CPG – Having an Adult Conversation about Crescent Point Energy – Reblog

Thought this blog that I wrote on Crescent Point back in April, 2013 was worth a re-blog. A lot of pain out there on this one, and from my weekend reading investors still hopeful Crescent Point can still meet its distribution obligations. Hope this blog answers some questions and gives everyone who was invested in CPG pause for thought. The proverbial writing was on-the-wall on this one and with the fall in oil prices since September only enhances the weak fundamentals that were clear, at least to us!

This blog has two objectives.  The first is to highlight the valuation divergence currently underway between our model price calculation and CPG’s stock price.  The second objective is to discuss why we use Net Income or earnings for our valuation analysis instead of cash flow per share.

Valuation divergences occur all the time in financial markets especially with individual equities.  Where the fundamentals and the market price of an individual stock price can go in opposite directions for whatever reason.  These divergences can correct themselves, with fundamentals changing positively or the stock price correcting to the appropriate valuation level without warning, so investors have to be vigilant.  Model Price is a service that calculates valuation, model price or fair market value, for over 2000 companies using the same company data for our algorithms.  No special treatment is necessary or special calculations for individual companies.  Also divergences can last for a prolonged period of time.  Timing when divergences can disappear is very hard to predict.

Sometimes a picture is worth a thousand words.  So let’s start with a picture.  Here is the long-term chart of Crescent Point Energy.

Crescent Point Energy with monthly price bars, EBV Lines (colored lines) and model price (dashed line)

Crescent Point Energy with monthly price bars, EBV Lines (colored lines) and model price (dashed line)

This model price chart displays our calculation of model price over the last 7 1/2 years.  After peaking in mid-2007, model price or our calculation of fair market value has steadily fallen over the last six years.

So what’s going on here?

Crescent Point Energy finally issued their 4th quarter and full year results on March 14, 2013.  I have downloaded the most recent financials, just as I have done with every annual report filed by CPG for the last few years.  This is fun reading for me.  Nothing like getting into the numbers, the balance sheet and don’t forget the all-important notes to the financial statements.

Three Reasons Crescent Point is notable!

First, the company clearly had a model price valuation either above its stock price – see chart above – or in the neighborhood of CPG’s trading value back in 2006 to 2009. Over time, since 2009, our model price calculation has eroded with no impact on the share price of CPG.  The gap in our calculated model price and CPG’s actual share price is getting wider as time goes on.  The market doesn’t seem to notice or doesn’t seem to care about this widening valuation gap.

One has to wonder why this is the case?  Doesn’t the market recognize the deteriorating fundamentals of the company’s earnings per share?  Certainly other Canadian oil companies have seen their share prices erode over the most recent past.  (Suncor and Imperial Oil are examples of this)  Are investors so enamored with the company and its annual distribution of $2.76 paid monthly that oil industry fundamentals are ignored?

Second, CPG has repeatedly paid investors distributions in excess of earnings for the last 4 years as I highlight in the table below.

2012 2011 2010 2009 2008
Cash Flow/Share 4.69 4.80 3.48 4.08 4.72
Net Income/Share 0.58 0.73 0.09 (0.19) 3.74
Distributions 2.76 2.76 2.76 2.76 2.61

The third item of note is the amount of shares Crescent Point has issued in the last two years.  The company has issued some 171 million shares!  At an average price of say $40 CDN, that’s a cool $6.8 billion of market value.  These shares were issued for company acquisitions and secondary offerings to investors.  CPG had a market capitalization at the end of 2009 of some $8.3 billion.  CPG’s market cap has grown to $14.8 billion as at mid March 2013, without a material change in the company’s share price!

Are you with me so far?

Let’s get into the current numbers and our model price chart.

Crescent Point Energy with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

Crescent Point Energy with weekly price bars, EBV Lines (colored lines) and model price (dashed line)

For those interested, a daily updated chart of CPG subsequent to this post will be maintained on Facebook, here.

As you can see we have calculated model price or fair market value of CPG to be $21.25 as at the close on April 9, 2013.  This is a 43% discount to CPG’s stock price of $37.67.  We use expected earnings estimates to determine the fair market value for every stock included in our database comprising of some 2,000 securities including CPG.  At the time of our calculation CPG had a mean earnings estimate for 2013 of $0.56.

Positives on Crescent Point

Are you shocked!  Yes there are positives.

The first positive is the company’s solid execution of production, which was ahead of consensus.  For instance, in this latest quarter – 4th quarter – production was 108,007 boe/d ahead of consensus of 102,000 boe/d.  This increase in production drove funds flow, highlighting …

… The second positive, again in the 4TH quarter funds flow came in at $1.18 and ahead of consensus of $1.14.  The company beat on both metrics keeping investors and investment bankers happy for another quarter.  Several analysts revised upward Cash Flow per Share (CFPS) to recognize improved company performance.

The company seems to be a well run company, executing in a industry that seems to be struggling with commodity pricing, output cost inflation and decreased industry equity valuations.

One does have a sense, like any other growth stock, if CPG were to disappoint in the above noted metrics, oil production and cash flow, investors will be annoyed with possible consequences for CPG’s stock price.

Cash Flow versus Earnings

This is where the rubber hits the road for investors.  Crescent Point, as I stated earlier, is paying out an annual $2.76 a share in distributions on a monthly basis.  This payout offers investors a yield of 7.3% based on CPG current stock price.  This yield is “juicy” and certainly higher then anything else of quality in the fixed income area.

