Premium Value Investing NewsletterDownload Free Issue

Safal Niveshak StockTalk: Cairn India

Statutory Warning: This report may cause a reaction, and acting on it can be injurious to your wealth.

Note: This StockTalk analysis has been written by Sridhar V. Sridhar owns the stock, so the following analysis may be biased. Be careful!

Cairn India is one of the largest independent oil and gas exploration and production companies in India. It, along with its joint venture partners, account for more than 20% of India’s domestic crude oil production.

The company is primarily engaged in the business of oil and gas exploration, production and transportation. Its average daily gross operated production was 205,323 BOE (barrels of oil equivalents) in FY12-13. The company sells its oil to major refineries in India and its gas to both PSU and private buyers.

Business overview
The oil exploration and production business is a high-risk venture globally, and investors need to be aware of this.

The business involves bidding for projects based on initial assessment of potential resources, which may or may not materialize or get fully exploited.

In layman terms, it is difficult to assess with precision as to exactly how much oil exists below the ground. However, players having the right skills and technical know-how have a reasonable estimate of the resource potential, and how they can exploit it.

Further, it’s a highly-capital intensive activity, where the gestation period of a project can range anywhere between 7-12 years or more.

Nature of industry
As mentioned above, the business itself is challenging because it’s a long-gestation activity, highly capital intensive, requires high technical skills & project experience, etc.

Further, revenues are subject to two factors – the amount of output and oil price.

The government may have certain restrictions on the amount of output, and it may also impose royalties on the producer.

Further, oil prices are benchmarked to international oil prices, hence there is oil price risk plus foreign exchange conversion risk in a company’s dealings with customers.

In simple terms, revenues are linked to international oil prices quoted in US dollar per barrel, and gets converted into Indian rupees, thereby getting exposed to oil price and forex risks.

Key players: ONGC is the leader in the Indian oil & gas exploration and production industry. Then, there are companies like Oil India, Reliance Industries, Essar Oil and several other players.

Cairn is not an oil marketing or distribution company, hence we are not discussing about HPCL, BPCL, etc. here, though these companies also might have exploration arms/units.

Exploration and production companies are also referred to as upstream oil companies, and marketing/distribution companies are known as downstream. (I tried my best not to use such complex terms -but if you read them elsewhere, this might be of help :-)).

Competition: Competition comes from large players such as ONGC, RIL, etc. However, crude oil being an essential commodity with more demand and limited supply in India, these companies can be expected to have a stable pricing.

Petrol, diesel, LPG and kerosene are subsidized in India, and the subsidy burden is taken up by ONGC, the largest exploration and production behemoth in India.

Private players are not affected by this subsidy burden, hence those including Cairn, RIL, etc. have a significant edge over PSU players.

Cairn is contributing to about 25% of the domestic consumption as per recent estimates.

A major portion of our oil supply is from imports and predominantly from Middle Eastern countries such as Iraq, Saudi, Qatar, and Kuwait.

Paying for oil increases the import burden and also widens the Current Account Deficit. The situation worsens when the payment has to be made in US dollars because the rupee deprecation increases the outflow of foreign exchange.

Hence, the Indian government is taking steps to encourage domestic production and aiming to have a better energy security for the country. This is a positive for players such as Cairn, ONGC, and RIL.

Entry barriers: The industry has high entry barriers given the huge upfront costs required (that run into billions of dollars), uncertainty about reserve potential and actual results, environmental and social impact, permissions or approvals from Govt., royalty to Govt., etc. Some point are discussed below under the “Moat” heading.

Cairn’s financial performance
1. Growth in Revenue, Profits: Before you start questioning the numbers, remember that Cairn is relatively a new player in the oil and gas space. And this business takes several years to break even, and profits come in after this stage.

This is the cause for the change from negative to positive numbers during 2006, 2007 and later periods.


All figures in Rs Crore except %; FY change in 2008 has been incorporated in FY09

As the business has gained stability and with steady growth in the number of wells and output in Rajasthan, the potential for growth is high.

Cairn’s sales and profit growth have been excellent over the past 2-3 years, and we can expect moderation in future. But I hope the consistency would remain.

I don’t want to paint a rosy picture, but if some new production happens, and if government gives approvals for higher output in future, we can expect accelerated growth for the company.

Even if we take a conservative 15-20% annual growth in sales, it would add consistent earnings to the company’s cash reserves.

The company’s margins are pretty high, since the project is now commercialized and is in a steady growth state.

2. Returns on Equity/Capital: Cairn’s ROE and ROCE during FY12 were 16.4% and 18.1% respectively. I did some calculation based on March 2013 results and the ROE comes to around 25% for FY13.

