DNO International: Strong Buy As Upside Trend Expected To Continue

| About: DNO ASA (DTNOF)
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DNO International (OTCPK:DTNOF), an independent exploration and production company, has surged by 43% in 2013. The upside trend is not over for the stock with potential triggers for further upside over the next one year. This research presents the reasons for the bullish outlook and the stock's upside potential considering the best case and worst case scenario for the company. The scenario analysis concludes on a 25-42% upside in the given time horizon.

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. The company's asset portfolio currently stands at 20 assets in six countries. For the year ended December 2012, DNO International has proven and probable reserves of 520.3 MMboe with 90% of the reserves in the Kurdistan region of Iraq. The company's reserves in Kurdistan come from the Tawke oil block, which is among the largest oil blocks in Kurdistan. DNO International has a 55% stake in the Tawke block with Genel Energy PLC (OTCPK:GEGYF) holding a 25% stake. The remaining 20% stake is held by the Kurdistan Regional Government. For the first half of 2013, DNO International had a production rate of 33,917 boepd, which includes production from Kurdistan, Oman and Yemen.

Current Valuation In Line With Oil Majors...

After a 43% upside in 2013, DNO International's valuation (EV/EBITDA) seems to be in line with major oil & gas companies. DNO International currently trades at a EV/EBITDA of 5.4 compared to a peer average of 5.0.

...However, The Stock Keeps Rising

Even on trading at a marginally premium valuation to major oil & gas companies, DNO International has been exhibiting a bullish trend with the stock rising by 9.1% over the last one month. Potentially, there could be two reasons for the current stock movement - First, the sentiments are too bullish and the stock is overvalued. Or, there is some major positive factor the stock is discounting and might continue to discount in the foreseeable future.

In my opinion, the latter reason is true and I will focus on the key factors the stock is discounting in the following part of my article.

The Game Changer For DNO International

DNO International has a high proved and probable reserve of 520 MMboe. Nearly 90% of the company's reserves are in the Kurdistan region of Iraq. The game changing story for the company started in 2004, when it signed a production sharing contract with the Kurdistan Regional Government. Two years after signing the contract, DNO International had the success of the first oil discovery in Tawke field. With rapid operational progress, the Tawke facilities have the sustainable capacity to export more than 100,000 barrels a day, with a company strategy to bring proven sustainable production capacity to 200,000 bopd by the end of 2014. In the second quarter of 2013, the company reported a highest production rate of 112,949 barrels per day and a highest single day sale of 102,393 barrels. Therefore, the target of 100,000 barrels per day exports is on the cards. Further, the strategic location of Tawke field increases the probability of exports in early 2014.

Also, given the strong operational progress, it would not be surprising to see DNO International achieve a production target of 200,000 barrels per day by the end of 2014. On September 16, 2013, DNO International released its operational update and the guidance for the third quarter of 2013. The Tawke field has continued to show strong operational progress. Tawke-20, the Company's first horizontal well in the field, has tested 8,000 bpd from each of ten producing intervals and is on course to deliver 25,000 bpd of oil. The initial testing for Tawke-23 has also shown success and DNO International is focusing on ten fracture zones with production potential. The company is also in the testing and drilling stages for Tawke-21 and Tawke-22. The point of importance here is that the drilling activity is robust and drilling success is high.

Based on the current drilling trends, DNO International expects revenue for the third quarter of 2013 to be $750 million, which would be 39% higher than the revenue for the third quarter of 2012. Further, the production from Kurdistan, Oman and Yemen will reach record gross levels of around 85,000 boepd, corresponding to an estimated Company Working Interest (CWI) production of 50,000 boepd (38,354 boepd for 2012).

In order to determine the revenue, EBITDA and EPS outlook for 2014 and 2015 based on the company's production target, I have created several scenarios, which, in turn, would help determine the best case, base case and worst case valuation.

Scenario One - Best Case

DNO International achieves a gross production level of 100,000 boepd in 2014 and 200,000 boepd in 2015 from Kurdistan and maintains the existing production levels in Oman and Yemen. Further, the company is able to export the entire production from Kurdistan to international markets.

In terms of probability, it is highly unlikely that the company is able to export the entire production. Therefore, I would assign a low probability of the best case scenario outcome. In an unlikely event of this scenario panning out, a 100% upside from current levels would be on the cards based on the derived EV/EBITDA multiple and the valuation gap when compared to other oil & gas majors. I must mention here that the company is in a good position to fund its growth through internal accruals. It is therefore safe to assume that the net debt position might not increase meaningfully in 2014 and 2015.

Before I talk about the second scenario, one of the assumptions, which will generate curiosity among readers, is the price of export. All the scenarios have USD50, USD60 and USD70 levels for price of crude exports. The price has been kept well below the international prices because most of the exports will be to Turkey. Due to proximity, Turkey is aiming at buying crude at attractive prices and the exports will certainly be at prices well below the current Brent crude oil levels.

