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Cairn India Ltd
Royalty Already Priced in
What's Changed
EPS F2012E, F2013E +22%; +27%
We reiterate our Overweight call on Cairn India.
Three key reasons: 1) strong production CAGR of
21% over F2011-15E; 2) EPS should double over the
next two years; and 3) valuation looks attractive
with the stock discounting oil price of US$76/bbl
excluding royalty, and trading at a P/E of 6.1x, one
of the cheapest amongst global peers.
Strong FCF generation: Higher oil price and higher
production should enable Cairn to generate strong cash
flows of US$3bn in F2012, implying that stock is trading
at FCF yield of ~17%, the highest among Asian E&Ps.
Production on a roll: Cairn plans to produce 210kpbpd
when its three fields MBA are fully operational, which we
estimate by end F2013. The company plans to enhance
its production from an estimated 210kbpd to 240kpbp by
focusing on Enhanced oil recovery (EOR).
Concerns on Cairn-Vedanta deal overdone: Cairn
has underperformed the market by 4% and oil prices
(Brent) by 57%, since the deal was announced, largely
on concern that royalty would be made cost recoverable
as part of the deal. Assuming royalty, Cairn’s NAV
would be Rs371/share, implying an upside of ~10% from
current levels. Valuations for F2012e would still be
attractive at a P/E of 7.5x, EV/EBITDA of 4.2x, and FCF
yield of 10%, still amongst the cheapest globally. If we
were to assume oil prices at US$110/bbl, assuming
royalty cost recoverable, our DCF would be
Rs427/share, largely in line with our current target price.
We have marked- to-market our short-term oil price
assumptions to current forward curve and raise our
EPS by 22% for F2012E and 27% for F2013E. Our
target price remains the same at Rs429/share since
gains from higher oil prices were offset by reduced value
of EOR resources, since we are now assuming longer
lives compared to higher production.
Investment Case
Summary & Conclusions
We reiterate our Overweight call on Cairn India and
maintain our price target of Rs429, implying upside of
28% from the current level. Three key reasons for
our OW rating are:
1) Cairn has strong production CAGR of 21% in
F2011-15e, driven by ramp-up in the Rajasthan Basin, as well
as contribution of its existing asset in Ravva (Exhibit 1).
3) We estimate Cairn’s earnings to nearly double from
Rs32/share in F2011 to Rs65/share in F2013 driven by both
higher oil prices and higher production growth.
3) Valuation looks attractive: Cairn trades at P/E of 6.1x and
EV/EBITDA of 3.7x on our F2012e earnings, implying
discounts of 52% and 42%, respectively, to its global peers.
The stock price is currently discounting an implied crude oil
price of US$76/bbl (Brent), compared with our long-term
assumption of US$90/bbl. The Free cash flow yield should
move from 5% in F2011 to an impressive 17% in F2013 as
compared to Asian average of ~6%.
Production on a Roll
We estimate Cairn India’s production to show impressive
growth of 21% (CAGR) in F2011-15 as it ramps up
Rajasthan production from current level of 125kbpd to over
210kbpd by end F2013. The company would then further
increase production by 30kbpd through EOR to 240kb/d by in
F2015.
As shown in Exhibit 1, we expect Cairn’s production to exit at
150kb/d in F2012 from Mangala field. We now assume
Bhagyam to commence production from C4Q11 at 20kb/d and
ramping to 40kb/d by C2Q12. We estimate Cairn to exit
F2012 with production rate of 170kbpd, as against company
guidance of 175kbpd.
We also assume Aishwariya (10kb/d) to start production
during C4Q12 and ramp to 20kb/d by C2Q13. We estimate
F2013 exit production at 200kb/d and F2014 exit at 210kb/d.
With additional 30kb/d through EOR, we estimate Cairn to
reach plateau production of 240kb/d in F2015.
We had earlier assumed EOR to add ~100kb/d to its
production profile, over the next eight years. Based on
discussions with management, we believe Cairn plans to
increase its reserve life of Rajasthan fields to 12 years with
incremental EOR production of 30kb/d taking the plateau to
240kb/d.