We still need to wait for the annual report to get a better insight into this. However, looking at the past trends, I see improvements though it may not confirm the rule book.

The opportunity for returns to improve is high, and if you understand this business, Cairn has crossed the introductory, exploration stage and is in the production and commercialization mode in many wells across Rajasthan Block.

Given the long-term nature of the business, the growth will continue for several years until it reaches a saturation point.

3. Moat: You might think that a moat is irrelevant here given that this is a commodity-oriented business.

Of course, Cairn deals with a commodity, but think of it as a toll-bridge, or a company selling products that must be purchased for essential needs. If you want to use petrol, diesel, LPG, kerosene, petrochemical products/byproducts, etc…you will somehow end up buying this commodity which is short is supply.

Moreover, this is not like other commodities which can be recycled and reused.

Once you use it, it’s exhausted – it’s a non-renewable resource. Whether you drive a car or two wheeler, you will be paying for fuel. And similarly for cooking gas, inverters, generators, and machinery (factories), you will be using fuel that is derived from crude oil.

We cannot go back to “bull and cart” era and neither can we do without fossil fuels, as solar, wind and other forms may not replace traditional fuel so quickly. So there is a demand and it is durable and sustainable.

Secondly, not every company can get in to oil and gas exploration. The Rajasthan block that is explored by Cairn and ONGC in a 70-30 Joint Venture is one of the biggest resources in India (probably KG basin might get closer to it).

How many companies in India can set up a block like Rajasthan or the KG basin, which requires enormous investments that are in the range of billions of dollars?

Finding a block itself is not easy, and if you found one you need multiple approvals, environmental clearances, huge capital, employee base, etc. So there is a hurdle/wall which makes it difficult for several competitors to enter.

4. Potential: The Rajasthan basin is estimated to have over 7 billion barrels of oil per day, and Cairn is currently producing roughly 200,000 barrels per day. So there’s a huge growth potential ahead for the company.

5. Debt/Leverage: Cairn is debt free and is capable of generating a stream of free cash flows in future.

How’s the management?
Cairn’s management quality is sound and consists of a strong team of technical and managerial personnel.

Last year there was some news on management changes when Rahul Dhir left Cairn to pursue another assignment. However, with the entry of Vedanta, the results have been positive as they retained the same brand, experts, technicians, and managerial personnel.

So, despite the entry of a new promoter, the business model and its functioning are running well.

If you are not a great Vedanta fan, you don’t have to agree with me, but Cairn’s functioning style is completely different from those of Sterlite, Hindustan Zinc, Sesa Goa, etc.

What’s the valuation?
A. DCF (using free cash flows): Rs 385

Historical Cash Flows: This is just to understand the past trends and have a base to start with.


Note: The year 2008 has been left blank because due to the FY change in 2008, the numbers are incorporated in year 2009. For example the financial year ending in 2008 December has been extended to March 2009 and has been incorporated in 2009 figures. Prior to 2008, the company’s financial year ended in December. The cash flows in the past have been inconsistent due to the development stage of the projects.

A brief of my assumptions are below.

  • Free cash flow (or Owners Earnings) from 2013 (estimated) till 2022 have been considered. Stage 1 Growth: 15% (for years 1-5). Stage 2 Growth: 10% (for years 6-10) – based on production growth trends
  • Discount rate: 15%
  • Terminal growth rate: 5% (after 10 years)

Here are the FCF estimates for the next ten years…


The present value of future cash flows and terminal value comes to Rs 385.

B. Dividend Discounting & Terminal Book Value Method: Rs 330

Key assumptions:

  • Book Value Growth: 7.3% (average of last 6 years)
  • Current Book Value: Rs 253 (consolidated for 2011-12)
  • Estimated Book Value as of Year 10 is based on 7.3% growth over 10 years.
  • Risk Free Rate: 7.3% (10 year govt bond yield as on June 14, 2013)
  • Dividend: Based on dividend for 2012-13 being taken as a conservative figure for future years. Not a good estimate, but on a conservative basis we can expect dividends to remain constant or grow gradually


All figures in Rs Crore except %

C. Relative Valuation method: Rs 570
Production assumptions under this method are:

  • Rajasthan – 180,000 barrels of oil per day (bpd)
  • Ravva – 21,000 bpd
  • Cambay – 4,500 bpd

Other assumptions:

  • Oil Price: $80 (Cairn sells at 10-15% discount to brent, and a lower price to account for commodity cycle risk)
  • No of production days: 300 (assuming lower working hours, holidays, etc)
  • US-INR Rate: Rs.54


Disclaimer: Most of the above analysis involves estimates about future business environment, which may or may not materialize, hence readers are requested to do their own due diligence.

