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Morningstar | No-Moat Santos Accelerating Cooper Basin Gas Development. FVE Unchanged at AUD 6.50.

Our AUD 6.50 fair value estimate is unchanged and Santos trades at close to fair value. The shares have more than doubled since June 2017 AUD 3.00 lows, as energy prices have risen and concerns around LNG resource sufficiency have ebbed. News Santos is accelerating Cooper Basin natural gas development is more confirmatory of our investment thesis than additive, pleasing though it is. A fourth Cooper drill rig has begun work and will drill eight wells by the end of this year, taking total 2018 Cooper Basin wells to 90, the most in four years. Santos has reduced development costs in the Cooper by 40% since 2015, and can more readily access vast already-discovered gas resources. Cooper basin gas production jumped by 8% in the June quarter to 15.4 petajoules, if evidence was required.

The non-LNG component of our Santos fair value estimate is AUD 2.30 per share or 35% of total, substantially the Cooper Basin. But this probably belies the Cooper's importance given its moaty asset attributes and that it operates in support of the Gladstone LNG project in Queensland, which comprises a similar additional 34% group fair value share. While we ascribe no moat to Santos, competitive advantage regardless stems from the Moomba hub, where efficient scale discourages replication of infrastructure which can gather, store and ready gas for piping to east coast markets, including for export via Gladstone.

The market has long fretted over a perception of insufficient gas reserves for Gladstone, something we have not. Our confidence is in no small part due to the Cooper’s gas--although we’ve also thought Gladstone’s indigenous coal seam gas reserves have been under-appreciated. Santos last listed its contingent 2C gas resources in the Cooper/Eromanga basins at almost 3.0 trillion cubic feet, or tcf, more than a third of total company gas resources, with additional multi-tcf conventional upside potential. A substantial portion of current Cooper production is going to Gladstone LNG.

Our fair value estimate equates to an unchanged fiscal 2022 EV/EBITDA of 6.7 crediting 5-year non-third-party group revenue CAGR of 7.2% to AUD 3.1 billion by 2022. This is despite our forecast for oil price declining by 17% to an unchanged mid-cycle USD 60 per barrel (2021 real). This assumes just 16% five-year own-production growth, 3.0% CAGR, to 67 million barrels of oil equivalent, or mmboe, by 2022. Most of this comes early with the final stages of Gladstone LNG’s two-train ramp-up. The only new project assumed in this is PNG LNG brownfield expansion in which Santos has only a modest 13% interest. But the market has until recently been assuming less Gladstone LNG production and a higher third-party gas contribution making up the difference. Our midcycle Brent crude price forecast is unchanged at USD 60 per barrel (2021 real).

Our fair value estimate implies a 2022 P/E of 16.3, price/cash flow multiple of 12.0, and fully franked dividend yield of 2.4%, all discounted at WACC. In nominal terms the metrics improve to 10.3, 7.6, and 3.8% respectively. Our dividend yield forecast assumes a 40% payout ratio, and re-initiation of dividends from this first half of 2018, the first since end 2015. Confirmation awaits release of first half 2018 result on Aug. 23. Our target payout approximates 30% of free cash flow, at the high end of Santos' 10-30% guidance range. But our optimism reflects Santos having already creditably reduced net debt by 15% to USD 2.4 billion in the six months to June, and that before USD 220 million in noncore Asia asset sale proceeds. 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 to EBITDA just 1.3.