What’s Bugging Santos?

This story features SANTOS LIMITED, and other companies. For more info SHARE ANALYSIS: STO

In this week's Weekly Insights:

– What's Bugging Santos?
– My Rant
– M2 Attractive, If You Don't Mind The Debt
– Reporting Season: Surprises & Disappointments
– This week's presentation at PhillipCapital in Sydney

What's Bugging Santos?

By Rudi Filapek-Vandyck, Editor FNArena

The energy sector has been one of the best performing in 2014, despite an overall lacklustre ASX200 index performance thus far. Investors owning shares in Woodside Petroleum ((WPL)) and in Oil Search ((OSH)), sticking with the large caps, have enjoyed solid gains, plus dividends, with more of the latter to come in future years.

Those owning Santos ((STO)) shares do not share the general enthusiasm that has enveloped the energy sector and judging by the questions received in the week past, they are questioning as to why Santos shares are not participating in the sector's outperformance.

Not only have Santos shares been left behind thus far in 2014 with the share price virtually unchanged since early January (paying a low-ball dividend only), at a price of $14+, the share price is at the same level as in early 2012, where it was in 2009, and even in April 2008.

To be fair, a similar observation can be made about shares in Origin Energy ((ORG)) which is also working hard towards completion of a mega-LNG project in Queensland. As it happens, share prices of Santos and Origin are currently both around the same price (face value), but Origin offers a much higher dividend yield on the back of its cash flow generating power grid network and retailing operations.

Analysts at UBS recently mused Origin shares are likely held back by serious question marks, and low returns, from its power grid-related operations. This is probably correct. I wrote about the industry's longer term structural challenges in February (see Weekly Insights "Boring Today, In Turmoil Tomorrow", published on 17 February 2014) and it is probably a fair call investors are now waiting to hear more good news about further progress in completing APLNG while keeping a wary eye on the stabilising trend for what once were solid, reliable growth engines for the company linked to Australia's power grid.

But at least Origin shares have participated in the sector's outperformance this calendar year while Santos' shares have not, yet Santos' stands to benefit from early progress and success at the Oil Search ((OSH)) linked PNG LNG project. This does not make a lot of sense, at least not at face value.

What then is holding back Santos?

In one word: risk.

A few months ago energy analysts at JP Morgan calculated that if Santos were to adopt the same dividend policy as has Woodside Petroleum, its implied dividend yield could potentially be as high as 14.4%, franking included. Assuming investors were to give Santos the same treatment as they have given Woodside shares, this then implies the share price seems destined to surpass its all-time high of $20 reached during the crazy, hazy days of mid-2008, when the financial world temporarily believed an oil price rise from US$70 to US$137/bbl would not lead to a global recession.

Financial markets don't pass up a guaranteed good news story, so the risks associated with JP Morgan's potential (!) scenario are today simply too high for general comfort. Lucky for us investors, the company invited the analyst community over to visit its mega project under construction in Queensland and some have used the opportunity to update on their questions, doubts, worries and concerns regarding the company's future.

Short term uncertainties:

– Santos became a major player in the non-conventional gas scene in NSW through the acquisition of Eastern Star Gas which subsequently has been proved a less than perfect operator. As such, Santos' operations at Narribri are at risk of regulatory backlash, if not of challenges from opponents through NSW courts.

– The Enterprise Bargaining Agreement (EBA) between project contractor Bechtel and the unions expired on 5th June and a new agreement has not been signed, lifting the risk of strike action on Curtis Island. This can impact on the overall schedule of the project and Santos would likely miss its target of first LNG sales in Q3 2015 were the unions to decide to interrupt work. While this represents a minor impact overall, it is being perceived as an uncertainty, regardless.

