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Drilling out the moolah

A cash rich balance sheet, aggressive capex plans and production ramp-up are the precise ingredients Cairn needs to march ahead

Cairn India is one of the few successful hits of the domestic oil exploration history. Having struck black gold in the deserts of Rajasthan in 2004, there was really no looking back. In December 2011, Scotland-based Cairn Energy Plc, the promoter of Cairn India sold 58.5 per cent stake in the company to Anil Agarwal's Vedanta Resources. Initially there were reservations in some quarters about how Vedanta would manage Cairn given that it had no prior experience in running an oil exploration company. Much of those fears proved unfounded given the steps and the strategic decisions the company has taken since

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Strengths and opportunities
Post the success of its Barmer oilfield, the market had become concerned that Cairn would remain a single field player. Also, doubts over the actual production coming on-stream made the market jittery. But Cairn has addressed those fears by expanding its asset base. Today, Cairn has one block in Barmer (Rajasthan), two blocks on the western coast of the country, six on the eastern side and another in South Africa.
Cairn's current production stands at 1,75,000 barrels a day. That is still quite far from the potential of 3,00,000 barrels a day. Though full utilisation may still be far away, Cairn is putting its focus into increasing output incrementally. With its Aishwarya field in Rajasthan coming on-stream in the last quarter of FY13, production is set to receive a boost to around 183 kbpd ('000 barrels a day) in the next couple of months. At its peak, Aishwarya will produce 10,000 barrels a day. With further exploration approvals received from the Government, Cairn is more likely to reach production levels of 240,000 barrels a day by FY15.
In a bid to move away from its dependency of its single field, Cairn has undertaken an aggressive capex programme that will see it investing $3 billion between FY14-16. Around 80 per cent of that capex will be invested in the Rajasthan alone. During this period, Cairn will drill around 450 wells that will include 100 exploratory wells. This is in itself a huge step-up for the company which drilled only 25 wells in FY13.
The company has drilled 157 out of the 162 approved wells in Mangala (Rajasthan). It plans to drill the remaining wells along with 48 infill wells (new wells drilled between producing wells in a bid to maximise output) in FY14 itself. At the company's Bhagyam field (also in Rajasthan), 66 out of the 81 approved wells have been drilled. Cairn plans on drilling 16 additional wells in this field.
Cairn India is expected to generate cash from operations to the tune of $5.6 billion over the next three years (Nomura estimates). That puts the company in a comfort zone as far as its ambitious capex plans are concerned -- they will need an outlay of only $3 billion during that time -- leaving Cairn with enough change at its disposal.
Cairn India is already cash rich. Cash and investments total over ₹21,000 crore (FY13). That comes to around ₹111 per share or one-third of the current market price.
Cairn has guided that it will distribute 20 per cent of its net profit as dividend to shareholders, in the absence of any other capex and acquisition plans, cash and investments could amount to $5 billion by FY16. According to Jeffries, this has the potential to allow the company to raise its payout to as much as 50 per cent without affecting operations in any way.
Cairn invoices its sales in dollars. A higher dollar nudges up both its topline and bottom-line. As such it stands to gain substantially from the recent decline of the rupee. According to Goldman Sachs Global Investment Research, Cairn India could gain as much as 6 per cent in its FY14 EPS for every rupee decline against the dollar.

Concerns
Some of the key concerns include fall in global oil demand and the consequent lower crude price.
Excessive supply due to ramp-up of oil production in Saudi Arabia is another factor bearing on crude prices. An unexpected fast pick-up of shale oil production among in a number of large countries including the US, China, Brazil and Estonia could also impact crude demand and price in the future. The US has the largest reserves of shale oil in the world. Every $1/bbl fall in the Brent crude price could potentially result in impacting Cairn's FY14E earnings by around 1.4 per cent (Deutsch Bank estimates). Then there are local risks -- that of the Government delaying permissions or introducing policies that could impact the fortunes of oil exploration companies. This risk is real as the Government has a history of announcing ad hoc policies that affect the fortunes of the sector participants.

Financials
As a company whose revenues are dependent on capacities coming online, Cairn has seen a phenomenal growth in its topline over the past couple of years. Revenues have grown from ₹10,277 crore levels in FY10 to ₹17,524 crore in FY13. But historical run rate as applicable to other stable businesses does not apply to Cairn. Nor are they any good at indicating future growth rates. Because as discovered wells reach maturity, their output starts to slide down threatening to take topline down with it. Cairn's Mangala field according to the management is already showing signs of plateauing at 1,50,000 barrels/day. This is why Cairn needs to invest continuously to find new assets to ensure its profitability sustains. Oil exploration is a hit-and-miss game with more misses than hits. But when companies do hit oil, they can potentially even buy the bank. And that is what Cairn is setting out to do -- find its next Barmer oil field.

Valuations
What is important is that Cairn trades at a very reasonable valuations of 9 times its trailing 12 months earnings. A sum of the parts estimate of fair value taking into consideration plateauing of production at 2,10,000 barrels a day between 2016-18 and a 15 per cent decline thereafter puts Cairns value at ₹350 (Jeffries estimate). That means Cairn trades at around 15 per cent below its valuation. Deutsche Bank values Cairn's assets at ₹330 per share while ICICI Direct values it at ₹360 per share. Buy with a five year investment horizon.