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Morningstar | Fiscal 2018 Costs Impress for No-Moat Beach and We Increase our FVE to AUD 1.60.

We increase our fair value estimate to AUD 1.60 from AUD 1.35 per share. Beach reported underlying fiscal 2018 EPS of AUD 0.13, in line with expectations. But that result included lower-than-expected operating costs of USD 17.70 per barrel of oil equivalent, down 3% on a like-for-like USD 18.20 for fiscal 2017, and beating our USD 19.70 forecast. It was only higher than expected tax which contained the result to target. And the lower operating costs have now persisted for long enough to satisfy they reflect a structural shift, rather than a transient effect. Beach has reported underlying EBITDA margins at or in excess of 60% for the past three halves, well ahead of the prior 10-year average of 47%, and we increase our midcycle EBITDA margin assumption to 60% from 55% prior. There is considerable fair value leverage around even modest percentage moves in margin.

Much of the improvement on the cost front was anticipated as the Lattice Energy acquisition was bedded-down. But the integration is now almost complete, and we anticipate some lagged cost creep in sympathy with energy prices, to cap substantial margin gains from here in. The market appeared disappointed with the result, the shares down as much as 9% immediately post release. Whether this reflects too much anticipation built-in, the shares having risen 60% since March AUD 1.20 lows, or disappointment at substantially upgraded capital expenditure plans and the unchanged AUD 1.0 cent final dividend, is not precisely clear. Beach expects fiscal 2019 to be its biggest ever investment year, with capital expenditure guidance in the range AUD 460-540 million. That contrasts with around AUD 315 million in fiscal 2018 and just AUD 160 million in fiscal 2017. Perhaps the market smells excess risk and would have preferred a second-half dividend payout considerably better than just 11% of underlying earnings. We certainly were, but the improved price/fair value is welcome regardless.

At around AUD 1.75, Beach shares remain marginally overvalued. Beach did try to allay fears around overspending, qualifying that 80% of expenditure plans remain discretionary. Most will target gas for supply into the lucrative east coast market, in support of efforts to drive production to in excess of 30 million barrels of oil equivalent, or mmboe, by fiscal 2021. Our unchanged target remains at a guidance-respecting 30 mmboe. Nearer term, fiscal 2019 guidance is for 26-28 mmboe, broadly in line with annualised second-half fiscal 2018 output. We remain at a guidance high-end 28 mmboe but our EPS forecast regardless increases to AUD 0.12 from AUD 0.106, due to our reduced operating cost expectations.
Beach is working with Cooper Basin operator Santos to optimise drilling, including horizontal wells to extract higher volumes, and is enjoying less unplanned down-time at its Victorian assets. The Cooper comprises 60% of our Beach fair value estimate. The drilling and higher prices are supporting more rapid debt repayment, reducing the interest burden. Since the January 2018 Lattice acquisition, net debt has fallen by a creditable AUD 220 million to AUD 640 million. Net debt/EBITDA is just 0.8 at end June, more than comfortable, and Beach is targeting improved net gearing of 20% by end fiscal 2019 from 26% currently.
Beach will have creditably more quickly deleveraged its post-Lattice Energy balance sheet on the higher oil prices, but will still need to continue to reinvest 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 2023 EV/EBITDA exit of 4.5, suitably lower than larger peer Santos 6.9, for example, in keeping with Beach's lesser field life. Beach has approximately 10 years proven and probable 2P reserve life based on the midcycle 30 mmboe production target. We've cut our DPS forecast to AUD 2.0 for fiscal 2019 and fiscal 2020, following fiscal 2018 being held at that level. The implied 17% payout of underlying earnings equates to an underwhelming 1.1% yield at the current share price. Growth and debt conservatism look set to take trump yield for now.