STO - BUY IMO, page-63

morningstar report released this week...

Santos Limited (STO)
Update: Santos??? First Quarter In Line With Expectations; Free Cash Flow Reduces Net Debt Again
Recommendation: Accumulate Change: No Change


We retain our AUD 5.30 per share fair value estimate, with first-quarter 2017 production down 2% to 14.8 million barrels of oil equivalent, in line with expectations. Santos maintains all 2017 guidance. The marginal production decline reflects cyclone activity and the sale of the Victorian, Mereenie, and Stag assets, substantially offset by stronger production from the Fairview and Roma gas fields. The Fairview and Roma improvement favourably reduced third-party gas feed to Gladstone LNG by 7%.

GLNG continues to ramp up, with gross quarterly output up 8% to 1.4 million tonnes, or two thirds of full capacity. We forecast an above 10-fold increase in Santos EPS, from an admittedly low AUD 0.04 2016 base to almost AUD 0.50 by 2019. This reflects GLNG achieving full capacity, third-party GLNG feed continuing to fall substantially from first-quarter 2017's 57% level, and crude oil prices rising from current USD 52 per barrel levels to our midcycle USD 60 forecast. Complete displacement of GLNG third-party gas would increase our fair value estimate to AUD 6.00, but this is not our base case. The current AUD 3.60 share price pitches Santos on attractive prospective 2019 price/earnings of 7.4 and franked dividend yield of 5.4%, assuming a 40% payout. Shares are 30% undervalued, with the market not fully crediting the leverage in rising equity gas contributions through Gladstone.

We like Santos??? focus on supporting five core, low-cost/long-life natural gas assets, all with significant upside potential. The company???s forecast free cash flow break-even for 2017 is USD 34 per barrel. This is the way to improve the company???s competitive position, though we don???t expect a moat for the company anytime soon, as PNG and Gladstone's LNG trains were built at the peak of the resources investment boom. In our base-case oil price regime, Santos is not expected to generate midcycle returns on invested capital above its cost of capital. Our high fair value uncertainty rating stands.