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Profit from Cairn’s huge discount

Trading at a discount to cash and its 10 per cent stake in Cairn India, shares in Cairn Energy look a compelling bargain ahead of a major drilling campaign
July 4, 2013

Despite an excellent long-term track record and the potential for massive exploration upside over the next 18 months, Cairn Energy (CNE) is currently valued at less than its net cash plus its 10 per cent shareholding in the 560bn rupees (£6.2bn) Indian-listed oil producer Cairn India. At that price, we believe investors with a moderate taste for risk stand to make substantial profits should management's strategy of investing heavily in project development and frontier oil exploration pan out.

IC TIP: Buy at 252p
Tip style
Speculative
Risk rating
High
Timescale
Long Term
Bull points
  • Trading at discount to cash and stake in Carin India
  • Solid track record
  • Exposure to high impact exploration
  • Chart support
Bear points
  • Negative sentiment towards sector
  • Lack of immediate catalysts

True, such a lowly valuation doesn't exactly inspire confidence at first glance. But unlike other out-of-favour resource groups, there is nothing fundamentally wrong with Cairn. On the contrary, the company is well funded and debt-free, it has a balanced portfolio of high-quality assets in favourable jurisdictions, and it has an enviable 20-year track record of creating value for shareholders. What's more, it has a major exploration schedule lined up over the coming 18 months (see table).

Cairn’s busy drilling schedule
Well nameLocationResults expectedPotential impact
FrodeNorwayJulyLow
Foum Draa FMoroccoYear-end 2013Medium
Juby MaritimeMoroccoQ1 2014Medium
Prospect LSenegalQ2 2014High
Spanish PointIrelandQ2 2014High
PYGreenlandSummer 2014 (non-firm)Very high
K ComplexUKMid-to-late 2014High

Source: Jefferies

Indeed, to put things into perspective, Cairn's management was able to return $3.5bn (£2.2bn) to shareholders in 2012, as well as make two major acquisitions totalling $933m, and the company still had cash and investments left over worth $2.4bn as of 31 March 2013.

So why are the shares trading at a discount? There are three main reasons. First, there has been a sector-wide sell-off in natural resources equities as a result of waning commodity prices and deteriorating sentiment. Second, Cairn spent close to $1bn on exploration during 2011 in the Atlantic Margin offshore Greenland, without striking oil in commercial quantities. This not only resulted in huge writedowns, but it dramatically lowered investor confidence in Cairn's remaining Atlantic Margin exploration assets spread across Morocco, Senegal, Ireland and Greenland - despite there being little to no geological read-across. Lastly, even though Cairn currently has substantial cash resources at its disposal, the company essentially plans to spend all its money - and then some - over the next five years. Cairn's strategy is to spend between $250m and $300m a year on exploration and appraisal activities, in addition to the $1.5bn (partially financed by debt) needed to build its major development assets in the UK North Sea.

CAIRN ENERGY (CNE)

ORD PRICE:252pMARKET VALUE:£1.52bn
TOUCH:251-252p12-MONTH HIGH/LOW:310p245p
FWD DIVIDEND YIELD:nilFWD PE RATIO:na
NET ASSET VALUE:604¢*NET CASH:$1.5bn

Year to 31 DecTurnover ($bn)Pre-tax profit ($bn)Earnings per share (¢)Dividend per share (¢)
2010nil-0.30-55.0nil
2011nil-1.19-215nil
2012nil-0.1911.1nil
2013**nil-0.09-13.3nil
2014**nil-0.16-16.3nil
% change----

Normal market size: 10,000

Matched bargain trading

Beta: 1.41

£1=$1.52

*Includes intangible assets of $1.39bn, or 230¢ a share

**UBS adjusted forecasts

So if Cairn is going to spend all its capital, investors have to believe its management will generate a solid return on the money it is investing in project development and exploration. Cairn's management wouldn't disclose forecast internal rates of return on the development projects, as they are all operated by other experienced partners such as Norway's Statoil and FTSE 350 constituents Premier Oil (PMO) and Enquest (ENQ). But they estimate the projects will churn out between 25,000 and 35,000 barrels of oil per day net to Cairn from 2016 onwards - generating between half a billion and three-quarters of a billion dollars in free cash flow every year based on $95-a-barrel oil.

Admittedly, returns on exploration drilling are impossible to predict. But Cairn's strategy to target large, basin-opening prospects that would demand a huge premium in a sale is a good one. According to broker UBS, wells scheduled to be drilled in Senegal, Morocco, Ireland and Greenland over the next 18 months have the potential to increase its 358p 'risked' estimate of net asset value by nearly four and a half times. Moreover, Cairn recently signed a one-year agreement for a drill rig that starts in the second half of 2013, so the risk of drilling being delayed is fairly low. That said, drill results from the first well may not be released until the very end of 2013, leaving investors with a possibly uncomfortable six-month-long wait until the action really hots up.