Final Intrinsic Value
In summary, here are the approx. intrinsic valuations calculated as per various methods…

  • Discounted free cash flow – Rs 385
  • Dividend discount & terminal book value – Rs 330
  • Relative valuation – Rs 570

Based on these, the fair value range for Cairn’s stock comes to around Rs 365 to Rs 425 per share.

Assuming a margin of safety of 30% to the average of this range, the safe purchase price for Cairn is Rs 275.

Don’t ignore the risks!
Crude oil price dependence: Cairn’s revenue is based on crude oil prices, and any decline in oil prices can impact the revenues.

Foreign currency risk (Rs. Vs $ rates)

High cost of exploration: This can be a challenge if there are unexpected costs that add up making the project less profitable.

Judgment of reserve estimate: The approach taken by Cairn in judging estimate has been reasonable or on the conservative side.

Govt. approvals/permissions: This is an integral part of the business, and also serves as a Barrier to Entry. Given that we are an energy-deficient country the Government realizes the importance of exploration and has been encouraging the sector. However, getting timely approvals can be a challenge. If the business plans and execution is good then getting these approvals in place should not be an issue though it can be time consuming.

Potential shale oil supplies: Recently the US as well as other countries have initiatives shale gas exploration, which is a different method of exploration that is expected to bring in new supplies. Sale exploration involves fracturing from rocks below the surface. If there is a bumper output from shale production, oil prices can decline, and competition may arise. However, the above is mitigated to an extent because shale exploration process is highly complex, expensive and the costs involved will motivate suppliers to price oil higher, because the process is currently more expensive than conventional exploration. (I’m not an expert in this – someone from oil industry can comment on this.)

Demand: Some industry experts view that demand may reduce or saturate, and there are talks about shale boom leading to high supply-low demand situation. But if we look at India itself, which is within our Circle of Competence, the demand for fuel is very high – be it for petrol, diesel, gas variants, etc. I recently heard from local autowala that CNG prices have been increased on various occasions. And they still have to use it as CNG has fitted vehicles are becoming common.

Challenges and barriers mentioned above such as high cost, uncertainty, environmental or social issues, royalty fees, etc. are sometimes discouraging many global players in to venture in to this space. Nevertheless Cairn, BP and several other are exploring select pockets of opportunity.

Recent developments
The company’s Chief Executive P. Elango recently said, We plan to drill more than 450 wells in Rajasthan block over a three year period, a significant increase from the current rate of 25 wells drilled in FY2013.

“The Rajasthan block’s current production is at around 175,000 bpd (barrel’s per day). We expect to exit FY2014 with a production in the range of 200,000-215,000 bpd.”

Cairn’s current production comes from five fields – Mangala, Bhagyam, Aishwariya, Raageshwari and Saraswati. The Mangala field, the management has said, is producing at plateau rates of 150,000 bpd.

Aishwariya commenced production in March and is expected to ramp up to approved rate of 10,000 bpd over the next few months.

Bhagyam, the second biggest oilfield behind Mangala, is expected to ramp up to the approved rate of 40,000 bpd by the second half of current fiscal.

Disclosure & Disclaimer: I, Sridhar V, hold Cairn as part of my personal portfolio and may have recommended to others. Readers are advised to do their own independent assessment and take professional advice before taking any decision. You can expect some errors or forward looking statements, so do your own research as well.



Attention: Safal Niveshak RSS Subscribers
In case you haven’t heard, Google Reader has shut down today onwards.

If you’re a Google Reader user, that means you’ll need a new tool to read your subscriptions.

Option 1 — Subscribe by email
This is the best option and many of you have already converted. If you subscribe through email, you’ll also get exclusive content that I just can’t provide over RSS.

Click here to subscribe by email.

Option 2 — Pick an alternate RSS reader
You’ll need to pick a new reader. Feedly seems to be doing well and they have a one-click Google Reader import.

Whatever your choice, please keep reading Safal Niveshak. 🙂

Print Friendly
About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.

Comments

  1. Chiradeep Rao says:

    Dear Sridhar :

    Enjoyed reading the analysis.

    I would still not buy CAIRN as a long term buy & hold for one reason and that is Vedanta. ( you have mentioned that as well in your note on management ) .

    Past history on corporate governance with the Vedanta Group has been patchy. There are a lot of unhappy campers with the Sesa Goa/ Sterlite Industries merger ratio and valuations . There is nothing to stop Mr Agarwal from using the cash on CAIRN’s books for another acquisition which may be good for Vedanta as a group but not so good for CAIRN share holders.

    For me its a good short term trade when it falls but it does not make it to my long term portfolio.

    Cheers

  2. Bhushan says:

    Good analysis. If you take out the new owner factor, then it is a gem. But with some owners, you have to be careful. What if they divert cash from one business to other? It is possible in india and with our ‘stringent’ monitoring mechanism. Also this company will undergo lot of restructuring and mergers.

