Stockwatch: asset sales and tribunal verdict boost payout prospects

After a judgment in this mid-cap company’s favour, Edmond Jackson offers his verdict on the FTSE 250 stock.

Despite recent years of financial losses and a mixed operations’ narrative, mid-cap oil exploration and production group Cairn Energy (LSE:CNE) is adding grist to its payout potential. 

Following last autumn’s sale of its Senegal assets for $525 million (£390 million) with a further $100 million due according to performance, it was announced on 17 December that Cairn would pay a special dividend of 32p a share – on 25 January, to registered holders as of 8 January. Currently around 210p, that implies a return of more than 15%. 

Circa 85% capital upside if litigation award is fully paid out 

The market price has jumped from around 170p due to news on 23 December of a $1.2 billion arbitration award, plus interest and costs, awarded after six years of litigation between Cairn and the Indian government. This related to a 2006 re-organisation of Cairn’s India business before listing on local stock exchanges, the government had contested was unlawful tax avoidance. 

Yet an international arbitration tribunal in the Netherlands ruled in Cairn’s favour, such that an estimated million for interest and $20 million for costs may take the total to $1.4 billion or £1.07 billion.  

That equates to 181p a share based on 590 million issued, and compares with a market capitalisation of £1.3 billion. Other things being equal therefore, the market has credited only about a quarter of the cash value of the litigation award. 

Either Cairn has fallen off investors’ radar after a long decline from over 500p a decade ago, and/or the market is highly cautious the Indian government will pay up. 

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A self-serving analysis would suggest India will, if it wants to attract future foreign investment. This would pave the way for another substantial payout or even series of special dividends, according to how the board weighs up its corporate development options, to best maximise shareholder value. 

India initially digs in its heels, somewhat

Only three months ago Vodafone (LSE:VOD) similarly won a $2 billion tax refund claim case against India, which was decided by an international arbitration tribunal in The Hague. At the time, several members of its government said that they would reject the ruling. It could, however, be nationalist flourish – appealing to the Indian populace by showing that its government has not simply kowtowed – than what the country will end up doing. 

In response to Cairn’s award, the government has said that it will study the order and “will consider all options and make a decision on the further course of action, including legal remedies before appropriate fora”. That would appear to imply some form of appeal. 

Ultimately, it depends on whether India wants to be seen to be following judgments based on international law and arbitration, as a basis for commitments to the country. You take your view as to the event risk involved, where the market sees only a 25% probability of full settlement. 

Do wider fundamentals underwrite the stock anyway?

One way to consider this is whether Cairn is sufficiently well supported by its underlying fundamentals and oil-price prospects anyway, such that the litigation is a speculative nicety “in for free”. To buy into a fundamentally risky oil E&P stock, you should reckon on at least 25% upside potential.

I cannot give firm answers on Cairn’s projects, but to simplify, recall how I made a case for Royal Dutch Shell (LSE:RDSB) last March at around 1000p: oil companies were cutting investment spend in response to Covid-19, thus sowing the seeds of an oil price rebound as demand recovers yet supply stays constrained. 

This essential hypothesis has borne out in the way oil has roughly doubled in price since the March drop, aided by Asian demand, while that area of the world remains relatively robust. Hence, E&P stocks have recovered usefully – Shell by around 30% and Cairn by around 150% from March lows – Cairn’s greater upside given it is perceived riskier  

At first sight, the table of recent years’ results is off-putting – not even revenue posted in respect of 2014 to 2016. Heavy losses are involved, albeit much lower when normalised – i.e. amortisation charges are to an extent involved. Despite a production base, there is no dividend policy, capital expenditure often being well in excess of operational cash flow. This has put Cairn’s identity in no-man’s land versus E&P stocks that typically polarise between big-cap dividend payers and smaller ones focused on exploration. Mid-caps can be useful hybrids but Cairn has plenty to prove financially. 

Yet the recent years’ chart has still shown this stock broadly tracking oil prices. It is only when a bumper discovery is made or, on the downside, management makes duff acquisitions or assumes too much debt, that an E&P stock diverges up or down.   

Over 200p, Cairn has re-gained 2019 highs when oil prices averaged $64 a barrel, $7 lower than in 2018. The consensus forecast for 2021 is for $48 to $54 oil, hence on a chart basis the stock is modestly pricing in the litigation win. 

Its 2020 trend has broadly tracked the sector: a sharp fall from late February to mid-March, then a volatile but evolving recovery. This is why I would tend to prioritise oil prices than fret overly about operational details. As I explain below, I am medium-term bullish on oil.

Messy income statement yet decent balance sheet and cash flow

Cairn’s first-half 2020 results showed net oil production averaging 22,400 barrels a day, at the top end of guidance, with an average realisation price of $40.2 a barrel versus average production cost of $16.3 a barrel. Fundamentally that is a good show. 

Amid the pandemic, however, continuing operations’ revenue eased 20% to $215 million and cost of sales doubled to $70 million; then depletion/amortisation charges whittled gross profit down to $37 million. A raft of further costs – $239 million constituting impairment, also $68 million unsuccessful exploration costs – ramped the reported operating loss up to $284 million versus a $73 million like-for-like profit. On an underlying basis, Cairn remains profitable though. 

The interim cash flow statement was more robust, despite a 21% slide in net cash from operations to $136 million. Investment spending of $278 million was only partially offset by $105 million from a disposal, but altogether closing cash managed to advance 46%. 

Net assets are around 200p a share and liabilities show no bank debt, just $262 million lease liabilities and $139 million decommissioning provisions, while end-June cash was £84 million. That is a clean contrast to the multi-billion debts bedevilling Premier Oil (LSE:PMO) and Tullow Oil (LSE:TLW).  

Bullish oil price outlook for the next two to three years? 

I feel a speculator can take heart that oil prices look likely to be supportive. Brent crude continues to edge up, at $50.4 a barrel, and OPEC and Russia have agreed to tentatively increase output from January. 

Demand will be the key: currently some oil traders suggest the biggest economic bounce in 15 years will come. Obviously, that assumes broad global success with Covid-19 vaccination, with pent-up spirits released for travel. 

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 Fossil fuels will remain the go-to energy source for the next two years; alternatives cannot fill any gap arising in a post-Covid era. Supply will be constrained because oil majors have cut five years’ worth of capital expenditure in one year, while US president Joe Biden is anti-fracking and pro-environment. 

It is a speculative view, but I think oil prices can beat expectations, towards $55 and better, hence it makes sense tactically to consider equity candidates for exposure. 

A higher risk/reward play 

Recognise the aspect of risk, India may well prevaricate and this weighs on Cairn’s share price. But in terms of overall risk/reward profile, the arbitration verdict offers attractive upside – also a 32p special dividend in the New Year – with downside risk limited by net asset value and a decent outlook for oil prices. Buy. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.