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Cairn India
Reuters: CAIL.BO Bloomberg: CAIR IN Exchange: BSE Ticker: CAIL
Royalty issue no longer an
overhang; reiterating Buy
16% upside potential even after Rajasthan royalty impact; reiterating Buy
We rate Cairn India (CAIL) a Buy with a target price of INR365, which implies
upside potential of 16%. Our positive investment case is premised on: 1) robust
EPS CAGR of 26% over FY11-13E driven by 22% CAGR in production and higher
oil prices; 2) free cash yield of above 14% in FY13 and FY14; and 3) higher
recovery rate from Rajasthan driven by EOR and exploration upside. We now
conservatively assume that the pre-conditions to the Cairn-Vedanta deal will be
accepted and cut our FY12/13 EPS by 27%/8% and valuation by 17%.
Cutting FY12/13 earnings by 27%/8% and valuation by 17%
The Cairn-Vedanta deal has been conditionally approved by the government of
India with pre-conditions that entail CAIL paying the royalty and cess. We now
conservatively factor these into our estimates thereby reducing our FY12/13 EPS
by 27%/8% and valuation by 17% to INR365.
Royalty condition acceptance to clear way for production boost at Rajasthan
We expect resolution of the Cairn–Vedanta deal to allow management to focus on
ramping up Rajasthan crude oil output from 125kbpd currently to 165kbpd (+32%)
by end-CY11 and 175kbpd (+40%) by end-CY12. Moreover, with potential
acceptance of royalty and cess conditions, we expect receipt of government
approvals for increasing Mangala peak output to 150kbpd (from 125k bpd) leading
to further upside to production by end-CY12. The current stock price is factoring in
the worst-case impact of the deal, and is trading at a FY13 FCF yield of c15%.
Buy with 16% upside to target price of INR365; oil price the key risk
We value CAIL at INR365 on a DCF-basis with no terminal value. Our WACC of
11.1% is based on Deutsche Bank's CoE assumptions for India (6.7% risk-free
rate and 8.1% risk premium). Key risks are lower oil prices, slower production
ramp-up in Rajasthan and exploration failures.
Cairn – Vedanta deal impact
priced in
We rate Cairn India (CAIL) a Buy with 16% upside potential to our reduced target price of
INR365. Taking a conservative view of the impact of the Cairn–Vedanta deal on Cairn India,
we factor cost recovery of royalty and cess at INR2500/t, thereby reducing our price target
for the stock by 17% to INR365. At our target price the worst-case impact of the deal is
priced in. Our Buy rating on the stock is premised on a robust oil price outlook, eventual
Rajasthan crude production ramp-up to 210kbpd, expectations of higher recovery rate from
Rajasthan with successful implementation of enhanced oil recovery (EOR) techniques, and
exploration upside in Rajasthan. We estimate an EBITDA CAGR of 31% and EPS CAGR of
26% over FY11-13 driven by 22% CAGR in production and higher oil prices. Over the next
three years (FY12-14), we estimate Cairn India to generate cUS$7.3bn of cash. The stock
trades at 6.9x FY12E PER, 1.2x FY12E PBV (with RoE of ~20% in FY12 and FY13) and
EV/Reserves of US$14/boe, at a discount to regional peers.
We expect resolution of the Cairn–Vedanta deal to allow management to focus on ramping
up Rajasthan crude oil output from 125kbpd currently to 165kbpd (+32%) by end-CY2011 and
175kbpd (+40%) by end-CY2012. Moreover, with potential acceptance of the Rajasthan
royalty and cess conditions, we expect pending approval for an increase in Mangala peak
production to 150kbpd (from 125k bpd) to be received sooner rather than later, which we
expect to be positive for the stock. This could take the CY12 exit production to 200kbpd, 14%
above our assumption. CAIL has indicated that the Mangala reservoir performance and
surface facilities have the capability to support production of 150kbpd, subject to ONGC and
government of India approval.
