Spartan Delta has a (positive) cash flow problem (OTCMKTS: DALXF)
In an article published nearly two years ago, I called Spartan Delta (OTC:DALXF) a “once in a decade” opportunity. Not because I expected the current exceptional strength in natural gas prices, but because the company should be able to perform well at lower natural gas prices as well. The stock price is now trading nearly 300% higher and Spartan Delta doesn’t even look like the company I talked about two years ago, as the company has gone through a series of acquisitions and is now l one of the largest natural gas producers in Canada’s Montney region.
Spartan Delta has its primary listing in Canada, where it trades on the Toronto Stock Exchange with SDE as its ticker symbol. The average daily volume in Canada is quite good, with nearly half a million stocks change hands daily. As Spartan Delta reports its financial results in Canadian dollars, I will use CAD as my base currency throughout this article unless otherwise specified.
The first quarter was exceptionally bad, thanks to the high price of natural gas
Sometimes you just know when a quarter is going to be great, and I think virtually every company in the energy sector has released or will release great results for the first quarter reporting period thanks to very high commodity prices . I was really looking forward to Spartan Delta’s results, as this almost unhedged natural gas producer stood to benefit from the very high natural gas price (CA$4.85/cfm on average during the period). Unfortunately, the company decided to enter into hedging contracts during the first quarter and approximately one third of the full year volumes are currently hedged, which will weigh on this year’s results somewhat.
In the first quarter of the year, Spartan Delta produced just over 72,000 barrels of oil equivalent per day, with approximately 63% of the oil equivalent production rate actually being natural gas. So, while the company is undeniably benefiting from high oil, condensate and NGL prices, the price of natural gas remains the main driver.
Total revenues generated by Spartan Delta in the first quarter exceeded C$320 million and after taking royalties into account, the net revenues were approximately C$294 million before recording a loss of C$71 million on derivatives.
The loss on derivatives is related to the small number of hedges entered into in February.
These hedges weighed on the financial results, but only C$22m of the hedging loss was actually realized in the first quarter, the rest of the hedging losses will be realized in the coming quarters. If Spartan Delta were happy to hedge at these price levels, hopefully the company will continue to hedge some of its production.
Despite the setback from coverage losses, Spartan Delta has remained highly profitable as the company’s production and transportation expenses remain exceptionally low. And despite recording an impairment charge of C$7.5 million, the company’s pre-tax profit was C$82 million, resulting in a net profit of C$61 million. Canadian dollars or 0.40 Canadian dollars per share. And that includes the entire C$70.7 million of realized and unrealized hedging losses. Excluding unrealized hedging losses, net income would have been 60% higher at approximately C$0.65/share.
We also see this clearly in the company’s cash flow statement. Reported operating cash flow was C$138 million, but this includes a C$24 million investment in working capital, so the underlying operating cash flow was approximately C$162 million and C$160 million net of lease payments. The total capex was rather high at C$108 million, but this is due to the fact that Spartan Delta loads the capex in advance and the capex for the full year will be significantly lower.
For fiscal 2022, Spartan Delta expected to spend a total of C$330 million throughout the year, which includes growth capital (meaning sustaining capital is just under the C$330 million Canadian dollars mentioned above). This means that normalized quarterly investments are approximately C$82.5 million, which would have resulted in a normalized free cash flow of approximately C$78 million. With 153.5 million shares outstanding, free cash flow per share just exceeded C$0.50. And again, that includes growth investments.
Net Debt is Declining Fast, Meaning Spartan Delta Will Turn to Shareholder Rewards
Spartan Delta has made a few acquisitions over the past 18 months, and a significant portion of those acquisitions have been debt financed. This likely also played a role in Spartan’s decision to hedge some of its natural gas production for this year, and at the end of the first quarter, Spartan Delta had net financial debt of approximately C$355 million ( note: the company mentions net debt of just over C$400 million, but this includes lease debt).
Considering that net debt to adjusted cash flow is now rapidly dropping to 0.5, Spartan Delta has started thinking about what it can do with the incoming cash flow, as that internal target will likely be met by now. the end of the current quarter. In his quarterly updateSpartan mentioned it is “to evaluate strategies to maximize shareholder returns through the potential expansion of its capital budget and a capital return framework”.
Considering that Spartan generates over C$300 million in free cash flow based on a C$5 natural gas price and after factoring in the C$330 million capital budget, I think that it should be a case of and/and/and. Spartan can continue to reduce debt, increase capital spending and pay a dividend. If C$100 million were allocated to each of these three items, the number of shares would decrease by approximately 5%, while allocating C$100 million per year to dividends would result in a dividend per share of 0. $65 Canadian, which would also be very significant.
I have held a long position in Spartan Delta since management acquired the assets of Bellatrix following bankruptcy in 2020. I invested in this company for the management team as it successfully sold three previous businesses in the oil and gas sector and I would. Don’t be surprised if Spartan Delta was heading in the same direction.
I have sold quite a bit of my Spartan Delta over the past few weeks. Not because I don’t believe in the company or the strategic plan to pursue moderate levels of growth, but because Spartan had become an overweight position in my portfolio given the five-fold increase in share price since I originally bought shares.