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IOC: Reasons for Optimism Flow Like Liquid, Taking Target to $45
- No Longer Guardedly Optimistic. With increasing evidence of a commercial liquids stream associated with InterOil’s world-class natural gas discoveries, we adopt a decidedly more bullish stance for IOC shares. Based on calculations we include on the next page of this note, we estimate that a natural gas liquids stream could enhance the value InterOil’s proposed liquefied natural gas (LNG) project by at least 12.5%. Including these expectations in our prior LNG valuation analysis and incorporating the outperformance of InterOil’s refining and marketing operation lead us to increase our price target to $45 per share from $34.
- Refining and Marketing Assets Exceed Expectations, Again. This morning InterOil Corp. reported operating and financial results for 1Q 2009 of $161.7 million in revenue, $0.07 in EPS, and $0.38 in CFPS. These results compared well with our estimates of $129.0 million in revenue, ($0.08) in EPS, and $0.09 in CFPS. Including hedge book adjustments, InterOil generated $0.79 in cash flow per share.
- Midstream operations performed significantly better than our expectations while downstream sales fell well below our estimates. Midstream revenue of $145.5 million vastly exceeded our $58.2 million estimate while downstream revenue of $78.6 million fell well short of our $126.0 million forecast. The significantly higher Midstream revenue led to much higher gross margins than we forecasted. This margin outperformance drove InterOil’s 1Q 2009 upside.
- Outperformance Leads Us to Increase Near-Term Estimates. InterOil’s refining and marketing operations continued to outperform our expectations in 1Q 2009. With hedges substantially reducing near- and medium-term price risk, we are increasing our margin estimates for these operations. These changes lead us to increase our 2009 and 2010 EPS estimates to $0.36 and $0.17, respectively, from ($0.45) and ($1.17). Similar changes occur for our respective 2009 and 2010 CFPS estimates as they increase to $1.65 and $1.05 from $0.25 and ($0.36).
- Liquidity Position Improves and Should Continue to Do So. InterOil’s balance sheet remained strong through 1Q 2009, as the company exited the quarter with $42.6 million in cash and $161.4 million in debt instruments. This translates to a ratio of net debt-to-total capital of 31.8%. The terms on InterOil’s 8% subordinated convertible debenture allow for the company to force conversion should the company’s share price remain above a $32.50 level over a 15-day period. InterOil shares have closed above this $32.50 threshold for an eight-day period through yesterday. While potentially creating short-term IOC share price volatility, we view the conversion of these 8% debentures as a definitive positive for InterOil, as it would vastly reduce the company’s cash interest expense. Conversion also would further clarify InterOil’s liquidity position.
- Valuation Complicated, but Compelling. Primarily as a result of an increase in the estimated value of InterOil’s natural gas and liquids production, we are increasing our price target to $45 per share. We base our $45 price target on a 20-year discounted cash flow model with an implied probability-weighted success of IOC’s LNG facility of 75%. In our discounted cash flow valuation model we use an 11.7% weighted average cost of capital and a 3% terminal growth rate.
CONDENSATE COULD ADD 12.6% TO LNG VALUE
- Along with the 382 Mmcfpd of natural gas at which the Antelope-1 well tested, InterOil also experienced significant flows of condensate. Over the test period it appears that about 13 barrels of condensate flowed for every million cubic feet of natural gas. Further delineation of the Antelope structure, via two side-tracked wells, indicates that the condensate portion of the reservoir covers a substantial area. While the first of these side-tracks only tested an area approximately seven feet from the original Antelope-1 discovery well, the second side-track extended the area of analysis approximately 100 feet. Much geological and engineering work remains to be completed to better understand the condensate, if not oil, potential of the reservoir.
- However, sufficient evidence of substantial, commercially producible amounts of natural gas liquids exists to incorporate at least a 50%-weighted probability of success into our valuation model. On InterOil’s conference call, management advanced a conservative estimate that the value of condensate is about 3.5x that of natural gas. This estimate is consistent with other independent analysis that we have read over the past few months. In fact, some industry experts estimate that the value of natural gas liquids, typically produced in association with natural gas, in certain specific instances may prove to be worth more than the overall liquefied natural gas (LNG) stream.
- Based on calculations we include in a table below, we estimate that, at a rate of 12 barrels of condensate per million cubic feet pf natural gas, InterOil could expect the value of its production to increase by about 12.6%. We base the magnitude of this calculation on the $7.50/Mmbtu figure on which we value IOC’s LNG project. Our IOC target price increases to $45 per share as a result of incorporating this risk-adjusted, $8.45/Mmbtu figure into our LNG analysis. Additionally, we assigned InterOil $300 million in incremental capital expense in order to construct a liquid stripping plant. Our probability of success for the entire endeavor remains unchanged from our previous analysis, at 75%.
- We base our $45 price target on a 20-year discounted cash flow model with an implied probability-weighted success of IOC’s LNG facility of 75%. In our discounted cash flow valuation model we use an 11.7% weighted average cost of capital and a 3% terminal growth rate. The primary drivers of our InterOil valuation relate to the company’s proposed Papua New Guinea LNG facility. We predicate our current estimates on a 75% probability of project success and a spread of $4.00/Mmbtu for the resulting LNG.