Value Pick: Suncor

Value stocks tend to fall into two categories: they are either not well known or they are potential turnaround situations, companies that have fallen upon hard times. Suncor fits neither bill: It is one of the most well regarded oil producers focused exclusively on the Canadian Oil Sands; it has also performed exceptionally well in recent years in terms of earnings growth and share price performance. Yet even after all the goodness that has been recognized by the market is baked into the share price, James Cole of AIC Ltd. thinks Suncor is still cheap.

Suncor is one of the first producers to venture into the Canadian oil sands, long before it was conventional wisdom that converting tar sands into oil was an economically viable business. Cole, incidentally has owned Suncor in AIC Canadian Focused Fund since 2002 when it was unknown and in hindsight had the more typical characteristics akin to a value stock.

Oil producers operating in the Canadian Oil Sands have “huge competitive advantages” says Cole versus conventional oil producers, and Suncor is one of the best outfits in the region, one of two pure plays in the oil sands.

“They have 50 years of reserves vs. a conventional company that may have 10 to 12 years; they have no finding costs, no exploration risks; they have a constant production rate, no declines; and they have a high level of political stability.” This greater stability allows Suncor to run a “very efficient manufacturing facility” allowing it to concentrate on the costs of production.

Suncor is able to turn out a barrel of oil for a mere $28 all in, including royalties (which are protected until 2015) versus a $40 marginal cost per barrel for recent entrants to the oil sands and well short of the current oil price which has been hovering around the century mark.

Costs are one thing and growth is another. On that front, Suncor is slated to see a doubling in production over the next five years, a factor of growth that simply blows away the oil majors who are dealing with many if not all the aforementioned issues that Suncor is blissfully unhampered by.

This growth could translate to a doubling in Suncor’s share price over the next five years if Suncor simply holds its current valuation. Cole sits firmly in the peak oil camp. He assumes that global oil reserves have peaked, and oil prices will remain high and could perhaps move even higher.

Suncor’s valuations could come down if production slows thereafter, and that is perhaps the greatest risk to Cole’s forecast which would simply temper the share price appreciation rather than negate it. “If they end up saying we have now exploited the best portion of our resources, at that point they generate huge amounts of free cash, over $5bn of free cash,” says Cole.

In the mean time, Suncor is spending heavily to ramp up production to 525,000 barrels per day by 2012 from current output of 280,000 barrels per day. Despite the high capital costs, the company is out of the woods when it comes to financial risk. Leverage in dollar terms and debt-to-equity peaked in 2000 “…when they were doing a significant expansion relative to size of company,” says Cole.

Debt-to-equity peaked at 1.6 times in 2001 and has come down to 0.2 times due to the generous amounts of cash flow that Suncor is throwing off. The company’s (fixed charges coverage), operating income relative to interest has risen from a sketchy multiple of four in 2001 to a well-cushioned 27 times today.

Cole estimates intrinsic value at $125 per share based on discounted cash flow analysis roughly double its current share price.

Suncor would meet a great business in the eyes of Warren Buffet says Cole because it earns a high returns on invested capital, and they have the ability to deploy substantially more capital at similarly high rates of return. “Most businesses fail on at least one of those criterion.” Suncor appears to be hitting all the marks.