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Morningstar | Even Cyclones Can’t Dampen Santos’ Party, the Drill-Bit Hitting Paydirt. FVE Increased to AUD 8.15. See Updated Analyst Note from 16 Apr 2019

We increase our Santos fair value estimate by 4% to AUD 8.15 per share, due to a combination of higher near-term Brent crude prices and the time value of money. We up our 2019 and 2020 Brent crude price forecasts by 9.1% and 9.6% to USD 68.15 per barrel and USD 67.65 per barrel, respectively, in line with the futures curve. Our long-term Brent price forecast is unchanged at USD 60 per barrel in 2021 dollars. Higher prices drive our 2019 and 2020 EPS forecasts 9% and 24% higher to AUD 0.48 and AUD 0.56, respectively.

Santos reported a 16% increase in first-quarter production to a record 18.4 million barrels of oil equivalent, or mmboe, marginally below our expectations. Operations were impacted by cyclone activity in Western Australia and facility outages in the Cooper Basin. The record production reflects a first full quarter’s contribution from the recently purchased USD 2.15 billion Quadrant assets. Santos favourably reassures Quadrant’s integration is proceeding well and is on track to deliver the USD 30-50 million in annual integration synergies promised. The company also maintains all 2019 guidance including production of 71-78 mmboe and capital expenditure of USD 1.1 billion. We reduce our production forecast to by 1.9 mmboe or 2.4% to 76.5 mmboe, following the cyclone’s impacts.

Our fair value estimate equates to a little changed 2023 EV/EBITDA of 6.4, crediting five-year non-third-party group revenue CAGR of 11.0 % to USD 4.3 billion. This supports five-year EPS CAGR of 8.9% to AUD 0.73 by 2023 for a nominal P/E of 9.8 at the current AUD 7.15 share price, or 15.5 when discounted at WACC. Our comfort to credit such production levels is supported by growth projects and favourable activity on Santos’ part. Santos has just reported a spectacular 245 metre net hydrocarbon intersection at its Corvus-2 appraisal well within tie-back distance of both the Devil Creek and Varanus Island gas facilities owned by Santos.

The well confirms a significant liquids-containing gas resource, opens up potential additional exploration plays, and should at the very least increase facility’s utilisation and life. The drill rig will now move to appraise the promising Dorado oil discovery which came with the Quadrant acquisition. We have perhaps conservatively only applied USD 300 million or AUD 0.20 per share value for Dorado given that it’s still early status. But prior drilling encountered 132 metres of net hydrocarbon pay, including 80 metres of net oil pay. And Dorado is favourably located in shallow waters in high-quality sandstone reservoir. Given the solid foundation, any gains will be readily accommodated from a fair value perspective. It wouldn’t surprise to see our Dorado carrying value meaningfully increased post intended drilling, perhaps doubling.

On the balance sheet front, Santos’ net debt favourably declined to USD 3.4 billion at March 31, down from USD 3.6 billion at end December. Somewhat elevated net debt/EBITDA of just over 1.6 is manageable and we expect it back to 1.0 levels by as soon as 2022. This is a creditable outcome given net debt/EBITDA levels were above 4.0 just three years ago and Santos has also had to digest Quadrant. The balance sheet is no longer requiring of focus, that effort can be better put to growth pursuits. Santos still targets production growth to greater than 100 mmboe by 2025 versus 58.9 mmboe in 2018. Our net debt/EBITDA forecast fully credits that being achieved, in addition to assuming a modest payout of 35% of NPAT in dividends. The payout equates to a fully franked yield of 2.3% in 2019, growing in nominal terms to 3.6% by 2023 all else equal. Not earth shattering but respectable given anticipated 8.9% EPS CAGR.