Canadian Natural: Solid Performance, But Valuation Remains A Headwind (NYSE:CNQ)

Note: All amounts discussed, except the prices in the covered call calculator screenshot, are in Canadian Dollars.

On our last coverage of Canadian Natural Resources Limited (NYSE:CNQ), (TSX:CNQ:CA) we looked at how this free cash flow gusher was returning cash to shareholders and admired its aggressive buybacks and special dividends. While we liked the play we put our weight being the others and we literally owned every single oil sands play, except CNQ.

So there’s upside and you can come out ahead. For our money, we major positions in MEG Energy Corp. (MEG:CA) and Suncor (SU), (SU:CA) and minor positions in Cenovus Energy (CVE), (CVE:CA) and Imperial Oil (IMO) (IMO:CA). We don’t own any CNQ and rate it as neutral/hold.

Source: The 3-Way Booty Split

We could see the fan club rolling their eyes at avoiding what they thought was the best of the best. It was a mixed bag though, with IMO winning the contest and CNQ coming in at a respectable second.

CVE did the worst out of the lot. Our own performance in these was significantly better as we had used covered calls and the average trade delivered about 17%. We look the 2024 budget and the recent operational performance for CNQ and tell you why this one is getting close to our buy point.

Q3-2023 & The Budget

CNQ’s low decline asset base continued to perform as expected with volumes and margins coming in ahead of analyst expectations in Q3-2023.

The company raised its quarterly dividend by 11% to $1.00 per quarter alongside its Q3-2023 press release. For 2023, the forecasted free cash flow allocation was shown to be as follows. Note, that this slide is from the January 2024 presentation but until its year end numbers are finalized, these will have to get the “forecasted” tag.

CNQ did pretty much what it set out to do and there were no silly value destroying acquisitions like some other players engaged in. For 2024, the budget was $5.42 billion.

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This is a pretty big number. As a baseline, 2019 capex was $3.6 billion, so we are about 50% over that. Of course there has been an inflationary erosion of the value of money so realistically, this is about 25% over inflation-adjusted 2019 numbers. We next get to the key numbers for production. CNQ forecasts a 3-7% growth per share in production.

We are not debating the usage of the “per share” amounts. Those are actually the most relevant and CNQ’s buybacks should count in the equation. But what is interesting here is the growth in Natural Gas production. This is still up relative to Q3-2023 numbers of 2,151 MCF a day, but it came in definitely below where the analyst community was aiming. This has generally been a problem in Canada where Natural Gas production levels are held as a merit badge by companies, all while pricing continues to go down the gutter. AECO 2024 strip is now close to averaging just $2.00 Gigajoule.

CNQ has actually shown some restraint here and liquids growth will be the bulk of the capital allocation. But longer term, this is one reason that CNQ has probably not done even better. From 2019 base, natural gas production should be up 46% on an absolute basis in 2024. Liquids should be up just 17%. Again these are total numbers and per share numbers are higher. But CNQ has become gassier over time and that is going to hurt at least on a relative basis.

Valuation & Verdict

You can ignore the gas and buy it for the rest of the asset base. You should do just fine over the long run.

There is some significant growth potential with SCO reliability project and the company’s own portfolio offers long term growth potential.

With a 30 year plus reserve life index, CNQ should command a premium multiple over the US E&P’s, especially since it is still liquids focused. But in the Canadian space, you are paying a premium multiple for this. On an EV to EBITDA basis, 0.5 to 1.5 multiples are pretty massive.

Especially for this sector which is still held in complete disdain by the market. If you back off from that number and focus on the free cash flow yields, you reach an even larger value differential. CVE for example sports almost a double free cash flow yield on similar pricing. SU is also significantly better. What this tells us is that CNQ premium is still in place. As a company that did not cut its dividend during COVID-19 and has executed better than both CVE and SU, one might argue that it makes sense. For us, it is still a bit too much. You are in essence paying for the Natural Gas which is currently generating zilch. We are still placing our bets on the SU and CVE and we recently added CVE after its massive underperformance. For CNQ, we think covered calls can still work out, especially since we expect Natural Gas prices to move up later in the year. We would choose an “at-the-money” or a slightly “in-the-money”, as there is a chance the premium compresses for CNQ. One example from the US side shown below.

The implied volatilities are bit lower on the Canadian side but you can do a similar trade in Canadian dollars as well on TSX/Montreal Exchange. For a direct buy, we would really need to see CNQ below 5.0X EV to EBITDA. We continue to rate this as a hold.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.