ARC Resources: Cannibalizing Undervalued Shares To Unleash Exceptional Returns

seekingalpha07-11

ARC's low costs, superior production mix, and international gas pricing exposure make it a low-risk/high-return investment.The start of production from its Attachie project in 2025 will provide a ...

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While our investor community mostly agreed on ARC's quality, not everyone agreed on the undervaluation of the business, claiming that it's trading close to NAV, while many other Canadian O&G names, like Birchcliff (BIR:CA) or Peyto (PEY:CA), trade deeply below NAV. In this article, I will review Q1 results, update the investment thesis while building the five-year projection, explain why NAV might not be the best way to look at the valuation and explain why I believe ARC is currently the best pick among large-cap producers. Q1 Results Even the highest-quality business can be a bad investment if you overpay. Before I jump into the projection and valuation, let me quickly remind you of the quality of ARC Resources so we can better understand what we are buying. During the first quarter, ARC has reached a production level of 352,416 boe/d (37% liquids). About half of its revenue is made of high-margin condensates, which is the reason why people don't call ARC a gas company but rather a mixed company. Q1 results (Based on ARC's Financial Report) Hedging is like a double-edged sword: In times of declining commodity prices, as we saw with gas prices in Canada, hedging protects your profitability. Recently, we witnessed large hedging gains from Peyto (PEY:CA) or Tourmaline (TOU:CA), while ARC reported a small hedging loss. During the cycle, hedging is usually a losing or zero-sum game, and investors should pick a company that is aligned with their goals of being exposed to the upside/downside of commodity prices or, rather, guaranteed results. I like to say that high margins and a clean balance sheet are the best kinds of hedges. And that is exactly what ARC is all about. Building ARC's Five-Year Cash-Flow Projection ARC has several large milestones ahead and several competitive advantages in the form of very low costs in combination with locally undersupplied high-margin condensates and future up to 30% exposure to international gas prices. I will discuss these points further as we move down in the projection.  Benchmark: I am building the projection based on AECO and HH strip prices and US$80WTI, which is close to the current strip. Later, I am going to make a sensitivity analysis to see the value under different pricing assumptions. Benchmark Pricing (Author's Projection)   Production: ARC has a 5-year growth plan that focuses mainly on developing its liquids-rich Attachie project. Due to the higher liquid content, the overall production mix should move above 40% liquids, which should increase not only revenue but also FCF margins.  Realized condensate prices: ARC's condensates are sold at nearly identical prices to its benchmark \"Edmonton condensates,\" which is trading close to WTI prices. Good to remember is that there is high demand for these condensates, as those are highly undersupplied in Canada and have to be imported from the US.  Realized gas prices: Over the past three years, ARC's realized prices (excluding hedging) reached 100% of Henry Hub, which I am using in the projection. I am not accounting for KJM/TTF exposure now, but I will explain the potential upside later.  Production & Prices (Author's Projection)   Revenue per BOE: As you can see, I expect a huge boost to revenue per average barrel in 2025, as the Attachie project adds higher priced liquids and the production mix hits a 40% liquid content. Also, the higher benchmark prices for HH gas are going to contribute to that.  Costs: I am using the guidance from management. It is important to keep in mind that transportation costs will be higher due to the KJM/TTF exposure, but I am making the model with this exposure and will explain the potential upside later.  Corporate expenses: Compared to last year, management is guiding for higher G&A costs, share-based compensation, and taxes.  Costs (Author's Projection)  FFO, Capex & FCF: Funds from operations should see a substantial upside next year. Since Capex is guided to flat at ~C$1800M per year for the next five years, the gain in FFO will fully translate into FCF, which should double the direct rewards to shareholders, mainly via buybacks. Capex, Debt & FCFE (Author's Projection) Let's review the projection. Five years Projection (Author's Projection) With the current strip pricing, ARC investors can expect a 12% buyback/dividend yield in 2025, which should grow to 14% as the second phase of the Attachie project starts its operations. Keep in mind that this is still during high Capex spending. If ARC were to switch to a 100% payout, just sustaining its production with no growth, it would be able to pay out an 18% yield in 2029. Further upside from KJM/TTF exposure ARC has four significant long-term contracts in place, which together expose 630MMcf/d of gas to international