  3. Thanks for the analysis Sridhar!

    Here I am reminded here of Buffett who said – “Somebody once said that in looking for people to hire, you look for three qualities: integrity, intelligence, and energy. And if you don’t have the first, the other two will kill you.”

    I believe Anil Agarwal and his Vedanta Group seriously lack in terms of integrity and have mistreated minority shareholders and other stakeholders in the past. So I would rather make a mistake of omission here rather than one of commission. Not to say that Cairn’s business remains outside my circle of competence.

    Here’s a Wikipedia link that suggests that varied violations that Vedanta has committed in the past, and I am sure this would continue in the future as well.

    Plus, how do you answer the question that precious cash from Cairn won’t be diverted to satisfy the Chairman’s whims?

    Talking about valuations, I believe you need to take the same discount rate for calculating IV using DCF and DDM. And the terminal growth rate cannot be more than 1-2%, as if the company were to grow at 5% till eternity, it will someday become larger in size than the world GDP! Regards.

  4. Maheswar says:

    Thanks for the analysis Sridhar.

    Based on what little I know about Production sharing contracts in E & P industry, the contract signed by Cairn for the Rajasthan field seems to be currently upto 2020. After that they have to renegotiate with the govt to extend the contract and the terms of the contract could change significantly after 2020 which may not be to the benefit of Cairn. Same applies to other fields although the dates may be slightly different.

    Also Cairn seems to be enjoying a lower corporate tax rate currently which is expected to go up from FY17 based on what i read on the internet. Comment from Kotak Securities from last year – “However, a higher production profile beyond FY15 without a considerable increase in reserves is unlikely to change the valuation of stock meaningfully given (1) the peculiar nature of production sharing contract, under which share of profit petroleum of the government will rise from the initial 20 per cent to 50 per cent (by FY16 as per our estimates) in stages, based on cost recovery and (2) applicability of full corporate tax rate of 32.4 per cent from FY17.” In view of the recent upward movement in crude prices, several brokerages have also revised the company’s earnings estimates”. Here’s the link from where i got this info.

    The above two factors may affect future valuations. Just my two cents worth.

    Regards

  5. Hi Sridhar,

    Fellow Cairn India investor here.

    Here are some observations I made in your analysis:

    1. Production Sharing Contract: In India, mineral rights are owned by the Govt. i.e. if you find oil under your land it is not yours but the govt’s. So the Govt enters into a production sharing contract with an operator who will drill and extract the oil. All exploration costs have to be recovered from the sale of oil extracted (this is called cost oil) and the remaining oil (profit oil) is divided between the govt and the operator depending on the investment multiple. So basically what this means is out of the 200,000 barrels produced in RJ, 30% will be taken by ONGC as JV partner after Cairn India costs are reduced . Out the remaining 70%, Cairn India will be eligible a minimum 50%. Cairn’s operating interest in Cambay and Ravva are much less, like, 22.5%. The RJ PSC is also expiring in 2020 and therefore if it is renewed govt will negotiate a higher profit share which I think you may not have factored in your model.

    2. You have mentioned that Rajasthan asset has a potential of 7bn barrels. But that is just the Oil in place. Most of it will not be recovered. Less than 30% of that will only be recovered. That 30% is called recovery factor. if my memory serves me right, currently only 1.2 bn is recoverable. Again, only 70% of that is for Cairn and upto 50% will to go the govt based on the investment multiple. You have also assumed that production will grow, most oil fields hit a peak and then production declines. The Mangala field is already in decline I think. This means you cannot model growing revenues.

    3. You have also used the dividend discounting and terminal book value method. I think that this method is not appropriate for an oil company, especially Cairn. Cairn assets are mostly capitalised exploration and development costs which will have to be written down as production takes place. DCF model is unquestionably superior in this situation.

    I recommend that you read more about the RJ block which is the chief asset of the company from its RHP that it filed with SEBI at the time of IPO. Further, if you are interested you can read “The Prize” and “The Quest” by Daniel Yergin. “The Prize” is like the oil industry bible. There is also another book called Oil 101 which helps too.

    Also you are welcome to review my rather incomplete Cairn India DCF model. I will email it to you, if you can give your email. I can also also go through yours if you are comfortable with that.

