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Cairn India Limited (CAIR IN)
Downgrade to N: Side effects of acquisition
We expect Cairn India to start paying a 20% royalty on oil
production from its main producing Rajasthan field
We believe the recent slowdown in bureaucratic decisionmaking
will hamper Cairn India’s plan for a quick ramp-up of
its oil production
Downgrade rating to N from OW and lower target price to
INR350 from INR405
We expect Cairn India to start paying a 20% royalty. We believe the huge success of
Cairn India in notching the largest oil discovery in India after the discovery of Bombay
High in the mid-1970 has resulted in the ironic situation it finds itself in. Excited by the
upside potential, Vedanta group (VED) is now closer than ever to gaining control of the
CAIR, with the government approving the sale of majority stakes in CAIR by Cairn Plc to
VED. VED already owns 28.5% of the shares of CAIR and has agreed to buy another
30% from the existing owner Cairn Plc. The government has approved the transfer subject
to CAIR paying a 20% royalty on its share of production from Rajasthan field. We believe
CAIR has little choice but agree, as any opposition would mean that government and JV
approvals required for either day-to-day operation or long term production ramp-up would
become difficult. CAIR management has now decided to approach its shareholders
through a postal ballot, outcome to depend on a simple majority. Note that Vedanta Group
and Cairn Plc together own c80% of the shares of Cairn India.
Operational parameters in line: We further believe the Rajasthan field is on course to
achieve the guided peak output of 240,000 bopd as operational parameters are turning out
to be even better than management’s guidance. The reserves upside in its Barmer
formation in Rajasthan could increase the peak output. However, once the cost recovery
touches the 3.5 times of capex, the profit share of CAIR gets capped at 50%, hence the
impact of higher production on valuation is less pronounced. A hike in peak output from
240,000 bopd to 350,000 bopd, an increase of 46% changes the valuation by merely 11%.
Valuation and Risks. We are downgrading our rating on Cairn India to N from OW and
lowering our TP by 14% to INR350 on account of the additional impact of the royalty
payment despite upping the oil price by 8% in line with our in-house view. We have
valued Cairn India on DCF for production from known reserves, and a risk-weighted
multiple for reserves upside potentials. Crude oil price, exchange rate, new discoveries,
pace of ramp up of production being different from our assumptions can lead to upside
and downside risk to our rating and target price.
Investment view
We believe Cairn India has little choice but to start paying a 20% royalty. We believe the extraordinary
success of Cairn India in notching the largest oil discovery in India after the discovery of Bombay High in the
mid-1970 has resulted in the ironic situation it finds itself in. Excited by the upside potential, Vedanta group is
now closer than ever to gain control of the company. Cairn Management confirmed in its media release that
they would approach the shareholders of Cairn India through a postal ballot to seek approval for agreeing to the
preconditions set by the government for the Cairn-Vedanta deal. They also confirmed on the analyst
conference call that a majority decision would suffice. With Cairn Plc and Vedanta jointly controlling a c80%
stake in CAIR, the outcome of the postal ballot would depend on choices the two make. We believe that by
agreeing to a reduced transaction price of INR355/share instead of the previously agreed INR405/share, the
two entities viz. Cairn Plc and Vedanta are likely to agree to these preconditions.
We believe the recent slowdown in bureaucratic decision-making will hamper Cairn India’s plan
for a quick ramp-up of its oil production The Comptroller & Auditor General (CAG) in its draft report
has levied a series of allegations against certain officials of the Ministry of Oil and Directorate General of
Hydrocarbons for favouring RIL and Cairn India by allowing them to retain their entire exploration
acreage, turning a blind eye to increases in capital expenditure and giving additional area in violation of
the Production Sharing Contracts. As a result we believe the government officials are likely to become
extremely cautious in decision making. We already see some evidence of this, namely approval to Cairn
India on further exploration in Rajasthan and approving production from existing fields are all withheld.
