(Editor's Note: Investors should be aware that trading in DTNOF and DTNOY is illiquid. Investors with access to the Oslo Stock Exchange can consider shares of DNO.OL)
Between Initiation and Re-Initiation
I had initiated DNO International (OTCPK:DTNOF) on October 1, 2013 for a potential 25%-42% upside. The rally made my estimates look significantly conservative as DNO International surged by 71% three months after my initiation. It is pretty natural to witness some profit booking after the stellar rally and DNO International corrected by 20% over a period of one month, after peaking out at $4.1. Post a correction all the way down to $3.26, DNO International has surged back above $4 levels as the company's annual results (declared last week) had some surprises in store. I am re-initiating DNO International for another 60% upside. This re-initiation looks at the new developments since my initiation and its incremental impact on growth.
A Quick Company Overview
DNO International is an independent E&P company, geographically focused on the Middle East and North Africa with operations in Yemen, the Kurdistan region of Iraq, Tunisia, Oman, Ras Al Khaimah and Somaliland. As of December 2012, the company had proven and probable reserves of 520mmboe with 90% of the assets in Kurdistan. The Tawke asset in Kurdistan, where the company holds 55% stake, has over 700mmboe of extractable resources.
Stellar Results For 2013
As I mentioned earlier, DNO International corrected all the way back to $3.26 after touching an all time high of $4.1. The pre-result rally from $3.26 to $3.95 has been justified by the company's stellar performance for 2013. More importantly, the rally is a sustainable one and I will discuss the forward looking reason in the next section.
Coming to the results, the company recorded record high revenue of NOK2.97 billion ($475 million). While this was only 4% higher than last year, the important point to understand is that 2012 included export revenues. The full year EBITDA for 2013 was NOK2.0 billion ($329 million) and this translates into a healthy EBITDA margin of 69%. Another important factor would be the operating cash flow as DNO International has been incurring significant capital expenditure. For 2013, the company generated a healthy operating cash flow of NOK.17 billion ($276 million). The EBITDA cash conversion ratio was therefore high at 84%. I must mention here that DNO International also has a strong cash position of NOK1.6 billion ($258 million) as of 2013. These numbers do justify the pre-result rally. The important point to analyze is the reason why this rally will sustain over the next one year and the next few sections explain that.
Impact Of Export On Margins
On looking back at the growth story of DNO International, the company exported outside Iraq in the fourth quarter of 2012. Subsequently, payment issues resulted in exports being banned. With the export pipeline to Turkey functional, exports will again play a key role in the company's growth. I had discussed this factor in my initiation. I want to discuss it more in terms of numbers here as growth in 2014 will primarily be driven by exports.
In the fourth quarter of 2012, when exports were driving growth, DNO International had an EBITDA margin of 88% and a netback margin of 87%. The netback (USD/boe) was $53.07. If this is compared with the fourth quarter of 2013, the significant positive impact of exports is evident. For the fourth quarter of 2013, the EBITDA margin was 71% and the netback margin was 60%. Further, the netback (USD/boe) for the quarter was $25.15. Very clearly, exports are a game changer for the company.
The reason for elaborately discussing the margin is the fact that Tawke (the asset to be discussed) is now connected to the new Kurdistan export pipeline at Fish Khabur. DNO International has also set a new single day record for deliveries (pipeline and tanker) of 136,600 barrels. The year 2014 will therefore be an export driven year and the bump-up in revenue will be robust. I will discuss it in terms of numbers later in the coverage.
The Tawke Asset
The re-initiation is primarily based on the developments in the Tawke asset and the export pipeline to Turkey. Two more potential surprises, which were not discussed in my earlier article (Peshkabir license and Tawke Jurassic), can result in stock upside towards the end of 2014 and the beginning of 2015. This section will however discuss the Tawke asset and the reason for re-initiation as Tawke and the export pipeline were also discussed in the initiation.
DNO International holds 55% stake in the Tawke asset with Genel Energy (OTCPK:GEGYF) owning 25% and the Kurdistan Regional Government owning the remaining 20%. The Tawke asset is estimated to hold over 700mmboe of reserves and is one of the biggest assets in Kurdistan.