Highlighting my table (see above) the company seemingly does have the cash flow to pay such a generous distribution to its’ shareholders.  However earnings of the company over the last few years have been meager to say the least.  So which row of numbers, cash flow/share or net income/share, is more relevant to you the investor?

We use earnings per share in the calculation of model price.  Why?  Here is the distinction.

Ask yourself why the accounting profession, which I belong, has spent the last hundred years trying to define earnings of a company.  The reason for this pickiness is the earnings of a company belong to the common shareholders after all actual and potential stakeholders are accounted for.  An accumulation of these earnings is held in the retained earnings of the company.  The company builds equity, if you will, over time through compounding belonging to the owners of the company – the shareholders.

Cash Flow belongs to the enterprise.  Various stakeholders, debt holders, pension liabilities, banks, suppliers, employees all have claims against the cash flow of the company.  A company must continually invest in plant and equipment, people, R&D to maintain their competitive position.  Various managements, over time in the annals of financial history, can and have, restricted expenditures, boosting cash flow substantially in the short term only to the determent of the company longer term.  (I am NOT saying this is the case with CPG) In other words cash flow can be manipulated, volatile and of little use to the common shareholder as information regarding the financial net worth of their company.  Don’t get me wrong, cash flow is important to the company.  Without positive and sustainable cash flow the viability of the company can be impacted.  I am not arguing otherwise.  The issue becomes what number, cash flow or earnings, is more credible for valuation purposes – we favor net earnings of the company.

Lastly I found this quote from Graham and Dodd!

“No one questions the importance of cash flow– it is required to service debt and finance future growth, and it is the best predictor of the future stream of dividends.  However, we reject the notion that cash flows should be thought of as being the same as earnings.”  From Graham and Dodd’s Security Analysis – Fifth Edition. Page 262.

Model Price is falling for CPG

CPG maybe meeting and exceeding expectations with regards to production and cash flow however actual net income along with other metrics we use in our model price algorithm has been less impressed yielding a downward sloping model price calculation over the last 5 years.

Looking at the published financial statements of Crescent Point Energy (CPG), December 31, 2012, we can review the retained earnings to see how much has been accumulated on behalf of shareholders.  The retained earnings balance has a deficit of $2.755 billion dollars.  In other words the company has paid common shareholders $2.755 billion more than what they are entitled to.  So there is an overdraft, if you will.  Who is covering this overdraft?  Strangely enough, the common shareholders themselves are covering this overdraft with dilution of their own shares.

Huh?

OK, the accountants – yes the guys and gals with the green eyeshades – have determined that common shareholders have been paid too much by way of distributions relative to accumulated of Net Income – retained earnings – of the company since inception.  So who made up or funded this $2.755 billion difference?  The common shareholders with additional shares issued!    As additional shares are issued the less fractional share of the company you own.  From the beginning of 2010 – assuming you purchased shares on this date – your share or ownership stake in CPG would have been diluted by some 45%.

So What?

“So what?” you say, and continue;  “My CPG shares are trading in the stock market at the same value that I purchased them back in January 2010 and I’ve been receiving my distribution to boot.  Certainly this makes CPG is one of the best performers investment wise considering both equity and fixed income alternatives.”

To which I say; “Yes, you are right!  However …”

One has to ask, “Without major corporate finance activity in the last two years would CPG have been able to pay their distributions?”

“What if CPG is too generous with the company’s distribution (yield), which is directly responsible for the elevated valuation of CPG’s current stock price?”

“What if CPG is relying on secondary share offerings to fund the company’s current high distributions instead of relying on its’ own business operations?”

“What if capital markets, which can be fickle, are not as generous to CPG in the future as they have in the past?”  The last secondary issue for CPG was back on November 1, 2012 the company issued 18.75 million shares at $40 per share.  With investors down 6 percent, will they readily accept more shares even though they have been collecting their distribution?

The second consideration is the law of large numbers.  With a market capitalization of $14.8 billion and distributions of over $1 billion dollars annually to shareholders Crescent Point is no longer a small-capitalized company.  As companies get larger, laws of compounding and acquisition size become problematic, as the numbers just get unrealistically large for the company to manage or to meet shareholder expectations.

I’m just saying there are limits both in terms of investor’s appetite for additional CPG shares and compounding law of large numbers.  Today there are “clear blue skies” and no sign of investor fatigue of corporate activity but in the future who knows.  I do have to ask the question with corporate activity possibly diminished can CPG sustain its distribution policy to its shareholders.  Leading to the ultimate question of this blog, without the generous distributions of CPG are investors and market participants more willing to see the clear divergence gap opening up between our model price calculation and the CPG’s share price.  Who knows!

Conclusion

So there you have it.  This will be an interesting situation in seeing how this divergence gap, between our model price calculation and CPG current stock price resolves itself, and I will be in the front row.  With all the corporate activity CPG has been doing over the last few years, both acquisitions and secondary offerings, coupled with large distributions relative to what is available in fixed income, investors can be challenged in deciphering what fair market value would be for Crescent Point Energy in the public markets.  The Model Price Service – our Facebook App – crunches the numbers and calculates model price consistently focusing on the relevant inputs that calculate our model price, including our focus on earnings instead of cash flow.  Pundits and experts may rely on cash flow and yield but unfortunately these attributes are NOT variables that make up fair market value of a public company in my estimation or variables used in our calculations.

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