I strongly recommend an overweight position in Cairn Energy PLC (CRNCY). Cairn Energy currently owns a 10 percent equity stake in its erstwhile India subsidiary Cairn India Limited. In 2011, Cairn Energy sold its majority stake in Cairn India to Vedanta Limited (NYSE:VEDL), which currently owns 60 percent of Cairn India.
I foresee up to a 100 percent upside in Cairn Energy driven by more than a 100 percent upside in Cairn India's stock price. There are multiple catalysts over the next 24 months that should drive Cairn India's stock price. Cairn India's stock price has corrected more than 50 percent in the last one year, driven by a dramatic fall in oil prices and a $3.1 billion tax demand imposed on it by income tax authorities in India. The stock is clearly mispriced as it trades below the value of its monetary assets, despite generating healthy free cash flows from its core business activity (exploration and production of crude oil and gas).
At the current price, risk-reward metrics favor an overweight position in Cairn Energy.
- A negative outcome of the tax dispute with Indian government seems more than priced in
The current enterprise value of Cairn Energy is about $575 million (Market Value - $1,300 million and Cash - $725 million). It appears that at the current price, the market has fully written off the $450 million worth (at current market price) of Cairn Energy's stake in Cairn India.
Cairn Energy has made it clear that its worst-case liability in the litigation with the Indian tax authorities is the loss of its 10 percent stake in Cairn India. So, basically there won't be any cash outflow if Cairn India loses the litigation.
- Cairn Energy is adequately funded to develop its core assets - Catcher and Kraken
Cairn Energy has also informed investors that it is not reliant on the sale of its Cairn India stake to meet its capital funding needs. It has adequate funding available to develop its E&P assets - Catcher and Kraken. In the recent quarterly earnings, Cairn Energy has maintained that the development of Catcher and Kraken is on track to yield first oil in 2017. The fields will deliver peak production of 22,500 boepd.
NPV of Cairn Assets
Potential upside in Cairn Energy based on successful resolution of litigation is more than 100 percent
There is a more than 100 percent upside in Cairn Energy's stock price if the litigation issue is favorably resolved. Besides a victory in the litigation, there are other important positive catalysts too that would help Cairn India's stock price post significant gains from current levels.
Potential triggers that would help Cairn Energy realize the full value of its investment in Cairn India
1. Good chance that the government of India may cut cess - a form of tax they levy on crude oil production. The oil ministry has agreed to the proposal - A 50 percent cut in cess should help Cairn's EBITDA improve by 35 percent. A few days back the oil ministry gave its nod for applying an ad valorem (in proportion to prevailing crude oil prices) cess on crude oil unlike the existing fixed cess of $4,500 per tonne. The matter is now to be given a nod by the finance ministry.
2. A potential favorable outcome from ongoing tax litigation - I assign a high probability to Cairn winning the litigation
Cairn India is facing a $3.1 billion tax demand from the income tax authorities in India. The income tax authorities have raised the demand, as Cairn India did not deduct withholding tax on the capital gains its erstwhile parent - Cairn Energy PLC - made on oil and gas assets it transferred to Cairn India.
The income tax authorities have also served a tax demand notice ($1.6 billion) on Cairn Energy PLC for the same reason and has also attached its residual shareholding in Cairn India (10 percent of Cairn India) until the time the dispute is resolved.
The matter is under litigation and I believe there is more than a good chance for Cairn to win the litigation due to:
- Precedent court ruling favors Cairn Energy (Andhra Pradesh High Court verdict on Sanofi Pasteur purchase of Shantha Biotech). The ruling was made after the introduction of retrospective tax amendment.
- The Cairn Energy case appears to be even more strong than the Sanofi-Shantha case. The Sanofi-Shantha transaction involved the sale of the stake to a third party. In the case of Cairn Energy, the transfer of the stake was part of an internal restructuring and there was no sale to a third party.
