Cairn Energy PLC (LON: CNE) – Generating sustainable free cash flow with a decent growth rate trajectory

Cairn Energy PLC is a FTSE 250 listed Oil and Gas Exploration, Development and Production Company. It operates with three business divisions, namely Senegal, UK & Norway, and International. The Senegal operation focuses on appraising the offshore discoveries and explore prospects for further drilling. The UK & Norway division is engaged into exploration activities in the Norwegian Sea, North Sea, and the Barents Sea. It also manages the asset development in the UK. The International operation comprises interest in all other regions where the Company holds exploration licenses, including Mauritania, Ireland, Morocco, Greenland, Western Sahara, and the Mediterranean. The exploration activity of the Group is principally located in frontier and emerging basins. The Company has been listed on the London Stock Exchange for over 30 years.

On 29 September 2020, the Company is expected to release the half-yearly results for FY20.

 
(Source: Presentation, Company Website)

Key Fundamental Statistics



Industry Outlook Dynamics
 

According to the World Energy Outlook 2019 report, energy demand is expected to grow between 1% to 13% until 2040. As per the IBIS World, the market size of global oil & gas exploration and production industry is about USD 3.2 trillion in 2020. It has grown at an average rate of 2.4% per annum over the past five years (between 2015 to 2020). The future demand for energy consumption will be affected by several factors, including change in climate policies and adoption of alternate source of energy. Moreover, 65% of total oil consumption is contributed by transport; hence, it can be impacted by the usage of electric vehicles as well. Contrarily, the rising population and increasing urbanization can surge the energy demand for economic activities.


(Source: Annual Report, Company Website)

Growth Prospects and Risk Assessment

The Company delivered a robust operational performance in FY19 and delivered production at the top-end of the guidance. Moreover, a significant milestone was attained in Senegal and Mexico. Meanwhile, the disposal of Norwegian business coupled with exits from Ireland and Nicaragua’s exploration position demonstrates the Company’s focus on capital allocation. Furthermore, the Company is actively involved in reducing carbon emission and targeting to provide sustainable energy from renewable sources as well.

 
(Source: Presentation, Company Website)

The Company is able to maintain adequate capital allocation balancebetween a strong balance sheet, investment for growth and returns to shareholders. It is expanding operations to Senegal, Norway, and Mexico, which is expected to generate good production volumes for the Company. Further, the Group has entered various strategic alliances with the government to expand operations. It has well established internal control systems which help them to mitigate the risks associated with the working of the company. The Group invests heavily in data and has a technical team with strong experience to mitigate exploration risk. CNE was awarded 5 licenses in the Offshore Exploration Licence Round in the UK.

However, the Company is exposed to the following principal risks and uncertainties:
 

1. Lack of exploration success can lead to no value creation, negative market reaction, and failure of the balanced portfolio business model.

2. Failure to replenish the portfolio can impact the ability to sustain production levels and replace reserves.

3. Lack of adherence to the environment, safety, health, and security policies can damage the reputation and bring regulatory penalties.

4. Underperformance on Kraken and Catcher assets can delay or reduce cash flows and can lead to increased operational costs.

5. Misalignment of joint ventures can put a negative impact on asset value and can cost schedule overruns.

6. Diminished access to debt markets can reduce capital availability.

 
The exploration projects are core value driver for the Company; any exposure to appraisal and exploration failure will impact the upside potential of projects. The Group’s strategy is based on building and maintaining a balanced assets portfolio, and any new opportunities must meet the strict investment criteria and securing them will depend on the existing competitive environment. The Company operates in multiple geographies, and profits can be impacted negatively due to foreign exchange rate fluctuations. Global political uncertainty regarding trade policy also poses a risk for the Group, including protectionist measures and regulation or legislation in local markets.

Segment Analysis

In FY19, the Company reported four operating segments, namely Senegal, UK & Norway, East Atlantic, and LATAM (Latin America). However, the revenue was mainly contributed by the UK & Norway division only.