Valuation
We value Cairn India at INR365/share using DCF to estimate NAV of the Rajasthan block, the
Ravva field, and the Cambay block. For our DCF, we use a WACC of 11.1% based on
Deutsche Bank’s cost of equity assumptions for India (6.7% risk-free rate and 8.1% risk
premium). Our DCF model is based on cash flows (from FY13) over the life of the field and
assumes no terminal value. The stock trades at 6.9x FY12E PER, 1.2x FY12E PBV (with RoE
of ~20% in FY12 and FY13) and EV/Reserves of US$14/boe, at a discount to regional peers.
We risk weight potential upside from CAIL’s exploration prospects at 10%. Exploration
prospects are likely to be accretion to reserves based on further exploration in its blocks.
CAIL factors US$110/bbl to perpetuity at the current market price
Assuming CAIL is unable to add to its hydrocarbon resources or increase recovery rates from
Rajasthan (beyond EOR), we believe that, at the current market price and US$/INR of 45, the
stock is discounting a Brent crude price of US$110/bbl to perpetuity, a ~ 3% discount to the
spot price and ~14% discount to Deutsche Bank’s long-term forecast of US$125/bbl. Cairn
India’s valuation increases by about INR3/share for every US$1/bbl increase in the oil price.
Robust free cash flow generation ahead
We estimate CAIL to generate robust free cash flow (FCF) driven by a ramp-up in Rajasthan
oil production and high oil prices. We estimate the FCF yield at 8.2% for FY12 rising to over
14% in FY13 and FY14.
Risks
Downside risks include a weaker-than-expected oil demand outlook and excess crude oil
supplies, which may pose a downside risk to the oil price. Every US$1/bbl fall in the Brent
crude price reduces Cairn India’s valuation by INR3/sh or 0.8%. Other risks include any
change in the regulatory environment of the Indian Oil & Gas sector and policy issues such as
the dispute on cess in Rajasthan. Exploration and production activities face risks such as
operational, financial, geological and meteorological issues.
Assuming Rajasthan royalty as cost recoverable
In August 2010, Cairn energy Plc announced that it would be selling the majority of its stake
in Cairn India (CAIL) to Vedanta Resources Plc at a total consideration of INR405/sh which
included a non-compete fee of INR50/sh for Cairn Energy Plc's 40% stake in CAIL.
Subsequently, Cairn Energy Plc and Vedanta have modified the deal terms to remove the
non-compete fee of INR50/share from the sale consideration, bringing down the transaction
price to INR355/ share. This amount is close to our estimate of a INR65/sh reduction in
CAIL's valuation if Rajasthan royalty is made cost recoverable. The deal modification,
therefore, looks to be in lieu of reduction in CAIL’s valuation if the government’s preconditions
are accepted, thereby indicating the willingness of both Cairn Energy Plc and
Vedanta Group to accept the conditions set forth by the government. If Cairn Energy and
Vedanta accept the pre-conditions, these will then need to be accepted by CAIL's Board of
Directors for them to be effective. CAIL’s management has already stated that it will not
accept any condition in the Cairn-Vedanta deal that will be detrimental to CAIL’s valuation.
Cairn Energy and Vedanta hold an 81% stake in Cairn India. Hence if a shareholder’s vote is
sought to decide on acceptance of the deal pre-conditions, considering the eagerness of the
majority shareholders to close the deal, it is likely to be accepted despite its adverse impact
on Cairn India valuation.
Last week, the deal was conditionally approved by the government of India. The preconditions
set forth by the government include: i) royalty (20%) on crude production from
Rajasthan block should be made cost recoverable, ii) the ongoing arbitration between CAIL
and the government of India on payment of cess should be withdrawn, iii) no objection
certificate (NOC) from ONGC, CAIL's partner in Rajasthan block, should be sought.
CAIL currently does not pay any royalty to the government for its Rajasthan block, which as
per the production sharing contract (PSC) terms, should be borne in full by the licensee of the
block i.e. ONGC. Moreover, CAIL believes that it is not liable to pay any cess on the block,
but is paying the same at INR2500/t ‘under protest’. CAIL has already initiated arbitration
proceedings against the government of India on the cess issue.
Hence, against our earlier assumption that ONGC pays 100% royalty for the Rajasthan block,
we now conservatively assume that royalty will be made cost recoverable and OIDA cess will
be payable by CAIL at INR2500/t.
