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Morningstar | Beach Is Making the Most of Higher Energy Prices to Reduce Debt; FVE Upgraded 23% to AUD 1.35

We increase our fair value estimate for Beach Energy by 23% to AUD 1.35 per share on higher energy prices, reduced forecast capital intensity, and time value of money. Along with reduced capital intensity, the magnitude of the fair value increase is ahead of the 10%-12% upgrades recorded for peers like Woodside and Oil Search, reflective of Beach’s higher costs and shorter field life, meaning relatively more of the total cumulative production is skewed to the near term. While our midcycle Brent crude price forecast is unchanged at USD 60 per barrel (2021 real), our forecast average for the 3.5 years to calendar 2021 increases by 10% to USD 70.80. At AUD 1.85, no-moat Beach shares remain overvalued, with the market implicitly crediting too much field life and growth potential, in our view. Beach has just announced a 320% increase in proven and probable, or 2P, reserves to 313 million barrels of oil equivalent, but more than two thirds of this increase is due to the Lattice and Toyota Tsusho acquisitions, meaning 2P field life is increased by just a third to 11 years from seven. However, our fair value estimate already credits a more-than-fair 17 years of average field life, including resource conversion to reserves.

Beach reported a 20% increase in fiscal fourth-quarter revenue to AUD 470 million, beating our AUD 430 million target by 9%. The figure is flattered by inventory draw-down and a higher proportion of third-party sales, but we still increase our fiscal 2018 EPS forecast by 8% to AUD 13.1 cents from AUD 12.1 cents, given a stronger-than-credited operating performance. Beach is working with Cooper Basin operator Santos to optimise drilling, including horizontal wells to extract higher volumes, and is enjoying less unplanned downtime at its Victorian assets. This, along with higher prices, is supporting more rapid debt repayment, reducing the interest burden. Since the January Lattice acquisition, net debt has fallen by a creditable 25% to AUD 640 million.

Debt reduction reflects solid oil prices and below-guidance fiscal 2018 capital expenditure of just AUD 288 million. With our increase to near-term energy price forecasts, we now expect group net debt/EBITDA of less than 1.0 by end fiscal 2019, improved on our prior 1.4 estimate, and well below mid-fiscal-2018 annualised levels nearer 2.0. Beach will have creditably deleveraged its post-Lattice Energy balance sheet more quickly on the higher oil prices, but will still need to continue reinvesting a high proportion of cash flows to stay in business, given often shorter field reserve life than its peers. Our fair value equates to a 2022 enterprise value/EBITDA exit multiple of 4.7, suitably lower than larger peer Santos’ 6.9, for example, in keeping with Beach’s lesser field life. In conjunction with USD 60 Brent, we assume a slightly softer long-run AUD/USD exchange rate of 0.75.

In addition to higher earnings, we have increased our fiscal 2018 DPS forecasts by 10% to AUD 0.05. We caution that this presupposes an increase in the payout ratio to 40%, from more recent payouts at only half that level. Management has not provided updated dividend guidance, but we think the balance sheet and cash flow are increasingly supportive for a lift. Second-half fiscal 2018 free cash flow excluding acquisitions came in at AUD 217 million. Our fiscal 2018 DPS forecast equates to a handy if not earthshattering 3.5% yield at our fair value estimate or a lesser 2.6% at the current share price.

Fair value uncertainty remains high, with Beach, a comparatively high-cost producer, still facing all the operational and environmental risks associated with oil and gas exploration and production. And while margins are improving, we don’t see Beach becoming a low-cost hydrocarbon producer, with sub-10% midcycle returns including goodwill not sufficiently above the weighted average cost of capital to warrant a moat.