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Morningstar | Santos Quickly Justifies Harbour’s Rejection With Acquisition of Its Own; FVE Increased to AUD 7.00

We increase our fair value estimate for no-moat Santos by 7.5% to AUD 7.00 per share following the announced purchase of Quadrant Energy for USD 2.15 billion, using cash balances and debt. Santos’ first-half 2018 underlying NPAT of USD 217 million was in line with our USD 215 million expectations, with no implication for fair value or earnings forecasts. But the overshadowing Quadrant acquisition looks a beauty, and our initial assessment of 7.5% fair value accretion has every chance of proving conservative. In 2019, the first full year of earnings contribution, we estimate Quadrant to drive 26% EBITDAX per share growth (the X stands for exploration), close to Santos’ assessment of around 30%.

Under CEO Kevin Gallagher’s direction, Santos is again showing itself making all the right moves. Not too long ago, an acquisition of this scale would have resulted in a sharp rebuke from a market still smarting from Santos’ debt crisis. Now, the shares rise and at AUD 6.95 trade close to our increased fair value estimate. Risk around Santos’ midyear rejection of Harbour’s AUD 7.00 takeover bid is rapidly evaporating.

Quadrant increases Santos' pro forma 2017 proven and probable, or 2P, reserves by 26%, or 220 mmboe, to 1,068 mmboe, and production by 32%, or 19 mmboe, to 79 mmboe. That places Santos in the realms of Woodside’s 84 mmboe 2017 production. Santos isn’t buying anything it doesn’t already know well, isn’t overstretching its balance sheet, and isn’t running off on a tangent. It already owns material stakes in Quadrant assets and anticipates combination synergies of USD 30 million-USD 50 million annually. We assume the low end, which would mean no increase in administrative costs despite the increase in scale. Santos expects Quadrant to result in net debt/net debt plus equity of just 34% at end 2018 versus the current 25%, and for this to fall below 30% by end 2019. We estimate 26% by end 2019, and the dividend policy (only recently announced) will stand.

Quadrant’s assets are plain-vanilla, long-life conventional Western Australian offshore hydrocarbon assets with a large inventory of molecules from which to backfill existing infrastructure and from which to increase resources and drive growth.

Santos expects Quadrant’s high-calibre projects to reduce its free cash flow break-even by USD 4 per boe to USD 32 per boe, speaking to the high quality of the acquired assets. Quadrant has high-margin, CPI-linked contracts that delivered a realised 2017 average price of USD 4.90 per gigajoule, ahead of Santos’ AUD 4.57 in 2017.

Incorporating Quadrant, our Santos fair value estimate equates to a slightly reduced fiscal 2022 enterprise value/EBITDA of 6.3, now crediting five-year non-third-party group revenue CAGR of 11% to AUD 3.7 billion by 2022. Around half of this growth reflects Quadrant. We assume 40% five-year own-production growth, representing a 6.8% CAGR, to 80 million barrels of oil equivalent, or mmboe, by 2022. Again, almost half of this reflects Quadrant, with the balance coming from the final stages of Gladstone LNG’s two-train ramp-up. The only new project assumed in this is the PNG LNG brownfield expansion, in which Santos has only a modest 13% interest. Our fair value estimate deducts a USD 500 million prepayment from Alcoa on a 12-year 120 TJ/day contract with Quadrant from 2020. Prepayment accounts for approximately the first 18 months' supply. However, we ascribe only USD 300 million value for Quadrant’s Dorado oil discovery, given that it is early days. Dorado encountered 132 metres of net hydrocarbon pay, including 80 metres net oil pay, and two appraisal wells are planned in advance of 2020 front-end engineering and design. Dorado is favourably located in shallow shelf waters in high-quality sandstone reservoir. Our midcycle Brent crude price forecast is unchanged at USD 60 per barrel (2021 real).

In addition to delivering Santos increased asset ownership and operatorship, Quadrant strengthens Santos’ offshore operating capability and confers 52,000 square kilometres of Carnarvon Basin acreage, from which multiple near and medium-term development and appraisal opportunities arise. Dorado is a case in point.

The Quadrant transaction will take Santos’ ownership of the Varanus Island and Devil Creek gas hubs to 100% from 45% and adds 28.6% stakes in BHP Billiton’s Macedon gas and Pyrenees oil hubs. It also confers a 52.5% interest in the Ningaloo Vision oil field with Inpex. Facilities across the assets include well head and production platforms, pipelines, processing facilities, and storage tanks. Infrastructure and Quadrant’s offshore operating expertise will be able to be leveraged across Santos’ portfolio to potentially powerful effect.