Deutsche Bank crude price outlook: Near-term forecast lowered;
long term unchanged at US$125/bbl
In the Commodities Quarterly dated 5 July 2011, Deutsche Bank’s global commodities team
marginally reduced its oil price forecast by 3% for CY11 to US$114/bbl on the back of a
weaker economic growth outlook for the current year and the release of 60m bbls from the
strategic petroleum reserve (SPR) by the IEA. However, the long-term forecast has been left
unchanged at US$125/bbl as oil demand- supply fundamentals remain strong.
Deutsche Bank has trimmed its 2011 World GDP growth forecast by 0.4% to 3.9% and
expects oil demand to rise by a more normal 1.4mmb/d in 2011 as compared to the
significant rise of 2.8mmb/d in 2010. Moreover, the IEA has called for a coordinated
drawdown of 60mmbbls of strategic reserves over a 30-day period. While it has already
begun in Korea, the US is expected to auction 1mmb/d of crude for August delivery, and
Europe and OECD Asia will jointly release another 1mmb/d of products. This release should
offset any upside risk from geopolitical forces in the near term.
However, over the medium to long term, the supply-demand fundamentals remain strong.
Deutsche Bank expects oil demand to grow by 1.7mmb/d each in 2012 and 2013, driven by a
demand increase in China, Brazil and the Middle East, particularly by their electricity
generation needs. On the supply side, non-OPEC supply should rise by 0.6-.5mmb/d through
2011 and 2012 but reach a plateau by 2014, thus putting pressure on OPEC to raise
production. Deutsche Bank sees Saudi Arabia spare capacity down to 2.5mmb/d in July as it
makes up for the lost Libyan production. Kuwait, Qatar and the UAE, together account for the
only other spare capacity, totaling a bit less than 1mmb/d. In less than a year, OPEC has gone
from 5mmb/d of spare capacity to an estimated 3.35mmb/d in May.
India Equity Research Reports, IPO and Stock News
Visit http://indiaer.blogspot.com/ for complete details �� ��
Cairn India
Reuters: CAIL.BO Bloomberg: CAIR IN Exchange: BSE Ticker: CAIL
Royalty issue no longer an
overhang; reiterating Buy
16% upside potential even after Rajasthan royalty impact; reiterating Buy
We rate Cairn India (CAIL) a Buy with a target price of INR365, which implies
upside potential of 16%. Our positive investment case is premised on: 1) robust
EPS CAGR of 26% over FY11-13E driven by 22% CAGR in production and higher
oil prices; 2) free cash yield of above 14% in FY13 and FY14; and 3) higher
recovery rate from Rajasthan driven by EOR and exploration upside. We now
conservatively assume that the pre-conditions to the Cairn-Vedanta deal will be
accepted and cut our FY12/13 EPS by 27%/8% and valuation by 17%.
Cutting FY12/13 earnings by 27%/8% and valuation by 17%
The Cairn-Vedanta deal has been conditionally approved by the government of
India with pre-conditions that entail CAIL paying the royalty and cess. We now
conservatively factor these into our estimates thereby reducing our FY12/13 EPS
by 27%/8% and valuation by 17% to INR365.
Royalty condition acceptance to clear way for production boost at Rajasthan
We expect resolution of the Cairn–Vedanta deal to allow management to focus on
ramping up Rajasthan crude oil output from 125kbpd currently to 165kbpd (+32%)
by end-CY11 and 175kbpd (+40%) by end-CY12. Moreover, with potential
acceptance of royalty and cess conditions, we expect receipt of government
approvals for increasing Mangala peak output to 150kbpd (from 125k bpd) leading
to further upside to production by end-CY12. The current stock price is factoring in
the worst-case impact of the deal, and is trading at a FY13 FCF yield of c15%.
Buy with 16% upside to target price of INR365; oil price the key risk
We value CAIL at INR365 on a DCF-basis with no terminal value. Our WACC of
11.1% is based on Deutsche Bank's CoE assumptions for India (6.7% risk-free
rate and 8.1% risk premium). Key risks are lower oil prices, slower production
ramp-up in Rajasthan and exploration failures.
