>CAIRN INDIA LIMITED (CLSA)

BARRELS OF CASH

With the start-up of Cairn’s Rajasthan block imminent in the next couple of months, we expect focus to shift to cashflow generation. In this context, it will be important to track offtake agreements, the pace of production ramp-up and the crude pricing formula. The global crude price trajectory remains the key variable, though; we expect this to continue to trend up in 2H-09 and 2010 as demand supply tightens. Cairn is the most leveraged Indian play on this theme. BUY.

Production start-up imminent. With production from Cairn’s Rajasthan block expected to commence soon, we expect focus to shift on crude offtake agreements, the pace of production ramp-up and the crude pricing formula. The resolution on cess will take more time and is likely to require arbitration – Cairn may pay the cess under protest in the interim at current rates (Rs2500/tonne, $68m in FY10, $223m in FY11).

We model a gradual ramp-up. Initial cargoes will go to the government nominated refiners (IOC, HPCL, MRPL) but this covers only 35-40% of expected production in FY10-11. We expect more allocations to these refiners but Cairn will soon also require marketing freedom (sale to private refiners, exports) to ensure that the production ramp-up is not compromised as the state-owned refineries may not be geared near term to process more than 80kbpd of Cairn’s crude. Our models build peak output for Mangala in July-10; Cairn’s revised development plan indicates peak in Mar-10.

Pricing agreements soon. Cairn is still in negotiations with the nominated refiners on the pricing formula; we anticipate a decision soon. Our models are set at a 10% discount to Brent – the similar Duri-Widuri basket has traded at annual average discounts of 2-13% over the last 16 years. We had anticipated pricing for initial cargoes to be lower but media reports quote initial pricing with IOC, HPCL, MRPL for 64kbpd of offtake at Bonny-Light minus US$2.5-3.5/bbl (= ~2% discount to Brent); this will be a positive surprise. The pricing formula is important (1ppt impacts fair value by 1.1-1.6%) but the crude price trajectory is more relevant ($1 = 1.5-3.5%).

Strong leverage to crude. We expect crude to continue to trend upwards in 2H-09 and 2010 as demand-supply regime tightens on OPEC-compliance and disappointments in non-OPEC production. Cairn’s resource base and attractive fiscal contract makes it a perfect play on this theme. With the stock discounting $53/bbl based on the 2009 correlation with spot-Brent (R2:0.82x) and US$63/bbl on our DCF, we find risk reward favourable. Our target price (Rs250/sh, 12% WACC) is based on $80 long tem Brent.

Attractive cashflow multiples. While reported EPS will depend on the pipeline depreciation policy (Cairn still undecided, we assume a write-off in four years), our DCF implies 4.5x P/CE on full ramp-up. We anticipate a re-rating beyond these levels as earnings multiples also come into focus. Cairn’s strong multi-year cashflow profile should help; it will generate $1.6bn in average annual cashflow over ten years at $80 Brent ($1.3bn at current Brent). At 5.7x P/CF (10-year peer average), it could trade at Rs310/sh if accorded full going-concern valuations. Cairn is our top pick. BUY.

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