In my initial initiating coverage, the best case scenario was that only 50% of the production volume is exported from Tawke. This was to discount any delay in exports from the pipeline, which was expected to be completed in December 2013. According to the fourth quarter presentation, Tawke is already connected to the export pipeline at Fish Khabur through a 12 inch pipeline. Further, a new 24 inch pipeline is being installed to supplement the existing 12 inch pipeline. In other words, it can safely be assumed now that a majority of the production in 2014 will be exported. This is the first major change in assumption towards the positive as compared to my initiation in October 2013.
The table below gives the revenue, EBITDA and valuation assumptions considering exports from Tawke to Turkey. At 100,000 boepd production from Tawke, the revenue for 2014 is expected to be $1.7 billion and EBITDA at $1.4 billion considering a sale price of $70 per barrel. I have earlier discussed the EBITDA margin during the period of exports in 4Q12. While the EBITDA margin was 88%, I have considered a more conservative estimate of 80% as the total sales includes Kurdistan, Oman and Yemen.
Further, in order to consider a stress case scenario, I would consider production from Tawke at 90,000 boepd with a sales price of $60 per barrel. In such a scenario, the revenue and EBITDA would be $1.4 billion and $1.1 billion respectively. When I go down to valuations, I would consider this case as it gives a relatively conservative estimate.
The table below gives the best case revenue, EBITDA and valuation scenario from my initiation and my re-initiation. Clearly, the impact of completion of the pipeline is significant and it is therefore not surprising to see a renewed rally in the stock. Of course, this is not the only factor, which will drive upside for DNO International as compared to the last coverage. With the most important factor discussed, I would move on to the other surprises that might be in store during 2014 and early 2015.
Results From Tawke-21 and Tawke-22 Will Spur Upside
The Tawke license has yielded positive surprises for DNO International. In October 2013, Tawke-23 tested a new production record of 32,500 boepd. The impact on the stock price was significant with a 5% upside related to the production news. As of December 2013, Tawke-21 and Tawke-22 wells have been completed and undergoing testing. Going by the past record for Tawke horizontal drilling, it is entirely likely that production surprises are announced soon. This will help the stock gain further momentum as the production target of 200,000 boepd in 2015 becomes more realistic. The drilling for Tawke-24 and Tawke-26 along with three other horizontal wells is also planned for 2014 and can potentially spring surprises during the course of 2014.
I must also mention here that the wellhead capacity has increased significantly over the past one year in the Tawke license. From below 100,000 boepd in 2012, the wellhead capacity in 2013 was at 155,000 boepd. By the end of 2014, DNO International plans to increase the wellhead capacity to 270,000 boepd.
Appraisal of Tawke -29 (Jurassic) and Peshkabir
While all the Tawke horizontal wells will be production or development wells, DNO International will also undertake appraisal for two more prized licenses - Tawke 29 (Jurassic) and Peshkabir in 2014. Before I discuss these two licenses, the chart below gives the exhaustive list of drilling program scheduled for 2014 and early 2015. In all, the planned capital expenditure for 2014 is NOK2.7 billion ($432 million) and this spending will translate into higher reserves and production in 2014 and 2015.
Coming back to the two appraisal assets, DNO International has 55% stake in both the prospective resources in the Kurdistan region of Iraq. DNO International is targeting prospective resources of 150mmboe in Tawke-29 (Jurassic).
Should the appraisal program in the third and fourth quarter of 2014 confirm this, there is a potential addition of 82mmboe to the company total reserves. What is positive in this appraisal program is the fact that Tawke-17 has already confirmed oil in the Jurassic Sargelu. Tawke-29 will just appraise the extent of the Jurassic reservoir.
The Peshkabir appraisal, which is slated for the second and fourth quarter of 2014, is a bigger potential than Tawke Jurassic. DNO International is targeting prospective resources of 225mmboe and the company's 55% stake would translate into potential reserves addition of 125 mmboe. Both these appraisals therefore have a combined potential of adding 200-225 mmboe of resources in 2014. If this were to happen, the rally in DNO International stock will certainly gather more momentum.