Scenario Two - Base Case

In my opinion, this is the most likely scenario for the company and DNO International is currently discounting this outcome for 2014 and 2015. This scenario assumes that the production level for Oman and Yemen remains constant (as for the first half of 2013). Further, DNO International is able to export only 50% of the production volume. Even if the company is able to export more than 50% of the production volumes from Kurdistan, this scenario also discounts the factor of delay in commencement of exports in 2014. This is likely as the pipeline to Turkey is expected to be completed by the end of 2013. It is very likely that there will be some delay in the completion of the project. Therefore, this assumption looks realistic and can give the closest EPS estimates for 2014 and 2015.

In this particular scenario analysis, I have specifically added the stressed EV and the stressed EV/EBITDA as this scenario is the most likely scenario. The addition of the stress case gives a more conservative valuation estimate.

With only 50% of the production being exported at a price of USD50 and with the company reaching a production target of just 90,000 boepd, the stressed EV/EBITDA comes to 3.5. With an average EV/EBITDA multiple of 5 for the sector (as shown above), the second scenario implies an upside of another 42% from current levels. It is therefore not surprising to see the bullish momentum in the stock (talked about earlier) despite the current EV/EBITDA of 5.4, which is at a premium to peers.

What will be more interesting to analyze is the scenario where an export agreement is not reached and all the oil has to be sold in the local market at an average price of USD37. This scenario will outline the downside or the minimum upside from current levels. Even this scenario can result in further stock upside because the significant increase in production levels in 2014 and 2015 will translate into an EBITDA and EPS explosion for the stock.

Scenario Three - Bear Case

As mentioned above, this scenario assumes no exports with all sales in the local market at USD37. Before discussing the valuations based on this scenario, I must mention that the probability of this scenario panning out is also minimal considering the fact that the export pipeline is largely in place and the Kurdistan Regional Government is supportive of exports (as it increases their revenue share).

Even if we assume that exports are halted by the Iraqi central authorities or due to the Kurdistan Government failing to reach an agreement with Turkey, the EPS upside and stock upside prospects remain on the back of significant increase in production.

On considering a lower production target and a stressed EV, the EV/EBITDA multiple for 2014 comes to 4.0 and this implies a stock upside of nearly 25% based on the average peer EV/EBITDA valuation of 5.0.

Scenario Analysis Results

Based on the scenario analysis and the likely outcome, it is very likely that DNO International will see another 25-42% upside over the next one year. A one year timeline would test all the scenarios. For investors, I must mention here that the stock is beginning to discount the upcoming increase in production and an EBITDA/EPS explosion. I would therefore recommend buy at current levels without waiting for any correction in the stock.

It is also important to understand here that 2013 is not just a randomly chosen year for upside in the stock. The 43% YTD upside in DNO International has been on the back of strong operational progress (mentioned earlier in the article). As this operational progress makes the target of 100,000 boepd look more realistic for 2014, the stock is discounting the positivity.

The important analysis here was - Has the stock already discounted all the positivity?

The scenario analysis and the stress test show that there is still significant juice left in the rally and the rally momentum might increase as the company enters 2014 on a positive note.

I will not forget to add here that the very recent gas sales and purchase agreement with the Kurdistan Regional government also adds to the positives and serves as a trigger for some more upside.

On September 18, 2013, DNO International signed an agreement with the Kurdistan Regional Government for the gas sales from the Dohuk license where DNO International has a 40% stake. According to the agreement -

Initial deliveries will be around 100 million cubic feet per day sold on a take-or-pay basis for the duration of the Production Sharing Contract or until deliveries reach one trillion cubic feet. The price of gas will range between $3 and $4 per thousand cubic feet over the life of the contract.

With this agreement in place, DNO International will see incremental revenue growth in 2014. The impact on the EPS is likely to be in the range of 4-6 cents as shown in the analysis below. DNO International further plans to explore oil reserves in the Dohuk license once the gas pipeline is up and running. Therefore, positive prospects remain in the field and 2014 can uncover further reserves, which will result in positive price action.

Risk Factors

Risk One - The highly unstable Middle-East region is one of the primary risk factors. However, I believe that this risk is always discounted in the equity prices of companies operating in the volatile region. It therefore implies that unless there is a war or a war spill-over scenario in the region, the markets have discounted the regional risk factor.

Risk Two - The export pipeline to Turkey will serve as one of the primary EPS drivers for DNO International beyond 2014. Iraq has threatened to cut the revenues to Kurdistan over the pipeline to Turkey. Any delay or halt in exports from the pipeline can negatively impact DNO International's growth. However, my analysis discounts this factor and this negativity is offset by high expected production levels in 2014.


DNO International has a strong track record of operational success in the Kurdistan region. This is reflected in the revenue growth and the strong revenue guidance provided by the company. The recent gas sale agreement with the Kurdistan Regional Government and the potential resumption of exports in 2014 serve as the primary upside triggers for the stock. The current market price of $2.4 and a current market capitalization of $2.5 billion are cheap for a company sitting on proved and probable reserves of 520 MMboe. As the company achieves a production target of 100,000 bopd in the near-term and 200,000 bopd by the end of 2014, the stock price will see significant upside. The positivity is already being discounted by the stock with a 43% rise in prices for YTD2013. This uptrend should continue well into 2014 and early 2015 as production and export targets are achieved. The stock can be considered with a initial time horizon of one year and an initial upside target in the range of 25-42%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.