Initiation Summary
DNO International (DTNOF, Financial) is an independent E&P company, geographically focused on the Middle East and North Africa with operations in Yemen, the Kurdistan region of Iraq, Tunisia, Oman, Ras Al Khaimah and Somaliland. This initiation on the company discusses the key factors to be bullish on the company with a one year time horizon and a potential 100% upside. The trigger factors include the company exploration and production plan, the potential for exports outside Kurdistan and the forward valuations.
Company Overview
DNO is a Middle East and North Africa (MENA) focused E&P listed on the Oslo Stock Exchange and the OTC exchange in the United States. The Company holds stakes in oil and gas blocks in various stages of exploration, development and production both onshore and offshore in the Kurdistan region of Iraq, the Republic of Yemen, the Sultanate of Oman, the United Arab Emirates, the Tunisian Republic and Somaliland.
DNO International revenue has grown at a CAGR of 27.8% in the last five years from $148 million in 2009 to $505 million in 2013. This growth has been achieved as a result of successful exploration programs, resulting in significant production growth over the years. As of December 2013, DNO International had a company working interest production of 39,170boepd.
I however believe that the biggest part of growth for the company is yet to come with proven and probable reserves of 520mmboe as of December 2012 (last reserve statement reported). I will discuss the reasons later on the factors that will propel growth over the next 1-2 years.
DNO International has 20 assets in six countries. However, 90% of the company’s assets are in the Kurdistan region of Iraq. The coverage will therefore focus on the assets in Iraq and the growth potential from the assets.
Financial Overview
This initiation will discuss the company’s forecasted financials later. I will throw some light on the company’s current fundamentals. I believe this is important as the company’s growth largely depends on high level of capital expenditure. A strong financial position will ensure robust financial flexibility for DNO International to fund its growth.
As mentioned before, DNO International clocked revenue of $505 million for the year ended December 2013 and this is the highest level of revenue clocked by DNO International. The EBITDA for 2013 was $340 million, translating into a healthy EBITDA margin of 67%. The company income statement looks attractive with revenue CAGR of nearly 28% and robust EBITDA margin.
I will focus a bit more on the cash flow and the balance sheet as high growth company can easily get into the debt trap. For the year ended December 2013, DNO International reported operating cash flows of $294 million, which is higher than the 2012 operating cash flow of $269 million. More importantly, the EBITDA cash conversion ratio is healthy at 86% and this is a positive point to note. With positive operating cash flows, the company has been able to fund its capital expenditure (partially) through internal accruals. It is also heartening to see (from a financial perspective) the company maintain a strong cash balance of $275 million as of December 2013.
From a leverage perspective, the numbers are equally good with DNO International having a debt of $238 million as of December 2013. This implies a debt to EBITDA of 0.7 and EBITDA interest coverage of 16.8. DNO therefore has high financial flexibility and it can take more debt on its books for expansion with ease. This also points to the fact that the company is well managed.
While talking about growth, it is important to discuss the capital expenditure. DNO International’s capital expenditure has increased from $45 million in 2010 to nearly $300 million in 2013. For 2014, the company plans a capital expenditure of nearly $460 million. The important thing to observe here is that the company’s capital expenditure has directly translated into high revenue and operating cash flow growth over the years. This speaks volumes about the management credibility and efficiency.
Management
I have already mentioned few important points in the financial section, which speaks volumes about a good management. A high EBITDA cash conversion, sound balance sheet management and effective conversion of capital expenditure to revenue and cash inflows underscores the management credibility.
Talking about excellent financial management, Mr. Haakon Sandborg is the company’s vice president and CFO. Mr. Sandborg has 30 years of experience in the oil industry and in banking. I believe it is his competence and expertise that has resulted in DNO International having sound fundamentals. As higher production makes DNO International cash rich further, the fundamentals will only get better under Mr. Sandborg over sight.
Two other key figures I would like to mention in the management team are Mr. Tore Lilloe (VP – Exploration) and Mr. Trond Myrseth (VP – Operations). Both gentlemen have over 30 years of experience each in the oil & gas industry and are the key pillars in a sound management team. The expertise of this team is reflected in the company’s high impact exploration program over the last few years. The results have been phenomenon in terms of exploration success and I believe that this is likely to continue.
The competency of the management is also reflected from the point that DNO International was one of the earlier movers into the resource rich region of Kurdistan and is also among the earliest in terms of commencing production.
In short, DNO International has a sound management team with many years of experience behind them. This team has the potential to turn DNO International into a large exploration company.
I must mention here that the equity markets have responded to the positive developments in the company and the stock has surged by 106% in the last 16 months. I certainly do believe that there is immense upside potential even from current levels and I will back my conviction with numbers.
Revenue And EBITDA Estimates
While the past looks excellent, what will make the stock move from these levels is the way forward for the company in terms of production growth, export growth and exploration success. I have specifically mentioned exports growth as this will be the game changer for DNO International in 2014 and beyond.
