Forum Topics STO STO STO valuation

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Added 4 months ago
Justification



The market hates this compelling ASX income play

Santos continues to trade at a valuation that implies no growth in the years ahead. Our analyst Mark Taylor thinks that is misguided.

Joseph Taylor

02 December 2024

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At any time in history, there are certain stocks and sectors that are loved, and other stocks and sectors that are loathed. You don’t need to look very hard to see which area of the ASX is most hated right now.

In fact, I already made that clear in this article: it’s the energy sector. Today we’re going to take a look at an energy company that our analyst Mark Taylor thinks offers especially good value, and flesh out some of the reasons why.

First, though, a spoiler: this is not the first time I have underlined the value on offer in this share. In fact, I have highlighted it several times recently, during which time it has only continued to get cheaper.

I highlighted this company on September 20 at $7.05 per share, and again on October 15 at prices of around $7 per share. As we write, the shares have fallen to around $6.60. The company in question is Santos, Australia’s second biggest oil and gas producer.

Santos shares have drifted between $6 and $8.50 per share over the past four years and ultimately delivered a flat share price return, with dividends taking a shareholder’s total return to around 15%.

As Mark Taylor noted in his recent stock pitch, this is far behind the ASX200’s total return over the same period.


Why has Santos underperformed?

Mark Taylor sees a pretty clear reason for Santos’ underperformance in recent years: investors are concerned that the switch to renewable energy source will hit oil and gas demand. Mark, however, isn’t sure those concerns stand up to scrutiny.

I dived into some of the reasons for Mark's skepticism in an earlier article, but here is the elevator pitch:

  1. Global oil and gas demand continues to grow, fueled partly by population growth and the desire for better living standards in developing economies.

  2. In many cases, hydrocarbons cannot feasibly be replaced. Road transport vehicles look most vulnerable due to the rise of EVs, but not all use cases are as practical or cost-effective. Aircraft fuel and petrochemicals used for purposes other than fuel look especially hard to supplant.

  3. Natural gas has a particularly strong demand outlook, in part because of its potential to replace coal as a much cleaner source of back-up power.

Taken together, Taylor thinks that concerns surrounding medium-term demand for oil and gas producers like Santos may be overblown. Yet these worries appear to have weighed heavily on Santos shares, sending the company’s valuation to a multi-year low relative to earnings (shown by the blue line below).

At an Enterprise Value/EBITDA multiple of around 5 times, Taylor believes that Santos is being credited with essentially no earnings growth potential in the coming years. Even though, thanks to its Barossa and Pika growth projects, the company looks set to increase production and profits.

Taylor thinks these higher earnings could support a higher share price in the medium-term, even if markets do not award Santos a juicier multiple for delivering growth. And, of course, the shares could move even higher if investors are willing to change their view of the business.

Also looks cheap from other angles

Santos doesn’t just look cheap relative to its historic valuation multiple and its growth prospects. It also looks cheap versus peers that it has historically traded in line with – especially in the further out years, implying that markets are overlooking Santos’ growth potential.

At an enterprise value of around $15 billion, Santos also trades below what Taylor estimates it would cost to replace Santos’ gas production infrastructure alone.

Oil price assumptions offer further margin of safety

Mark’s discounted cash flow valuation for Santos relies on two main assumptions: 1) production growth thanks mainly to Santos’ new Barossa and Pika projects coming online in the near future and 2) mid-cycle Brent crude oil prices of 60 USD per barrel.

Given that Brent crude oil is currently over 70 USD per barrel and only traded below 60 USD barrel during the early days of the pandemic, this provides something of a margin of safety. Indeed, Taylor said that a mid-cyle oil price of 40 USD would be needed for him to get to Santos’ current share price.

What closes the gap?

Taylor thinks that Santos is worth $10 per share compared to recent prices of around $6.50.

While this implies plenty of potential upside from here, it is worth mentioning that Taylor recently cut this Fair Value by 20% as he assumed higher capital expenditures needed to produce each barrel of oil.

As we’ve alluded to already, Taylor is not relying on much other than earnings growth here. He expects that Santos can grow its earnings per share by an average of 13% over the next ten years, helped by the new projects coming online and potentially some share buybacks.

The combination of a strong earnings growth profile and a robust balance sheet, with net debt just over 1x annual adjusted profits, could also set the stage for healthy dividend growth. Indeed, Taylor forecasts distributions rising beyond USD 0.40 per share (0.60 AUD) from USD 0.26 in the last full year.


If Taylor is correct, this could result in a future yield on cost approaching 8% in the further out years of his forecast.

Combined with a seemingly cheap entry price, could make Santos shares an appealing option for income investors that don’t mind going against the crowd. The shares currently have a four-star Morningstar rating.