    Thanks
    Arun

    • Hi Arun,
      I take all your points and feedback.
      I fully agree that my valuation, models, etc are not perfect. I’m not a full-time analyst tracking Cairn, so I have taken a constant production for most wells assuming a peak.
      Probably i’ve missed a case where the wells can drop in production. But I’ve also not taken any additional production from Srilankan project.
      I frankly dont have all the information 100% to be precise on the value or future prospects. Please do share your model, from which I can learn more.
      I’m not aware of any market research or study where one can forecast the sales or EPS of any manufacturing company with precision, as we may not know the future demand and supply and how the company plans to produce and sell. In case some one has this info. it would be a useful guide.
      Unlike other industries such as FMCG, telecom, auto, metals, etc this sector is based on new opportunities and projects. It has similarities to infrastructure sector, which involves huge initial outlay and returns kick in later on. The same risks also apply to players such as ONGC, RIL, etc but since their wells are more mature investors are confident in them. If Cairn manages to bring in more projects in its pipeline we can see more stability, but till then the risk of projects losing steam exists.

      Appreciate everyone for their comments and suggestions.
      BTW let me tell you that I’m not a supporter or activist of the group. As long as this company is well run I would hold the stock. To my knowledge Cairn is not involved in any issues so far.

      • Arunkumar L says:

        Your email, Sir?

        • Sridhar says:

          Hi Arun,
          I agree with your points on Production Sharing Contract and this will actually make the Relative Valuation wrong or quite different as ONGCs share has to be taken out of the calculations. I accept my mistake of ignoring the sharing aspect. The assumptions under Relative Valuation are too simplistic hence that value is not given much importance.
          The other two methods which are based on Cairn’s DCF and BV-TV method would be more reliable.
          Hence the valuation range of Rs 365 to Rs 425 is used.

    • Shivam Mundada says:

      Please send DCF model for Cairn India as I want to submit it for competition in NMIMS , Mumbai called as ShareLock and I am still not getting any model to decide whether to buy or hold stocks of Cairn India

  6. Thanks. It was a very good read.

    Some observations:

    The future FCF table does not show the Terminal Value, though you have considered it in calculating the NPV per share of INR 385. A significant value (more than 40%) comes from the Terminal Value. Thus, we are paying for things that we expect to happen post 2022. That is a scary thought! Can we really predict the Global Factors that determine the Oil Price so long into the future?

    Why would the book value grow only by 7.3% CAGR. Wouldn’t the book value growth be equal to Opening Book + Cumulative Profits – Cumulative dividend. The thing is that if the Company does the FCF as we are assuming in our first model, the terminal book value would be much larger than 513. We may say that we are being conservative, but wouldn’t there be an inconsistency in Model 1 and Model 2? Or I am missing something here?

    Our analysis takes as base the Current Oil Price, and goes into the future with this assumption. But, do we really know if the Current Oil Price is a good staring point? Rather, we should do the valuation assuming some normalized Oil Price, say a Price which gives us a intrinsic Margin of Safety. Who knows how alternate fuels would affect demand for oil and gas in the future (which we are considering in valuations)? There are many reports predicting the doom of hydrocarbons.

    While there are many reasons to have a doubt on the integrity of the Vedanta Group, I think they have handled Hindustan Zinc very well. It is one of the best turnaround stories, post privatization. But yes, that Group does not have the perception of good corporate governance in the minds of investors.

    I would also like to admit that while I have some questions on the analysis, I do not have better alternatives to value the business. Like Buffet says, “I have three boxes on my desk: In, Out, and Too Hard”.

    I would put Cairns into the “Too Hard” box.

  7. A difficult situation or a stock can be an opportunity for someone, while it could be Too Hard form others. Each individual can have their own opinion.
    A large shoe company which did a market study in interior Africa found no opportunity since people didn’t use footwear. However, their competitor thought that the market was virgin, untapped and had a huge potential. So its just the way you look at it or perceive it.

    • Thanks. I take your point. Appreciate it.

    • Hi Sridhar, I think Rohan is not opposing your views here. He had asked some pertinent questions that you can respond to clear his doubts and put forward your stand.

      • Sridhar says:

        Hi Rohan,
        Ill try to answer your specific questions as far as I can.
        PV of 10 year cash flows = Rs.38619 crores
        PV of Terminal VAlue = Rs.34598 crores
        The Rajasthan project in my humble opinion is expected to go on for another 20 years from now. So the Terminal Value can be the value from years 11-20.
        So we are paying 40% for the cash flows from years 11-20, as you rightly pointed. Its been discounted but we are paying for it. This is not very different for any oil and gas exploration or production company, but since Cairn is a new player your concern or risk is a valid point.

        Book Value growth of 7.3% – I’ve used the past growth rate as a reference. It is a conservative number, and I’ve deliberately been conservative here. If the company makes a 20% dividend pay out its growth of BV will be slow or gradual. In this method I’ve been conservative to be frank. These are my assumptions which can be wrong but I have been conservative and believe I’ve been reasonable.

