Spartan Delta Has A (Positive) Cash Flow Problem

Stock Market

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Introduction

In an article published almost two years ago, I called Spartan Delta (OTC:DALXF) a “once in a decade”opportunity. Not because I was expecting the current exceptional strength in the natural gas prices, but because the company should be able to perform well at lower natural gas prices as well. The share price is now trading almost 300% higher and Spartan Delta doesn’t even resemble the company I discussed two years ago as the company has completed a series of acquisitions and is now one of the larger natural gas producers in Canada’s Montney region.

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Data by YCharts

Spartan Delta has its primary listing in Canada, where it’s trading on the Toronto Stock Exchange with SDE as its ticker symbol. The average daily volume in Canada is quite good, with almost half a million shares changing hands on a daily basis. As Spartan Delta reports its financial results in Canadian Dollar, I will use the CAD as base currency throughout this article, unless indicated otherwise.

The First Quarter Was Exceptionally Wrong, Thanks To The High Natural Gas Price

Sometimes you just know when a quarter will be exceptional, and I think pretty much every company in the energy space has published or will publish excellent results for the Q1 reporting period on the back of very strong commodity prices. I was really looking forward to seeing Spartan Delta’s results, as this almost unhedged natural gas producer was slated to benefit from the very strong natgas price (C$4.85/mcf on average during the period). Unfortunately the company decided to enter into some hedging contracts during the first quarter and approximately a third of the full-year volumes are currently hedged so that will weigh a little bit on the results this year.

Production Overview

Spartan Delta Investor Relations

In the first quarter of the year, Spartan Delta produced just more than 72,000 barrels of oil-equivalent per day, with approximately 63% of the oil-equivalent production rate actually consisting of natural gas. So while the company is definitely benefiting from the high prices for oil, condensate and NGLs, the natural gas price remains the main driver.

The total revenue generated by Spartan Delta in the first quarter was in excess of C$320M and after taking the royalties into consideration, the net revenue was approximately C$294M before recording a C$71M loss on derivatives.

Income Statement

Spartan Delta Investor Relations

The derivatives loss is related to the small amount of hedges entered into in February.

Hedge Book Overview

Spartan Delta Investor Relations

Those hedges weighed on the financial results but only C$22M of the hedge loss was effectively realized in the first quarter, the remainder of the hedge losses will be realized over the next few quarters. If Spartan Delta was happy to hedge at those price levels, I hope the company continues to hedge a portion of its production.

Despite the setback related to the hedging losses, Spartan Delta remained very profitable as the company’s production and transportation expenses remain exceptionally low. And despite recording a C$7.5M impairment charge, the company’s pre-tax income was C$82M, resulting in a net income of C$61M or C$0.40 per share. And that includes the entire C$70.7M in realized and unrealized hedging losses. Excluding the unrealized hedging losses, the net income would have been 60% higher at approximately C$0.65/share.

We also clearly see that in the company’s cash flow statement. The reported operating cash flow was C$138M, but this includes a C$24M investment in the working capital position, so the underlying operating cash flow was approximately C$162M and C$160M after deducting the lease payments. The total capex was rather high at C$108M, but that’s due to Spartan Delta front-loading the capex and the full-year capex will be substantially lower.

Cash Flow Statement

Spartan Delta Investor Relations

For FY 2022, Spartan Delta was guiding to spend a total of C$330M throughout the year, which includes growth capital (meaning the sustaining capex is quite a bit lower than the aforementioned C$330M). This means the normalized quarterly capex is just around C$82.5M, and this would have resulted in a normalized free cash flow of approximately C$78M. With 153.5M shares outstanding, the free cash flow per share just exceeded C$0.50. And again, this includes the growth investments.

The Net Debt Is Decreasing Fast, Which Means Spartan Delta Will Be Looking Toward Shareholder Rewards

Spartan Delta has completed a few acquisitions in the past 18 months, and a substantial portion of those acquisitions were funded with debt. This likely also played a role in Spartan’s decision to hedge a portion of its natural gas production for this year, and as of the end of the first quarter, Spartan Delta had a net financial debt of approximately C$355M (note: the company mentions a net debt of just over C$400M, but this includes the lease liabilities).

Considering the net debt vs. the adjusted funds flow is now rapidly dropping to 0.5, Spartan Delta has started to think what it can do with the incoming cash flow as that internal target will likely be reached by the end of the current quarter. In its quarterly update, Spartan mentioned it is “evaluating strategies to maximize shareholder returns through the potential expansion of its capital budget and a return of capital framework.”

Considering Spartan is generating in excess of C$300M in free cash flow based on a natgas price of C$5 and after taking the C$330M capex budget into consideration, I think this should be a case of and/and/and. Spartan can continue to reduce debt and hike its capex and pay a dividend. If C$100M would be allocated to each of these three elements, the share count would decrease by approximately 5% while earmarking C$100M per year for dividends would result in a dividend per share of C$0.65 which would be quite meaningful as well.

Asset overview

Spartan Delta Investor Relations

Investment Thesis

I have had a long position in Spartan Delta ever since the management acquired the Bellatrix assets out of bankruptcy in 2020. I invested in this company for the management team as it has successfully sold three previous ventures in the oil and gas sector and I wouldn’t be surprised if Spartan Delta would be heading in the same direction.

I have sold a little bit of my Spartan Delta in the past few weeks. Not because I don’t believe in the company or the strategic plan to pursue moderate growth levels, but because Spartan had become an overweight position in my portfolio considering the share price quintupled since I originally purchased shares.

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