pricing. I don't know exactly how these prices are going to be benchmarked and what the related costs will be. ARC shared the economics of the Cheniere Corpus project, where the break-even is at KJM US$8/MMBtu. LNG contracts (ARC's presentation) The current KJM price is above $12/MMBtu, which could bring an additional C$240M of net revenue every year of the contract. KJM is highly volatile, and Japan is trying to restart and build more nuclear energy capacity. Even if it happens, LNG should still be competitive, and all these contracts should bring additional value. How is the market valuing ARC's shares? The return for shareholders is driven by a combination of spending for growth, buybacks, and small quarterly dividends. When you invest in a dividend-focused company like, for example, Tourmaline (TOU:CA), the management lets you decide about the capital allocation; thus, even if you find the stock currently richly valued, you can simply decide to reinvest the dividends somewhere else. With ARC, the management chooses for you, as they prioritize buybacks over dividends. If the management executes buybacks despite the stock being overvalued, the value will move from long-term investors to those who are selling the shares. For that reason, it is important to keep an eye on the valuation not only at the moment of buying but also during the holding period. There are many methods to value a company. The most common is using multiples like P/E, EV/EBITDA, etc. I don't consider the use of multiples to be a valuation, but rather \"pricing.\" It can be used for historical or industry comparisons, but it won't tell you the rate of return on your investment. Different Valuation Methods (researchgate.net) I always base the valuation on discounted free cash flow. So, after I finish the projection, I simply discount the resulting FCFE during the growth period and calculate the terminal value from sustainable FCFE in the final year of my projection. Using the right discount rate is highly subjective for commodity companies. Even if I use WACC, the valuation highly depends on the assumed prices. Since I assume mid-cycle prices, I am comfortable with a 15% discount rate, but I always combine the valuation with sensitivity analysis to understand the upside/downside. When discounting my modeled free cash flows (without the boost from four LNG contracts), I arrive at a target share price of C$25.7 with a 15% discount rate. I would argue that for one of the highest quality O&G companies, this is a great potential return offered by Mister Market. Present value with different discount rates (Author's Calculation) Discounted cash flow is also a valuation method used in independent NI 53-101 reserve reports. These reports are very valuable resources for investors to understand the company's assets. These reports calculate the value of potential future cash flows based on production from booked reserves. The resulting values are presented at different discount rates. The CEO of such a petroleum evaluation company recently explained that North America's oil assets are trading at 1P-NAV-10 (Proved reserves at a 10% discount rate) and 2P-NAV-20 (Proved+Probable at a 20% discount rate). These values for ARC's assets come at C$12,075M and C$10,819M, and it was calculated with slightly higher prices compared to the current strip. So you could say that ARC is trading at a premium, while companies like Birchcliff and Peyto are selling at deep discounts. Reserves valuation (NI 53-101 report) The issue with such a report is that it only accounts for booked reserves, and ARC only booked ~13% of its internally identified drilling locations. This, in my opinion, moves ARC's assets from trading at a premium to trading at deep value territory. Booked locations (ARC's presentation) Sensitivity ARC is hedging a very small part of its production. Thus, you get the upside as well as the downside. I am running my valuation with a 12.5% discount rate to see how much the FCF generation is sensitive to different commodity prices and where the ARC's break-even point is. Sensitivity analysis (Author's Calculation) As you can see, ARC still generates long-term FCF even at Henry Hub, US$2/MMBtu and US$50WTI. With a very clean balance sheet, there is no reason for ARC to hedge a large portion of its production. Final thoughts ARC is cannibalizing its shares, so investors have to keep the valuation updated to make sure that management doesn't destroy value by reinvesting into expensive shares. Even without upside from significant international gas price exposure, the DCF shows that ARC is currently valued at 15+% return, so buybacks are still highly value accretive. While on the surface, ARC appears to trade at a premium to its NAV, the fact that only ~13% of its drilling locations are booked makes that argument invalid. While smaller players like Peyto are priced for higher returns, the undisputed quality of ARC makes it, in my opinion, one of the best picks among the large-cap core O&G names.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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