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Morningstar | Santos Production Miss But Strong Free Cash Flow on Pricing Impresses. No Change to AUD 8.15 FVE.

We make no change to our AUD 8.15 per share fair value estimate for no-moat Santos. The company reported lower than anticipated second-quarter production, steady at 18.6 million barrels of oil equivalent, or mmboe. However, there are no longer-term consequences in the numbers and our base-case forecasts are intact. Lower than expected production reflected planned maintenance in the Cooper Basin and PNG LNG, impacting further than we’d allowed for. However, Santos’ LNG price achievement of USD 9.10 per million British thermal units, or mmBtu, was marginally better than expected, slightly above the implied contract slope to lagged crude. This contrasts favourably with Woodside’s subslope second-quarter price achievement due in part to greater spot exposure.

Regardless, softer than expected second-quarter revenue, down 5.5% to USD 959 million, sees our 2019 EPS forecast for Santos decline by 6% to AUD 0.45. The company has tightened 2019 production guidance to 73-77mmboe from 71-78mmboe. We reduce to 76mmboe from a prior guidance-high-end 78mmboe. Our 2020 EPS forecast of AUD 0.50 is little changed.

Santos has plans to grow production by two thirds to more than 100mmboe by 2025 from 2018’s 59mmboe base. This includes the immediately base additive production of around 19mmboe via the Quadrant acquisition, growth in PNG LNG capacity, development of the Dorado oil discovery also coming via Quadrant, and increments from elsewhere across Santos’ existing portfolio including the Cooper Basin. We project production to grow by 80% to 106mmboe by 2024; Santos says Quadrant’s integration has exceeded expectations.

Our Santos fair value equates to a 2028 EV/EBITDA of 6.7, crediting 10-year non-third-party revenue CAGR of 6.2 % to USD 4.7 billion. This supports 10-year EPS CAGR of 6.8% to AUD 0.93 by 2028 for a nominal P/E of 7.4 at the current AUD 6.90 share price. Our comfort to credit these earnings levels is supported by quality growth projects and a strong track record.

We assume a midcycle Brent crude price of USD 60 per barrel in 2022 dollars.

At AUD 6.90, we think Santos is materially undervalued, the market undercrediting for the growth potential. Final investment decisions, or FIDs, on PNG LNG expansion, Dorado oil and Barossa to Darwin, could be key catalysts for share price appreciation to fair value. Dorado is potentially the most fair value impactful of these, where FID is slated for 2020. Dorado should be cost-competitive given shallow water, near gas infrastructure, and support services. And it should be particularly value-accretive given likely low capital intensity for high-margin oil production. We project Santos’ majority 80% equity share of the WA project should represent a 14.5mmbl or 20% increment to current group production rates.

Santos generated USD 300 million in second-quarter free cash flow, reducing net debt by USD 0.3 billion to USD 3.1 billion. This represents the 13th consecutive quarter of positive free cash flow cementing CEO Kevin Gallagher’s credentials as an astute operator. A record 102 wells were drilled at Gladstone LNG during the quarter with 100% success rate and 25 wells in the Cooper Basin with a creditable 80% success rate, including the fastest ever Cooper total well execution of just 4.3 days. Efficiency is everything and improved upstream group production cost guidance is for USD 7.25-7.75/boe versus USD 7.50-8.00 prior. Including allowances for growth project capital and a sustained 35% payout ratio, we project net debt/EBITDA creditably falling below 1.0 by 2023, from 1.7 in 2018, and 4.2 in 2015.