Cairn – Vedanta deal impact
priced in
We rate Cairn India (CAIL) a Buy with 16% upside potential to our reduced target price of
INR365. Taking a conservative view of the impact of the Cairn–Vedanta deal on Cairn India,
we factor cost recovery of royalty and cess at INR2500/t, thereby reducing our price target
for the stock by 17% to INR365. At our target price the worst-case impact of the deal is
priced in. Our Buy rating on the stock is premised on a robust oil price outlook, eventual
Rajasthan crude production ramp-up to 210kbpd, expectations of higher recovery rate from
Rajasthan with successful implementation of enhanced oil recovery (EOR) techniques, and
exploration upside in Rajasthan. We estimate an EBITDA CAGR of 31% and EPS CAGR of
26% over FY11-13 driven by 22% CAGR in production and higher oil prices. Over the next
three years (FY12-14), we estimate Cairn India to generate cUS$7.3bn of cash. The stock
trades at 6.9x FY12E PER, 1.2x FY12E PBV (with RoE of ~20% in FY12 and FY13) and
EV/Reserves of US$14/boe, at a discount to regional peers.
We expect resolution of the Cairn–Vedanta deal to allow management to focus on ramping
up Rajasthan crude oil output from 125kbpd currently to 165kbpd (+32%) by end-CY2011 and
175kbpd (+40%) by end-CY2012. Moreover, with potential acceptance of the Rajasthan
royalty and cess conditions, we expect pending approval for an increase in Mangala peak
production to 150kbpd (from 125k bpd) to be received sooner rather than later, which we
expect to be positive for the stock. This could take the CY12 exit production to 200kbpd, 14%
above our assumption. CAIL has indicated that the Mangala reservoir performance and
surface facilities have the capability to support production of 150kbpd, subject to ONGC and
government of India approval.
Valuation
We value Cairn India at INR365/share using DCF to estimate NAV of the Rajasthan block, the
Ravva field, and the Cambay block. For our DCF, we use a WACC of 11.1% based on
Deutsche Bank’s cost of equity assumptions for India (6.7% risk-free rate and 8.1% risk
premium). Our DCF model is based on cash flows (from FY13) over the life of the field and
assumes no terminal value. The stock trades at 6.9x FY12E PER, 1.2x FY12E PBV (with RoE
of ~20% in FY12 and FY13) and EV/Reserves of US$14/boe, at a discount to regional peers.
We risk weight potential upside from CAIL’s exploration prospects at 10%. Exploration
prospects are likely to be accretion to reserves based on further exploration in its blocks.
CAIL factors US$110/bbl to perpetuity at the current market price
Assuming CAIL is unable to add to its hydrocarbon resources or increase recovery rates from
Rajasthan (beyond EOR), we believe that, at the current market price and US$/INR of 45, the
stock is discounting a Brent crude price of US$110/bbl to perpetuity, a ~ 3% discount to the
spot price and ~14% discount to Deutsche Bank’s long-term forecast of US$125/bbl. Cairn
India’s valuation increases by about INR3/share for every US$1/bbl increase in the oil price.
Robust free cash flow generation ahead
We estimate CAIL to generate robust free cash flow (FCF) driven by a ramp-up in Rajasthan
oil production and high oil prices. We estimate the FCF yield at 8.2% for FY12 rising to over
14% in FY13 and FY14.
Risks
Downside risks include a weaker-than-expected oil demand outlook and excess crude oil
supplies, which may pose a downside risk to the oil price. Every US$1/bbl fall in the Brent
crude price reduces Cairn India’s valuation by INR3/sh or 0.8%. Other risks include any
change in the regulatory environment of the Indian Oil & Gas sector and policy issues such as
the dispute on cess in Rajasthan. Exploration and production activities face risks such as
operational, financial, geological and meteorological issues.
Assuming Rajasthan royalty as cost recoverable
In August 2010, Cairn energy Plc announced that it would be selling the majority of its stake
in Cairn India (CAIL) to Vedanta Resources Plc at a total consideration of INR405/sh which
included a non-compete fee of INR50/sh for Cairn Energy Plc's 40% stake in CAIL.
