Santos: Interim result 2014
Recommendation
The early start to the PNG LNG project, of which Santos owns a 13% stake, is an example of the change that this once sleepy gas producer is undergoing. The project will produce about 7m tonnes of LNG a year, all of it at oil-linked prices. Although PNG LNG made only a small contribution to the half year result – volumes rose just 2% – revenue rose 25% partly because oil and LNG attract higher margins than gas.
This is, in a microcosm, the change that management is trying to engineer across the business. Long a producer of low margin gas, Santos has chased oil and LNG projects to lift margins. When the Gladstone LNG (GLNG) project is complete in 2015, about 70% of output will be linked to oil prices. That means higher production will lead to a disproportionate increase in profit.
That has been known for a while which is why Santos has been on our buy list. What was unclear before this result was what management intended to do with higher cash flow. Dividends appear to be part of the answer. The company raised the interim dividend by a third to 20cps (fully franked, ex date Aug 27) and noted it would pay more as cash flow improved.
Key Points
- PNG LNG starts early
- Concerned about GLNG returns
- Share price up, downgraded to Hold
Unlike, for example, Woodside, Santos has ample development projects to replace and grow output. Dividends will surely rise but they are unlikely to match the payout ratio of Woodside and the company won't shut its wallet as peers have done.
Worried about Gladstone
The company’s capital expenditure was noteworthy for its diversity. The largest portion, almost $800m, was spent on GLNG and another $150m on completing PNG LNG but Santos also spent almost $450m on projects in the Cooper Basin. In contrast, Western Australian fields received just $30m of investment.
Half-year to 30 June | 2014 | 2013 | /(-) (%) |
---|---|---|---|
Production (mmboe) | 25 | 24.5 | 2 |
Underlying NPAT ($m) | 258 | 250 | 3 |
Operating cash flow ($m) | 744 | 629 | 18 |
EPS (cents) | 26 | 25 | 3 |
DPS (cents) | 20 | 15 | 33 |
Franking (%) | 100 | 100 | n/a |
The attention lavished on the Cooper Basin is significant. It’s a lot of money to spend on aging fields that, only five years ago, were thought to be in decline. There are two objectives being pursued: Santos believes the Cooper Basin has a lot more life yet and it is desperately trying to find new gas to fill its Queensland LNG plant.
We’ve long argued that GLNG is short of gas. Santos and its partners have already bought some third party gas but, with drilling results less than spectacular, more is likely. The expenditure at the Cooper Basin could almost be classified as a GLNG expense.
Price matters
This highlights a potential pitfall at GLNG: if wells continue to disappoint, expensive gas will have to piped to the plant to fulfill contracts, reducing margins. Like Woodside’s Pluto, GLNG could ultimately deliver plenty of cash but a poor return on capital. We are therefore cautious about paying too much for Santos today and stick strictly to our recommendation guide.
The market greeted these results enthusiastically but they were merely average. Production was flat this year with PNG LNG offsetting declines in other fields, but that will soon change. Over the next two years, output should soar closer to 80m barrels of oil equivalent (boe) from just over 50mmboe today. As that potential nears, so does the prospect of higher profits and dividends.
That prospect, rather than approval of the interim results themselves, explains the market’s reaction and why, despite rising 10% since Santos: Result and upgrade (Buy - $13.72), we remain interested. With the share price creeping above our recommendation guide, however, we are downgrading to HOLD.