ENCANA CORP. $93 (Toronto symbol ECA; Conservative Growth Portfolio, Resources sector; Shares outstanding: 750.0 million; Market cap: $69.8 billion; SI Rating: Average) is a leading North American producer of natural gas and oil.

The company took its current form in April 2002 through the merger of PanCanadian Energy Corp. and Alberta Energy Corp. Soon after, it sold most of its conventional properties to focus on what it calls “key resource plays”, including early-stage natural gas fields and oil sands. We thought this was a great idea. These assets cost more to develop, at least initially, but can last decades longer than conventional properties.

Thanks to this strategy, plus higher oil and gas prices, EnCana’s earnings jumped from $1.44 a share (total $1.4 billion) in 2003 to $5.36 a share ($4.1 billion) in 2007 (all amounts except share price and market cap in U.S. dollars). Cash flow per share rose from $3.90 in 2003 to $11.06 in 2007. Revenue grew from $10.2 billion in 2003 to $21.5 billion in 2007.

EnCana now plans to split itself up into two new companies — one focusing on natural gas, the other on oil. The gas company will represent about two-thirds of EnCana’s current production, with the new oil business accounting for the remaining third.

The gas company will keep the EnCana name, while the oil company will assume a new name. Shareholders will receive one new common share in each new company for every EnCana share they hold. Investors will not be liable for capital gains taxes until they sell their new shares.

EnCana intends that the initial combined dividends of the two companies will be equivalent to its current annual dividend rate of $1.60 U.S. per share (1.7% yield).
We feel the break-up makes sense. Their smaller size and narrower focus will make the two new companies easier to manage and value.

Technology helps cut operating costs

The new gas business will own major gas fields in Alberta, Northeastern British Columbia, Wyoming, Colorado and East Texas. Most of these fields are in remote, mountainous areas. That makes them more expensive to operate than regular deposits.

However, new technologies are helping bring down operating costs while extracting more gas. A good example is horizontal drilling, which involves drilling development wells sideways or at an angle to reach isolated pockets of oil and gas, or to follow a reservoir spread out in a narrow layer. Horizontal drilling works well in situations where conventional drilling is either impossible or too costly.

The United States will account for about 55% of the new gas company’s production, with Canada supplying the remaining 45%.

EnCana’s new gas company will also assume control over its offshore projects. This includes the $550 million Deep Panuke natural gas project south of Nova Scotia. Deep Panuke should begin operations in 2010, and increase EnCana’s daily gas output by about 8%.

The new oil company will consist mainly of EnCana’s two joint ventures with U.S.-based oil producer ConocoPhillips. One joint venture operates EnCana’s oil sands properties in Alberta. These are well-established properties with much lower operating costs than similar oil sands projects. The company expects oil sands output to grow 5% a year over the next five years.

EnCana’s other joint venture processes the heavy, tar-like oil from the oil sands at refineries in Illinois and Texas. This integration of production and refining cuts EnCana’s risk, and gives its oil business more predictable cash flows. Recent upgrades to these refineries will also expand their capacity, and improve reliability.

Share buybacks will continue

EnCana will probably continue to use its strong cash flow to buy back its shares until shareholders approve the break-up. In the first three months of 2008, it repurchased $311 million U.S. of its stock. It aims to buy back 2% of its shares in 2008.

The gas business will probably wind up with 60% of EnCana’s debt, while the oil operations will get the remaining 40%. At March 31, 2008, EnCana’s long-term debt was $9.4 billion U.S. That’s just 14% of its market cap.

The stock now trades at 15.3 times its 2008 forecast earnings of $5.95 U.S. a share, and at 7.2 times projected cash flow of $12.64 U.S. a share.

This spinoff is different

The EnCana break-up is a little different from a typical spinoff, in that the two portions are of comparable size. More often, the company that is created and handed out or spun off to shareholders is much smaller than the parent.

However, regardless of the relative sizes of the two firms, the principle is the same. The management is breaking up the original company into two or more parts, to increase shareholder value.

EnCana has no controlling shareholder, so the two new companies will also be widely held. Longer term, their smaller size and high-quality assets could turn them into attractive takeover targets for larger energy companies.

EnCana is a buy.