        Oil Price: Cairn sells brent oil and its oil is priced at 10-15% discount to brent. Going by current brent price of about 105 we may get some number around $90. However, I have assumed a reasonable estimate or $80/barrel.

        Alternate Fuels: If people start using alternate fuels instead of crude, then such a dramatic scenario is beyond the scope of our model. In that case one has to use common sense and exit (sell). This point can be added under Risks – pls forgive me if I forgot to include this.
        When alternate energy becomes cheaper than crude and widely available then that risk exists.

        Doom of Hydrocarbons: I personally think its still far away – I frankly dont have any data or research with me to validate this. Please dont believe me or take my words. Alternate fuels might be technically possible, but making it available commercially and on a mass scale is still a challenge. I like to invite other experts to share their views on this.

        Corp. Governance: So far I’ve not seen any issue, but its a potential risk.

        All said and done, its a large business dependent on new opportunities and projects, which can be compared to sectors such as real estate, infrastructure, projects, contracts, etc. Cairn is capable of bidding and executing new projects in India and abroad. This is difficult to quantify and I’ve not included in my model. However, business analysis is not just based on current data and excel modeling……one needs to understand the business potential as well. This is what we call “Going Concern”. If the company is not capable of executing, then its life will be finite, else the company will adapt to new markets, products (alternate energy), trends, etc. I wish I could put all these scenarios in the model – but its not that easy -:)

  8. Ashok Manek says:

    Good analysis….

  9. Sridhar,
    With all due respect, I’d be short Cairn. Mr Agrawal is up to the gills in debt in entities which were used to acquire Cairn. These debt loads will shift to Cairn or a merged, de-merged, restructured entity in whatever form. If Cairn can be stuffed with debt, I’d bet that it will be.
    I don’t intend to find fault. One thing that I have done a lot and very successfully when it comes to these bigger companies that have decent news and research coverage is to dig through past.

    I am quoting a May 2012 Financial Times article: “In 2010 it bought Cairn India, owner of a magnificent oil prospect discovered by Cairn Energy. Vedanta didn’t have the money, but Sesa Goa and Sterlite did. They were tapped for cash and reorganised to suit the parent’s needs. The result is the fine iron ore mine which had drawn investors to Sesa is mixed with oil, another business entirely. They have run for the hills, and the shares have fallen 60 per cent from their peak that August. … Like Sesa, Sterlite and (now) Cairn India, the interests of outside shareholders are subsidiary to those of the controlling family. And the Lex column in Mar 2012: “So Mr Agarwal could look clever this time. But that should not stop him working harder to dispel the sense that he is surrounded by eunuchs too reverent to point out how opaque his company seems to investors. Vedanta’s share price, down 40 per cent over the past year, illustrates this mistrust. Again and again, they are asked to believe in the latest deal, in spite of a looming commodity-cycle downturn.” Ouch …
    You’ll probably glean more by reading Vedanta’s annual reports and filings than looking at Cairn in isolation.

