Stock Review: CAIRN INDIA

 

At a time when the episode of Cairn's acquisition by Vedanta is unfolding, the shareholders of the petroleum explorer are facing a confusing predicament. With crude oil prices soaring above $100, a number of broking houses are valuing Cairn's shares at 420 or higher apiece. This is higher than the 405 per share at which Cairn's promoters are trying to sell it off. However, ONGC has refused making a counter offer, saying even 405 is on a higher side. Whom should a Cairn's investor believe?

Cairn's scrip, which had maintained a close relationship with global crude oil prices until July 2010, has stagnated since then although oil prices gained 35-40%. The key factor has, of course, been the Cairn Energy's decision to sell its controlling stake in the company at 405 per share to Vedanta, setting 355 as the open offer price for retail shareholders.

Just as the RIL-BP deal last month established a benchmark for valuing RIL's exploration assets, the Cairn-Vedanta deal created a benchmark for Cairn's assets, which didn't exist earlier. This effectively snapped the link between Cairn's share price and crude oil prices. Capital in its research report in February 2011 called the deal "a value destroyer one for Cairn India shareholders," arguing that without the deal the scrip would have run up to . 450 levels along with crude oil prices.

Some foreign broking firms have in recent past recommended the company to retail shareholders giving price targets 4-10% higher than what Vedanta would end up paying for the controlling stake. Morgan Stanley, for example, had set a price target of . 429 in its January report, while Singapore-based Mirae Asset and Hong Kong-based Kim Eng Research estimated the worth of Cairn's share price between 420 and 448 in February.

The key to understand this mess is actually the point at the heart of the standoff between Cairn India and ONGC — royalty payments. As per the arrangement, ONGC is paying the entire royalty for Rajasthan project, but claims — giving reference of the production sharing contract (PSC) — that it is 'cost recoverable' or recoverable from the project's revenues. However, Cairn doesn't accept this and even the abovementioned foreign broking firms appear convinced that Cairn will not be made to bear the royalty payment burden in any way. On the other hand, if ONGC were to acquire Cairn, it would still have to continue paying the royalty at 100%. Thus, ONGC's valuation view on Cairn implicitly discounts for the royalty payments as well. Considering the royalty rate at 20%, it is no wonder that ONGC doesn't find Cairn attractive at 405.

This basically means that the government's decision on royalty payment is the biggest uncertainty for Cairn's share price. If ONGC's view is upheld, Cairn India could see a substantial de-rating on bourses.