CAIRN INDIA: Royalty Burden a Value Destroyer

The continuing delays in government approvals will mean that Cairn India is likely to miss out on its production growth targets in Rajasthan beyond the current 125,000 barrels per day.
Although the company has invested in expanding production capacity, actual output of every incremental barrel depends on government approvals. Experts view these delays as tactics by the government to force Cairn to accept the royalty burden for its portion of production — a compromise that will significantly erode the company’s value.
“We see a clear case of the government armtwisting Cairn India through approval delays in output ramp-up till Cairn India accepts the royalty conditions, which will hurt Cairn India’s valuations significantly,” mentioned a result update report of Elara Capital. The broking firm maintained its ‘sell’ rating with target of . 270.
“We believe Cairn has little choice but agree, as any opposition would mean that government and JV approvals required for either daily operation or long-term production ramp-up would become difficult,” mentioned a HSBC Securities’ report on the company. HSBC downgraded its rating to ‘neutral’ from ‘overweight’ with a price target of . 350.
Since the Cairn India’s board had earlier assured its shareholders that no government condition would be accepted that is detrimental to shareholder value, it has decided to approach the shareholders for their view on the compromise. However, this is likely to be a mere formality considering 80% of the company’s shares are held between Cairn and Vedanta Group — both of which are eager to see the deal through.
The company’s Mangala field is producing 125,000 barrels per day and its Bhagyam field will be ready by the end of 2011. However, the company can’t produce anything more than current 125,000 bpd without government approvals. A delay here means the company’s production would stagnate at current levels for an extended period.
Cairn India’s June 2011 quarter results were better from the March 2011 quarter. Since the production is unlikely to change for the next couple of quarters, the company’s profitability will depend mainly on oil prices. The company’s acceptance of the royalty burden could prove a value destroyer for its retail shareholders in the near term.