  10. Saurav Jalan says:

    Hi Sridhar,
    Nice Analysis. Would also like to thank you for your effort for writing down your views about the company. I would like to bring forward a few points based on my understanding about the business and the company.
    In a commodity business, the competitive advantage lies in being the lowest cost producer and Vedanta group has acquired an expertise in being one of the lowest cost producer in the world in non-ferrous metals business like zinc, copper, aluminium etc over a period of time. Although, there have been many environmental issues with regards to the Vedanta group and some financial issues in the Sesa-Sterlite merger but that doesn’t discount the fact that the promoter of Vedanta Group Mr. Anil Agarwal has been a self made billionaire and one of the largest wealth creators in the history of Indian business. Moreover, even at 59 he is as hungry, determined and enthusiastic as he was at the age 17 to build institutions which could outlive him. If we consider the last decade i.e 01.04.2003 – 31.03.2013 then two of his companies viz Sterlite Industries and Hindustan Zinc have been 912 !! and 760 !! baggers respectively based on the closing prices at BSE between the given time period after adjusting for bonuses and splits but sans dividend. This is much more than the so called HDFC’s, Infosys’s, ITC’s, Nestle’s, HUL’s etc who pride themselves of their corporate governance and ethical leadership. Moreover, these days a ‘jamat’ of NGO’s have mushroomed all over India the accountability of majority of them is very much questionable themselves.
    Now talking about Cairn India, which is a prized jewel in the Oil & Gas exploration business. It is amongst the world’s fastest growing independent Oil and Natural Gas exploration and production companies in the world with 1.3 billion boe of gross proved and probable reserves and resources as of 31 March 2013. Has won the award for the fastest growing energy company in the world at the Platts Top 250 Energy Company Awards 2012. It has also won the Golden Peacock Award 2012 for excellence in Corporate Governance.
    Also, it is one of the lowest cost operator; placed in the lowest decile amongst the global peers which is a huge moat in a commodity business as during downturn when everybody else will die the lowest cost operator will die last. The government is sincere about reducing the import bill and Cairn India has and will play a big role to achieve this objective in my opinion. As many facts have already been mentioned above in the above post and subsequent comments, so I would skip that and would like to present my views on the company for the next 5 years .
    Some common sense analysis based on FY 13 numbers:
    Balance Sheet: Very Healthy with no debt and more than 15K crores in cash and equivalents translating into cash per share of Rs 83.44.
    Net Capex through FY 2016 is US $ 3 billion almost all of which would be taken care by the cash reserves.
    PAT = Roughly 12K crores translating into a diluted EPS of Rs 63.06, a 51.55% growth over previous year.
    Earnings yield @ACP of Rs 290 = 63.06/290*100 = 21.74% almost thrice of current 10 year bond yields of 7.5 %. Your partnership in the business as a minority shareholder is fetching you around 22% annual return which is thrice the risk free return. How long would this gap remain is only a matter of collective wisdom but for me this looks awesome presently. The company is paying around Rs 11.5 out of it in the form of dividend translating into a dividend yield of around 4% tax-free in the hands of the investor. The company has framed a policy of around 20% dividend payout including DDT.
    Earnings yield after adjusting cash = 63.06/(290-83.44)*100 = 30.53 % almost 4 times the current bond yields.
    ROIC based on FY 13 results = 35.30 %; Net Cash flow from operations = Around 11K crore rupees. Almost the entire PAT is almost falling to net cash flow from Operation. Since, the next 3 years capex could be funded through cash reserves so I am considering that almost the entire net cash flow from operations would be FCF. This translates into FCF of around Rs 58 per share.
    FCF Yield based on FY 13 earnings = 58/290*100 = 20% almost 2.75 times the current bond yields of 7.5.
    Since, the business is heavily regulated and subjected to Govt. Policy fluctuations, it wouldn’t be prudent to take a 10 years+ view in estimating earnings considering the general elections next year. So, I am taking 5 years view in my estimation.
    Estimated FCF (assuming 15% conservative growth) for the next 5 years = 58(1.15) ^5 = Rs 117 per share. Let’s assume that the market re rates the stock like it has done presently at 5 times FCF.
    Present Valuation given by the market = 58*5 = Rs 290
    Valuation in 2018 based on present formula = 117*5 = Rs 585
    Stock CAGR return (5 years) = 15%
    These are extremely conservative numbers and the company is growing at a much faster pace than the above estimation. The stock has the potential for significant upside as the nature of the business has the potential to bring positive black swan discoveries. Also, they will start the commercial distribution of gas in the current year itself and the government has already doubled the gas prices to $8.4/mmbtu. The cost of extracting this gas for Cairn India is lower than ONGC and Oil India at $ 3/mmbtu. This would also be an additional source of revenue.

    So, in the words of Mr. Mohnish Pabrai “Low risk with uncertainty is an opportunity to create phenomenal amount of wealth.”

    Disclaimer: I hold this scrip in my portfolio and my opinions could be biased.

    Thanks
    Saurav Jalan

  11. Vikas Bargale says:

    Hi,
    Good analysis and excellent discussion on Cairn India.
    But one basic thing. Please name me one great investor who has made great money in oil stock ( not commodity)
    As far as my reading goes, none.
    So in simple, Oil stocks are out, more so if its out of your circle of competence.

    Regards,
    Vikas

  12. Saurav Jalan says:

    Dear Vikas,

    Warren Buffett had made a 7 bagger in Petro China between 2002-08. Also, I guess lot of big investors in US might have made money in Exxon Mobil John D Rockefeller Sr. being the greatest of all of them as a promoter investor of Standard Oil. Harold Hamm the CEO founder of Continental Resources is a dollar billionaire because of his 70 per cent stake in the company according to Forbes magazine. The majority of Middle-East and Russian billionaires have made money in the Oil and Gas business. They may not be as famous as Buffett or Charlie Munger but they are seriously wealthy.

  13. Sridhar says:

    Hi Saurav,
    Thanks for sharing the interesting facts on successful oil investments and also for the comments on Cairn. Its quite interesting.
    Past facts show that investing in oil and gas is not an untouchable for investors. Whether to pick Cairn or not is an individual’s choice.

  14. Vikas Bargale says:

    Hi Saurav,
    Thanks for the info, you provided. I think its my lack of reading. My mistake!
    But one point you should also understand that the great investors, who made money in Oil stocks, must be in the board of directors and know all the insider info.( In fact, this is also one of the reason for such huge investing success of WB) But such things are not possible for small retail investors like us.
    So one of the best way in stock investing is invest within your own circle of competence.

