Santos (ASX: STO) has traded sideways for two years but the future looks bright according to Morningstar’s Mark Taylor. At a current price of around $8, the shares trade roughly 35% below his estimate of Fair Value.

How does Santos make money?

Santos is Australia’s second largest oil and gas exploration and production pureplay behind Woodside Petroleum (ASX: WDS). The company has with interests in all Australian hydrocarbon provinces, Indonesia, and Papua New Guinea.

Santos' Gladstone and Papua New Guinea LNG projects are attractive in that they are large, long-life, have low cash operating costs, and offer expansion potential.

Well-timed East Australian coal seam gas purchases in the past set the scene for liquid natural gas, or LNG, exports. Equity sales in some of these assets also helped bolster the firm’s balance sheet and brought on attractive project partners.

Santos is now one of Australia's largest coal seam gas producers and continues to prove additional reserves. It is the country's largest domestic gas supplier but is generating a growing portion of its revenue from higher margin export pricing.

Two big growth projects underpin optimism

Santos’ second quarter earnings report on July 18 featured an update on its Barossa and Pikka profjects, both of which have the potential to expand production and revenue significantly.

Barossa, which is located in the Timor Sea, will replace the previous Bayu-Undan project in backfilling the firm’s Darwin LNG operations. The project will increase Santos’ overall production by around 20% and accounts for around 10% of Morningstar’s fair value estimate. As a result, our Santos analyst Mark Taylor was glad to hear it is now 77% complete and on-track for first production in 2025.

The Pikka oil project in Alaska is also on track, now 57% complete and on schedule for production in 2026. This could add a further 17% to Santos’ current production capacity and comprises around 6% of Taylor’s fair value estimate.

Solid demand picture

Taylor thinks Santos can grow its earnings per share at a double-digit clip for the next decade. This forecast is underpinned by Santos’ two new projects, share buybacks and a healthy demand picture for its key commodity, natural gas.

Natural gas is less carbon-intensive than coal or oil and stands to benefit from efforts to minimise emissions. Even though the use of renewables like wind and solar is growing rapidly, Taylor does not think these technologies will be able to meet the global energy needs within the next few decades, if at all.

Natural gas has grown its share of primary energy consumption to 24% from 22% over the last 10 years and Taylor expects this strong demand to continue.

Solid financial footing

In the past, Santos has often carried what many viewed an unsustainable level of debt. This is no longer the case.

Net debt has fallen from a high of US 6.9 billion in 2015 to around USD 3.5 billion at the end of 2023. Meanwhile, the company’s operating cash flow remains robust. With a net debt to EBITDA (earnings before interest, tax, depreciation and amortisation) of 0.9, the company could – in theory – pay off a significant amount of its debt in a single year with cash generated by the business.

The maturity profile of Santos’ debt also looks comfortable, with a weighted average term to maturity of around 5.5 years. In other words, the company doesn’t face a wall of debt coming due soon and has plenty of time to refinance or pay off what is owed.

Taylor expects Santos to maintain its gearing at conservative levels despite capital expenditure on expansion projects and ongoing buybacks. This, of course, depends on operating cash flow remaining healthy.

Attractive assets but no moat

Taylor has attached an Uncertainty rating of High to his valuation of Santos. This mostly reflects the company’s exposure to commodity price volatility.

Like most commodity producers, Santos lacks a moat. The primary source of competitive advantage for resource stocks stems from maintaining lower costs than peers. Taylor doesn’t think Santos qualifies on this front. LNG is an upfront capital-intensive business, and Australia’s remoteness and underdeveloped industrial base makes for particularly high capital costs compared to countries like the US.

Although the low operating costs of the company’s Gladstone and Papua New Guinea LNG projects ensure cash profits for Santos throughout the commodity cycle, high capital costs detract from this and preclude a moat being awarded.

On July 22nd Santos shares traded at a price of roughly $8 per share, 35% below Taylor’s estimate of Fair Value. They currently command a four-star Morningstar Rating.

Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.

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