Cairn India

Cairn India (Cairn) is a good prospect for investors with a medium-term perspective and high-risk appetite. The company is a promising play on the hydrocarbon exploration and production sector in India, with reserves higher than initial expectations in its Rajasthan fields, and not being fettered by the subsidy regime. Recent significant increase in reserve estimates and production potential in its Rajasthan block, in-place sales arrangements, and good progress on processing and transport infrastructure, underpin our recommendation.

At the current price (Rs 291), the stock discounts its trailing 12 months earnings by a whopping 67 times. However, the company is likely to ramp up production and earnings significantly over the next two to three years, which should translate into reasonable valuation levels, going forward.

Despite its sharp run-up from the initial public offer price of Rs 160 in late 2006, and from lows of around Rs 100 in October 2008, we see further upside in the stock, primarily due to the company being at an inflection point in a market which depends significantly on imports to meet its oil and gas requirements.

Leg-up to production

The onshore Rajasthan block (comprising Mangala, Bhagyam, Aishwarya (MBA), Barmer Hill and other fields), in which Cairn has 70 per cent stake and potentially its most prolific production interest, received a significant boost in March this year.

The company announced an increase in the field's potential resource base to 6.5 billion barrels of oil equivalent (boe) from 4 billion boe earlier. With this, the company estimates production potential of 240,000 barrels of oil per day (bopd) at peak capacity, significantly higher than the 175,000 bopd estimated earlier.

In the near term, the company plans to ramp up production at the Mangala field from around 30,000 bopd currently to 125,000 bopd in the latter half of the current fiscal, and going forward to 150,000 bopd subject to government approvals. The Bhagyam (40,000 bopd) and Aishwarya (20,000 bopd) fields are expected to commence production in the next calendar. With additional exploratory and drilling work underway and enhanced oil recovery measures also being undertaken, actual production figures may surprise on the positive side. Cairn's strong execution track record and low cost of production also lend confidence.

Cairn's other production blocks — Ravva (22.5 per cent interest) and CB/OS-2 in Cambay (40 per cent interest) are in declining phase. Efforts to halt the decline and increase production are being undertaken. In addition to the above, the company has eight exploration blocks, including one in Sri Lanka.

The company has also been provisionally awarded bids for two blocks in the recent NELP VIII auction.

Tying up other ends

The other pieces of the picture also seem to be falling in place for Cairn. Tie-up of sales arrangements for 143,000 bopd to PSU refiners, MRPL and IOC, and private refiners Reliance Industries and Essar Oil provide comfort on the off-take arrangement for potential increase in production. Negotiations for additional tie-ups are underway.

Uncertainties regarding pricing also seem to have been addressed with Cairn pricing the Rajasthan crude (a thicker variety akin to Nigerian bonny light) at 10-15 per cent discount to monthly Brent averages.

The company's current output of around 30,000 bopd at Mangala is processed using the Train 1. Commencement of operations at Train II (50,000 bopd capacity) in late April is expected to give a fillip to Cairn's increased production endeavours. Train III which is expected to be commissioned this quarter and Train IV in the next fiscal will also further production.

Work on the 670 km special heated pipeline to carry Cairn's crude to end-customers from the Mangala Processing Terminal has also made good progress, with the pipeline up to Salaya in Gujarat expected to commence operation this quarter. The additional stretch up to Bhogat is likely to be completed in 2011. Crude transport via the pipeline as against the special heated trucking arrangement currently is expected to translate into substantial savings on transportation for Cairn.

Financials revving up

At a consolidated level, the company turned the corner in the 15-month period to March 2009. It registered profits (Rs 803 crore) on sales of Rs 1,433 crore, as against losses of Rs 21 crore in the five-month period to December 2006 and Rs 25 crore in the 12-month period ending December 2007.

Commencement of production in the Rajasthan block in late August 2009 also had a significant positive impact on the company's financials in the December 2009 quarter, with net sales growing 135 per cent over the previous year to Rs 495 crore, and profits increasing 23 per cent to Rs 291 crore.

We expect both topline and bottomline to grow significantly with the planned increased production in Rajasthan in the current fiscal and production plateau being reached over the next two to three years.

Though the company has a healthy margin profile (net margins around 56 per cent in the March 2009 period and 59 per cent in the December 2009 quarter), its return on equity was quite low at around 2.4 per cent for the March 2009 period.

This is however expected to improve with increasing profits, going forward. Debt-to-equity at around 0.1 as on March 2009 was also quite comfortable, leaving enough headroom for the company to resort to leverage, if required, for additional capital requirements.

Risks

Being a strong proxy play on crude, Cairn's fortunes are in a way inexorably linked to that of global crude price movements. Its advantage might turn into a disadvantage if currently buoyant oil prices (around $75 to $85 a barrel) do an encore of 2008 and dip sharply, whether due to speculative reasons or from a weakening in global economic conditions.

Sustained rupee appreciation will also hurt the company. Also, hydrocarbon exploration and production being an inherently risky business, Cairn may incur losses if exploration efforts don't fructify into success or don't match initial expectations.

On the regulatory front, the company has been paying in protest, cess on crude at an increased rate (Rs 2,575 per tonne), pending a dispute with the Government and its 30 per cent joint venture partner in the Rajasthan block, ONGC. An adverse outcome of the arbitration proceedings will be a negative for Cairn.

via BL