Investors are making mistakes with MEG Energy

Management of MEG is helping themselves but doing investors no favors.

MEG Energy (MEG.TO) has some of the best SAGD assets in the Western Canadian Sedimentary Basin. Operating costs are relatively low, sustaining capital is relatively low, and the lifespan of the reservoir is measured in decades, not years.

What is the problem? The problem is the delusion that investors benefit from buybacks.

My model of MEG puts a value of over CAD$40 a share on the company at current oil prices. The stock is trading for less than CAD$20 so what is wrong with buybacks?

The answer is nuanced and important. Buybacks may well increase the share price while delaying the retirement of debt for a few months, but the higher price only benefits those who own MEG shares today and see their holding as a “trade” expecting to sell the stock when the market re-rerates the company’s shares and giggle all the way to the bank. While they are giggling, they should ask what next? Where is there another long term cash flow machine they can invest in to replace their MEG shares and how much income tax will they pay on the sale?

Here is my model.

If oil prices remain in the CAD$90 range, MEG should be able to pay a dividend in aggregate of about CAD$1.5 billion a year for the next 30 years or more. With 300 million shares outstanding, that is CAD$5.00 a share for a very long time. The present value of a CAD$5.00 dividend stream (starting in year two after debt is repaid) at a 9% discount rate for 30 years is somewhere around CAD$45.00 a share and there is every reason to believe MEG can expand its footprint very close to its existing SAGD operations and perpetuate that dividend stream for another 30 to 50 years using the same surface facility. Why 9%? For the past century, stock market returns including dividends and reinvestment have lagged 9% on average¹ and a 9% return will outperform most of the time.

Sure, commodity prices will vary and inflation can alter the equation as can deflation, but the outcome of persistent inflation is higher prices for real assets - real assets like MEG’s oil. Costs are so relatively low inflation will be immaterial to the outcome.

Suppose MEG buys back 10% of its shares for CAD$600 million or so (30 million shares at CAD$20 a share) and the share price re-rates to CAD$40, as buyback fans hope. The retaining shareholders get none of that money.

If you own 1,000 shares that cost you CAD$10 (you bought when they shares were under pressure in 2020, for example) and get a capital gain of $30, half of which is taxed lets say at 40% you net out CAD$31 a share or CAD$31,000. You just sold your CAD$40 shares for less than fair value owing to the tax hit and are deprived of the dividend stream for the next few decades.

For those who kept their shares, with fewer shares outstanding, dividends should be a bit higher and in this hypothetical case would be CAD$1.5 billion less the $600 million buyback over 270 million shares is CAD$3.33 in the first year after the buyback and CAD$1.5 billion divided by 270 million or CAD$5.55 in future years. The present value of $3.33 in year two and $5.55 for the ensuing years at a 9% discount rate is a bit less than the present value of CAD$5.00 from the outset for the same period. Do the math yourself since I am tired of spoon feeding critics.

So the investors who sell into the buyback are worse off and the investors who keep their shares are worse off. Who is better off?

Management and sell side fund managers and brokers.

Management

Management of MEG have compensation that includes stock price based derivatives. A dividend stream is not tied to the share price. Investors who think buybacks benefit them are either (1) short term traders indifferent to longer run value or (2) friends of Derek Evans and his management team.

Stock price is primarily driven by commodity price and giving management millions for the rise in the commodity price makes no sense. Management’s compensation should be based soley on things management can control - operating costs, drilling results, capital outlays etc.

Sell side fund managers and brokers

Fund managers prefer higher stock prices since their compensation is tied to assets under management. Buybacks inflate stock prices and money managers charge their fees on the higher portfolio value that results. The dividend stream that investors actually get is unaffected by the stock price. Basically, the fund managers are being paid to watch commodity prices rise. Their compensation comes at the expense of the actual investors who hold units of their funds.

Brokers love traders. While traders as a group lose money brokers make a few cents on every trade. Brokers like buybacks since they trigger trades during the buyback and trades by those who want to realize their gains if the buyback pumps up the stock price.

1. Ignoring dividend reinvestment. With dividend reinvestment the S&P has returned ~11.8 percent since 1900, of which about 5.5% is price and the remainder dividend. The analysis of MEG excludes dividends since MEG pays none, but the result is conservative with respect to the point of this article. A 9% rate excluding dividend reinvestment reflects the volatility of oil prices and the higher risk of the sector compared to the S&P in total. Readers can repeat the analysis using their own assumptions on rate.