    Regards,
    Vikas

  15. Nice analysis, thanks for sharing.

    I would not invest in the company as the management is not supposedly investor friendly. I cannot easily understand the sector as well.

  16. Great Analysis! By reading other comments, I strongly feel better to stay away as there are other stocks may give better results than Cairn. Will want and see for other stocks which will come in Stock talk.

    Thanks!
    Naveen

  17. This is just brilliant analysis…… I am a very naive investor, who just picks out great well known companies and buys the shares…….sometimes it works, sometimes it does not……this kind of analysis is a revelation to me. I hope I can analyse my investments like this some day. Need to learn a lot.

  18. This is my first day in this website….and I am just loving it….its just wonderful 🙂

  19. Mokhtar says:

    Hi Sridhar and all those keeping a watch on Cairn,

    What have ul made of the latest quarterly results?

    Positives:
    Higher PAT
    Higher Other Income(what is it?)
    Rajasthan block maintaining its production and on tract at 180000bpd.
    Government gas pricing policy favourable
    EOR approvals received(shows that they can achieve 200-215000 bpd by year end.
    All Blocks had some progress as indicated.

    Negatives:
    Srilankan block still a drag. No significant monetization of the discovered gas well.
    Lower Sales figures
    Pledged shares. Dont seem to understand Why!!!)
    Rajasthan block profit payout to government rose from 20%to30%.

    Overall Cairn seems to be panning out well.

    Any thoughts?

  20. Hi Mokhtar,

    The Q1 results were not good frankly, because one would expect higher sales and profits given higher output and favorable currency trends.
    Sales and profits de-grew in the quarter, which was disappointing. This is also due to the profit petroleum payout to the Govt.
    This will have an impact in future as well, but that does not undermine the fundamentals of the business which are still strong.

    I’m not sure about the Other Income part. Probably you can check the 2012-13 annual report notes to know more. I guess it must be related to forex gains but not sure about it.

    Srilanka Block: I think they are still working out the options for commercialization. Given that this is a highly regulated business it may take time. Let me know in case you find any news on issues or concerns. It took many years for Rajasthan to monetize and deliver profits, so it can be patience testing.
    Lower Sales: This is due to higher profit share and lower crude realizations (discount to brent was more).
    Pledged Shares: Looks like foreign promoter share are pledged. I dont have much details. If someone here knows about this please share the same.

    Dividend payout has also been consistent with what they promised.

  21. Rajendra says:

    Dear Vishal
    It is July 2014, one year after Sridhar had written this report. it is unfortunate that I did not visit this site before. I had been a investor in Cairn India. Have already exited from this investment with huge loss.
    Had I read the comments above before, I would have not invested in this company. The great lesion: Integrity of management must be the 1st parameter in selecting the stocks for investment. Mr Agrawal again did the same mischief in July 2014 with the minority shareholders by doling out money from Cairn to his sister companies. (of course at this low interest it can only be termed cheating)
    Vishal you are doing a great service to investors. Thanks to you.

  22. Vishal / Sridhar, The article is indeed very detailed and gives deep insights.

    As you rightly mentioned, the main risk Cairn India faces in the Crude Oil price. Now with Crude coming down to below $50, what is your view in Cairn India at current levels ? Buy / Hold / Sell ?

  23. Cairn seems to be trading below fair value in above article. And that is when markets are making all time highs…
    Is it a good time to average down? Or with AA trying to merge all 3 of his cos.. its better to exit?

  24. Dear investors,

    Cairn india has been a significant underperformer in the past 1 and half years (perhaps the most in Nifty). However, it has corrected substantially. Is it a good buy at around 195? It is trading below its book value.

  25. Parvin Worliwalla says:

    Vow! That was like an exhaustive primer on Cairn India 🙂

    Everyone knows the corporate misgovernance prowess of Mr.Agrawal (LOL) and so I was just trying to check up on what’s happening in Cairn now, that I came across this article.

    The comments are all so insightful, and whatever could go wrong has all gone wrong! Vedanta is siphoning off cash from Cairn, the merger push and oil prices down!

    This case reinforces two lessons for me:
    1. Integrity of promoters if the most important criteria. As Buffet says “You can never have a good deal with a bad person”
    2. Don’t mess around in companies where success and returns to shareholders depends on too many key variables

    Also, what struck me was the humility of some people to accept mistakes in their research. Its an amazing quality to have. 🙂

    A similar merger and IMHO misgovernance is the case of Tata Metaliks merger into Tata Steel. Too bad that such a respected name can also do something similar to Vedanta!

Speak Your Mind

*