Pieridae Energy: 2x FCF on lower balance sheet concerns

Introduction

Pieridae Energy (TSX:PEA:CA) is a natural gas producer in Canada that still goes unnoticed. It’s a strategy the company employed when it licensed an LNG plant on Canada’s east coast. to avoid attracting negative attention, but now Canada doesn’t seem too interested in building LNG plants on the east coast (and licensing other plants has been an extremely slow process), so In this article, I will look at Pieridae Energy from the perspective of natural gas production. Now that the potential LNG plant doesn’t seem to be happening anytime soon, I’m only going to look at Pieridae from a “current” investment profile.

Pieridae’s most liquid listing is its primary listing on the Toronto Stock Exchange, where the company is trading with PEA as stock symbol. The average daily volume in Canada exceeds 300,000 shares per day. Pieridae currently has 158.2 million shares outstanding and at the current share price of CA$1.25, the market capitalization is just under CA$200 million.

A robust production profile

Pieridae’s primary business strategy was to obtain a licensed and operational LNG plant on the east coast. The company didn’t want to be too dependent on natural gas sales to third parties, so it slowly began acquiring its own natural gas projects in Canada before getting an LNG plant approved. This allowed Pieridae to build a sizeable natural gas production platform, which allowed the company to quickly improve its balance sheet thanks to very high natural gas prices in the first half.

Since I consider the average natural gas price of over C$7 to be exceptionally high for AECO gas (the current spot price is slightly above C$4 and on some days in August the spot price of natural gas even turned negative), I’m going to look at Pieridae from an H1 perspective.

During the first half, the average production rate was approximately 38,000 barrels of oil equivalent per day, and unfortunately Pieridae could not take advantage of the high price of natural gas because it covered part of its production. A prudent decision given that the balance sheet contains a working capital deficit as well as net debt (discussed later), but the average realized natural gas price of around C$4.35-4.40 is quite close to the current spot price and allows me to get a glimpse of the Pieridae from a more “normalized” revenue perspective.

The total income in the first half just exceeded C$254 million and after making the C$42 million royalty payments and receiving the C$14 million in third-party revenue, the total reported revenue came to just a little less than 226 million Canadian dollars. An increase of almost 50% compared to the first half of last year. Premium income already includes the impact of existing hedges.

Total operating expenses increased slightly to C$192 million and, as you can see in the image above, financial expenses are quite high, exceeding C$50 million per year. This is mainly related to the debt position and the cost of debt.

Net income generated during the six months was just over C$335 million, which equates to C$0.21 per share. Around 2/3 of the first half net result was generated in the second quarter thanks to the high price of natural gas which – despite the existing hedges – contributed to boost the result.

Cash flow from operations was just over C$38 million on a reported basis, but after isolating changes in the working capital position and covering the C$0.8 million in lease payments, first-half adjusted cash flow from operations was approximately C$76. M As the company only spent C$13 million in capital expenditures, the underlying free cash flow was C$63 million. And again, that’s based on an average realized natural gas price of around C$4.35-4.40.

A substantial portion of free cash flow was used to reduce debt: during the first half of the year, nearly C$30 million of long-term debt was repaid, and approximately 90% of this amount was repaid in during the second quarter due to the “cash sweep”. mechanism’.

Unfortunately, the balance sheet needed (and still does) repairs

The cash sweep deal helps Pieridae stay on course: right now, net debt needs to come down fast. Not only because the absolute and relative amounts are relatively high, but also because cash flows are suffering from the high cost of debt: at the end of June, the average interest rate on the term loan was 20.4%.

This means that by simply repaying approximately C$30 million in the first half, interest expense will decrease by approximately C$6 million per year, which will increase the free cash flow result by C$0.04. per share. Based on the Q2 results, Pieridae had to make another cash payment of C$13.5 million on the term loan, so the gross debt and net debt will continue to decline. I expect the company to end 2022 with a gross debt level of approximately C$75 million lower than YE2021 net debt of C$204 million (in June net debt was C$191 million Canadian dollars).

The main reason that debt reduction does not go faster is the accumulation of working capital. So, although the net debt position is declining relatively slowly, the working capital position is improving. At the end of 2021, Pieridae had a working capital deficit of approximately C$88 million, but fortunately this deficit was reduced to C$62 million by the end of June. Excluding financial debt, the working capital deficit improved from C$67m to C$32m so if all goes well, working capital (excluding current financial liabilities) should be positive by the end of this year and this will allow Pieridae to reduce its financial debt at a more aggressive pace.

And that could pave the way for a massive improvement in the terms of the remaining gross debt. The entire term loan matures in October 2023, one year from now. What if Pieridae is able to reduce net debt to, say, C$100 million by then (which should be a relatively easy task unless PEA suddenly wants to rapidly increase its production rate) and if the term loan could be refinanced at a rate of 11-12% (which would still be relatively high), the savings on interest charges could be enormous.

We started this year with a gross debt of C$231 million, which costs the company about C$46 million a year in interest charges. Assuming that C$100 million of debt can be refinanced at a cost of 12% of the debt, interest charges will drop to just C$12 million. This savings of C$34 million in interest expense would immediately accrue to shareholders and increase free cash flow by nearly C$0.25 per share per year.

The third quarter will be bad, but the future looks better

Based on the full-year forecast, the production rate is expected to increase by a few percent in the second half of the year, but Pieridae will also increase its capital expenditure as it plans to spend $17-22 million. Canadian dollars in sustaining investments and 25 to 25 million Canadian dollars. 30M growth investments. Assuming a full-year capital bill of around C$45-50 million, H2 2022 investments are likely to double H1 investments. This is good because Pieridae is obviously still making a lot of money at current natural gas prices. Hedging is proceeding slowly as well, but Q3 will still be a tough one for the company as around 60% has been hedged at C$2.66. Using a spot price of C$4 for unhedged production, the average realized natural gas price will be approximately C$3.20.

But from the fourth quarter, the share of covered production drops sharply. In the fourth quarter, only 25% of production is covered. Applying a spot price of C$4.50, the average realized natural gas price would reach about C$4 and the cash flow machine would start spewing money again.

Investment thesis

This makes Pieridae a very attractive call option on the price of natural gas. Cash inflows from the first half were used to quickly improve the balance sheet and after a difficult Q3, Pieridae should be more exposed to spot prices, which will translate into better financial performance. Now, and in the coming quarters, the focus will (and should be) on balance sheet management. But a reduction in debt combined with a reduction in interest rates on the refinancing of the term loan in the fourth quarter of 2024 will accelerate the free cash flow result.

Taking all elements into account (including the increase in investments in H2), Pieridae Energy is currently trading at just twice underlying free cash flow. The market is clearly still concerned about the balance sheet, but the situation is improving day by day. If you expect the price of AECO gas to stay above C$4 for the next two years, Pieridae Energy is definitely a candidate to consider, as the stock price will simply need to be reassessed as balance sheet risk is reduced.