For these reasons, our NAV has remained unchanged as
gains from higher oil prices are offset by reduced value of
EOR resources.
What Is the Issue related to Royalty?
Based on media reports (Economic Times, Business
Standard, December 7, 2010) one of the key reasons why the
GOI has not yet approved the deal has been issue pertaining
to cost recovery of royalty.
As per the terms of the Production Sharing Contract (PSC),
despite owning a 30% stake in the field, ONGC (74% owned
by the Government of India) has to pay 100% of the royalty on
all Rajasthan production, and Cairn has exemption paying
royalty. Royalty equates to 16.7% of the crude price realized.
Several media reports (Economic Times, Bloomberg,
February 10, 2011) have suggested that both Oil Ministry and
ONGC believe that though royalty is exempted initially for
Cairn, it should be cost recoverable before profit petroleum is
paid to the Government and profits are shared by both the
partners. Thus, if royalty were to be made cost recoverable, it
would mathematically mean initially the year Cairn does not
expense for royalty, but by the end of the year when it pays
profit petroleum, its profits are lowered by the royalty amount.
This implies that Cairn may gain only to the extent of deferring
its royalty payment to end of year, if royalty is made cost
recoverable.
In Exhibits 8 and 9, we show an illustrative calculation of how
royalty affects Cairn’s profits at different level of profit
petroleum.
At current market price, we believe the stock price is
discounting the worst outcome for the stock and the
downside remains limited, even if the government
announces the royalty to be cost recoverable
Cairn India management commentary is pro minority
shareholders: Cairn India’s management has been
forthcoming and assured in analyst conference calls that the
Cairn India board will not accept any condition tied to the
approval of the deal that negatively affects the value of the
business. The board remains committed to protect minority
shareholders as reiterated by the management during the
analyst conference call post F4Q11 results.
What Does PSC Say about Royalty Issue?
Under the PSC, ONGC has two roles: First, as part of the
pre-NELP, it is the licensee of the field, which obliges it to
pay 100% of royalty under Article 16.4(a) of the PSC. Second,
it is also the government nominee holding 30% interest in the
field as a contractor along with Cairn India.
Media reports (Business Standard, Economic Times,
February 17, 2011) have suggested that ONGC has cited
Clause 3.1.9 in the accounting procedure of the PSC,
which says that duties, levies, fees, charges, etc., paid by the
contractor to government are cost recoverable. ONGC has
not commented on the reports.
Media reports (Business Standard, Times of India,
February 14, 2011) have suggested that Cairn in its
discussion with the government, has argued that Clause 3.1.9
of the PSC is applicable to costs incurred by the
contractors, and not the licensee. Also, the contractor and
the licensee could well have been different entities, making it
legally impossible for the licensee to recover its costs using a
clause meant for the contractor. Neither ONGC nor Cairn
India has commented on the reports.
Valuation
Valuation Based on Net Asset Value
To derive our base, bear and bull cases for Cairn India, we use
an NAV valuation for the company based on sum-of-parts and
DCF for individual fields. We then add the NAV of the total
resources to NAV of reserves to arrive at the base case
valuation
Reserves: We use a DCF methodology to assess the cash
flow of individual fields owned by Cairn India based on its 2P
reserves. For our base case, we use an 11% cost of capital for
the life of the fields and a beta of 0.82x (Exhibit 11). We
calculate EV-based NAV at ~US$15.7bn. We use long-term oil
price assumption of US$90/bbl.
We estimate Rajasthan Core NAV to be at US$10.3bn
(Rs240/share) excluding EOR potential, which we estimate is
another US$2.3bn (Rs53/share) assuming it adds 30kb/d to
overall production taking plateau to 240kb/d and increasing
reserve life to ~12 years. Overall, we estimate Rajasthan NAV
to be at Rs293/share including the EOR production. We value
NAV for Ravva and Gauri at US$115mn, or Rs7.1/share.
Resources: We value the company’s contingent resources on
the basis of the imputed NAV/boe (US$/boe) based on our
level of conviction. For the Rajasthan other fields and
Rajasthan Exploration upside and KG Basin resources, we
have used EV/BOE of US$9.7/bbl as we await more clarity
from the company on the field exploration and development
plan. Based on this, we compute a value of US$3bn
(Rs62/share) for these resources.