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mikebrisy
Added 4 months ago

@Chagsy I don't have a view on the value of $STO, but I'd steer a wide berth around any research note that doesn't specifically call out the following:

  • Opex per boe, now and expected future
  • Resource base, including developed and proven undeveloped resources matched to assumed production profile.
  • Specifically, the status of the Surat basin gas resource against remaining life of the LNG contracts, and the like GLNG plant utilisation over the next 10 years
  • Capex and production profle over next 5 years


This is not one that gets anywhere near my top 100 stocks..... unless there is a major slump in the oil price. (Then it might be a short term trade.)

Anchoring any analysis back to historical prices and financial multiples is almost meaningless.

I’ve always found GS pretty good on oil and gas, albeit on the optimistic side when we are mid-cycle … they have $STO at $7.90 at the mo.


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Bear77
Added 4 months ago

Good points @mikebrisy - I do hold STO in my SMSF - I don't have the numbers in front of me but their recent https://www.santos.com/news/santos-announces-updated-capital-allocation-framework-and-carbon-storage-growth-target/ Announcement (two weeks ago) suggests they have some capex requirements in FY25 but that their "updated capital allocation framework will target returns to shareholders of at least 60 per cent of all-in free cash flow from 2026, following a period of major capital investment to bring significant new production online from the Barossa and Pikka projects" [in FY2025 I assume]. So reduced capex requirements after this current FY based on that.

I agree with your points and you have the real-world experience to back it up of course. I do however think that the oil price is down, and that STO's share price is also down, and that this new updated capital allocation framework shift towards returning more capital to shareholders from FY26 onwards could generate some interest in the company, particularly if we have anything such as an escalation in Middle East tensions that causes a spike in oil prices. So I hold them for a short-to-medium-term trade myself, but I do agree that assuming the share price will mean-revert at some point to a higher level is not a great strategy.

9

Chagsy
Added 4 months ago

Thanks @mikebrisy and @Bear77 for your replies.

I must confess this was posted as a bit of a tease. I don't hold, and have little intention of holding, but am interested (perhaps overly) in taking contrarian positions. Not always to my advantage. I do not particularly understand commodity companies but suspect we are at a period of low enthusiasm for energy companies. As much as we would like to hope that they won't be needed in the future, my reading around the subject would suggest that inthe medium term all forms of carbon emitting energy sources are likely to have increasing demand.

It's deeply unfashionable and lots of investment vehicles will have mandates restricting their involvement. From a purely monetary POV this presents an opportunity. I wonder whether STO is one. This analyst certainly thinks so. I completely take your point about the lack of disclosed metrics used to derive his predictions for future earnings growth. I suspect that these were not published as this was mostly a bit of fluff publication, but honestly, if they were disclosed I wouldn't understand them. You will no doubt counter I have no business investing in a company I don't understand intimately - and you would be right! But contrarian plays often don't need any detailed understanding, just faith in the reversion to the mean. (ok that last statement was just to bait you)

c


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mikebrisy
Added 4 months ago

297b7aee171be7b6f30476d8d73d016a71d1de.png

10 year view. Not a great company.

Good prices? 2016/17 oil low; 2020 COVID panic. Each were 12-24m trades. Now, we’re mid cycle. Where’s the thesis for any upside?

Otherwise, nothing to see here. Call me next time oil is $30.

13

mikebrisy
Added 4 months ago

@Bear77 I agree, if you are focused on the detail of what’s going on, companies like $STO can be good trading stocks.

But it doesn’t pass my filter of a company with competitive capability, positioned to grow profitably for 5-10 years. Which is why I only invest in resources at deep cyclical lows.

So it’s a self-fulfilling prophecy ,… because of that, I don’t invest the time and effort to do the research in that sector.

But I accept that others who specialise in the sector can do well.

6

Bear77
Added 4 months ago

Your comments prompted me to revisit my investment thesis for STO @mikebrisy and @Chagsy - and I've realised my conviction level in Santos isn't high - you're right Mike, they haven't got a good track record of TSRs and I thought we were more towards the bottom of the cycle than the middle, but you certainly know the energy sector a whole lot better than I do, so I defer to your assessment Mike. So based on being mid-cycle and Santos not being a company I would want to hold for years, i.e. it only being a trade, it seemed fairly obvious that there are better places to invest that capital, so I sold all of my Santos today. So far I have bought another $26K worth of De Grey (DEG) at $1.91/share and with the other half of the proceeds of that STO sale, I've upped the cash level a little so that I have some more dry powder for the next opportunity.

CBUS pays me 5.25% p.a. interest on the cash in my transaction account (in my SMSF) so the cash isn't dead money, it's just money earning 5.25%, and it's nice to not have to sell something to buy something, which used to be the way I always seemed to operate; nowadays I am happy to have a higher cash weighting at various times.

We never know what tomorrow will bring.

9

edgescape
Added 3 months ago

Being a primary producer linked to a widely available commodity is always going to be a challenge I think unless you can keep costs down.

6