The breakup of segmental revenue and gross profit for FY19 are as follows:


(Source: Annual Report, Company Website)

Synopsis of Recent Developments

27 July 2020: The Company entered an agreement to sell entire 40% interest in the Sangomar Offshore, Rufisque Offshore, and Sangomar Deep Offshore Contract Area to LUKOIL, for a cash consideration of up to US$400 million. Following the transaction completion, the Group intends to return at least US$250 million to shareholders.

21 July 2020: The arbitral tribunal has indicated that it is expected to give a decree by the end of summer regarding the proceedings against the Government of India for over US$1.4 billion in retrospective taxes.

7 May 2020: The Company announced that Ian Tyle, Chairman of the Board, has decided to retire from his position after serving for around seven years on the Board. He will continue to hold the position until the Board appoints a successor, which is expected to take place within the next twelve months.

5 May 2020: The Company announced the completion of exploration on Block 7 of Eni operated Ehecatl-1, which is located in the Sureste Basin offshore Mexico. The Cairn holds a 30% working interest through the subsidiary, Capricorn Energy Mexico. The purpose of exploration was to prove the availability of hydrocarbons in the Lower Miocene. The well has been permanently abandoned as it did not find any reservoir hydrocarbons.

Operational Key Performing Indicators in 2019

Delivered Exploration Success: In 2019, the Company completed the exploration of six wells and discovered six new prospects for drilling in the period 2020-21.

Progressed Developments: The Company matured SNE field development project to Final Investment Decision in Senegal. Also, it progressed well against key predefined project milestones for the Nova development project.


(Source: Annual Report, Company Website)

Top Shareholders Statistics


 

Operational Update (as on 27th March 2020)

In light of current market conditions, the Company will make substantial reductions and deferrals have already been identified for the 2020 programme, representing an overall 23 per cent reduction in capital expenditure for 2020. The planned capital expenditure for UK producing assets in 2020 is expected to be under USD 45 million, which was reduced from the initial forecast of USD 65 million. The Group has reduced capital expenditure on Sangomar Development Project from the original forecast of USD 400 million to under USD 330 million. The Capital expenditure on exploration activities is now expected to be around USD 100 million versus the original forecast of USD 150 million.

Financial Highlights - Reflecting Sustainable Earnings Growth Trajectory (31 December 2019)


(Source: Annual Report, Company Website)
 
For the financial year ending 31 December 2019, driven by an increase in the oil sales for the period, the group’s revenue increased to USD 533.4 million (FY2018: USD 410.3 million). The gross profit stood at USD 243.1 million in the financial year 2019 (FY2018: USD 107.7 million), reflecting the lower cost of sales for the period. Driven by lower operating expenses for the period, the group reported an operating profit of USD 154.9 million in FY2019 (FY2018: operating loss of USD 129 million). The company’s PBT (profit before tax) from continuing operations stood at USD 119.5 million in FY2019 as against a LBT (loss before tax) from continuing operations of USD 1,211.6 million in FY2018. The profit attributable to the shareholders stood at USD 93.6 million in FY2019 (FY2018: loss attributable to the shareholders of USD 1,135.5 million). The basic earnings per share stood at 16.08 cents in FY2019 (FY2018: basic loss per share of 195.59 cents). The diluted earnings per share stood at 15.92 cents in FY2019 (FY2018: diluted loss per share of 195.59 cents).

Financial Ratios – Strong Profitability Margins versus the Industry Median 
 

Reported profitability metrics for the financial year 2019 were higher against the industry median, reflecting higher revenue generated and better control over expenses. Cairn Energy Plc has delivered a return on equity of 8.4% which was slightly lower as compared to the industry median but improved significantly as against last year comparatives. On the liquidity front, Cairn Energy Plc’s current ratio was higher than the industry median of 1.27, reflecting sufficient liquidity to meet short-term obligations. On leverage front, the debt-equity ratio was 0.19x, which was lower as compared to the industry median of 0.44x, reflecting that the company is less leveraged as compared to peers.  

Share Price Performance


Daily Chart as on 5 August 2020, before the market close (Source: Refinitiv, Thomson Reuters)

On August 5, 2020, at the time of writing (before the market close, at 8:50 AM GMT), Cairn Energy Plc shares were trading at GBX 134.90, up by 4.01 per cent against the previous day closing price. Stock 52 week High and Low were GBX 216.80 and GBX 57.35, respectively.