Net Cash: We estimate the company to end F2012e year with
net cash of US$2.6bn including the dividend payout
(Rs62/share) which we add to our NAV.
Overall, we arrive at a net asset value of US$18.3bn, which
equates to Rs429/share (Exhibit 12).
Our price target NAV for Cairn is Rs429/share, implying
28% upside potential from current levels.
Exhibit 11
Cairn India: Cost of Capital Calculations
Long Term
Risk Free Return (Rf) (%) 8.0
Market Premium (Rm) (%) 6.0
Beta 0.82
Cost of Equity (Re) (%) 12.9
Equity (%) 70.0
Cost of Debt (Rd) (%) 8.0
Tax rate (%) 19.9
Debt (%) 6.4
WACC (%) 11.0
Source: Company data, Morgan Stanley Research estimates
Risks to Price Target
We see the following risks to our price target:
• Crude volatility: Global crude prices are cyclical and volatile,
so Cairn’s earnings, too, may correlate with sector cyclicality.
• Price of Rajasthan crude: Could be limited by its viscous
nature, which would lower realizations relative to Brent.
• Delay in Government Approvals: Production ramp-up could
be delayed, if government approvals don’t come through as
expected.
• Royalty to be made cost recoverable: If royalty is made cost
recoverable, our price target will be lowered by ~Rs58/share.
Morgan Stanley & Co. Limited is acting as financial adviser and
sponsor to Vedanta Resources PLC (“Vedanta”) on Vedanta
Group's proposed acquisition of 51% to 60% of Cairn India
Limited ("Cairn India"), as announced on 16 August 2010.
Morgan Stanley & Co. International plc. is also Corporate
Broker to Vedanta.
This report was prepared solely upon information generally
available to the public. No representation is made that it is
accurate and complete. This report is not a recommendation or
an offer to buy or sell the securities mentioned. Please refer to
the notes at the end of this report.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Cairn India Ltd
Royalty Already Priced in
What's Changed
EPS F2012E, F2013E +22%; +27%
We reiterate our Overweight call on Cairn India.
Three key reasons: 1) strong production CAGR of
21% over F2011-15E; 2) EPS should double over the
next two years; and 3) valuation looks attractive
with the stock discounting oil price of US$76/bbl
excluding royalty, and trading at a P/E of 6.1x, one
of the cheapest amongst global peers.
Strong FCF generation: Higher oil price and higher
production should enable Cairn to generate strong cash
flows of US$3bn in F2012, implying that stock is trading
at FCF yield of ~17%, the highest among Asian E&Ps.
Production on a roll: Cairn plans to produce 210kpbpd
when its three fields MBA are fully operational, which we
estimate by end F2013. The company plans to enhance
its production from an estimated 210kbpd to 240kpbp by
focusing on Enhanced oil recovery (EOR).
Concerns on Cairn-Vedanta deal overdone: Cairn
has underperformed the market by 4% and oil prices
(Brent) by 57%, since the deal was announced, largely
on concern that royalty would be made cost recoverable
as part of the deal. Assuming royalty, Cairn’s NAV
would be Rs371/share, implying an upside of ~10% from
current levels. Valuations for F2012e would still be
attractive at a P/E of 7.5x, EV/EBITDA of 4.2x, and FCF
yield of 10%, still amongst the cheapest globally. If we
were to assume oil prices at US$110/bbl, assuming
royalty cost recoverable, our DCF would be
Rs427/share, largely in line with our current target price.
We have marked- to-market our short-term oil price
assumptions to current forward curve and raise our
EPS by 22% for F2012E and 27% for F2013E. Our
target price remains the same at Rs429/share since
gains from higher oil prices were offset by reduced value
of EOR resources, since we are now assuming longer
lives compared to higher production.
