At any time in history, there are certain stocks and sectors that are loved, and other stocks and sectors that are loathed. You don’t need to look very hard to see which area of the ASX is most hated right now.

In fact, I already made that clear in this article: it’s the energy sector. Today we’re going to take a look at an energy company that our analyst Mark Taylor thinks offers especially good value, and flesh out some of the reasons why.

First, though, a spoiler: this is not the first time I have underlined the value on offer in this share. In fact, I have highlighted it several times recently, during which time it has only continued to get cheaper.

I highlighted this company on September 20 at $7.05 per share, and again on October 15 at prices of around $7 per share. As we write, the shares have fallen to around $6.60. The company in question is Santos, Australia’s second biggest oil and gas producer.

Santos shares have drifted between $6 and $8.50 per share over the past four years and ultimately delivered a flat share price return, with dividends taking a shareholder’s total return to around 15%.

As Mark Taylor noted in his recent stock pitch, this is far behind the ASX200’s total return over the same period.

santos-chart

Mark Taylor sees a pretty clear reason for Santos’ underperformance in recent years: investors are concerned that the switch to renewable energy source will hit oil and gas demand. Mark, however, isn’t sure those concerns stand up to scrutiny.

I dived into some of the reasons for Mark's skepticism in an earlier article, but here is the elevator pitch:

  1. Global oil and gas demand continues to grow, fueled partly by population growth and the desire for better living standards in developing economies.

  2. In many cases, hydrocarbons cannot feasibly be replaced. Road transport vehicles look most vulnerable due to the rise of EVs, but not all use cases are as practical or cost-effective. Aircraft fuel and petrochemicals used for purposes other than fuel look especially hard to supplant.

  3. Natural gas has a particularly strong demand outlook, in part because of its potential to replace coal as a much cleaner source of back-up power.

Taken together, Taylor thinks that concerns surrounding medium-term demand for oil and gas producers like Santos may be overblown. Yet these worries appear to have weighed heavily on Santos shares, sending the company’s valuation to a multi-year low relative to earnings (shown by the blue line below).

santos-valuations

At an Enterprise Value/EBITDA multiple of around 5 times, Taylor believes that Santos is being credited with essentially no earnings growth potential in the coming years. Even though, thanks to its Barossa and Pika growth projects, the company looks set to increase production and profits.

Taylor thinks these higher earnings could support a higher share price in the medium-term, even if markets do not award Santos a juicier multiple for delivering growth. And, of course, the shares could move even higher if investors are willing to change their view of the business.

Also looks cheap from other angles

Santos doesn’t just look cheap relative to its historic valuation multiple and its growth prospects. It also looks cheap versus peers that it has historically traded in line with – especially in the further out years, implying that markets are overlooking Santos’ growth potential.

santos-versus-peers

At an enterprise value of around $15 billion, Santos also trades below what Taylor estimates it would cost to replace Santos’ gas production infrastructure alone.

Oil price assumptions offer further margin of safety

Mark’s discounted cash flow valuation for Santos relies on two main assumptions: 1) production growth thanks mainly to Santos’ new Barossa and Pika projects coming online in the near future and 2) mid-cycle Brent crude oil prices of 60 USD per barrel.

Given that Brent crude oil is currently over 70 USD per barrel and only traded below 60 USD barrel during the early days of the pandemic, this provides something of a margin of safety. Indeed, Taylor said that a mid-cyle oil price of 40 USD would be needed for him to get to Santos’ current share price.

What closes the gap?

Taylor thinks that Santos is worth $10 per share compared to recent prices of around $6.50.

While this implies plenty of potential upside from here, it is worth mentioning that Taylor recently cut this Fair Value by 20% as he assumed higher capital expenditures needed to produce each barrel of oil.

As we’ve alluded to already, Taylor is not relying on much other than earnings growth here. He expects that Santos can grow its earnings per share by an average of 13% over the next ten years, helped by the new projects coming online and potentially some share buybacks.

The combination of a strong earnings growth profile and a robust balance sheet, with net debt just over 1x annual adjusted profits, could also set the stage for healthy dividend growth. Indeed, Taylor forecasts distributions rising beyond USD 0.40 per share (0.60 AUD) from USD 0.26 in the last full year.

dividend-yield-forecast

Combined with a seemingly cheap entry price, could make Santos shares an appealing option for income investors that don’t mind going against the crowd. The shares currently have a four-star Morningstar rating.

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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.