Suncor: Very Cheap And Offering A High Yield (NYSE:SU)

Article Thesis

Suncor Energy Inc. (NYSE:SU) is a major Canadian integrated oil company with vast oil sand assets. The company operates with attractive fundamentals, and with China reopening its economy, the outlook for oil prices is healthy. Since Suncor trades at a very inexpensive valuation, I believe shares have considerable upside potential.

The Macro Picture Remains Solid

Oil prices have pulled back from the very high levels seen last summer, but most energy companies will remain quite profitable with oil in the $80s. And I do believe that there is a good likelihood that oil prices will remain around that level, or possibly rise beyond it. Oil prices have pulled back in recent months due to worries about an economic slowdown. But while a slowdown or a potential recession could hurt oil demand to some degree, there are other factors to consider on top of that.

First, sanctions on Russia and its oil industry due to the ongoing war in Ukraine will likely result in lower output over time. As no maintenance and parts will be coming from the West any longer, it is likely that Russian oil output will decline in 2023 and possibly beyond, as fields mature over time while not a lot of new supply will be coming online.

Second, China is opening up its economy. This will result in increased economic activity, which will drive oil use for trucking, plastics production, and so on. Flights and auto traffic should grow as well as fewer people are locked down, which will result in additional oil demand.

Third, supply from the Strategic Petroleum Reserve has ended, which will impact the supply-demand situation. When the US government becomes serious about filling up its reserves again, additional demand for oil will be added.

At the same time, many energy companies aren’t investing enough cash to grow production, such as Shell (SHEL) and BP (BP), which are forecasting that their output will decline slightly over the coming years. All in all, this makes for an environment where I believe that it is likely that oil prices will remain higher for longer. That does not mean that we will revisit the highs seen last summer, although that is not impossible, either. But even if it just means that oil will continue to trade in the high double-digits, that would make for a highly compelling environment for most energy stocks, as they are trading at inexpensive valuations now, and since oil at $80 or above makes them highly profitable.

Suncor’s Attractive Fundamentals

Suncor Energy’s shares have risen by 28% over the last year, which is not too compelling relative to the performance of other energy companies such as Exxon Mobil (XOM), which is up 55% over the same time frame. But this recent underperformance is why Suncor might actually have more upside potential than many other energy stocks — its shares have not risen as much as those of many peers, making for a below-average valuation and above-average upside potential.

Suncor’s underperformance over the last year was largely driven by investors worrying about some operational issues. Suncor has experienced some accidents, and while that does indicate that there might have been some problems when it comes to safety measures and controls, it is unlikely that those past accidents will negatively impact the company in the long run.

Suncor’s business fundamentals are attractive:

The company is active in different areas, but the most important ones are its synthetic crude oil (oil sand) business and its refining business. Combined, these generate around 75% of Suncor’s funds from operations. Its offshore and bitumen businesses provide some diversification but aren’t really “core” businesses. Processing the oil it generates itself allows Suncor to capture higher margins, especially during times when crack spreads are high, such as last year when the price premium of diesel and gasoline versus crude oil exploded upwards. The refining business also provides some protection in case oil prices pull back, as oil is an input cost for the refining business.

In its oil production business, Suncor benefits from low decline rates and low break-even cash costs. This is typical for oil sand assets and holds true for other players in this space as well, such as Cenovus (CVE) or Canadian Natural Resources (CNQ). Oil sands projects have very high upfront costs, but those have been paid in the past — today, investors benefit from the low run rate costs of these assets and from the long reserve lives and low decline rates these oil sands projects provide. As a result of these oil sand-specific properties, oil sand players such as Suncor don’t have to invest massively in new projects, even the maintenance capital expenditures are relatively low. This allows Suncor to generate highly attractive free cash flows, which, in turn, can be used for shareholder returns via dividends and buybacks, for debt reduction, or for M&A.

Over the last year, Suncor Energy generated CAD$8 per share in adjusted funds from operations, or cash flow adjusted for maintenance capital expenditures and dividends. Growth capital expenditures, e.g. for capacity expansion at oil sands projects or refineries are not yet accounted for here, but dividends, which are an important part of SU’s investment thesis, are already subtracted. CAD$8 per share is equal to around US$6 per share, with the dividend of ~US$1.55 already being accounted for. That means that, before dividends, Suncor has available cash flows of around US$7.50 per share with oil prices where they were in the Q4 2021 to Q3 2022 period. Per Suncor’s presentation, WTI averaged $93 in that time frame.

Today, WTI trades around 10% lower, which would indicate somewhat lower cash flows, all else equal. On the other hand, Suncor has lowered its interest expenses over the last year by paying down debt. On top of that, Suncor also reduced its share count via buybacks, giving each remaining share a larger portion of the company-wide profits and cash flows. I believe that these factors could offset the headwind from slightly lower oil prices, which is why I do not believe that a cash flow estimate, after maintenance capital expenditures, of US$7.50 over the next year is unrealistic. But let’s still round that down to US$7.00 to be on the conservative side. In this scenario, Suncor would offer a very attractive 21% cash flow yield based on a share price of US$34.

Suncor has a solid capital allocation framework in place:

The company will use its free cash flows in different ways, depending on its current net debt level. The higher the net debt position, the larger the allocation to the “debt reduction” bucket, whereas more cash is diverted to shareholder returns at lower net debt levels. This makes sense, as the benefits from balance sheet strengthening are higher when debt levels are higher, as interest rates are higher, all else equal, and since paying down debt will ease investor concerns when debt levels are high. But when debt levels are low, there are no debt-related concerns anyway, thus spending more cash on debt reduction does not generate similar benefits. Net debt totaled CAD$14.6 billion at the end of the September quarter, down CAD$1.5 billion over the first nine months of 2022. This means that Suncor will pay out roughly half of its after-dividend free cash flow via buybacks in the near term, while the other half is used for further debt reduction. If Suncor hits US$7 per share in free cash flow this year, that would make for around CAD$12 billion. Subtracting CAD$3 billion in dividends (SU increased the dividend after the slide from above has been released) gets us to around CAD$9 billion of spending capacity between buybacks and debt reduction before growth capital spending, and to around CAD$7 billion in buybacks and debt reduction capacity after accounting for what SU calls “Economic Capital”, or growth spending. With around half of that being used for debt reduction, it is pretty likely that Suncor will hit the next net debt target, CAD$12 billion, in the first half of 2023. At that point, the company will, according to its capital allocation framework, increase its buybacks further. Investors can thus expect that Suncor will ramp up its buyback spending considerably this year, which should be highly accretive to its cash flow per share thanks to the low valuation SU trades at today.

Takeaway

SU has underperformed many energy peers over the last year, but that is why its shares are still pretty cheap. Shares are trading with a cash flow yield of around 20%, which makes for a very undemanding valuation. With shares offering a dividend yield of 4.6% and with a hefty pace of buybacks going forward, Suncor looks attractive as an income pick and as a total return stock.