Treasure Chest: The Santos Equity Raising Debate

This story features SANTOS LIMITED. For more info SHARE ANALYSIS: STO

By Greg Peel

Oil & gas producer and LNG aspirant Santos ((STO)) decided to withdraw an intended hybrid debt/equity issue last month when the oil price suddenly crashed. The oil price has only traded lower since, spurring an assumption by the market the company will need to raise straight equity to cover its required capital expenditure on its near-completed Gladstone LNG facility, and to avoid a further credit rating downgrade.

Last week Standard & Poor’s downgraded Santos’ rating to BBB (negative watch) from BBB+, based on the fall in oil prices. Analysts are unsurprised by the “negative watch” element given this downgrade was made on assumptions of US$80/bbl oil in 2015 and US$85/bbl oil in 2016 on an exchange rate of US$0.80. S&P is also assuming Santos’ 2015 production will be near the top of the guidance range and that capex will fall by $200-700m.

Even on what Credit Suisse describes as “bullish” oil price assumptions (current spot prices are much lower), Santos’ critical funds from operations (FFO) to debt ratio only “approaches” an investment grade 30% in FY16. This would leave no capital available for growth projects, the broker notes. Credit Suisse values the company’s as yet unsanctioned resources at $1.70/share.

Credit Suisse is calling for Santos to raise equity now. The issue for Santos is one of clearly not wishing to raise equity at a time its share price has collapsed. But CS warns that if no capital is allocated to new projects, FFO will tumble with production from 2018 onwards. The broker has set a $9.10 share price target.

At the time of writing, Santos is trading at $7.16. On Friday, JP Morgan actually raised its target for the stock just a little, to $16.14, or some 125% above the current trading price. JPM’s analysts are implying they do not see a necessity to raise equity, and they noted last week that Santos’ announced capex reductions, driven by the oil price collapse, were greater than the broker had expected. Asset sales are an option for balance sheet bolstering, but it’s not a particularly good time to be trying to sell oil assets, JP Morgan admits.

Citi’s current price target is not quite as bold as JP Morgan’s, at $15.17, but this morning the broker issued a lengthy report explaining why it does not believe Santos needs to raise new equity. Citi suggests that $2.1bn of exiting undrawn debt facilities, a $1.5bn operating cash flow forecast for 2015 (at US$70/bbl, not US$80/bbl), and $2bn of capex and exploration cost, Santos will still have “significant available liquidity” by end-2015. Santos should be cash flow positive by 2016 with GLNG up and running.

When Santos announced its intended hybrid issue, the market assumed it was to raise necessary capital, Citi suggests. Thus when the issue was withdrawn, the next obvious step was to assume a straight equity raising would be needed. But Citi does not believe the initial hybrid issue was about increasing liquidity but about maintaining an investment grade credit rating. The broker expects Santos needs to maintain an investment grade rating for its existing debt covenants and/or contracted gas sales arrangements, and believes required ratios can be met as long as Brent crude is trading above US$79/bbl in 2017, assuming an 80 cent Aussie.

Citi suggests Santos could still issue a hybrid bond in 2015, fully underwrite its dividend reinvestment plan (DRP), and refinance debt to reduce the interest cost impact on FFO. Operational expense can fall by 20% given falling industry costs. Put those together and Santos remains investment grade at US$62/bbl oil, Citi calculates, and sales of non-core assets (which the market is currently ascribing no value to) could bring that number down to US$46/bbl.

And Santos could hedge its production. “We strongly believe,” says Citi, “STO is not about to come equity raising”.

Credit Suisse is the only FNArena database broker to have a Sell equivalent rating on Santos (Undeperform). Three other brokers lean towards Citi’s more positive view and retain Buy or equivalent ratings, being JP Morgan, Macquarie and Deutsche Bank.

UBS is concerned asset sales will not be possible in the weak market, and suggests “the equity drums beat louder” in maintaining a Hold equivalent rating. Morgan Stanley is also in the middle, looking to asset sales along with an underwritten DRP and possible reduced dividends.

The consensus FNArena database target prices is $12.40, suggesting 73% upside, but on a range from $9.10 (Credit Suisse) to $16.14 (JP Morgan).
 

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