February 6, 2003; Canadian Oil Sands Trust Increases Ownership in Syncrude

COS is paying Encana (ECA) C$1.07 billion for a 10% interest in the Alberta project to extract oil from sand and convert it to a valuable, clean product.  While we are also recommending Encana we would rather be the buyer of an interest in Syncrude than the seller.  Yet it can also make sense for Encana to concentrate its financial resources on projects that it operates and in which it has the controlling interest. 

The price is about a 14% discount to recent proportionate Enterprise Value for COS whose sole asset is a 22% interest in the plant.  The price is less than 60% of Present Value that we estimate.  The valuation of the long life project is especially sensitive to rate of return just like the price of a 30-year bond fluctuates more with a small change in interest rate.  Often, investors and corporate managers overstate the return they seek as a means of limiting risk.  That is understandable, but it has the consequences of biasing decisions to short life projects.  As a result, long life projects can be systematically undervalued as we think is the case here.  Long-term investors can capture that undervaluation for their own benefit. 

The acquisition will be financed in part by a private placement of about 8.6 million units at C$34.75, or C$300 million, with Capital Group, the California investment managers.  Another 10.7 million units will be offered in Canada at C$35 per unit.  The remainder will be financed with debt thereby maintaining a conservative ratio of debt below 0.2 times present value.  The steep discount in offering price indicates less market liquidity than one might expect for the size of the trust.  Yet a 45% increase in ownership in the project exceeds a 36% increase in units outstanding.

There are no plans to list the shares in the U.S.    For the trust to keep its ability to bypass double taxation of dividends, it must be about 50% Canadian owned as we understand it.  A U.S. listing might lead to too much U.S. ownership.  The lack of marketability in the U.S. probably contributes to the undervaluation we perceive. 

Investors who hold the units for a long time will realize the value in distributions currently at 5.3%.  The distribution may double after about three years when a 50% expansion of capacity is on line and continue to grow slowly thereafter, essentially indefinitely.  U.S. investors are subject to a 15% withholding tax that may be recoverable in taxable accounts.  Some of the distribution appears to be sheltered from tax because it is considered a return of capital.

February 6, 2003 (posted Feb 9); Meter Reader: Low Fee, Low Debt Stands Out