Credit Suisse, Cairn- Govt approval delayed—a valuation discount means the stock should do better than oil medium term EPS

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Govt approval delayed—a valuation discount means the stock should do better than oil medium term EPS


● The GoI has deferred a decision on the CNE—VED transaction. A
Group of Ministers will now deliberate and recommend a course of
action to the Cabinet Committee. This process can take time;
CNE/VED have extended deal timelines to 20 May 2011.
● CAIL valuations are now at a 28% discount to spot crude; this
number has averaged much lower historically. De-risking on start
of production recently should ideally have reduced this discount.
● Given the recent dilution in the petroleum ministry’s stand on linking
royalty payments to the deal, government approval still seems likely,
although delayed. Clarity on the deal can potentially allow Cairn /
government to re-focus on operations, alleviating near-term concerns
on volume growth / drilling; which could reduce the discount.
● Having raised the royalty issue, the government is likely to keep
insisting on it becoming cost recoverable. CAIL will most likely have
to litigate to get clarity on this—which can take several quarters. A
part of the discount could persist until then. While a fall in crude is a
key risk, the CAIL stock should do better than oil medium term.
A speed bump, or the last nail?
The government of India was expected to approve the CNE/VED
transaction—post the delinking of the approval from the question on
royalty payments. The Cabinet Committee on Economic Affairs
yesterday deferred the decision to a Group of Ministers (yet to be
formed) instead. The stock market regulator—SEBI—has meanwhile
approved Sesa Goa’s open offer for 20% of CAIL stock at
Rs355/share. This offer will stay open between 11-30 April 2011. CNE
and VED have decided to extend the deal timelines from 15 April to 20
May in order to accommodate the new developments. The GoM now
has to deliberate and provide a recommendation to the CCEA. Final
approval can take some time—just getting the CCEA to discuss the
matter took a few weeks this time around.
Delinked from oil prices—now at a discount to spot crude
Other than during the crisis induced volatility, CAIL stock prices have
typically moved in line with spot crude, but now trade at a 28%
discount (implied oil price versus spot on our model). Material upside
to CAIL can therefore be had if: (1) crude prices increased
significantly or (2) the discount disappeared.
Approval for the deal may eliminate part of the discount
While the government seems stuck in paperwork near term, the
approval should come given: (1) a relatively weak legal position (we
think) and (2) implications for future foreign investments in India. The
approval is more relevant to Cairn Energy’s valuations—bringing
about clarity on their cash flow. With CAIL trading close to the open
offer price anyway, transaction fortunes may not have much impact on
CAIL near term.
There can be relief that company operations progress. Approvals for
increased Mangala / Aishwariya production, for more exploratory
drilling in Rajasthan can come through post closure of the deal.
Petronas owns 14.91% of CAIL, and is now reportedly looking to
sell—which intention should not depend on the CNE – VED deal. This
can be a overhang on the stock near term, however.
Royalty is more important; but the genie is out of the bottle
We think a bigger reason for the discount is the government’s
insistence on royalties at the Rajasthan block becoming cost
recoverable. This would impact CAIL’s cash flows and valuations
materially (c.15% cut on NAV)— something the CAIL board has
resolved not to accept. However, the government, having raised this
issue cannot back off now, in our view. CAIL will most likely have to
litigate and win the issue in court (arbitration), which could take
several quarters. Any discount related to royalties is therefore unlikely
to disappear soon, or on completion of the deal.

Cairn should do better than crude medium term
While a fall in crude prices remains a key risk, any increase in CAIL
discount to crude would make it attractive—especially relative to other
global oil companies. CAIL’s discount to crude should reduce over
time, as production volumes go up and cash generation remains
stronger than implied by stock price. Cairn may do better than crude
medium term. Corporate strategy (use of FCF) under new
management could remain a key question though.