Bullish Technical Indicator

From the technical standpoint, shares were trading above the short-term support level of 10-day, 20-day and 50-day simple moving average prices, which reflects an uptrend in the stock and carrying the potential to move up further.

Cairn Energy Plc Vs FTSE-Mid 250 Index (3 Months)


(Source: Refinitiv, Thomson Reuters)

In the last three months, Cairn Energy Plc share price has delivered 13.91% return as compared to 8.61% return of FTSE-Mid 250 index, which shows that the stock has outperformed the index during the last three months.

Valuation Methodology

Price/Cash Flow Approach (NTM)



To compare Cairn Energy Plc with peers, Price/Cash Flow multiple has been used. The peers are Serica Energy Plc (Price/NTM Cash Flow was 19.80), Genel Energy Plc (Price/NTM Cash Flow was 6.62), Independent Oil and Gas Plc (Price/NTM Cash Flow was 5.14), Hurricane Energy Plc (Price/NTM Cash Flow was 2.34) and Premier Oil Plc (Price/NTM Cash Flow was 1.56). The Average of Price/Cash Flow (NTM) of the company’s peers was 7.09x (approx.).

Business Outlook Scenario

The Group is estimating net production of 19,000 to 23,000 bopd with average production cost lesser than US$20/boe. The Company can maintain an adequate capital allocation balancebetween a strong balance sheet, investment for growth and returns to shareholders. It is expanding operations in Senegal, Norway, and Mexico, which is expected to generate good production volumes for the Company. Further, the Group has entered various strategic alliances with the government to expand the operations. The Company has a well-established internal control system, which helps them to mitigate the risks associated with the working of the Company. CNE was awarded 5 licenses in the Offshore Exploration Licence Round in the UK.


(Source: Presentation, Company Website)

In the financial year 2020, the Group expects capital expenditure to be around USD 615 million. The Company plan’s two further non-operated exploration wells in the Mexico. The Group expects Senegal based Sangomar field to targeting first oil in year 2023 with 100,000 bopd of gross production. In the latest operational update, the Company showed a decent increase in production and data gathered from exploration activities would be used to improve Block understanding and second well decision. The Group remained discipline while investing in the new projects, as the recent macro-economic factors are making the environment more challenging. The Group is continuously expanding the product portfolio and penetrating into new markets. It is planning to declare a special dividend to shareholders following the sale of Senegal Interests. Due to the outbreak of coronavirus (Covid-19), the oil prices have fallen substantially in the first quarter of 2020. CNE has shown good top-line and the bottom-line performance in the financial year 2019. Moreover, the Company’s balance sheet remains strong, and management is proactively reviewing options for further capital expenditure savings and deferrals, while retaining the financial flexibility to add value on an ongoing basis.
 
The souring demand outlook and a persistent supply overhang due to the coronavirus pandemic have been keeping the US crude futures locked in the range near $40 a barrel since late June. The relief of historic output cut by OPEC and allies is getting offset by the concerns of rising global coronavirus cases above 18 million. Meanwhile, on 4 August 2020, the oil prices jumped nearly two weeks high following the explosion at Lebanon’s main port. The stroking apprehensions over instability in the region led to the surge in Brent future oil price and currently trading at around $45.95 per barrel, up by 3.35% (at the time of writing as on 5 August 2020).
 
Over the course of 2 years (FY17 - FY19), the company's revenue surged from $33.3 million in FY17 to $533.4 million in FY19. Compounded annual growth rate (CAGR) stood at 300.23 per cent.

Based on the decent fundamental prospects and support from the valuation as done using the above method, we have given a “BUY” recommendation at the current price of GBX 130.10 (as on 5 August 2020, before the market close at 8:01 AM GMT+1), with lower-double digit upside potential based on 7.09x Price/NTM Cash flow (approx.) on FY20E cash flow per share (approx.).
 
*All forecasted figures and Peer information have been taken from Refinitiv, Thomson Reuters.

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