What is also important to mention here is that I have talked about the two biggest appraisals scheduled for 2014. In all, the total prospective resource (company's share) to be drilled in 2014 is 321mmboe and the conversion of these resources into reserves will be nothing short of a phenomenal event for the company.
Summarizing The Changes From Initiation
Point One - The export pipeline from Tawke is now complete, which was in the construction phase during initiation. Further, a new single day record for deliveries (pipeline and tankers) of 136,600 barrels has been achieved. The current pipeline of 12 inches will be supplemented with another pipeline of 24 inches to boost exports.
Point Two - With timely commissioning of the export pipeline, the revenue and EBITDA forecast have changed along with the EBITDA margin expectation. The revenue and EBITDA (as compared to initiation) is higher by 32% and 51% respectively.
Point Three - Tawke-21 and Tawke-22 have been completed on schedule (December 2013) and the testing of the horizontal wells can spring production surprises.
Point Four - Tawke-29 (Jurassic) and Peshkabir appraisal are in the pipeline for 2014 and can potentially add 200-225 mmboe to existing reserves.
Valuation Backs The Upside Potential
While the arguments for upside look good, it is important to analyze if the positive factors have been completely discounted in the stock price or a valuation gap exists. This section will compare DNO International with other oil & gas exploration companies. Genel Energy, with assets in Kurdistan, is currently trading at an EV/EBITDA valuation of 11.6 as compared to DNO International's EV/EBITDA valuation of 12.4.
Among Oil & gas majors, BP PLC (BP) is trading at an EV/EBITDA valuation of 6.0, Chevron (CVX) is trading at an EV/EBITDA of 5.3 and Exxon Mobil (XOM) is trading at an EV/EBITDA of 5.7. I must mention here that comparing BP, XOM and CVX might not be entirely appropriate. But I have taken these peers to arrive at a ballpark valuation estimate as Genel Energy is the only Kurdistan play to compare. Gulf Keystone (OTCPK:GUKYF) also operates in Kurdistan, but is yet to commence any meaningful operations to compare the EV/EBITDA valuation. I must however mention that companies operating in the Middle-East (especially Iraq) are subject to valuation discounting for the political risks. Considering that, it might not be wrong to look at relatively conservative valuation multiples from the E&P majors.
The E&P majors listed above have an average EV/EBITDA valuation of 5.7. DNO International's current valuation is significantly higher at 12.4. It is however important to look at forward valuations. In accordance with the scenario discussed above, DNO International is trading at an EV/EBITDA of 3.5 for 2014. This gives a valuation gap of 63% as compared to E&P majors. This upside can be considered to be conservative and I would not be surprised if DNO International outperforms my expectation by a big margin (as it was in the previous occasion).
The politically unstable region is one of the primary risks. That said, the stocks with operations in the Middle-East already discount the risk. Further, the current scenario is better than it was a year back. In terms of production and sales, the primary risk to the upside comes from exports being banned. In such a scenario, sales in the local market will be limited and at a lower price than from international markets. I believe that this risk panning out is minimal with the export pipeline operative and with Iraq and Kurdistan agreeing on exporting oil via Central marketing body. Earlier in January 2014, Genel Energy, which would also be using the same pipeline for exports, had also indicated that exports to Turkey by pipeline will resume soon. Things therefore seem to be falling in place and the risk can be considered to be minimal.
DNO International had an excellent 2013 in terms of production and exploration progress coupled with the stock soaring to new highs. The year 2014 is expected to be even better with significant revenue and EBITDA bump-up expected. At the same time, a high impact drilling and exploration program can bring forward more positive surprises in terms of production and reserves. The stock has seen a rally to $4 levels after correction to $3.26. With the factors discussed, the rally will continue and 2014 should be another big year in terms of stock price appreciation. DNO International is a "Strong Buy" and "Hold" at current levels with a 12-15 month time horizon. The timeline will test all the expected developments discussed in the coverage.