EUR 850.00 For Business Accounts Only

Morningstar | 2Q Production and Pricing Drive No-Moat Santos' Debt Lower. FVE Increased to AUD 6.50. See Updated Analyst Note from 19 Jul 2018

We increase our Santos fair value estimate by 3% to AUD 6.50 per share from AUD 6.30, with higher near-term energy prices and the time value of money partially offset by lower-than-expected noncore Asia asset sale proceeds. While our midcycle Brent crude price forecast is unchanged at USD 60 per barrel (2021 real), our forecast average for the four years to calendar 2021 is increased by 10% to USD 70.80 per barrel. At AUD 6.05, no-moat Santos shares remain undervalued, and we think the market is insufficiently pricing for LNG project worth. And this is before potential for incremental gains via debottlenecking and simply growing share of equity gas feed.

The PNG LNG project is a case in point with capacity having crept to 8.3Mtpa from less than 7.0 Mtpa in 2014. But Gladstone LNG and Darwin LNG are also potential contenders for capital-efficient expansion, and for Santos to provide a growing proportion of their gas feed. The Barossa gas project has progressed to front-end-engineering-and-design phase with a final investment decision slated for end 2019. Santo' 25% equity stake is double its 11.5% Darwin LNG stake, where the gas is likely to call home, just 300km away. Santos can monetise resource positions like Barossa early via partial sell-down, or leverage them to earn increased equity stakes in existing infrastructure.

Sell-down of the noncore Asia portfolio for USD 221 million, and Denison Trough assets for up to AUD 43 million, somewhat understated their combined value per our modelling, though with proceeds to be appropriately put to debt reduction. Group net debt stood at USD 2.4 billion at end June, before sale proceeds, and already creditably down on the USD 2.8 billion net debt figure from six months prior. Current net debt/EBITDA of 1.6 is eminently manageable and Santos' net debt target of AUD 2.0 billion by 2019 is within easy reach. Our modelling suggests the target could be all but met by end 2018, with accompanying net debt/EBITDA just 1.3.

Our fair value estimate equates to a fiscal 2022 EV/EBITDA of 6.7 crediting five-year group revenue CAGR of 4.5% to AUD 3.9 billion by 2022. That assumes just 16% five-year production growth, 3.0% CAGR, to 67 million barrels of oil equivalent, or mmboe, by 2022. This is lower than our prior 70mmboe target due to asset sales. The only new project assumed in this is PNG LNG expansion in which Santos has only a modest 13% interest; the rest being ongoing ramp-up of GLNG and other low risk brownfields activity.

Santos reported a 3% increase in first-quarter 2018 production to 14.2mmboe, despite planned one-month maintenance at Darwin LNG. Cooper Basin oil production was the highest in four years and owned LNG volumes at Gladstone rose 17% to 0.2 million tonnes, not counting LNG produced from Santos gas outside its 30% equity GLNG portfolio. Third-party GLNG sales as a proportion of total fell below 50%, down from 67% in fourth-quarter 2017, again highlighting potential for Santos to grow its share of gas feed.

All 2018 guidance is maintained, including production at 55-58mmboe. We target 56mmboe, down from our prior 58mmboe target due to announced asset sales. Despite this, our 2018 EPS forecast increases to AUD 0.38 from AUD 0.36 on higher pricing. Second-quarter revenue increased 12% to USD 886 million on those higher prices, including USD 9.74/mmBtu LNG price achievement.

Santos has at last put the market out of its misery, confirming reinstatement of dividends, targeting a range of 10%-30% of free cash flow. Our unchanged target payout ratio of 40% approximates a high-end 30% of estimated 2018 free cash flow, delivering AUD 0.15 per share for a 2.5% yield at the current share price.