- Arun Jaitley, the Finance Minister of India, has categorically stated that the government is keen on an early resolution of pending tax disputes involving foreign giants - Cairn and others (Vodafone (NASDAQ:VOD) and Shell (NYSE:RDS.A) (NYSE:RDS.B)). India is aggressively pushing for foreign direct investment and it may be ready to let go of cases where they do not see an obvious/intentional violation of the tax code. According to Mr. Jaitley, Cairn India is a legacy issue they have inherited from the previous government. Therefore, I believe that in the interest of future growth, the government is not likely to push too hard on grey areas.
- Cairn Energy has immense confidence in its position in the tax case. As per accounting norms, it has not made any provisions for impairment for the value of its stake in Cairn India.
3. A correction in Cairn India valuation - Cairn India's stock is clearly mispriced as valuation more than builds in the worst-case scenario and we will see a correction sooner or later.
At the current price, Cairn India's shares trade below the value of its monetary assets. Cairn India owns monetary assets worth $5.3 billion while its current market value is just $4.5 billion. Thus, the stock is available at a 15 percent discount to monetary assets (a negative enterprise value). The investors are not assigning any value to its oil and gas E&P business, which is strange and unexplainable looking at the ongoing business performance. Cairn India continues to generate free cash flow and has an EBITDA margin of 43 percent even at an average crude oil price realization of $43 per barrel. With ongoing cost saving initiatives and growing production, the EBITDA should further improve.
Source - Cairn India Annual Report 2014-15, Compiled by Vishal Manchanda
4. A re-rating in Vedanta's stock in case Cairn India happens to merge with Vedanta Limited - Vedanta Limited has already made a merger offer to minority shareholders (Cairn Energy and LIC of India) of Cairn India, but it has been unofficially rejected as they feel it does not fully value Cairn's potential. Minority shareholders have made it clear to Vedanta Limited that they need a substantially sweetened offer than the one proposed earlier. If a merger were to happen, it should immediately offer a 40-50 percent upside from current levels, but for Cairn Energy, there is more to gain post-merger.
The current offer values Cairn India at about INR 190 per share (30 percent higher than the current price). If the merger goes through, Cairn Energy would receive shares of Vedanta limited in lieu of shares of Cairn India. Post-merger, Vedanta's stock will be re-rated as the merger is particularly seen as important for the fortunes of Vedanta Limited. At the current price, Vedanta Limited is available at a 70 percent discount to its peer group companies. The primary reason for the sharp discount to the peer group is due to Vedanta Limited being excessively leveraged on a standalone basis. On a standalone basis, Vedanta is constrained to pay off the debts as iron ore prices are at multi-year lows and hence its profitability. The standalone net debt is about 9x EBITDA (last quarter EBITDA annualized).
Post-merger, the net debt-to-EBITDA ratio for Vedanta would be just 1.5x. Hence, if the merger materializes, investors' concerns related to debt repayment will be taken care of and the stock is likely to re-rate and trade at sector average valuation (10.7 x EV/EBITDA).
Source - Infinancials
Cairn India's valuations more than discount the worst case too
Even in the scenario, Cairn India needs to pay off the income tax demand ($3.1 billion), the stock still trades at an EV/EBITDA of 3.5 as against an industry average of 6.8. If the stock just catches up with the peer average, it can almost double from here.
Source - Infinancials
A background on the tax demand raised on Cairn Energy and Cairn India by the Indian income tax authorities
Cairn Energy PLC (UK-based company) had ownership interests in several oil and gas assets in India. These oil and gas assets were owned by Cairn India Holdings - a Channel Islands-based subsidiary of UK-based Cairn Energy Holdings, which in turn was fully owned by Cairn Energy PLC.
Cairn Energy intended to sell its stake in the Indian exploration operations. With the same intent in mind, the Indian oil and gas assets held by Cairn India Holdings were transferred to an India registered entity - Cairn India. Cairn India brought the 100 percent stake in Cairn India Holdings from Cairn UK Holdings. In lieu of the shares of Cairn India Holdings, Cairn UK Holdings was given a stake in Cairn India. Post IPO in 2006, Cairn UK Holdings was left with a 69 percent stake. Later on, Cairn Energy sold its majority stake in Cairn India to Vedanta Limited and currently holds about 10 percent in Cairn India.