– An US$18.5bn costing project based upon non-conventional gas extraction and including a 120km pipeline from The Comet Ridge to the Wallumbilla gas hub (with gas pipeline running to/from Cooper Basin, Brisbane and Gladstone) connecting to a 420km GLNG pipeline at Fairview, always runs the risk of technical difficulties and cost over-runs. While management has kept commentary sufficiently vague during the recent site visit, most analysts report post visit their overall confidence has risen. But all also acknowledge the project is still far from completion. Officially, the project is now over 80% completed. As things stand, Santos' GLNG is likely going to be the last to come online, shortly after Origin's APLNG in Q2-Q3 next year.

As usual, the devil tends to hide in details. Macquarie analysts, for example, report that while Santos is sticking to its US$18.5bn capex cost estimate for the project (for now), this does not cover everything, including the second train. All-in, Macquarie calculates, the project will cost some US$26.6bn, which is 44% larger than the original budgeted US$16bn.

Longer term uncertainties:

– Santos will not be able to source sufficient gas from the project's in-house sources. Third party supplies will have to make up the difference, on top of ongoing exploration. Many analysts see Arrow Energy as but a logical third party source of supply but so far no announcement about a deal has been made. Some analysts have incorporated a deal with Arrow in their forecasts, others are not so sure. Tip to traders: announcing a long term supply deal with Arrow will temporarily put a bid under the share price, but watch it when Arrow chooses an alternative or when the market gets a sniff there won't be any such deal.

– A general resource uncertainty is going to hang over the project for longer. It has dawned on analysts covering and researching Santos and the Gladstone LNG project how little knowledge and technical insights were in the mix when decisions were made to develop the project. This has led to erroneous decisions that will eat into the project's overall return rate and even today the company cannot be too confident about key components such as volumes and flow rates. Thus far, Fairview gas is surprising to the upside, which is a clear positive, but Roma is rather disappointing. In addition, the company's intention to drill 200-300 wells per year from 2015-2020 is seen by some as an indication that doubt about future in-house gas availability has become more prominent.

All in all, analysts estimate at least 30%, or nearly one third, of all gas associated with this project will have to be sourced from third parties, but it could be a lot higher if in-house sourcing and exploration disappoints. We won't know until much later.

– While everybody seems convinced Santos will be a key beneficiary of success at PNG LNG, and of sharply rising gas prices on the East Coast, and of the first mover advantage for Australian gas into Asian markets in general, there are serious doubts about how long this window of opportunity might be in place. If some of the more dire projections prove to be correct, and Asian gas prices settle at lower prices post-2017, then high cost projects in Australia might face the same challenges as have now fallen upon high cost producers in coal markets and in iron ore.

Whereas PNG LNG is one of the cheapest, highest quality new LNG projects in the world, with plenty of inherent growth potential, GLNG sits firmly on the other end of the costing scale, and will always be dependent on sourcing additional gas from elsewhere (exact quantity unknown).

All in all, most analysts seem prepared to give Santos the benefit of the doubt, conveniently assuming gas will start flowing from the project sometime next year (likely Q3) and there will be ultimately sufficient flow to support the second train, one way or another. On this basis, they are willing to set a price target/valuation on the stock of between $14.72 and $17.00. Ongoing progress and success in the year(s) ahead should further add to Santos' underlying valuation with GLNG gradually turning into the company's key valuation factor.

Most analysts acknowledge today the balance of risks remains skewed to the negative, but as the completion rate increases further, and Santos drills more wells and signs up more third party gas supplies, and GLNG moves closer to actual gas deliveries, Santos' share price should start moving closer to the price targets set.

But there is no guarantee and analysts at Credit Suisse are not buying it.

For years, CS analysts have been focusing on "what can go wrong" at Santos and their answer today remains: still far too much. In a recent research update, the analysts explain Santos' need for external gas supplies brings one helluvalot of possibilities to the table. How much is the company prepared to pay for third party supply? How much might it be forced to? How much third party gas exactly does it need?

Those three questions have a significant impact on Santos' margins and cash flows and ultimately on the value generated over the lifespan of the project. Avoiding the issue of how much gas exactly will need to be purchased for a moment, CS calculates non-allocated gas sourced at A$5/GJ means the analysts' Net Present Value (NPV) from GLNG to Santos rises by $0.44 per share. But if the gas is sourced at A$10/GJ the NPV would be $0.74 negative.

