Karoon Strikes The Right Balance

This story features KAROON ENERGY LIMITED. For more info SHARE ANALYSIS: KAR

Despite production challenges, Karoon Energy has silenced the sceptics with its new capital management program, which analysts suggest strikes the right balance between shareholder returns and growth.

-Karoon Energy reported a Q2 miss on production but a beat on revenues
-Maiden capital management program overrides results
-The right balance, say analysts
-Allowing room for further growth

By Greg Peel

In reporting on Karoon Energy’s ((KAR)) update last Thursday, Morgan Stanley (Equal-weight) anticipated a “welcome reaction” to the company’s June quarter results and capital allocation framework.

The stock fell -5%.

However, on that day the ASX200 was crushed by -1.2%, led down by Wall Street, so any specific reaction is difficult to determine. The next day the index bounced, and Karoon shares regained all they had lost the day before.

So, as you were.

Reading the Tea Leaves

Karoon’s initial capital management policy was scheduled to be released along with its June quarter production and sales numbers. The week before, Ord Minnett (Buy) contemplated what might be expected.

The broker believed a dividend payout ratio of circa 20-40% would be feasible after incorporating financial covenants from Karoon’s recent US$350m secured note issue, and a conservative oil price forecast of US$65/bbl, with Brent crude trading at circa US$85/bbl at the time. Ord Minnett anticipated a first-half 2024 dividend of US3.4c when the company reports in August, which represents a 25% payout ratio.

The broker’s forecast seemed ambitious, given consensus forecasts at the time ranged from a 3c peak down to no dividend at all, suggesting many in the market were not confident Karoon would actually pay up.

Most of the market’s scepticism, Ord Minnett assumed, was likely due to concern the credit metric conditions that apply to the senior secured note issues could limit Karoon’s ability to pay out dividends or conduct share buybacks. But the broker’s analysis of the debt facility documentation and the conditions therein led to a view the company could pay out as much as 50% or more of underlying profit as dividends.

Not that it would, given the board’s strategic growth ambitions. Ord Minnett thus settled on a forecast 25% payout, while anticipating Karoon could otherwise opt for a share buyback, which would be received more positively by the market and could attract new potential investors.

The Big Reveal

Last Thursday, Karoon Energy disclosed a big miss to consensus forecasts on June quarter production, owing to prolonged outages and maintenance programs at Bauna in Brazil. Second half production came in at 44% of the midpoint of guidance.

Yet, Karoon’s sales and revenues were a solid beat due to higher than expected oil prices achieved at both Bauna and Who Dat in the Gulf of Mexico, as well as the favourable timing of Buana oil cargo sales.

Hurdles nevertheless persist at Bauna, for which strikes at IBAMA, Brazil’s environmental regulator, are holding up approvals for Karoon’s repair of the SPS-88 production well at Bauna. Management sees its target for the September quarter as likely to slip, and production coming in at the bottom end of guidance if the repair is deferred to 2025.

All up, brokers trimmed their earnings forecasts and target prices on the June quarter update. But the news everyone was waiting for was that of capital management plans.

Karoon’s new shareholder return policy includes 20-40% payout of underlying profit in dividends and/or share buybacks beginning with the first half results due next month. Morgan Stanley estimates this represents a dividend yield range of 4.6-9.2%. The company will begin a US$25m buyback post results.

It was this news that had Morgan Stanley anticipating a “welcome reaction”.

Citi (Buy) suggests the new capital returns policy of 20-40% “strikes the right balance” between shareholder returns and the preservation of capacity to reinvest in the business. Even assuming the broker’s “conservative” oil price assumptions, this would suggest an average free cash flow yield of around 18% through to 2028.

Citi knows now this cash flow won’t necessarily fund the “empire building” through M&A that some had feared, and shareholders can enjoy now some of this cash flow via distributions.

The capital management program “strikes the right balance,” echoes Macquarie (Outperform). Including the US$25m buyback, and taking the midpoint of the 20-40% payout range, Macquarie sees a total shareholder yield in excess of 10% in 2024.

Morgans (Add) calls it a “substantial return profile”, also suggesting a circa 10% capital return in 2024. The broker expects this news, which “aligns perfectly” with management commentary around future growth, will gradually ease fears around Karoon’s inorganic growth strategy, which Morgans expects to be more a 2025 or beyond story, and opportunistic.

Citi believes Karoon will announce a dividend towards the lower end of the payout range at the August result, in order to strike the right balance between shareholder returns and sufficient balance sheet capacity for reinvestment. From the second half of 2024, Citi expects Karoon to continue to lean towards the lower end of this range.

The broker estimates a 6.3c (A$) total dividend in 2024 and 4.2c in 2025 at a 20% payout ratio. This is equivalent to about a 4% dividend yield in 2024 at the current share price and Citi’s US$80/bbl Brent price forecast, and 2% in 2025 at US$60/bbl oil.

Growth

Karoon has left the door open for further growth, so what’s the story there?

When it comes to Who Dat development, the story is mixed. The Who Dat East appraisal well failed to find significant hydrocarbons and is suspended pending analysis. But the Who Dat drilling campaign continues with Who Dat South due to commence drilling in the September quarter.

Who Dat West would then follow, subject to joint venture approval. Karoon owns 40% of Who Dat East, 30% of South and 35% of West.

Karoon is progressing its 100%-owned Neon/Goia projects in Brazil, but these are still in concept and Macquarie is looking for a more comprehensive update in August. This broker expects Neon/Goia have a good chance of being developed.

Ord Minnett views Karoon’s strategy of expansion via M&A positively, although the company needs to redeem itself in the eyes of shareholders, the broker warns, after struggling with the disciplined use of capital in recent years.

Back in late June, Karoon provided a reassuring operational update showing real progress toward correcting operational issues, which Morgans suggested was a much-needed confidence boost. In particular, the development of the Who Dat joint venture relationship appeared to be solid, in line with management commentary.

The broker felt the share price at the time (not dissimilar to today) implied dilution risk (capital raising), perhaps reflecting concerns around another acquisition in the short-term. But it was then that management flagged it would reveal its capital management approach in July; in other words the opposite of dilution.

These fears provide a unique opportunity to acquire shares in Karoon, suggested Morgans.

Of the five brokers monitored daily by FNArena covering Karoon Energy, four have Buy or equivalent ratings with one Hold. The consensus target is $2.39, suggesting 33% upside.

Not monitored daily are Jarden (Buy; target $2.25) and Wilsons (Overweight; $2.65).

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