Cairn India IPO – Fair price Rs. 120 per share

Cairn Energy (UK) is coming up with an IPO for its Indian assets as a separate company Cairn India Limited. The IPO price band is Rs. 160-Rs190 and the issue is open from December 11, 2006 to December 15, 2006.

Background: Cairn Energy is an oil exploration company which sells its explored blocks to production companies once it strikes oil. The company’s core competence is exploration (and has a very good track record in that) and has negligible experience in production.

Cairn energy as it has done with other explorations around the world was looking to sell off its Indian blocks after striking oil. However greed took them in. And the credit for that goes to Merrill Lynch. Merrill Lynch’s Oil and Gas expert Mr. Rahul Dhir made a presentation to them that rather than selling off the block to one of the oil companies, Cairn Energy would be better off spinning off the Indian assets into a separate company and coming out with an IPO in the Indian stock market. The valuation expected in IPO as presented by Merrill Lynch was more than twice what Cairn Energy was hoping to get by selling the block to Production Company. Although the Cairn energy top bosses were not convinced that Indian assets can command that kind of valuation they were done in by the greed. They offered Mr. Dhir of Merrill Lynch CEO designation for the Indian subsidiary and lucrative stock options in return of leading the IPO process.

Can you imagine an Investment Banker becoming CEO of a company in a highly technical business like that of oil exploration & production? That what ‘irrational exuberance’ can do to people. The mad gold rush at the Indian stock market is providing opportunity to I-Banks and promoters to fool small investors.

I had discussion with couple of analyst in top notch Investment banking firms who have come up with research reports on Cairn India IPO. Although both of them have written in their report that the IPO is slight overpriced privately they admit that is grossly overpriced. When I asked them why they are not mentioning that it’s grossly overvalued – their response was they can’t bet against the market. They admitted such is an appetite for new IPOs that a good stock is lapped up at any price irrespective of valuation. And ofcourse a company that has stuck oil cannot be a bad company. But the question is VALATION??

Few things that need to be highlighted which has not been properly highlighted:

1. The company has almost no experience in production. The company’s core competence is only exploration
2. The company rather than having a technical person as CEO has got an investment banker as CEO. Not only would it be de-motivating for operating personnel it would also hamper the operations. Expect change in management soon after the IPO.
3. The promoter is not interested in the production business. Expect no management support and possible stake sale in the near future.
4. MRPL or ONGC has not given any firm commitment regarding offtake of crude produced. Refinery plan at the well head has already been put into the dustbin. The quality of crude makes pipeline transportation difficult as the crude solidifies in the pipeline if the required temperature is not maintained. Hence transportation would be a costly issue and it need to be solved immediately so that pipeline infrastructure is ready at the time of start of production. Considering the situation right now, it seems that it would lead to delay in the project.
Comparable crude trades at a discount of Brent crude price. The discount rate is currently around 20%. In India only Essar and MRPL refinery apart from Reliance Refinery is capable of handling such crude. Considering the transportation problem, geographical location of plants and relative strength of players my bet is – Cairn would on its knees sell the crude to Reliance at a heavy discount. (This is if they don’t sell out of the project completely before the production starts).
5. ONGC has disputed the claim of Cairn India that they are not liable to pay the cess. ONGC has claimed that Cairn India would have to pay 70% 0f the cess as they hold 70% stake in the block.
6. Cairn Energy would not be using the proceeds from the IPO for capital investment. The money would flow out of India to the parent company and its shareholders.

How I-Banks fool us

“Chor – Chor mosere bhai”. This is the only explanation I have to explain why other I-Banks are not coming out with a negative report on Cairn IPO. Couple of points worth noting in the Macquarie report:
1. To reach at Enterprise Value / Reserve multiple of 12.5 they have divided the total market capitalization of international oil companies by reserves. However total market capitalization includes valuation due of refinery and marketing assets also which has been ignored. (Infact it’s a goal seek calculation. Just to justify the valuation of Rs. 160 – 190 this mistake has been committed knowingly). Real multiple should not be more than 6.5 as that of ONGC. If same multiple is used for Reliance oil & gas assets valuation, the oil and gas assets of Reliance alone should be valued at Rs. 1,35,000 crores!!!
2. Secondly, each such exploration contact has some government share (In this case it ranges between 20% and 50% depending on cost recovery). Valuation should be discounted by same percentage.

When you discuss the same with these I-Banks the only argument they have to defend their recommendations is not valuations but the fact that Petronas has taken 10% stake in pre-IPO placement @ Rs. 176.5 per share. For Petronas this might be a hedging option or a “getting your foot in strategy” to pre-empt any other bidder for the assets. Or there might be some fine print to the deal knowledge of which is not available in public domain.

Anyhow not going into too much detail, my conclusion is:

1. You will get an opportunity to buy Cairn India shares at a price around Rs. 120 atleast once between listing and start of production.
2. If you want to take an exposure in exploration business you would be better off buying Reliance Industries shares.
3. At IPO price the shareholder would not end up losing only under two conditions. Either oil prices sky rockets by atleast 30% or Cairn India strikes more oil.
4. Don’t be surprised if SEBI pulls them up or if IPO price is revised downwards