As you can imagine, in between sit all variations depending on what analysts are feeling comfortable with and willing to put through their modeling. Essentially, and this is a point highlighted time and time again by analysts at CS, buying Santos shares today with a longer term horizon requires one giant leap of faith.

One leap CS analysts are not willing to take.

CS does agree, in line with just about everyone else, Santos' revenues and cash flows stand to receive a big boost in 2015 and 2016 (assuming all goes well at PNG LNG and at GLNG) and this in itself should turn the stock into somewhat of an improved dividend play, but not to the extent of sector heavyweight Woodside whose yield appeal currently stretches as high as 6.3%. Taking the middle ground in present analyst projections, Santos' yield is more likely to jump from this year's 2.3% towards 3% in 2015, and possibly a little higher in subsequent years (add 100% franking and the implied yield rises above 4%).

This seems the obvious window of opportunity that is currently on the table for Australian investors. Post 2016, however, just about anything remains possible, in terms of cash flows, prices and project/share price valuation. That'll be the ultimate test for Australian investors and shareholders, but one that still appears so far away today.

If Credit Suisse projections are anything to go by, then by 2020 Santos' GLNG might not generate anything near taht which bullish analysts are projecting in terms of revenues, cash flows and valuation. This remains the future risk for a project that arguably would not receive the thumbs up from the same board were the initial vote on the Final Investment Decision to take place today. After spending US$15bn, this consideration has become purely academic.

Now all that is left is to find out the financial wisdom of that board decision made and approved by state and national governments back in 2010.
 

My Rant

Australian equities have posted yet another year of double digit returns of circa 12.5%. At least, if you believe the Australian Financial Review and just about everyone else who has been reporting on the share market's performance since the end of June. Alas, this is yet another example of low quality journalism. If we, the financial journalists and reporters of Australia, genuinely want to educate and to lift general knowledge among SMSF operators and other investors, we might want to lift our own game first. Yes, I am aware that it is far easier to simply calculate the advance of the ASX200 over a given period or grab the % number from a Bloomberg terminal, but that really cannot be an excuse for such general lameness as witnessed over the week past.

For the record, Australian equities have been trading on an average dividend yield between 4.2-4.5% for a while now, so one really cannot go too far wrong by including 4.5% (ex-franking) to the result which makes FY14 approximately a 17% return year. That's what the passive crowd should expect to hear from their well-remunerated funds management operators.

In further evidence most financial reporting is nowadays done from basic excel sheet tables, it was widely reported BHP Billiton ((BHP)) shares have been among the main support pillars under the share market's stellar performance for the financial year. Apart from the fact that just about each and everyone of those reports forgot to observe that nearly 100% of all gains had been made in 2013 (especially if one forgets to include dividends), it is there for anyone to see BHP shares thus far in 2014 are still below the $38 level at which they started the new calendar year.

It is there for everyone to see BHP shares have seldom traded above or even in the vicinity of $38. Granted, the shares sunk to $31 mid-last year after which they put in a recovery, but that's merely being lucky with the exact timing. Everyone can see on even the most basic of charts the shares have been, and still are, in a sideways trading range, with typical resources stock related volatility.

M2 Attractive, If You Don't Mind The Debt

M2 Telecom ((MTU)) has caught the attention of manager of funds, Leyland Private Asset Management, as the shares look cheap on the promise of ongoing strong growth in the years ahead, while representing somewhat of a novelty factor now that management has expressed the intention of building the unit formerly known as Dodo Electricity into a much larger operation inside the telecommunications group. Most people would describe M2 as a second-tier telco, but Leyland points out it is essentially a marketing machine, leaving the lumpy investments in infrastructure to others.