Valuation
The value of Cairn is essentially the value of its reserves in Rajasthan, Ravva, and Cambay. We value
these reserves on a DCF basis, using a WACC of 11% and Brent oil price of USD90/bbl. We assume an
11% discount to Brent for valuing Rajasthan crude oil and now additionally assume payment of royalty to
the government apart from factoring in delay in production ramp up. This result in lowering our DCF
based target price from INR405 to INR350. Under our research model, for stocks without a volatility
indicator, the Neutral band is 5ppt above and below our hurdle rate for Indian stocks of 11%, or 6-16%
around the share price. Our 12-month target price of INR350 implies a potential return of 8.3%, hence we
rate the stock Neutral.
Sensitivity analysis and risks
A company-specific downside risk that we see is non-renewal of the underlying PSC in 2020, slow ramp
up of production which can lead to reduction in our target price. Generic risks for E&P companies include
a fall in the crude oil price different from our assumed crude price, the failure to convert upside into
reserves and new discoveries.
Sensitivity of our target price to various scenarios
Scenario % change
USD10/bbl increase in Brent price 11%
INR1/USD increase in exchange rate 2%
Exemption from payment of royalty 22%
Exemption from payment of cess 11%
Non renewal of PSC after 2020 -17%
Source: HSBC estimates
Key Highlights from conference call
If royalty were to be cost recoverable, it would lead to a decline in the revenues and profit after tax
for the current quarter by INR12.9bn (US$ 289 m).
Bhagyam development on track and is expected to commence in Q42011. It is expected to achieve
FDP approved plateau rate of 40Mbbl/d by end 2011. However, its production ramp up and operating
budget still needs to be approved by the government.
Sri Lanka SL 2007-01-001 block: Drilling programme to commence in August 2011. USD200-300m
is expected to be spent in next 12 months. However, capex outlay will depend upon initial well
exploration results.
Saraswati field commenced production at the end of May 2011; currently producing at the rate of 250bopd.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Cairn India Limited (CAIR IN)
Downgrade to N: Side effects of acquisition
We expect Cairn India to start paying a 20% royalty on oil
production from its main producing Rajasthan field
We believe the recent slowdown in bureaucratic decisionmaking
will hamper Cairn India’s plan for a quick ramp-up of
its oil production
Downgrade rating to N from OW and lower target price to
INR350 from INR405
We expect Cairn India to start paying a 20% royalty. We believe the huge success of
Cairn India in notching the largest oil discovery in India after the discovery of Bombay
High in the mid-1970 has resulted in the ironic situation it finds itself in. Excited by the
upside potential, Vedanta group (VED) is now closer than ever to gaining control of the
CAIR, with the government approving the sale of majority stakes in CAIR by Cairn Plc to
VED. VED already owns 28.5% of the shares of CAIR and has agreed to buy another
30% from the existing owner Cairn Plc. The government has approved the transfer subject
to CAIR paying a 20% royalty on its share of production from Rajasthan field. We believe
CAIR has little choice but agree, as any opposition would mean that government and JV
approvals required for either day-to-day operation or long term production ramp-up would
become difficult. CAIR management has now decided to approach its shareholders
through a postal ballot, outcome to depend on a simple majority. Note that Vedanta Group
and Cairn Plc together own c80% of the shares of Cairn India.
Operational parameters in line: We further believe the Rajasthan field is on course to
achieve the guided peak output of 240,000 bopd as operational parameters are turning out
to be even better than management’s guidance. The reserves upside in its Barmer
formation in Rajasthan could increase the peak output. However, once the cost recovery
touches the 3.5 times of capex, the profit share of CAIR gets capped at 50%, hence the
impact of higher production on valuation is less pronounced. A hike in peak output from
240,000 bopd to 350,000 bopd, an increase of 46% changes the valuation by merely 11%.
