Denbury Resources (NYSE: DNR) CEO Chris Kendall is well aware of what oil stock investors want these days. He noted on the second-quarter call that investors are demanding oil companies "operate sustainable businesses that can return capital to shareholders." To do so, Denbury needs to generate enough cash to grow production with plenty left over to pay dividends and repurchase shares.
He further noted that Denbury "is in a strong position to meet shareholder demands for return of capital." That's because its business focuses on operating assets that have "been able to consistently and reliably generate free cash." Unfortunately, instead of returning this money to shareholders, Denbury has been using it to repay debt. That won't change anytime soon since it plans to "continue to prioritize debt reduction through the use of free cash in the near future," according to Kendall. The company has no choice because it has $2.5 billion of debt that it needs to address sooner rather than later given that all of it will mature over the next few years.
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Drilling down into Denbury's debt issue
On the one hand, Denbury has made significant progress in improving its balance sheet since the oil market downturn started four and a half years ago. Kendall noted on the call that it has already reduced its commitments by more than $1 billion since the end of 2014. Furthermore, it has pushed back its debt maturities to buy it more time. As a result, it doesn't have any debt coming due until 2021.
However, even with all the progress, Denbury still has serious financial issues since it has nearly $2.5 billion of debt outstanding. Given its current earnings level, the company's leverage ratio was 4.1 times debt-to-EBITDA at the end of the second quarter. While that's an improvement from 4.8 times at the end of last year's second quarter, it's well above the comfort zone of most oil companies. On average, companies in the sector are aiming for leverage ratios of less than 2 times debt-to-EBITDA, with some pushing theirs below 1.
Slowly chipping away
Denbury is taking a multi-pronged approach to reduce its debt. The company is using its free cash as well as smaller asset sales to chip away at the total. These moves helped reduce debt by $120 million during the second quarter. In addition, it completed a debt exchange that could eventually convert into stock. That conversion, which could happen by 2024, would reduce debt by another $246 million. Though it would be highly dilutive to existing investors considering that the company's current market value is less than $500 million.
The company expects to continue whittling down its debt in the coming year through a combination of free cash flow and asset sales. One of the deals it's working on is a potential joint venture for its infrastructure in the Rockies. That would enable it to offload a portion of the $250 million needed to build a new pipeline to support its growth in that region. The right JV could potentially bring in some cash to pay off debt while also reducing this capital commitment. That would boost its free cash flow in 2020, giving it more money to pay down debt.
However, with a leverage ratio that's more than double the comfort level of most peers, the company needs to make a more meaningful move. While Denbury did attempt a needle-moving acquisition last year, it was such a questionable strategic fit that investors forced the company to abandon that pursuit. It could try that route again if it finds a better match or ramp up its asset sales to pay off a larger portion of its debt. If it doesn't, then it could run into even more financial trouble if oil market conditions worsen in the next few years. That's because all of its debt matures in the 2021 to 2024 timeframe.
Denbury can't deliver what shareholders want
Denbury's CEO knows that today's oil investor wants sustainable growth, buybacks, and a dividend. His company, however, can't deliver any of that because it's plowing all its free cash into chipping away at its massive debt load. While the company has made some progress, it has a long way to go. It will probably need to focus on ramping up its asset sales to supercharge its debt reduction before it hits that upcoming maturity wall.
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This article was originally published on Fool.com