Production Growth
DNO International’s biggest asset is the Tawke asset in Kurdistan, which holds over 700mmboe of reserves. The Tawke asset also happens to be one of the biggest reserves in the Kurdistan region of Iraq. DNO International holds 55% stake in the Tawke asset, Genel Energy holds 25% and the Kurdistan Regional Government owns the remaining 20%.
The Tawke asset already has a wellhead capacity of 155,000bopd and DNO International plans to increase the wellhead capacity of 270,000bopd by the end of 2014.
More importantly, DNO International expects production to ramp up to 200,000bopd from the Tawke asset by the end of 2014. A 55% stake in the asset would imply a production share of 110,000bopd for Tawke by the end of 2014. This production growth, as compared to the company’s current production share of 39,170bopd, will be phenomenal and will impact valuations drastically.
Export Resumption
Going back to 2012-13, exports from Kurdistan region or Iraq was halted due to differences on payment between the Iraq government and the autonomous region of Kurdistan. This implied that DNO International sells oil in the local market, which is at a lower price than the price in international markets. For 2013, the revenue and EBITDA did take a hit due to exports being halted.
The scenario has changed in 2014 and the likely resumption of exports will boost revenue and EBITDA growth for DNO International. Baghdad has claimed preliminary accord in oil talks with Kurdistan and I believe that there will be a resolution relatively soon as halt in exports will hit Iraq as well as Kurdistan. Turkey, which needs Kurdish oil for growth, has also been active in helping the Iraq government and Kurdistan regional government to reach a resolution.
The second important factor, which will help exports, is the completion of a new Kurdistan export pipeline from Tawke to Fish Khabur. As the image below shows, this pipeline will help deliver oil to Fish Khabur (bordering Turkey). The exports from Tawke will not be an issue. The pipeline has a current export capacity of 100,000bopd and it is planned that the pipeline export capacity will be ramped up to 200,000bopd by the end of 2014.
Revenue and EBITDA assumption
I have assumed that the total production from Tawke will be 100,000bopd for 2014. This is conservative considering the fact that DNO International expects to ramp up production to 200,000bopd by the end of 2014. Assuming that the first half of the year is only local sales and the second half of the year witnesses exports (on resolution of the dispute), the total revenue estimate for 2014 works out to be $1.5 billion for company’s share of 55,000bopd (55% Tawke stake).
The local sales have been assumed at $60 per barrel and the exports have been assumed at $90 per barrel, which is also at a discount to current global prices. The assumptions are therefore conservative. I have also considered an EBITDA margin of 70% for 2014 and this translated into an EBITDA of $1.0 billion. If exports do resume in the second half of 2014 (very likely), the revenue and EBITDA growth will be stellar. This will result in a strong stock upside and a 100% upside in one year time looks likely.
I must mention that the 2015 estimates can be more robust as it can be a year of full exports and can trigger meaningful stock upside. A one year time horizon is good to discount the potential positives of 2015.
Valuation
It would be interesting to look at forward valuations as it will back the story of strong upside in the stock price over the next one year. As per the estimates, an EBITDA of 1.0 billion for 2014 and a current EV of $3.4 billion will result in an EV/EBITDA valuation of 3.4.
This looks extremely attractive when compared with other companies operating in the Middle-East. Genel Energy (GEGYF) currently trades at an EV/EBITDA valuation of 13.9. Another player, Gulf Keystone (GUKYF) needs to ramp up production before talking about its valuation estimates.
DNO International is therefore best placed in the Kurdistan region of Iraq to grow meaningfully over the next few years. Once the export resumes, the stock can gain strong upside momentum.
Risk Factors
One of the primary risk factors to the assumption is the geo-political risk, which is largely present in the Middle-East. I believe that this risk is discounted in the stock valuation. However, any escalation of tension in the Middle-East can further impact valuation and upside.
The second risk factor is the non resumption of export from Kurdistan to Turkey. While the probability of this might be low, it still remains a risk. In a scenario of no exports, I expect the revenue for 2014 to be in the range of $1bn to $1.2 billion. This still looks robust as bump up in production offsets the no export scenario to some extent. The primary point is that the production growth will result in robust revenue growth in any scenario.
Conclusion
DNO International has corrected from n all time high of $4.16 to $3.46. This correction has largely been on the back of profit booking after an over 100% rally in the last 16 months. Delay in the resolution of exports matter has also contributed to the correction. As exports resume, DNO International will see strong stock uptrend.
DNO International also has a strong exploration program lined up for 2014. I believe that a significant jump in 2P reserves during the year will also contribute to the stock upside besides the production growth. Assets such as Peshkabir and Tawke Jurassic can potentially add 375mmboe to 2P reserves in 2014.
Overall, DNO International has significant positives lined up for 2014 and 2015. The stock can double in all probability over the next one year.
