free cash flow to be virtually symbolic in nature. On a quarterly basis, the dividend will consume only $27 million per quarter or 11% of MEG’s quarterly free cash flow. Nevertheless, we believe the dividend initiation is an important development.

The fact of the matter is that when MEG shares pierced through the $30 level earlier this year—marking a 10-year high—they were far above the bargain levels seen in recent years. As the stock price has increased, share repurchases have grown less attractive relative to dividends. We’d rather that E&P management and boards of directors avoid playing games in estimating intrinsic value based on their own commodity price forecasts. As the stock price approaches fair value, we’d much rather see them shift away from share repurchases and toward dividends once the shares trade around conservatively estimated intrinsic value based on long-term WTI prices in the mid-$70s per barrel range. We suspect that MEG’s initiation of a small base dividend marks an important first step toward the company declaring significantly larger payouts as the shares rise to fair value and share repurchases lose their attractiveness. In our view, the dividend policy indicates that management will pursue the most sensible capital allocation policy available given the circumstances.

The quarter did nothing to change our estimate of MEG’s long-term earning power or intrinsic value. MEG offers investors extraordinarily long-lived reserves, abundant free cash flow at WTI above $75 and the WTI-WCS differential of $15, and a relatively simple operating model for an oil sands company.

That last virtue is notable when comparing MEG to its peers. MEG shareholders won’t have to bank on the success of a major turnaround as Suncor's (SU:CA) shareholders do; they won’t have to worry about rectifying underperforming refineries like Cenovus' (CVE:CA) shareholders do; and they won’t have to try to gauge the impact of diversification into potentially lower-returning conventional production upon shareholder value like Athabasca Oil's (ATH:CA) shareholders do.

The absence of these—and many other—potential issues render MEG’s capital distributions to its shareholders more predictable than those of its oil sands peers. In short, there’s a lot to like in MEG’s simplicity and focus, which is one of the reasons why we believe a premium valuation multiple is warranted. It’s also why we consider the shares a top pick among oil sands operators.

Conclusion

We recommend buying MEG shares during the ongoing selloff. The company’s cash flow torque to higher oil prices remains solidly intact, while the financial risk to shareholder value is close to nil over the long term.

Investors buying the shares at their current depressed price can benefit from a spectacular future free cash flow return yield when oil prices are high, which they will be at some point in the future. Consider that at $95 per barrel WTI, the shares at their current price would generate an approximately 20% free cash flow yield, all of which will now be distributed to shareholders. At that price, the share price will be much higher than it is today. The opportunity to buy MEG shares at $26.00 is a gift, and investors looking for long-term exposure to higher oil prices and a set-it-and-forget-it equity should buy now.

Analyst's Disclosure: I/we have a beneficial long position in the shares of MEG.TO, SU, ATH.TO either through stock ownership, options, or other derivatives.