M2 management recently caught the attention of investors through confirmation growth in FY14 will sit in the middle of guidance provided in 2013, suggesting management has a solid grip on what's happening inside the group whereas others have to caution and chop and change. Admittedly, management's task was easier in FY14 as it marks the first year in a long time there had been no acquisitions. M2 combines four well-known brands Commander, Engin, iPrimus and Dodo and all four have been purchased with debt instead of via the issuance of new capital from existing shareholders.

While using debt underpins double-digit growth numbers in the near future, it has also led to the company's balance sheet now carrying a significant load of debt. Debt to equity is now 108% but Leyland thinks the company's "capital light" business model offers sufficient offset. The funds manager's projections are not dissimilar from what consensus forecasts in FNArena's Stock Analysis show, including a healthy dividend yield of 5% for the year ahead.

The shares have essentially traded sideways over the year past. Goldman Sachs reiterated its Neutral rating on Monday. Citi sticks to a Buy rating.

Reporting Season: Surprises & Disappointments

Reporting season will soon be among us (only three more weeks) and quant analysts at Macquarie have tried to pin down who's likely to surprise to the upside and who's more likely to release a disappointing earnings report. On the positive side Macquarie's research had generated the following eleven high probability candidates: Telstra ((TLS)), Sigma Pharma ((SIP)), Computershare ((CPU)), CSL ((CSL)), ResMed ((RMD)), Virtus Health ((VRT)), APA Group ((APA)), Pact Group ((PGH)), DuluxGroup ((DLX)), Slater & Gordon ((SGH)) and Bendigo and Adelaide Bank ((BEN)).

Most likely to disappoint, according to the same research, are the following nine: The Reject Shop ((TRS)), Atlas Iron ((AGO)), Ten Network ((TEN)), Regis Resources ((RRL)), Medusa Mining ((MML)), Evolution Mining ((EVN)), Wotif.com ((WTF)) -presently on the verge of being snapped up by one of its international competitors- Adelaide Brighton ((ABC)) and Mermaid Marine ((MRM)).

Notes Macquarie: Since 2006, companies that have surprised positively, have outperformed by 2.4% on the day they report and have continued to outperform in the days following the surprise. Companies that have surprised negatively have underperformed by 3.0% on the day they report and have continued to underperform in the days following the surprise before beginning to drift positively after about 10 trading days.

Quant analysts at UBS equally released an interesting piece of research in which they argue the broader macro-economic environment for equities in Asia ex-Japan is such that investors are more likely better off by avoiding "Torpedoes" rather than trying to pick the next winner. Past research has taught UBS' quant team that a 20% correction in a share price is 4.1x more likely to occur when earnings growth rates are falling or are low, and right now this is such an environment.

Alas, the UBS report does not cite one single Australian stock amongst the Asian candidate Torpedoes for which the list this time around seems to be concentrated on the Hong Kong stock exchange. UBS does remind everyone that stocks trading on higher multiples receive more downward punishment from the moment they turn into Torpedoes.

Also, for those who remember the EPS growth chart from Citi in my Weekly Insights last week (The Next Commodities Bull Mark, subtitle The Flatline Recovery), here's a beauty from the UBS report:

Translation: do not bemoan the fact that equities over here in the region have consistently underperformed US markets, but acknowledge instead business leaders in the US of A are the best when it comes to creating wealth and benefits for their shareholders, including themselves. We are not going to come across a flatlined EPS growth profile like that for US companies any time soon.

This week's presentation at PhillipCapital in Sydney

This week, I will be presenting at a Seminar organised by PhillipCapital in Sydney.
Date: Wednesday 9th July 2014, 6.30pm until 9.30pm (my presentation is 6.30-7.30)
Location: PhillipCapital, Level 9/56 Pitt St, Sydney
Access is free, but registration is necessary. Send an email to info@fnarena.com

(This story was written on Monday, 07 July 2014. It was published on the day in the form of an email to paying subscribers at FNArena).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January last year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

For paying subscribers only: we have an excel sheet overview with share price as at the end of June available. Just send an email to the address above if you are interested.

Click to view our Glossary of Financial Terms