Australia | Dec 07 2016
Origin Energy's decision to spin off upstream oil & gas assets is seen as sensible but brokers have rushed to downgrade ratings on valuation.
-Valuation of new company dependent on debt load, overheads and offtake agreements
-Divestment will aid a reduction in Origin's debt levels
-May foreshadow further divestments in LNG business
-Credit Suisse questions IPO versus a trade sale
By Eva Brocklehurst
Origin Energy ((ORG)) is preparing to spin off its conventional upstream oil & gas assets via an initial public offering of shares (IPO). There are few details at this stage but the IPO is planned for some time in FY17. It will include the interests in Otway, BassGas and Kupe and projects in the Perth, Cooper, Bonaparte and Canterbury basins.
Significantly, the company will contract all of the current gas resources held by these assets prior to the IPO. Upstream assets related to APLNG, as well as the Browse and Beetaloo interests, will be retained. The main factors brokers require to determine valuation of the new company are the amount of debt load provided by Origin, the extent of corporate overheads and the offtake agreements that will be reached prior to the IPO.
Hence, Morgans does not hold great conviction in its preliminary valuation range for the spin-off at $1.5-1.7bn. The indicative valuation range suggests the company will be able to pay down a meaningful portion of its $9.1bn in debt and the broker calculates the combined return on invested capital of the IPO assets does not clear the company's cost of debt. On the basis of these factors alone the broker believes the move to spin off the assets is a positive.
Morgans downgrades to Hold from Add, following a 40% increase in the share price since coverage was initiated back in April. Share price strength, plus the significant unknowns surrounding the new company, gives the broker the impression the stock is trading at fair value. An ongoing recovery in oil prices and smooth ramp up of APLNG are the key upside catalysts.
Credit Suisse is less of a believer in the fair value of stock and reluctantly downgrades to Underperform from Neutral. The broker does not believe the IPO will be accretive to value although considers divestment is strategically the right thing to do. The divestment will materially reduce the capital intensity of sustaining earnings, about which Credit Suisse believes Standard & Poor's has been too generous in assuming they can sustain the company's debt levels.
The broker does not envisage any conglomerate discount in Origin's share price currently, although assesses it a more investable business after the divestment. All up, Credit Suisse concludes that the starting point of the share price just feels wrong.
Outside of the valuation, the broker's main difficulty lies with the use of an IPO rather than a trade sale. The broker asserts that equity markets, bidding with no synergies, should never outbid a trade buyer. Other bidders may exist but, strategically, the broker believes Beach Energy ((BPT)) is the right suitor for the assets. Has it had a look in? The Cooper Basin is the only asset in common between the two companies but the broker calculates material corporate cost synergies exist versus a stand-alone IPO business.
Origin will put in place gas supply contracts between the new company and the energy markets business to replicate current supply. The transfer price involved will determine the relative earnings split between Origin and the new company, and thus the value of the new company. This is not a zero-sum game, Credit Suisse contends, given the market will likely apply a lower multiple to the earnings in the new company than it will to Origin's energy markets business.
To Macquarie, packaging all the assets into a single asset is logical versus the piecemeal sales program that was previously flagged, as it produces a business similar to other mid-sized oil companies. Importantly, it offers growth opportunities in the Perth Basin, Kupe and Otway through new developments.
The broker envisages scope to reduce overhead costs for Origin which equal or exceed the cost structure added to the new company. An IPO accelerates the restoration of the dividend and the size of the dividend, in Macquarie's opinion. The broker is advising origin and thus restricted on offering a rating and target at present.
The transaction does not, on its own, solve the company's debt burden but should be helpful, Deutsche Bank notes. Strategically, the broker believes this could foreshadow a future second step in LNG divestments, which may help crystallise longer-dated value. The broker does not expect this to occur until such time as both APLNG debt becomes non-recourse to Origin and there is sufficient debt amortisation to allow two companies to stand independently.
This IPO is no game changer, in the broker's opinion, as Origin's earnings will experience a corresponding decline and debt will remain elevated. The broker considers execution risks are reasonable, given the relatively mature and short-life assets, some of which have been the subject of unsuccessful trade sale attempts over the past 18 months.
The company has positioned its integrated gas assets as Australia's "largest onshore unconventional gas developer ", but did not rule out further divestments over time, Morgan Stanley notes. The broker considers the IPO strategy a logical one and awaits execution details next year, agreeing that how much Origin will realise depends very much on the contracts which will be procured.
Citi values the new assets at $2.5-2.8bn, based on a US$50-70/bbl oil price outlook, and expects $1.8-2.1bn of IPO proceeds to flow back to Origin, after corporate costs are allocated. The broker believes the main driver for the divestment is a belief by management that the stock is trading at a discount to fair value.
While AGL ((AGL)) is trading at a premium multiple to that inferred by Origin's energy markets, Citi believes this is justified as AGL has a stronger growth outlook and balance sheet, while Origin retains material exposure to oil and LNG markets through APLNG.
The broker notes a de-merger also does little to change the chequered history of project execution and asset performance in energy & petroleum markets and does not de-risk APLNG, while value will be lost through fees and the IPO process. Citi downgrades to Neutral from Buy and expects a meaningful re-rating of Origin's multiple may take several years.
Ord Minnett adds up the sale proceeds as possibly netting as much as $3bn. The downside is this removes the natural hedge for the gas retailing business, and it remains to be seen what contractual arrangements can be made.
The run-up in the share price means the stock is now trading in line with the broker's valuation, leading to a reduction in the rating to Hold from Accumulate. In addition, the broker believes cash distribution from the APLNG to Origin could underwhelm in the near term and be a headwind for the stock in FY17.
FNArena's database shows one Buy rating (UBS, yet to update on the announcement). There are five Hold ratings and one Sell (Credit Suisse). The consensus target is $6.27, signalling 0.5% downside to the last share price. Targets range from $5.40 (Credit Suisse) to $6.95 (Citi).
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