Over the past few weeks I have been watching the developments of the energy industry, which has provided an excellent opportunity to search for investment stocks in this sector. One company I think is very interesting to analyze is Encana Corp (ECA). While there are many different factors to look at and consider when investing, in the article below I will analyze the company's total debt, total liabilities, debt ratios and what analyst and other top investors believe about its future profitability. From this analysis we should get an idea about the firm’s leverage and how much to expect in return for investing in it over the long term.
As a natural gas exploration and production firm, operating in the U.S. and Canada, it has developed a diverse and low-cost gas portfolio, attracting capital from several joint ventures, including Mitsubishi, PetroChina Company Limited (ADR) (PTR) and Kodiak Oil & Gas Corp (USA) (KOG). However, the winds of change reached this firm last year at the hand of the new CEO Doug Suttles, who previously ran BP Exploration and Production. Although there haven’t been any drastic announcements yet, the firm will be heading down a different path in 2014, causing some shifts in the portfolio.
Furthermore, the natural gas prices, which remain on the low end since 2012, have put some strain on the company’s balance sheet, pressing particularly on cash flow levels. Therefore, it’s crucial to remark that gaining knowledge about Encana's debt and liabilities is a key component in understanding the risk of investing in this company. By studying the debt part of a firm, investors can understand if it is capable of keeping its capital and using it for growth in the future.
Total Debt to Total Assets Ratio
This metric is used to measure a company's financial risk by determining how much of the company's assets have been financed by debt. It is calculated by adding short-term and long-term debt and then dividing this figure by the company's total assets. A debt ratio greater than 1 indicates that a company has more total debt than assets; meanwhile, a debt ratio below 1 indicates that a company has more assets than total debt. Used along with other measures of financial health, the total debt to total assets ratio can help investors determine a company's level of risk.
Encana Corp's total debt to total assets ratio has increased over the past three years, from 0.35 to 0.40. This means that since 2010, the company has acquired more debt than it has increased the value of its assets, which is certainly a warning sign for bond investors. However, as this figure is currently well below 1x (0.40), the firm faces low financial risk, as it has more assets than total debt.
Debt ratio = Total Liabilities / Total Assets
This ratio shows the proportion of a company's assets that is financed through debt. When the ratio is below 0.5, most of the company's assets are financed through equity and if not, then the company's assets are likely financed through debt. Companies with high debt/asset ratios are said to be "highly leveraged," making them vulnerable to creditors, if these start to demand repayment of debt.
Over the past three years, Encana's total debt ratio has grown from 0.62 to 0.71, which is usually not a good sign, in my opinion. The 2013 TTM numbers are above the 0.50 mark, indicating that the company financed most of its assets through debt this year. Since the number increased, so did the risk of investing in the company.
Debt-to-Equity Ratio = Total Liabilities / Shareholders' Equity
The debt-to-equity ratio is another leverage ratio that measures how much suppliers, lenders, creditors and obligators have committed to the company, versus what the shareholders have committed. A high debt-to-equity ratio generally means that a company has been aggressive in financing its growth with debt, possibly resulting in volatile earnings. It also indicates if a company will be able to generate enough cash to satisfy its debt obligations, making it a less risky investment.
I usually like companies with very low debt-to-equity ratios and conservative balance sheets. On the contrary, Encana's debt-to-equity ratio has escalated from 1.73 in 2011 to 2.43 in 2013. The ratio of 2.43 – which vastly surpasses 1 – implies that the company faces high risks, and so do its shareholders, since it's invested more than suppliers, lenders, creditors and obligators.
Capitalization Ratio = LT Debt / LT Debt + Shareholders' Equity
(LT Debt = Long-Term Debt)
The capitalization ratio tells investors the extent to which the company is using its equity to support operations and growth. Companies with a high capitalization ratio are considered to be risky: if they fail to repay their debt on time, jeopardy of insolvency increases, making it difficult to get more loans in the future.
Between 2011 and 2013, Encana's capitalization ratio has grown, from 0.46 to 0.53. This means that the company has reduced its equity levels in relation to its long-term debt, leaving less equity to support its operations and grow. Furthermore, the current ratio (0.53) indicates moderate financial risk.
Cash Flow to Total Debt Ratio = Operating Cash Flow / Total Debt
This coverage ratio compares a company's operating cash flow with its total debt, providing an indication of the firm's ability to cover total debt with its yearly cash flow from operations. The larger this ratio is, the better a company can weather rough economic conditions.
As Encana’s ratio currently stands below 1, the company does not have the ability to cover its total debt with its yearly cash flow from operations, making it highly susceptible to an economic recession or shifts in the global geopolitical scenario.
I also evaluate recent institutional activity in the stock, or in other words, which hedge funds bought the stock recently. Last quarter, both Jim Simons (Trades, Portfolio) and Steven Cohen (Trades, Portfolio), among other investment gurus, reduced their shares of Encana by over 50%, selling the stock at an average price of $17.34. This is rather discouraging, because it demonstrates that investors have little faith in the firm’s future profitability.
Nevertheless, currently, many analysts have a good outlook for Encana. Analysts at Yahoo! Finance expect the firm to retrieve EPS of $0.95 for the current fiscal year and an EPS of $1.20 for the next one. Analysts at Bloomberg, on the other hand, are estimating revenue to be at $6.17 billion for the current fiscal year, and $6.31B for the upcoming year. Also, on Oct. 3, 2014, Macquarie gave Encana a rating of "Outperform" with a target price of $20.77, implying significant upside potential from this point.
Although many analysts have a positive outlook towards Encana, I remain sceptical about its medium term profitability — not only because cash flow has decreased consistently since 2011, but because revenue, EBITDA and returns on assets have shown weak-to-downward trends since 2012. Furthermore, with the recent appointment of Doug Suttles as CEO, it remains unclear in which direction the company will be steering looking forward, leading me to believe that investors should wait before pounding on this stock. Also, the stock's trading price premium of 211% relative to the industry median of 20.80x is much too high for my taste, and I believe this firm is overvalued. So, I’d recommend shareholders to wait at least until next quarter’s earnings report before taking another look at this energy firm.
Disclosure: Damian Illia holds no position in any stocks mentioned.