Cairn India: Sell

Since our buy call in May, the Cairn India stock has tanked 18 per cent. Three factors have led to this. First, the company’s corporate governance was called into question. The surprise announcement in the June quarter results about a $1.25-billion loan to a subsidiary of Sesa Sterlite — also a part of the Vedanta Group — got the market’s goat.

Since Vedanta’s takeover of Cairn India in 2010-11, a section of the market was worried that Cairn’s cash may be used to bail out weaker companies in the Vedanta Group. The loan arrangement seemed to vindicate these concerns.

Next, the sharp slide in the price of crude oil — Cairn India’s main revenue generator — has been a big drag on the stock. From $115 a barrel in mid-June, the price of Brent crude has fallen to about $85 a barrel. While the price dip helped the public sector oil explorers — ONGC and Oil India — by cutting down their subsidy burden, Cairn, a pure play on crude oil prices, bore the brunt. The realisation for Cairn’s Rajasthan oil, a waxy variety, is priced at a 10-15 per cent discount to Brent; so a fall in the latter hurts the company.

Finally, Cairn’s financial performance in recent periods has been nothing to write home about. Profit in the June and September quarters was down 65 per cent and 33 per cent year-on-year.

While this is mainly attributable to accounting changes and reduced output due to shutdowns, the company’s operational performance was also weak with lower realisations and increased costs.

Due to the dip in profits, the Cairn stock, even after its recent fall, trades at about five times its trailing 12-month earnings, in line with the past three-year average. While it seems cheap on a valuation basis — ONGC and Oil India trade at 12-15 times — investors can consider exiting the Cairn stock. Three factors underlie the recommendation.

One, while trying to predict global crude oil prices can be a mug’s game, it seems more likely than not that prices may remain under pressure (below $90 a barrel) in the near- to mid-term.

This is due to economic weakness in Europe and China, more US shale oil supplies, and OPEC leaders, such as Saudi Arabia, choosing to cut prices and maintain market share rather than raise output. Weak oil prices could negate the benefit from expected higher output in Cairn’s mainstay Rajasthan asset.

Higher output from Rajasthan is crucial to Cairn’s growth. But here too, there is little to look forward to in the near term, with the company projecting flat production in 2014-15. It is optimistic of raising output sharply thereafter, with annual average growth of 7-10 per cent over the three years ending 2017.

But there could be a slip between the cup and the lip. The company has indicated that the peak output from the currently producing flagship Mangala, Bhagyam and Aishwariya (MBA) fields could be 180,000-200,000 barrels of oil per day — not much higher than the current production levels. The push to output may, therefore, have to come from new fields which are in tight reservoir formations and hence tougher to extract. This could mean uncertainties and delays.

Last but not the least, concerns about utilisation of the company’s cash hoard may remain an overhang on the stock, especially after the June quarter episode.

It is understandable if the market applies a valuation discount to the Cairn stock to factor in the risk of the company deploying capital sub-optimally.