It isn’t a good time to be a shareholder of Penn West Petroleum Inc. (TSX: PWT)(NYSE: PWE).
Although, to be fair, it hasn’t been a good time to be a Penn West shareholder for the better part of the last decade. As the company has struggled, so has the share price, which briefly fell below $5.10 during Monday’s trading session. That’s an all-time low.
The latest setback has been a minor accounting scandal. Management announced in July that the company had misrepresented operating and capital expenses for years, only discovered when the new CFO reviewed accounting practices. Although the scandal didn’t affect the company’s book value or net income, it did overstate operating profits for a number of years.
Now that the scandal is behind it, is this a good entry point? I think so. In fact, I think there’s huge upside if the company can execute its turnaround plan. Here are 3 reasons why I think the company succeeds and patient investors get rewarded handsomely.
1. A solid turnaround plan
Management has a simple plan. They want to sell non-core assets and use the proceeds to pay down debt, all while focusing the majority of capital expenditures in its 3 largest assets, located at the Cardium, Viking, and Slave Point fields. And so far, it seems to be working.
The company’s long-term debt has been reduced from $3.1 billion at the end of Q2 2013 to just $2.2 billion at the end of Q2 2014. Additionally, last week it announced another non-core asset sale for $355 million, which will further reduce the debt load.
Why is shrinking the business good news? Because Penn West owned too many marginal assets that were purchased when oil was at higher prices. It’s better to sell them and start over again, allowing the company to focus on more profitable operations. This will certainly result in some poor results for a year or two, but will ultimately make the company more profitable.
2. Cheap assets
Investors that are bearish on Penn West are focused on things like the company’s excessive debt, production that’s only marginally profitable, and the possibility of yet another dividend cut. Those are all risks, but investors who are willing to look past all that are buying some really cheap assets.
Penn West has assets of approximately $11.8 billion, with $1.8 billion of that classified as goodwill. Liabilities are approximately $4.4 billion. Even after excluding goodwill from the equation, Penn West has a book value in excess of $11 per share, which is more than double the current share price.
Most of Canada’s other energy giants trade at anywhere between 1.5x book value and beyond. Are Penn West’s problems so extreme that it deserves such a depressed valuation? Even if the company can recover to tangible book value, that’s still a potential upside of 125%.
3. Able to weather the storm
Another reason why Penn West shares have struggled lately is the decline in the price of oil. Investors are betting that the company is in big trouble if prices remain low.
And yet, that’s just not the case. Management has come out and said that they still expect the company to have an operating income of $700 million annually if oil stays at $80, and that’s not even factoring in any further decline in the Canadian Dollar or additional cost cuts. That’s easily enough to fund its capital expenditure budget, although it may not be enough to maintain the generous dividend, currently yielding in excess of 10%.
Still, investors should expect Penn West to cut the dividend. Management is hoping it can weather the storm with the dividend intact, but without an uptick in oil prices over the next few months, that’s unlikely. The good news is the market should take the dividend cut in stride. It seems like a foregone conclusion.
Penn West is struggling, but there’s huge potential if the company can execute on its turnaround plan. Shares could easily double if management can pull it off.
