Hold on to Cairn India stock, say analysts

Analysts expect oil production at Cairn's Rajasthan block to grow at a compounded rate of about 8% through FY13-16

On Tuesday evening, Cairn India’s board approved a plan to buy back shares worth up to Rs 5,725 crore at a price not exceeding Rs 335 apiece, through the open market. Assuming full utilisation of the proceeds at the upper price limit, the steepest reduction in equity capital would be about 8.9 per cent.

Though promoters will not participate in the buyback (but Cairn Plc may), the process may raise Vedanta group’s holding from 58.8 per cent to 64.5 per cent. Analysts believe the buyback is positive, as it addresses a few investor concerns and may raise Cairn’s earnings per share (EPS) seven-eight per cent and boost return ratios.

While the buyback is positive from a business perspective, analysts expect oil production at Cairn’s Rajasthan block to grow at a compounded rate of about eight per cent through FY13-16. The company’s focus on exploration activities in its key blocks and successful discoveries will drive the share price, believe analysts. Key downside risks are a sharp fall in crude oil price, strengthening of the rupee, etc.

Therefore, given the possibility of strong upsides from current levels, analysts believe investors should stay invested, not tender their shares in the buyback. “I do not think retail investors should tender in the buyback, as there is upside potential in the scrip, led by reserves accretion,” says Nitin Tiwari, oil and gas analyst at Religare Capital Markets.

Of the 12 analysts polled by Bloomberg this month, 11 have a ‘buy’ rating on the stock, while just one has a ‘hold’ rating. Their average target price stands at Rs 390, indicating a potential upside of about 20 per cent from current levels. With the buyback proposal, Cairn India has addressed key investor concerns at a single stroke. In a report, CLSA analysts said, “We see this move as a significant positive, as it (a) will provide support to the stock (b) removes the overhang of share sales at a discount by Cairn Energy and (c) gives a positive signal on Vedanta’s intent on the use of Cairn’s cash.”

While part of its huge cash kitty of $3.2 billion will now be put to effective use, the company will maintain its 20 per cent dividend payout ratio and stick to its capex target of $3 billion through the next three years. Analysts expect the company’s annual free cash flow generation to remain strong at $1.2 billion and support its capex plans.

Apart from improving investor sentiment on the stock, this move is likely to positively affect return ratios, too. Since the buyback will have to follow the new norms prescribed by the Securities and Exchange Board of India, Cairn India will have to utilise half the proceeds (subject to the highest price) within six months from the beginning of the buyback (estimated in January 2014). That means if the price is up to Rs 335, Cairn India will have to buy back shares worth at least Rs 2,862.5 crore.

However, the buyback price is slightly lower than analysts’ expectations, which explains the flattish stock performance on Wednesday.

“While the buyback price is marginally below our expectations, we believe the large buyback quantum is positive, as it highlights Cairn’s strong operational cash flow visibility ahead, efficient cash usage, which on reduced equity will improve yield, and increased potential of positive exploration drilling updates and reserve accretion in 2014, driving valuations higher,” says Ashish Jagnani, an analyst at UBS. Another positive is Cairn UK can use this opportunity to reduce its stake in Cairn India, without significantly disrupting the market price.

“The buyback announced represents 58 per cent of the traded volume in the last six months and could substantially increase liquidity in the stock. As a result, Cairn UK may use this opportunity to sell part of its 10.3 per cent stake. At the same time, we note Cairn UK has surplus to meet its capex requirements till December 2015 and is carrying out a buyback currently. So, a complete exit seems unlikely,” says Arya Sen, equity analyst at Jefferies India.