Investment Case
Summary & Conclusions
We reiterate our Overweight call on Cairn India and
maintain our price target of Rs429, implying upside of
28% from the current level. Three key reasons for
our OW rating are:
1) Cairn has strong production CAGR of 21% in
F2011-15e, driven by ramp-up in the Rajasthan Basin, as well
as contribution of its existing asset in Ravva (Exhibit 1).
3) We estimate Cairn’s earnings to nearly double from
Rs32/share in F2011 to Rs65/share in F2013 driven by both
higher oil prices and higher production growth.
3) Valuation looks attractive: Cairn trades at P/E of 6.1x and
EV/EBITDA of 3.7x on our F2012e earnings, implying
discounts of 52% and 42%, respectively, to its global peers.
The stock price is currently discounting an implied crude oil
price of US$76/bbl (Brent), compared with our long-term
assumption of US$90/bbl. The Free cash flow yield should
move from 5% in F2011 to an impressive 17% in F2013 as
compared to Asian average of ~6%.
Production on a Roll
We estimate Cairn India’s production to show impressive
growth of 21% (CAGR) in F2011-15 as it ramps up
Rajasthan production from current level of 125kbpd to over
210kbpd by end F2013. The company would then further
increase production by 30kbpd through EOR to 240kb/d by in
F2015.
As shown in Exhibit 1, we expect Cairn’s production to exit at
150kb/d in F2012 from Mangala field. We now assume
Bhagyam to commence production from C4Q11 at 20kb/d and
ramping to 40kb/d by C2Q12. We estimate Cairn to exit
F2012 with production rate of 170kbpd, as against company
guidance of 175kbpd.
We also assume Aishwariya (10kb/d) to start production
during C4Q12 and ramp to 20kb/d by C2Q13. We estimate
F2013 exit production at 200kb/d and F2014 exit at 210kb/d.
With additional 30kb/d through EOR, we estimate Cairn to
reach plateau production of 240kb/d in F2015.
We had earlier assumed EOR to add ~100kb/d to its
production profile, over the next eight years. Based on
discussions with management, we believe Cairn plans to
increase its reserve life of Rajasthan fields to 12 years with
incremental EOR production of 30kb/d taking the plateau to
240kb/d.
For these reasons, our NAV has remained unchanged as
gains from higher oil prices are offset by reduced value of
EOR resources.
What Is the Issue related to Royalty?
Based on media reports (Economic Times, Business
Standard, December 7, 2010) one of the key reasons why the
GOI has not yet approved the deal has been issue pertaining
to cost recovery of royalty.
As per the terms of the Production Sharing Contract (PSC),
despite owning a 30% stake in the field, ONGC (74% owned
by the Government of India) has to pay 100% of the royalty on
all Rajasthan production, and Cairn has exemption paying
royalty. Royalty equates to 16.7% of the crude price realized.
Several media reports (Economic Times, Bloomberg,
February 10, 2011) have suggested that both Oil Ministry and
ONGC believe that though royalty is exempted initially for
Cairn, it should be cost recoverable before profit petroleum is
paid to the Government and profits are shared by both the
partners. Thus, if royalty were to be made cost recoverable, it
would mathematically mean initially the year Cairn does not
expense for royalty, but by the end of the year when it pays
profit petroleum, its profits are lowered by the royalty amount.
This implies that Cairn may gain only to the extent of deferring
its royalty payment to end of year, if royalty is made cost
recoverable.
In Exhibits 8 and 9, we show an illustrative calculation of how
royalty affects Cairn’s profits at different level of profit
petroleum.
At current market price, we believe the stock price is
discounting the worst outcome for the stock and the
downside remains limited, even if the government
announces the royalty to be cost recoverable
Cairn India management commentary is pro minority
shareholders: Cairn India’s management has been
forthcoming and assured in analyst conference calls that the
Cairn India board will not accept any condition tied to the
approval of the deal that negatively affects the value of the
business. The board remains committed to protect minority
shareholders as reiterated by the management during the
analyst conference call post F4Q11 results.
What Does PSC Say about Royalty Issue?
Under the PSC, ONGC has two roles: First, as part of the
pre-NELP, it is the licensee of the field, which obliges it to
pay 100% of royalty under Article 16.4(a) of the PSC. Second,
it is also the government nominee holding 30% interest in the
field as a contractor along with Cairn India.
Media reports (Business Standard, Economic Times,
February 17, 2011) have suggested that ONGC has cited
Clause 3.1.9 in the accounting procedure of the PSC,
which says that duties, levies, fees, charges, etc., paid by the
contractor to government are cost recoverable. ONGC has
not commented on the reports.
Media reports (Business Standard, Times of India,
February 14, 2011) have suggested that Cairn in its
discussion with the government, has argued that Clause 3.1.9
of the PSC is applicable to costs incurred by the
contractors, and not the licensee. Also, the contractor and
the licensee could well have been different entities, making it
legally impossible for the licensee to recover its costs using a
clause meant for the contractor. Neither ONGC nor Cairn
India has commented on the reports.
Valuation
Valuation Based on Net Asset Value
To derive our base, bear and bull cases for Cairn India, we use
an NAV valuation for the company based on sum-of-parts and
DCF for individual fields. We then add the NAV of the total
resources to NAV of reserves to arrive at the base case
valuation
Reserves: We use a DCF methodology to assess the cash
flow of individual fields owned by Cairn India based on its 2P
reserves. For our base case, we use an 11% cost of capital for
the life of the fields and a beta of 0.82x (Exhibit 11). We
calculate EV-based NAV at ~US$15.7bn. We use long-term oil
price assumption of US$90/bbl.
We estimate Rajasthan Core NAV to be at US$10.3bn
(Rs240/share) excluding EOR potential, which we estimate is
another US$2.3bn (Rs53/share) assuming it adds 30kb/d to
overall production taking plateau to 240kb/d and increasing
reserve life to ~12 years. Overall, we estimate Rajasthan NAV
to be at Rs293/share including the EOR production. We value
NAV for Ravva and Gauri at US$115mn, or Rs7.1/share.
Resources: We value the company’s contingent resources on
the basis of the imputed NAV/boe (US$/boe) based on our
level of conviction. For the Rajasthan other fields and
Rajasthan Exploration upside and KG Basin resources, we
have used EV/BOE of US$9.7/bbl as we await more clarity
from the company on the field exploration and development
plan. Based on this, we compute a value of US$3bn
(Rs62/share) for these resources.
Net Cash: We estimate the company to end F2012e year with
net cash of US$2.6bn including the dividend payout
(Rs62/share) which we add to our NAV.
Overall, we arrive at a net asset value of US$18.3bn, which
equates to Rs429/share (Exhibit 12).
Our price target NAV for Cairn is Rs429/share, implying
28% upside potential from current levels.
Exhibit 11
Cairn India: Cost of Capital Calculations
Long Term
Risk Free Return (Rf) (%) 8.0
Market Premium (Rm) (%) 6.0
Beta 0.82
Cost of Equity (Re) (%) 12.9
Equity (%) 70.0
Cost of Debt (Rd) (%) 8.0
Tax rate (%) 19.9
Debt (%) 6.4
WACC (%) 11.0
Source: Company data, Morgan Stanley Research estimates
Risks to Price Target
We see the following risks to our price target:
• Crude volatility: Global crude prices are cyclical and volatile,
so Cairn’s earnings, too, may correlate with sector cyclicality.
• Price of Rajasthan crude: Could be limited by its viscous
nature, which would lower realizations relative to Brent.
• Delay in Government Approvals: Production ramp-up could
be delayed, if government approvals don’t come through as
expected.
• Royalty to be made cost recoverable: If royalty is made cost
recoverable, our price target will be lowered by ~Rs58/share.
Morgan Stanley & Co. Limited is acting as financial adviser and
sponsor to Vedanta Resources PLC (“Vedanta”) on Vedanta
Group's proposed acquisition of 51% to 60% of Cairn India
Limited ("Cairn India"), as announced on 16 August 2010.
Morgan Stanley & Co. International plc. is also Corporate
Broker to Vedanta.
This report was prepared solely upon information generally
available to the public. No representation is made that it is
accurate and complete. This report is not a recommendation or
an offer to buy or sell the securities mentioned. Please refer to
the notes at the end of this report.
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