Why Income tax authorities in India raised a tax demand on Cairn Energy?
The income tax demand arises from an amendment in the Indian Income Tax Act made in 2012. The amendment was more of a clarification that explicitly made it clear that a foreign company that derives its value from assets located in India should be deemed located in India. From a taxation perspective, this implies that if shares of such a foreign company, if transferred to another entity, the Indian tax authorities can claim capital gains tax on the transaction, if any. The amendment was to be applied prospectively and retrospectively on all transactions.
Why did the Indian government introduce the amendment?
The amendment was made to tax Vodafone, which failed to withhold tax on capital gains Hutchison (a foreign company) made when it sold its operations to Vodafone. Because of the lack of clarity in the tax laws, the Indian judiciary gave a clean chit to Vodafone. Hence, the Indian government introduced this amendment retrospectively in the tax laws so that they could still tax Vodafone for not withholding the tax. The matter is now sub judicial.
The tax demand on Cairn is an outcome of this amendment
Since the Cairn asset transfer transaction involved a transfer of shares of a foreign entity deriving its value from assets located in India, the income tax authorities claim that Cairn Energy PLC made a capital gain of approximately $1.6 billion and the foreign company should pay a capital gains tax on the same.
Hence, the income tax authorities slapped a notice on Cairn Energy this year demanding $1.6 billion in capital gains tax (excluding penalties and interest). The IT authorities have also disallowed Cairn Energy from selling its residual stake in Cairn India (10 percent).
The income tax authorities have also raised a tax demand on Cairn India, citing its failure to deduct withholding tax on the transaction. The tax demand raised on Cairn India is $3.6 billion that includes penalties and interest on the capital gains tax.
Cairn Energy and Vodafone cases have similarities but important differences that favor Cairn Energy
According to Cairn Energy, the important point that strengthens its case is that the transaction that income tax authorities are seeking to tax here was more of group reorganization. Hence, there was no change of ownership involving a third party (like in the case of Vodafone). There was no sale to a third party, which could have led to capital gains for the company.
Again, Cairn India, which has been penalized for not withholding the tax on capital gains accrued by the seller, has put some very strong arguments in its petition to the Delhi High Court.
- According to Cairn India, it cannot be penalized by expecting that it ought to have withheld tax by anticipating a retrospective amendment.
- There is no question of capital gains arising out of the transaction as the company had informed the transfer-pricing officer about the transaction in 2006.
- Cairn India has been served the demand notice in 2014 for a transaction that took place in 2006 and hence there is an unreasonable delay. Courts have earlier ruled that IT authorities should come up with a notice within four years if they find any discrepancy with the laws.
- The transaction was consummated by a share swap, there were no cash payments, so there is no way the company could have withheld any tax (even if it accrued).
I see a high probability of a favorable outcome for Cairn on the litigation
The ruling government in India is all out to create a conducive environment for foreign investors in an effort to promote growth. It is more forward looking and does not want to scare potential foreign investors over tax issues. While it is not going to give up on a fair demand, in the case of Cairn India, there are several strong arguments that will help its case.
- Cairn India is a victim of a retrospective taxation regime, which the ruling government is critical about.
- The Finance Minister of India has emphasized that the government is committed to fast track pending tax disputes involving foreign giants. This is in a bid to woo more foreign investment and spur economic growth.
- Precedent that would help the Cairn India case
Below is an excerpt from an article discussing retrospective tax issues:
"The Andhra Pradesh High Court gave a ruling in favor of Sanofi Pasteur Holding SA in February 2013, saying the case was similar to Vodafone's $2.2-billion tax dispute in which the Supreme Court in 2012 had dismissed the tax demand over the British firm's acquisition of 67% stake in Hutch-Essar in 2007. The judgment is critical as it came after the retrospective tax had been brought on the statute and it upholds the supremacy of the tax treaty provisions. In effect, the ruling means that the retrospective amendment to supersede the verdict in the Vodafone case related to the taxation of offshore transfers does not affect the provisions of the India-France DTAA because the DTAA overrides the Income Tax Act."