Valuation and Risks. We are downgrading our rating on Cairn India to N from OW and
lowering our TP by 14% to INR350 on account of the additional impact of the royalty
payment despite upping the oil price by 8% in line with our in-house view. We have
valued Cairn India on DCF for production from known reserves, and a risk-weighted
multiple for reserves upside potentials. Crude oil price, exchange rate, new discoveries,
pace of ramp up of production being different from our assumptions can lead to upside
and downside risk to our rating and target price.
Investment view
We believe Cairn India has little choice but to start paying a 20% royalty. We believe the extraordinary
success of Cairn India in notching the largest oil discovery in India after the discovery of Bombay High in the
mid-1970 has resulted in the ironic situation it finds itself in. Excited by the upside potential, Vedanta group is
now closer than ever to gain control of the company. Cairn Management confirmed in its media release that
they would approach the shareholders of Cairn India through a postal ballot to seek approval for agreeing to the
preconditions set by the government for the Cairn-Vedanta deal. They also confirmed on the analyst
conference call that a majority decision would suffice. With Cairn Plc and Vedanta jointly controlling a c80%
stake in CAIR, the outcome of the postal ballot would depend on choices the two make. We believe that by
agreeing to a reduced transaction price of INR355/share instead of the previously agreed INR405/share, the
two entities viz. Cairn Plc and Vedanta are likely to agree to these preconditions.
We believe the recent slowdown in bureaucratic decision-making will hamper Cairn India’s plan
for a quick ramp-up of its oil production The Comptroller & Auditor General (CAG) in its draft report
has levied a series of allegations against certain officials of the Ministry of Oil and Directorate General of
Hydrocarbons for favouring RIL and Cairn India by allowing them to retain their entire exploration
acreage, turning a blind eye to increases in capital expenditure and giving additional area in violation of
the Production Sharing Contracts. As a result we believe the government officials are likely to become
extremely cautious in decision making. We already see some evidence of this, namely approval to Cairn
India on further exploration in Rajasthan and approving production from existing fields are all withheld.
Valuation
The value of Cairn is essentially the value of its reserves in Rajasthan, Ravva, and Cambay. We value
these reserves on a DCF basis, using a WACC of 11% and Brent oil price of USD90/bbl. We assume an
11% discount to Brent for valuing Rajasthan crude oil and now additionally assume payment of royalty to
the government apart from factoring in delay in production ramp up. This result in lowering our DCF
based target price from INR405 to INR350. Under our research model, for stocks without a volatility
indicator, the Neutral band is 5ppt above and below our hurdle rate for Indian stocks of 11%, or 6-16%
around the share price. Our 12-month target price of INR350 implies a potential return of 8.3%, hence we
rate the stock Neutral.
Sensitivity analysis and risks
A company-specific downside risk that we see is non-renewal of the underlying PSC in 2020, slow ramp
up of production which can lead to reduction in our target price. Generic risks for E&P companies include
a fall in the crude oil price different from our assumed crude price, the failure to convert upside into
reserves and new discoveries.
Sensitivity of our target price to various scenarios
Scenario % change
USD10/bbl increase in Brent price 11%
INR1/USD increase in exchange rate 2%
Exemption from payment of royalty 22%
Exemption from payment of cess 11%
Non renewal of PSC after 2020 -17%
Source: HSBC estimates
Key Highlights from conference call
If royalty were to be cost recoverable, it would lead to a decline in the revenues and profit after tax
for the current quarter by INR12.9bn (US$ 289 m).
Bhagyam development on track and is expected to commence in Q42011. It is expected to achieve
FDP approved plateau rate of 40Mbbl/d by end 2011. However, its production ramp up and operating
budget still needs to be approved by the government.
Sri Lanka SL 2007-01-001 block: Drilling programme to commence in August 2011. USD200-300m
is expected to be spent in next 12 months. However, capex outlay will depend upon initial well
exploration results.
Saraswati field commenced production at the end of May 2011; currently producing at the rate of 250bopd.
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