Encana: Why Investors Should Take Notice

Karen is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

There is no doubt that Encana (TSX: ECA) has been a disappointment in the last few years. The company's decision to focus on natural gas was the epitome of bad timing, as natural gas proceeded to head south shortly after that decision, falling to lows of just over $2.00 from a high of over $13.00 back in 2008. 

More recently, the company is mired in uncertainty as they await the appointment of a new CEO.  Furthermore, investors are questioning the sustainability of the dividend.  Beyond these headline grabbing news items, however, lies tremendous value waiting to be realized as the natural gas market is increasingly seeing new demand from the transportation industry in North America.  Longer term, demand will also come from energy starved countries when the North American natural gas market is opened up to the world through LNG exports.  Encana is well positioned to reap the rewards.

Expanding natural gas market

There is an increasing investment in liquified natural gas in the transportation industry that is gaining momentum.   Last year, Ford Motors sold a record 11,600 natural gas vehicles, an increase of over 400% compared to 2 years ago.   The trucking industry is also becoming increasingly interested in LNG.  Bison Transport, one of Canada's largest truckload carriers, has partnered with Shell Canada to test the use of LNG and is currently running some of its fleet in Calgary on liquefied natural gas. Shell is opening fueling stations in Calgary, Red Deer, and Edmonton. Also, the railway industry is considering LNG as their fuel of choice. BNSF Railway announced plans to test the use of natural gas fired engines this year. Finally, LNG terminals are being planned and commissioned on the West Coast and in the Gulf, in order to open up a new market for natural gas, an export market that would supply energy starved countries.  It looks like we on the cusp of a big shift in the natural gas industry and significant increases in demand for natural gas. 

Why Encana?

With Encana's stock trading at approximately $19.00, and natural gas prices on a steady climb since 2012 (up 85%), Encana is in a sweet spot.  Commodity price expectations are in the process of being revised upwards, and the company has been focusing on improving its cost structure. The company is also well positioned to be a major supplier to LNG terminals when the time comes.

- The stock is trading at low valuation levels.  Price to cash flow is 4 times 2012 cash flow estimates.  This is a very attractive valuation.

- Encana is one of the largest natural gas producers with decades of inventory. 

- Overly negative sentiment on the stock and on the natural gas market, as evidenced by the fact that we have seen 5 consecutive quarters of positive earnings surprises from Encana, and we are now seeing natural gas price forecasts being increased.

- Good cash position.  There is currently almost $3 billion in cash on the balance sheet.  Although this will be reduced going forward to support spending, this is a good cushion. 

- Encana is focused on achieving greater efficiencies. Cost reductions and improved efficiencies are expected to be seen as early as Q3 or Q4 of this year.

Peer group analysis

<table> <tbody> <tr> <td> </td> <td>% Natural Gas</td> <td>P/CF (2012)</td> <td>P/CF (2013e)</td> </tr> <tr> <td>Encana <span class="ticker" data-id="247423">(TSX: <a href="http://caps.fool.com/Ticker/ECA.aspx">ECA</a>)</span></td> <td>90%</td> <td>4</td> <td>4.9</td> </tr> <tr> <td>Talisman <span class="ticker" data-id="247967">(TSX: <a href="http://caps.fool.com/Ticker/TLM.aspx">TLM</a>)</span></td> <td>62%</td> <td>4.1</td> <td>4.9</td> </tr> <tr> <td>Peyto <span class="ticker" data-id="247783">(TSX: <a href="http://caps.fool.com/Ticker/PEY.aspx">PEY</a>)</span></td> <td>89%</td> <td>14.5</td> <td>9.8</td> </tr> <tr> <td>Nuvista <span class="ticker" data-id="247748">(TSX: <a href="http://caps.fool.com/Ticker/NVA.aspx">NVA</a>)</span></td> <td>70%</td> <td>10.8</td> <td>11.9</td> </tr> </tbody> </table>

As we can see from the table, Encana is the most heavily involved in North American natural gas production. This has proven to be a liability in recent years, but given my thesis on the future of natural gas, this could easily become a great strength of the company. In the meantime, Encana will divert funds to liquids in order to strengthen cash flow and the health of the company. Further to this, Encana is one of the most attractively valued, at 4 times 2012 cash flow.

Peyto (TSX: PEY)

Peyto has been very successful in its natural gas strategy, achieving very strong production growth, a very low cost structure, and very strong capital efficiencies. Its share price performance and valuation reflect this however, with the stock up 37% year to date and a very expensive valuation of 14.5 times 2012 cash flow. At these levels, I think the stock is too expensive and I don't see much upside.

Talisman (TSX: TLM)

While the valuation is attractive, the company is struggling to gain focus and control costs.  Furthermore, the natural gas weighting is lower and given my thesis, I am looking for companies with a greater focus on North American natural gas.

Nuvista (TSX: NVA)

Nuvista is also trading at a premium valuation. With a much smaller resource base and higher cost structure, I believe that Encana fares much better than Nuvista if you want to play the changing gas market.

Bottom line

For the long term investor, industries and companies that are not in favor are great places to look for great ideas.  Out of favor companies have low valuations and low expectations, so this is where to find bargains.   Seeking out strong and healthy companies in an out of favor industry, with valuable assets and competitive advantages will minimize downside risk while being well  positioned to take advantage of the upside when the fundamentals turn around.  Encana is a prime example of this: an out of favor company in an out of favor industry.  And it looks like the tide is turning. 



Contributor Karen Thomas owns shares of Encana, Nuvista and Talisman. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus