Australia | Feb 04 2010
By Chris Shaw
Arrow Energy ((AOE)) has around 5.5Tcf (trillion cubic feet) of gas reserves and is on the verge of becoming the world’s first CSG-to-LNG development company without having to involve a major global player in the oil and gas sector. However, the market continues to have mixed views on the stock, as evidenced by the FNArena database showing a total of four Buy ratings, five Holds and one Sell recommendation.
Two to initiate coverage on Arrow this week were Macquarie and Bank of America Merrill Lynch. Again both stockbrokers offered different views, Macquarie putting an Outperform rating on the stock while BA Merrill Lynch was more cautious with its Neutral rating. Valuation has played a role in both cases, with Macquarie conceding the stock is not cheap in the context of the sector overall and BA Merrill Lynch seeing scope for investors to find a cheaper entry price in coming months.
What attracts Macquarie is the combination of what it considers an unmatched growth trajectory and the potential for a major player in the industry to be interested in acquiring Arrow’s assets in the future. These factors in combination justify a premium rating in its view and so offset the fact the stock is not cheap on fundamentals.
What Macquarie sees as the major constraint for Arrow is not geological issues but management’s ability to seek out viable commercialisation routes for its gas. This is having the effect of shifting focus to downstream issues and away from management’s core skill of cost efficient coal seam gas (CSG) production. It also means more work is being done in capital intensive areas where Arrow has few natural advantages.
Management has proven it can do a good job, BA-Merrill Lynch pointing out over the last ten years the company has generated annualised shareholder returns of 35%, though a good part of this share price performance occurred in 2007/08 when the battle for coal seam gas assets in Australia was at its peak.
On the plus side is the Fisherman’s Landing project, where a Final Investment Decision (FID) is due sometime in the current quarter. The lack of a major partner means there is more risk, but as Maquarie notes there are more than sufficient gas reserves and a buyer already secured for the project’s output, which means the first train of the project is likely to happen.
BA-Merrill Lynch agrees Fisherman’s Landing is likely to get the go-ahead but suggests a March quarter timetable for FID now looks optimistic. Assuming it drags into the June quarter BA-ML sees scope for the share price to come under some pressure, so potentially offering investors a chance to get set at a lower level.
The other point made by BA-ML is as the company moves to develop Fisherman’s Landing, the next stage of development poses new challenges and while the stockbroker has confidence in the management team, it simply doesn’t see enough value to be more positive on the stock given the current risks. Supporting this is BA-ML’s estimate of a bear case – bull case valuation range of $2.40-$8.70. Within this its base case valuation is $4.31, which assumes two LNG trains at Fisherman’s Landing by 2014 and some new domestic gas contracts.
BA-ML agrees with Macquarie’s view as the only large, pure play CSG company in Australia Arrow could be attractive as an acquisition target for a larger player. But BA-Merrill Lynch also believes there are some factors making a bid less likely in the shorter-term. The first is Shell’s stake in Arrow as this effectively limits the potential number of suitors. BA-ML doesn’t see Shell looking to take over the company unless the valuation equation is more attractive.
Macquarie also notes the relatively full valuation on which Arrow is trading at present assumes Shell commits to building an LNG project at Curtis Island, but as that company’s intentions remain unclear, there remains a risk Shell eventually decides to walk away from the proposed development.
Taking a longer-term view, BA-Merrill Lynch suggests the optimal monetisation path for Arrow’s Australian resources is through export-oriented LNG markets. It is its view the likely LNG supply side winners will be defined by asset quality and the strength of customer relations. For Arrow specifically this implies some risks when compared to more conventional developers such as Oil Search ((OSH)), which reinforces the stockbroker’s view the value simply isn’t there to be more positive on Arrow at current levels.
What makes UBS positive on the stock is the potential for further upgrades to reserves, while Credit Suisse is also positive on the potential for Arrow to announce possible expansion options later in the year. But as Deutsche Bank points out, there remains scope for project delays given the use of different technologies, while Deutsche is also cautious on the possibility of capex at Fisherman’s Landing increasing above what is currently expected.
Macquarie’s initiation comes with a price target of $4.35 while BA-Merrill Lynch’s target is $4.31, which compares to an average price target according to the FNArena database of $4.67. Targets range from Citi’s $6.13 and Credit Suisse at $5.50 to Deutsche Bank at $3.75.
Shares in Arrow today are slightly weaker and as at 12.10pm the stock was down 5c at $3.61, which compares to a range over the past year of $2.11 to $4.73.