The oil ministry has agreed to a proposal of oil companies for levying ad valorem cess (a form of tax on crude oil) instead of a fixed cess. The matter is now put up for the perusal of finance ministry.
A reduction in crude oil cess can improve Cairn India's average price realization for crude oil helping a sharp improvement in earnings. Currently, about 20 percent of Cairn's revenue is paid in the form of cess to the government. A 50 percent reduction in cess from current levels should help Cairn India realize 35% higher EBITDA from current levels (last quarter EBITDA - $150 million) if crude oil realizations remain at par with the last quarter ($51 per barrel)
The Indian government levies a cess of INR 4,500/tonne (approximately $9 per barrel) on crude oil sales. The cess was same when crude oil prices hovered at around $120. At the current price of crude oil, the cess takes away approximately 20 percent of Cairn India's revenues. The government has continuously revised the cess rates upwards with the growing crude oil prices. In the year 2004, when the crude oil prices moved from $40 to $60, the government upwardly revised cess at INR 2,500 ($39) per tonne from INR 1,800 ($28). In the year 2012, when crude oil prices touched $100 per barrel, the government of India revised cess at 4500 per tonnes (prevailing rates).
However, the government has not considered a downward revision when the crude oil prices have halved over the last year. Cairn India, along with ONGC and Oil India (Indian government-owned major E&P company), had written to the oil ministry to consider revising the cess. The oil ministry has agreed to the proposal and the matter has been put forward for the consideration of the finance ministry.
I feel a favorable decision is likely as the government intends to cut down its oil imports and a reduction in cess would allow E&P companies to spend more on new discoveries that look financially unviable at the prevailing price and tax regime. The domestic crude oil production in India is stagnant. Crude oil production during 2014-15 was 37.461 MMT, which was 0.87% lower than the 37.788 MMT produced during 2013-14. Given the limited domestic availability of crude oil and natural gas, the country is compelled to import about 80 percent of its domestic requirement.
Conclusion - A dramatic decline in crude oil prices over the last one year has led to a panic among investors and this in turn has led many stocks to trade much below their fair value. In the case of Cairn India, the extent of punishment appears to have been more severe as the situation was compounded by an unexpected litigation.
I would recommend investors to buy Cairn Energy for a 100 percent upside from the current levels over a horizon of 24 months.
Once again, I will summarize my thesis on Cairn Energy
- At the current price, investors do not ascribe any value to Cairn Energy's stake in Cairn India. Basically, a negative outcome from the litigation is already priced in.
- Cairn Energy is less than two years away from striking its first oil in Catcher and Kraken, which should strengthen positive sentiments on the stock price.
- If Cairn India is to merge with Vedanta Limited, a re-rating in Vedanta's stock price will help Cairn Energy realize a return even higher than its original investment in Cairn India.
- There are very strong arguments that support a favorable outcome for Cairn Energy in the litigation.
- Precedent rulings by the Indian High Court on similar tax disputes (Sanofi-Shantha and Vodafone-Hutch) strongly favor a positive outcome for Cairn Energy.
- The ruling government in India, led by Mr. Narendra Modi, is getting extremely proactive in creating a favorable environment for foreign investors to spur economic growth. They are strongly in favor of creating a fair, equitable and predictable tax environment. All in all, they are not in favor of disputes that are an outcome from a retrospective amendment in tax laws brought about the previous government.
- A favorable crude oil price environment is a free call option at the current stock price of Cairn Energy.
- The finance ministry is quite likely to give its nod on the ad valorem levy of cess on oil rather than a fixed cess. This should help Cairn India's stock price to post solid gains from current levels. A 50 percent reduction in cess looks likely on the cards which should help Cairn India's EBITDA by 35 percent from current levels.
Disclosure: I am/we are long CWNQY.
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.
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