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.
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
- 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
- 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.
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.
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. 🙂