Value Investor: Woodside plays the long game

Woodside’s decision to terminate the Leviathan joint venture reflects management's prudence, but also raises questions about the group’s near-term growth prospects.

Woodside Petroleum has been returning capital to shareholders and attracting yield investors. However, the current share price (north of $40) cannot be justified on the future outlook for Woodside, given its lack of near-term growth opportunities.

Last week, Woodside announced the termination of the Leviathan joint venture project due to the inability to reach a commercially acceptable outcome during negotiations. Funds earmarked for Leviathan totalled $1 billion, leading to expectations of another capital return to investors.

The decision to terminate the deal reflects Woodside’s prudent and careful approach to capital investment. CEO Peter Coleman stated that “while Woodside’s commitment to growth is strong, even stronger is our commitment to making disciplined investment decisions.”

This is good news for value investors, with management committed to growth and investment decisions based on the creation of value. However, the termination of the deal raises questions about Woodside’s growth prospects. Expansion from developments need time to be realised, with the Browse floating LNG development still in the design stage and production not expected to start until 2020.

While Woodside has several long-dated growth options, a temporary fall in production after 2016 is expected. Management is under pressure to invest in new projects, if they wish to offset the natural decline in production (and earnings and dividends).

Positively, concerns that management would buy overpriced assets for the sake of growth have been alleviated by the terminated Leviathan deal. While a merger or acquisition may reduce dividend payouts, it would likely add value, given management’s disciplined approach to investment.

Woodside’s overall growth strategy continues to be underpinned by strong global demand for natural gas and the increasing role of LNG in the global gas supply mix.

Although near-term growth opportunities are limited, the long-term outlook for LNG remains positive. It is expected that by 2030, global demand for LNG will be more than double the 2013 level of approximately 240 million tonnes per annum. This amounts to an average annual growth rate of 4-5 per cent.

The Asia-Pacific region comprises approximately 70 per cent of global LNG demand. Woodside is seeing significant demand growth across India and South East Asia. In addition to LNG’s use in power generation and commercial and residential applications, LNG is increasingly becoming an important transport fuel.

However, there is increased competition for supply into the Asian market – USA is set to become a global LNG exporter by 2016, with approximately 20 million tonnes per annum of new US LNG supply under construction at the end of last year.

Last week’s headline was that Russia's state-owned energy company Gazprom signed a 30 year gas supply agreement with the China National Petroleum Company - a deal worth more than US$400bn.

By the end of this decade, Gazprom will supply around 28 million metric tonnes per annum to China. As illustrated in the chart below, this equates to around a third of the expected demand from China/India.

Figure 1 – Global LNG Demand

Graph for Value Investor: Woodside plays the long game

Graph for Value Investor: Woodside plays the long gameSource: Wood Mackenzie, Woodside Investor Briefing, May 2014

Although the deal will take a chunk out of the Chinese import market, China is not the dominant player in global LNG, unlike in other commodities (such as iron ore). Further, China’s demand for LNG is growing and by 2030, demand for LNG from the China/India market is expected to be at least four times Gazprom’s supply.

We adopt a return on equity of 18 per cent, marginally below the five-year average of 20 per cent to reflect Woodside’s weaker near-term growth profile. The 12.5 per cent required return reflects Woodside’s strong balance sheet, large market capitalisation, and its mostly international earnings. We derive a fiscal 2014 valuation of $31.87.

Figure 2 – Future Valuation of Woodside Petroleum

Graph for Value Investor: Woodside plays the long game

Graph for Value Investor: Woodside plays the long gameSource: StocksInValue

WPL is trading significantly above value. The current market price implies a ROE of 24 per cent, or a RR of 9 per cent. Even consensus ROE estimates (blue above) are not so bullish.

The low level of reinvestment of capital, reflected in WPL’s high payout ratio, is why Woodside has slow intrinsic value growth in the near term (green above).

While WPL’s share price is currently supported by an attractive yield, this may not be sustainable long term if WPL secures suitable growth opportunities. Furthermore, an eventual recovery in interest rates will likely present downside risk to the share price as income seeking investors rotate out of higher-yielding equities into lower risk fixed income products.

With earnings difficult to predict due to variances in production volumes, exposure to commodity prices (namely, oil & LNG) and currency risk, we would require a 10 per cent margin of safety before investing in Woodside.

By Brian Soh and Amelia Bott of StocksInValue, with insights from Adrian Ezquerro and George Whitehouse of Clime Asset Management. StocksInValue provides valuations and quality ratings of 400 ASX-listed companies and equities research, insights and macro strategy. For a no obligation FREE trial, please visit StocksInValue.com.au or call 1300 136 225.