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Morningstar | Lower Pricing Trims Near-Term Earnings Expectations for Santos but Longer-Term Growth Stands.

We make no change to our AUD 7.85 fair value estimate for no-moat Santos, despite declines to near-term earnings estimates. The lack of fair value change since our October 2018 note reflects time value of money benefit, offset by a weaker near-term energy price outlook and a softened 2019 production estimate. Longer-term assumptions stand, including production growth to over 100 million barrels of oil equivalent, or mmboe, by 2025 and a midcycle Brent price of USD 60 per barrel. At AUD 5.95, Santos shares are materially undervalued, the market not sufficiently crediting expansion potential.

Our 2018 and 2019 EPS forecasts decline 12% and 44% to AUD 0.38 and AUD 0.46 respectively. 2018 earnings include just one month’s contribution from the around USD 2.0 billion Quadrant acquisition, less time than our prior forecast had anticipated. And oil price softened into the final quarter to a low near USD 50 per barrel versus the plus USD 80 levels prevailing in the September quarter. But the biggest price hit to earnings is in 2019, exacerbated by Santos guiding for production of 71-78 mmboe, down on our prior plus 80 mmboe forecast. We rein-in our 2019 production forecast to a guidance high-end 78 mmboe, most of the cut coming from Gladstone LNG. Our oil price forecast is USD 62.50 versus USD 82 at last update.

Excluding the acquisition of Quadrant, 2018 sales volumes of 77.2 mmboe were above the upper end of 74-76 mmboe guidance and production was within 56-58 mmboe guidance. Upstream production costs of USD 8.00 per boe and capital expenditure of USD 732 million were at the lower end of USD 8.0-8.6/boe and USD 725-775 million guidance respectively. In combination with an ultimate USD 1.9 billion Quadrant price tag, down from the USD 2.15 billion headline due to completion adjustments and cash acquired, net debt at end of period was a favourably lower than anticipated USD 3.6 billion at December’s end.

Net debt/EBITDA of just over 2.0 is currently elevated following Quadrant’s purchase, but manageable and we expect it back to 1.0 levels by 2022. Our fair value estimate equates to a 2022 EV/EBITDA of 7.2, crediting five-year non-third-party group revenue CAGR of 11.8 % to USD 3.9 billion. This supports five-year EPS CAGR of 25% to AUD 0.64 by 2022 for a nominal P/E of 10.7 at the current AUD 6.00 share price, or 17 when discounted at WACC. Our comfort to credit such growth levels is supported by growth projects and favourable activity on Santos’ part. The company drilled a record 305 wells at GLNG in 2018, up 77% and expected to increase to 350-400 wells in 2019. Similarly, Cooper Basin well numbers rose 40% in 2018 to 85, with an expected to jump to 100 wells in 2019. In conjunction with growth projects including PNG LNG expansion and Barossa backfill to Darwin LNG, we see little reason to doubt production expansion to 100 mmboe. That doesn’t include appraisal of the exciting Dorado oil discovery which came with Quadrant, nor ultimate expansion potential at GLNG. Appraisal of the Dorado discovery is planned for 2019.
Santos confirms a final investment decision on the Barossa project to backfill Darwin LNG is targeted for end 2019, success of which would extend life for more than 20 years and deliver around 9.0 mmboe average annual net production to Santos, more than double the current around 4.0 mmboe rate. And partner Oil Search’s 8.0Mtpa expansion aspirations via three new 2.7Mtpa trains at PNG LNG are progressing. Each 2.7Mtpa train would add 2.8 mmboe net to Santos. Barossa and PNG LNG alone account for two thirds of the growth required to achieve 100 mmboe. The PNG government and PNG LNG joint venturers are targeting gas agreements before the end of March 2019, to enable a front-end engineering and design decision to be taken for the proposed three new trains. Detailed engineering for Barossa is already underway with a final investment decision targeted for end 2019.