Subsequently, Cairn Energy Plc and Vedanta have modified the deal terms to remove the
non-compete fee of INR50/share from the sale consideration, bringing down the transaction
price to INR355/ share. This amount is close to our estimate of a INR65/sh reduction in
CAIL's valuation if Rajasthan royalty is made cost recoverable. The deal modification,
therefore, looks to be in lieu of reduction in CAIL’s valuation if the government’s preconditions
are accepted, thereby indicating the willingness of both Cairn Energy Plc and
Vedanta Group to accept the conditions set forth by the government. If Cairn Energy and
Vedanta accept the pre-conditions, these will then need to be accepted by CAIL's Board of
Directors for them to be effective. CAIL’s management has already stated that it will not
accept any condition in the Cairn-Vedanta deal that will be detrimental to CAIL’s valuation.
Cairn Energy and Vedanta hold an 81% stake in Cairn India. Hence if a shareholder’s vote is
sought to decide on acceptance of the deal pre-conditions, considering the eagerness of the
majority shareholders to close the deal, it is likely to be accepted despite its adverse impact
on Cairn India valuation.
Last week, the deal was conditionally approved by the government of India. The preconditions
set forth by the government include: i) royalty (20%) on crude production from
Rajasthan block should be made cost recoverable, ii) the ongoing arbitration between CAIL
and the government of India on payment of cess should be withdrawn, iii) no objection
certificate (NOC) from ONGC, CAIL's partner in Rajasthan block, should be sought.
CAIL currently does not pay any royalty to the government for its Rajasthan block, which as
per the production sharing contract (PSC) terms, should be borne in full by the licensee of the
block i.e. ONGC. Moreover, CAIL believes that it is not liable to pay any cess on the block,
but is paying the same at INR2500/t ‘under protest’. CAIL has already initiated arbitration
proceedings against the government of India on the cess issue.
Hence, against our earlier assumption that ONGC pays 100% royalty for the Rajasthan block,
we now conservatively assume that royalty will be made cost recoverable and OIDA cess will
be payable by CAIL at INR2500/t.
Deutsche Bank crude price outlook: Near-term forecast lowered;
long term unchanged at US$125/bbl
In the Commodities Quarterly dated 5 July 2011, Deutsche Bank’s global commodities team
marginally reduced its oil price forecast by 3% for CY11 to US$114/bbl on the back of a
weaker economic growth outlook for the current year and the release of 60m bbls from the
strategic petroleum reserve (SPR) by the IEA. However, the long-term forecast has been left
unchanged at US$125/bbl as oil demand- supply fundamentals remain strong.
Deutsche Bank has trimmed its 2011 World GDP growth forecast by 0.4% to 3.9% and
expects oil demand to rise by a more normal 1.4mmb/d in 2011 as compared to the
significant rise of 2.8mmb/d in 2010. Moreover, the IEA has called for a coordinated
drawdown of 60mmbbls of strategic reserves over a 30-day period. While it has already
begun in Korea, the US is expected to auction 1mmb/d of crude for August delivery, and
Europe and OECD Asia will jointly release another 1mmb/d of products. This release should
offset any upside risk from geopolitical forces in the near term.
However, over the medium to long term, the supply-demand fundamentals remain strong.
Deutsche Bank expects oil demand to grow by 1.7mmb/d each in 2012 and 2013, driven by a
demand increase in China, Brazil and the Middle East, particularly by their electricity
generation needs. On the supply side, non-OPEC supply should rise by 0.6-.5mmb/d through
2011 and 2012 but reach a plateau by 2014, thus putting pressure on OPEC to raise
production. Deutsche Bank sees Saudi Arabia spare capacity down to 2.5mmb/d in July as it
makes up for the lost Libyan production. Kuwait, Qatar and the UAE, together account for the
only other spare capacity, totaling a bit less than 1mmb/d. In less than a year, OPEC has gone
from 5mmb/d of spare capacity to an estimated 3.35mmb/d in May.
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