Merger sets the stage for growth

Suncor is new to our Conservative Growth Portfolio. We added it last August after it bought Petro-Canada, one of our long-time recommendations.

We avoided Suncor before the merger. Its focus on high-cost oil-sands production made it more volatile than other high-quality oil companies, and left it with more to lose if oil prices fell. However, the Petro-Canada takeover diversified Suncor’s operations. As well, cost savings from the merger will help it fund new oil-sands projects and pay down debt.

SUNCOR ENERGY INC. $33 (Toronto symbol SU; Conservative Growth Portfolio, Resources sector; Shares outstanding: 1.6 billion; Market cap: $52.8 billion; Price-to-sales ratio: 1.7; Dividend yield: 1.2%; SI Rating: Average) became Canada’s largest oil company when it bought Petro-Canada (old symbol PCA) on August 1, 2009. Petro-Canada shareholders received 1.28 Suncor shares for each Petro-Canada share they held.

Conventional oil and natural gas account for about 60% of the merged company’s production. The remaining 40% comes from oil sands. That includes its 12% stake in the massive Syncrude oil-sands development. Suncor also operates four refineries and over 1,800 retail gas stations under the Petro-Canada banner.

The company wants to expand its oil sands operations until they account for about 70% of its production. To that end, it is selling some conventional and offshore properties that belonged to Petro-Canada. However, Suncor will probably keep Petro-Canada’s projects in Libya and Syria.

So far, these sales have generated $1.5 billion. The company expects to sell an additional $2 billion to $3 billion of these assets over the next year.

Aside from the cash it is generating through asset sales, Suncor expects the Petro-Canada takeover to save it $400 million a year. It will put these funds toward its $13.7 billion of long-term debt, which is a reasonable 27% of its market cap.

Higher oil prices increased Suncor’s revenue by 165.9%, from $10.8 billion in 2005 to $28.6 billion in 2008. Despite the extra production from Petro-Canada, revenue in 2009 fell 11.0% to $25.5 billion. That’s because Suncor locked in the selling prices for 15% of its daily production at around $50 U.S. a barrel. These hedges hurt the company when oil moved up to around $80 U.S. in late 2009.

Suncor’s earnings rose 135.8%, from $1.37 a share (or a total of $1.25 billion) in 2005 to $3.23 a share (or $3.0 billion) in 2007. Earnings fell to $2.29 a share (or $2.1 billion) in 2008 due to losses at its refining and energy-trading operations. Lower oil prices cut Suncor’s 2009 earnings by 46.4%, to $1.15 billion. Earnings per share fell 58.1%, to $0.96, on more shares outstanding.

In the three months ended March 31, 2010, Suncor earned $475 million, or $0.46 a share. It lost $192 million, or $0.20 a share, a year earlier. Without unusual items, earnings would have fallen 24.5%, to $287 million from $380 million. Earnings per share fell 56.1%, to $0.18 from $0.41, on more shares outstanding. Thanks to the merger, revenue rose 52.6%, to $7.0 billion from $4.6 billion.

Fires at two upgraders cut Suncor’s daily production by 11.5%, to 564,600 barrels of oil equivalent (including natural gas) in the latest quarter from 638,200 barrels in the fourth quarter of 2009. (Upgraders convert tar-like bitumen from the oil sands into refinery-ready crude oil.) That was the main reason for the lower earnings. The upgraders are now back in operation.

Suncor’s production should continue to rise, partly because it recently received approval from Alberta energy regulators to expand its Firebag oil-sands project. Right now, Firebag is producing 60,000 barrels of oil a day. Suncor is now working on phase three of Firebag, which will cost $3.6 billion. Phase three will more than double Firebag’s daily output when it starts operating next year.

This latest approval covers phases four to six. Suncor did not say how much these projects would cost, or how long it would take to complete them. However, it aims to complete phase four in late 2012. Firebag’s production will rise to 310,000 barrels a day when all six phases are completed. Savings will spur 2011 earnings

Suncor will probably earn $1.60 a share in 2010.

The stock trades at 20.6 times that estimate. However, its 2011 earnings should jump to around $2.80 a share as it realizes more cost savings from the merger. That gives Suncor a more reasonable p/e ratio of 11.8.

Suncor is a buy.