Encana (NYSE:ECA), one of Canada's largest energy producers, embarked on a bold new strategic direction last year when it announced that it would focus the majority of its capital on five liquids-rich assets in North America, marking a sharp departure from its traditional gas-focused business.
Last week, the company took another huge step by announcing that it will purchase a sizable acreage position in the Eagle Ford shale of south Texas, one of the most prolific and sought-after oil plays in North America.
The markets greeted the move with initial optimism, promptly sending shares of Encana nearly 5% higher on the day. However, those gains have since been erased, with shares ending the week 1% lower. Did the markets get it right the first time, or is there a good reason for the subsequent correction?
Encana's bold move into the Eagle Ford
On Wednesday, Encana announced that it reached an agreement to acquire approximately 45,500 net acres in the Eagle Ford shale from Freeport-McMoRan (NYSE:FCX) for about $3.1 billion.
The acreage, located in Karnes, Wilson, and Atascosa counties of south Texas, produced approximately 53,000 barrels of oil equivalent per day in the first quarter of 2014, of which around 75% consisted of oil, 11% was natural gas liquids, and the remaining 14% was gas.
The asset generated $327 million in first-quarter cash flow for its operator. Freeport-McMoRan expects to use the deal's net after-tax proceeds of $2.5 billion to pay down debt and to invest in its deepwater exploration and development program. The acquisition is expected to close before the end of the second quarter.
Was it a good move?
There are numerous reasons to be optimistic about Encana's bold move. First, the acquisition gives the company a sizable acreage position in a world class, oil-rich play, augmenting its position in its existing five core liquids-rich assets in the Montney and Duvernay shales in Canada, the DJ Basin in Colorado, the San Juan Basin in New Mexico, and the Tuscaloosa Marine Shale in Louisiana and Mississippi.
Second, the metrics of the acquisition look solid. With a $3.1 billion price tag, Encana is paying roughly 2.4 times the asset's operating cash flow, which is significantly less than other recent Eagle Ford transactions. The asset should also be free cash flow-positive starting this year and will be immediately accretive to cash flow.
Third, the acquisition is credit-positive for Encana, since it will be funded with cash on hand, as opposed to taking on debt, while boosting the company's oil production and cash flow and improving its leverage metrics, according to credit rating agency Moody's. Encana expects the purchase to roughly double its current oil production.
Did the market overreact?
Overall, there really isn't anything to complain about with this transaction. Not only does it fit perfectly with Encana's new strategy of growing liquids production, but it will also be funded with cash on hand and is expected to be free cash flow-positive starting this year, allowing Encana to pursue its existing spending plans for the year without having to redeploy capital from its other five core growth plays.
Still, I would caution investors to remember that, despite Encana's aggressive shift toward liquids-rich drilling, the company remains heavily leveraged to natural gas. As of the fourth quarter, roughly 87% of its production consisted of gas. While this production mix will improve significantly over the next few years, the company's near-term fortunes are still highly dependent on natural gas prices.
As such, I think the market's response following the initial 5% pop was an appropriate one and that Encana is now more-or-less fairly valued at around $22 per share. Shares currently trade at nearly 14 times forward earnings, and the stock carries an EV/EBITDA multiple of nearly 9, both of which represent a substantial premium to Encana's gas-levered North American peers.
All told, while Encana's future certainly looks a lot brighter as a result of its new strategy, with cash-flow growth expected to accelerate sharply, I think the company's more favorable outlook may already largely be priced in.
Will this stock be your next multibagger?
While Encana is poised for stronger cash flow growth in the years ahead, there's a huge difference between a good stock and a stock that can make you rich. The Motley Fool's chief investment officer has selected his No. 1 stock for 2014, and it's one of those stocks that could make you rich. You can find out which stock it is in the special free report "The Motley Fool's Top Stock for 2014." Just click here to access the report and find out the name of this under-the-radar company.
Arjun Sreekumar has no position in any stocks mentioned. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.