Undervalued Woodside

The future outlook of oil and gas must be taken into account in any analysis of Woodside Petroleum (WPL). Assumptions about growth in demand, commodity prices, reserve base, technology evolution and world politics have to be made for any prediction to have a chance to be correct within reasonable confidence intervals.

What we can say with a high degree of certainty is that the oil and gas that we produce today is the result of a process that spans many millions of geological years, and that the total resources available for exploration and production is finite. What we can also say is that Australia has become an important world supplier for nations seeking energy supplies produced by a stable economic and political environment.

Liquefied natural gas

Liquefied natural gas (LNG) is created by chilling natural gas to minus 161 degrees centigrade, which turns it to a liquid. At this temperature, the gas is reduced to one 600th of its original volume, making it economic to transport by ship. It is then converted back to natural gas at its destination.

LNG demand is currently growing; it is safe, flexible, reliable, economic and environmentally acceptable. It is ideal for home heating, cooking and as a fuel for electricity generation (benefits that enable LNG to justify a premium over other fuels, which also offsets the higher costs of gas liquefaction, storage, and shipping) and has become a major export product for Australia, worth about $3.5 billion in 2005-06.

With world demand for LNG expected to double by 2010, and with experts predicting a global shortfall of LNG supply about the same time, to cater for this anticipated global demand surge Woodside Petroleum is ramping up its ability to supply an increasingly hungry LNG market by fast-tracking the development of Australia's first and largest LNG project: the multi-billion dollar North-West Shelf.

The graph below depicts the forecast growth in LNG demand throughout the Asia-Pacific region, within which 67% of the world's trade is conducted. What this clearly shows is that Asian market demand is expected to grow 80% by 2015, clearly dominated by Japan. The United States is also likely to be a major growth market for LNG imports, with an eightfold increase in demand forecast by 2015.

Source: Poten & Partners

Woodside is well placed to meet these growing levels of world demand.

With a 16-year unblemished record of safely supplying LNG, Woodside operates one of the most reliable LNG plants in the world. It has abundant reserves in the North-West Shelf, and other significant reserves suitable for establishing new production hubs such as the Browse and Pluto gas projects off Western Australia's Kimberley coast and the Sunrise gas project in the Timor Sea.

With estimated reserves of gas measured in trillions of cubic feet, the North-West Shelf, Browse, Pluto and Sunrise resources and infrastructure already in place puts Woodside in a commanding position to provide Asia-Pacific customers with a safe, secure and reliable source of energy resources well into the future.

Business performance

The chart above illustrates sound economic performance. Combined with sound management, the business has been able to generate compounding total shareholder returns (TSR) of about 21% per annum, a very impressive result.

The table below reveals Woodside’s fundamentals and reflects high levels of compounding returns to shareholders.

At the end of 2001 the company had $2554.2 million in equity from which it generated a net loss of $92 million and paid $140 million as a fully franked dividend. Owners received a return on their equity of 23.9% in 2002. Fast forward to 2006 (the most recent data) and although equity has grown, though retained earnings, to $3500.6 million, the business generated a NPAT of $1427 million and paid out nearly $713.3 million in dividends, a return on equity of 48.6%.

What’s even more impressive is that this is organic growth, entirely funded through retained earnings and borrowings (current gearing ratio is 43%). Not once in the past five years has the company called upon shareholders to stump up more money through a capital raising.

This is the hallmark of a great business – the ability to generate continuing high rates of return on rising equity. ROE, by the way, is the most important financial ratio in any analyst’s toolkit. Only businesses with high rates of return on equity can turn each dollar of retained earnings into more than a dollar of long-term market value. This is the reason Woodside’s share price has more than doubled over the past five years, from about $14 in 2002 to about $35 today, roughly, 21% per annum.

Business valuation

Woodside shares opened at $35.50 today. Stockval values the business at $41.31, indicated by the circle on the graph below. This valuation is based on equity per share (EQPS) of $6.30, forecast return on equity of 45% and an investor’s pre-tax required return of 14%. Think about it like this: if you have $6.30 generating 45% annually and you are happy with 14%, you can pay about 6.5 times equity for that $6.30 or $41.31. The market is therefore expecting much lower rates of return on equity (and we have been conservative in adopting 45%) or is requiring a return greater than 14% for a market leader with good future prospects.

Woodside is currently undervalued using our methodology, a rare find under current market conditions. Given the future prospects, future earning potential for this business and current pricing it does warrant investment consideration if one believes the long-term bullish arguments for natural resource demand and prices. It certainly is one to consider if an investor is comfortable with the estimate that this business could continue to generate return on equity of 45% or greater for the foreseeable future.