The share price of Cairn India has jumped 35% in the last 7 weeks, in part due to a recovery in oil price. We believe that the current share price does not offer any meaningful upside to our target price and hence we downgrade the stock to Hold from Buy. Note that our valuation builds in HSBC’s house view of Brent price at $45/60/75/b for CY16/17/18e.
Production from Cairn’s most important asset, the Rajasthan block, has peaked: The Rajasthan asset constitutes 95% of the value of all upstream assets of the company as per our estimates. We think the benefit of the ongoing enhanced oil recovery methods is, at best, likely to offset the natural decline in the producing reservoirs in the Rajasthan block. The company is already pumping about 400kb/d polymer based fluid to augment production. Note that the Rajasthan block has a current production of c175kboed. We are assuming flat oil production near term and a moderate decline thereafter. We also assume that the government will get a 10% additional share in profit, once the Rajasthan production sharing contract is extended beyond 2020.
Corporate actions will continue to be an overhang on the stock: Cairn India gave a loan of $1.25 bn to a group company in 2014 on a two-year term. We believe investors would have preferred that the company returned excess cash as dividend.
Additionally, as per the stock exchange filing by Cairn India, Group Company Vedanta has offered to merge Cairn India with itself. As per the merger proposal, minority shareholders of Cairn India will receive for each equity share held:
(i) One equity share in Vedanta and
(ii) One redeemable preference share (7.5% coupon and tenure 18 months) in Vedanta with a face value of R10. We believe the proposal requires an approval of a majority of minority shareholders of Cairn India. The acquisition proposal is out of the money for Cairn India’s minority shareholders on the current price. We believe this will continue to be an overhang on the stock near term.
Valuation and risks: We continue to value Cairn on the average of two methods: (i) reserve-based DCF valuation (Rs 150, previously Rs 148), using a WACC of 11% based on a risk-free rate of 7% and a beta of 0.8 (changed from 8% and 0.7 respectively) and (ii) discounted dividends over the contract life of the Rajasthan block, plus net cash (Rs 119 adjusted down from Rs 121). We use the discounted dividend method as we believe that in the medium term, shareholders are likely to benefit mainly from dividend and cash on company’s books. Upside and downside risks include higher or lower oil price than our assumption.
Cash on books the main source of Cairn’s value: Cairn India’s most important asset is its 70% stake in Rajasthan oil block. However, the majority of Cairn’s value in our estimates is owing to cash on its books. The company has cash on its books equivalent to Rs 99/share. The company has further lent Rs 1.25 bn (equivalent to Rs 42/share) to a group company that comes up for repayment/renewal in May 2016. We believe this money is unlikely to get repaid and the group company, given the cash situation, may want to roll forward.
PSC extension likely but at higher government profit share: Additionally, government in a recent policy statement, has mandated increase in government’s profit share by additional 10% once the production sharing contract (PSC) comes up for extension. Note that Cairn has filed a case at Delhi High Court seeking an early resolution of Rajasthan PSC extension. Therefore, government may rather wait for court judgement before finalising its stand on extension of Rajasthan PSC. We, in our estimates, are assuming that the profit share of government will increase 10% on extension of the contract (PSC) in 2020.
Merger proposal is an overhang
As per stock exchange filing by Cairn India, Group Company Vedanta Ltd (VEDL IN, CMP: R89, Buy, TP:R100) has offered to merge Cairn India with itself. Company has sought approval from the High Court before proceeding with the offer to minority shareholders. Additionally, Cairn India gave a loan of $1.25 bn to a group company in 2014 on a two-year term. We believe investors would have preferred that the company returned excess cash in form of dividend. We also believe that this amount is unlikely to get repaid in 2016, but would rather be rolled over at its current coupon of 3mUSD LIBOR + 3%, much lower than the current yield of c23% on Vedanta Plc bond.
Production to remain flat. We expect production to remain flat for some more time before declining moderately.