Cenovus: Record Valuation Discount Could Set Up Strong Returns

seekingalpha11-20

Cenovus delivered a solid Q3 with upstream production above expectations as the turnaround at Christina Lake was finished ahead of time.Downstream remains a drag on group performance, yet management ...

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KingWu We named Cenovus Energy (NYSE:CVE) our top pick among Canadian oils earlier this year as we highlighted its potential to pay out ~1/3 of its market cap over the next 2 years after management announced it would return 100% of (excess) FCF. Since then shares have underperformed peers, specifically post Q2 in August, and are currently down 21% vs top performer Suncor up +11%. Data by YChartsWhile we acknowledge this, we do not believe the story has changed meaningfully since our first note and Cenovus remains a deep-value opportunity in a sector where valuations become increasingly stretched. With no changes in the capital return outlook, an eventual inflection in the downstream business is key to rerate performance with peers in our view, especially as upstream has performed very well YTD. While refining margins have been down overall and are outside the scope of management's actions, actual margin capture fell to just ~30% of benchmark margins during Q3. Importantly, management addressed this as a key strategic priority during the call and Q3 saw several on-the-ground improvements across Lima and other US refineries which should help to inflect segment earnings into 2025. We also note CVE's relative valuation is currently sitting at the lowest level in years as peers are priced on average ~30% higher, up from ~10% earlier this year. While some discount might be warranted given operational pressures in refining, we believe the current record discount could set up strong long term returns. We therefore reiterate Cenovus at Overweight although we cut our price target to US$30/sh from US$34/sh (refers to shares listed on NYSE) as we factor in weaker oil prices and downstream estimates. This implies around 84% upside from current levels which we believe could be quickly to materialize upon any incremental progress in downstream. Additionally, forward dividend yield has surged to ~4% while we continue to estimate buybacks worth ~6% of market cap for a total TSR potential of almost 100%, confirming our top pick status as best value among North American oils. Key risks remain in weaker than expected macroeconomic and oil price developments, which could materially hurt Cenovus' ability to generate cash flows and fund shareholder distributions. Additional company-specific risks include further operational challenges as well as project cost overruns and delays, specifically in the downstream business. [Note: Canadian peers are Suncor (SU), Imperial (IMO) and Canadian Natural (CNQ). US peers are Exxon (XOM) and Chevron (CVX). All financials in C$ if not indicated otherwise, price target refers to US listed shares. All quarterly results from the Q3 mgmt review and financial statements.] Key Discussion Points In-line Q3 with strong upstream performance. Downstream remains a drag, but incremental progress is expected. Q3 continued Cenovus's solid YTD production growth, with average daily oil sands volumes up 2.7% y/y to above 600Kboe. Q3 production also surprised to the upside as the scheduled turnaround at Christina Lake came back online several days earlier than expected, halving its impact on production levels to ~20Kboed from ~40Kboed. Tie-in work for the Narrows expansion also continued during the Christina Lake downtime, with the pipeline now ~93% finished and first oil expected by mid-2025. Overall, growing production and rising refining throughputs drove an 8% y/y sales increase despite broadly lower price decks and narrower spreads. Adjusted funds flow (\"AFFO\"), which roughly equates to operating cash flow, was down 3% y/y while AFFO/sh was up 1%, driven by share repurchases YTD. Capex was up slightly to around C$3.5B, driven by 1) maintenance & optimization projects and 2) selective growth such as the Narrows tie-in. This drove Free Funds Flow (\"FFF\") 16% lower to C$3B with excess FFF after dividends and leases at C$1.7B.   YTD Variance Table (Company Filings)We believe the Q3 report perfectly highlights the key dynamics driving Cenovus' share price underperformance YTD: the strong value inherent to an improving and durable upstream business is held down by a refining segment plagued by (unplanned) turnarounds and operational challenges. During Q3, refining utilization in the US segment (the CA refining segment focuses on bitumen upgrading vs traditional gasoline & destillate refining) was around 89%, down 3pp vs Q2 yet still significantly above prior year's average of ~80%. We note that this included impacts from the turnaround at the Lima refinery, which was completed on time in late October. While we expect the turnaround to also have some impact to Q4 utilization figures, it should provide incremental benefits next year as the maintenance included several targeted investments in secondary units. Management noted it as an \"absolute urgency\" to improve downstream availability. Therefore, we view the proactive investment at Lima, the company's largest refinery at ~170Kbbld capacity, as a key driver to improve downstream performance. Company FilingWhile utilization was in-line, refining margins remained weak, with Cenovus' benchmark US Midcontinent crack spread down roughly 30% y/y during Q3 at around C$20/bbl. While this was only down marginally on a sequential basis (-3% q/q), actually realized refining margins plunged to $7/bbl, down more than 50% vs Q2's $15. This was driven by a much weaker market capture ratio of 35% (actual ref. margin vs benchmark) when calculated on a FIFO (first-in-first-out) basis, roughly half of Q2 and materially below expectations. Management notes the weak results were attributable primarily due to the adverse effect of processing higher priced feedstock purchased in prior periods. Narrowing WTI-WCS differentials were also a net headwind to realized refining margins. Company FilingsWith US refining opex/bbl continuing its YTD trend, up almost 14% q/q to C$14.4, segment operating profits turned sharply negative again. We note the segment's highly variable bottom-line performance, with strongly fluctuating profits and margins, have likely contributed to recent share underperformance. Therefore, we believe any incremental operational progress here will be key to improving investor perception of Cenovus going into 2025. Yet, with management having realized the urgency and several recently initiated programs expected to provide operational improvements by early next year, we remain confident in the segment. Recently stabilized WTI-WCS differentials and oil prices should also become tailwinds through Q4 and early 2025 as FIFO-accounted margins now factor in lower cost feedstocks. Company FilingsCompany Filings Relative multiples vs oil sands peers at a record low. Based on 2025E consensus EBITDA, Cenovus currently trades at 4.5x, slightly below its YTD average of ~5x and around 1.5 turns below its mid-2023 highs of 6x. While absolute valuation remains around in-line, relative valuation vs its Canadian peers has dropped to its lowest in over 2 years with the gap widening in recent months. As of mid-November, peers trade ~30% higher, around double the YTD average of 15%. While some discount might be warranted on the grounds of weaker execution, specifically in downstream, we view current valuation as overly cautious given that upstream continues to deliver, and several implemented new projects can be expected to gradually improve downstream performance going into next year. 1Y-Forward EV/EBITDA (Bloomberg) Valuation Update We keep our general SOTP valuation methodology, but flow through weaker near term oil and gas prices and roll forward our valuation to 2024 estimates. We also downward revise the multiple we apply to the downstream segment from previously 4.0x to 3.0x, primarily reflecting the inconsistent YTD performance at its US refineries. Therefore, we decreased our price target from US$34 to US$30 per share for the NYSE-listed equity. CVE NAV Model (Company Filings, WSR Estimates) This implies an 84% price upside which alongside a ~4% dividend yield and forward buybacks worth ~6% of current market cap should yield around 100% TSR potential, confirming Cenovus as our top pick despite the current operation challenges in downstream.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2484150499"}