**This was my application idea, so I apologize that it is a bit out of date**

 

We are long shares of Cairn Energy (CNE LN).  CNE LN is a special situation where the market is valuing the stock at a roughly ~30% discount to the net cash and investments on its balance sheet, despite the intention of management to return the vast majority of the cash to shareholders via a special dividend in January 2012.  As such, it presents an extraordinary risk/reward with a top notch management team that has a long history of value creation.

Cairn Energy, as it stands today, is a collection of:  (a) cash (£3 billion in net cash at year-end 2011 that is worth £2.12/share, or 82% of the current stock price); (b) a 22% stake in Cairn India (ticker: CAIR IN, $12 billion market cap) with a market value of £1.6 billion (£1.15/share) and (c) oil & gas exploration assets in Greenland, Spain, Lebanon, and Cyprus.  In recent years, the company has focused their exploration efforts in offshore Greenland, where they were the early entrant and accumulated a massive acreage position of ~25 million acres.  They have invested over £800 million (£0.60/share) in acreage, seismic, and the drilling of 8 frontier exploration wells over the last year (none of which were commercial).  Assuming no value for the unproven exploration assets, the NAV of the company is £3.27/share (2/3 cash and 1/3 the CAIR IN stake).  This compares to the current stock price of £2.56/share (28% upside).  [A quick side note on CAIR IN taxation:  if Cairn sells the remainder of their stake in the open market through secondaries they pay no taxes;  if they sell them in a private off-market transaction to a strategic player they will owe ~11% of the market value in taxes].  

The management team at Cairn has been together for over 20 years and has a strong track record of not only proving out and monetizing frontier exploration assets, but returning excess cash to shareholders.  Following early gas discoveries in Bangladesh, the company discovered the largest oil field in India (> 1 billion barrels of oil) and took the asset public in 2007 through CAIR IN (which currently has a ~$12 billion market cap).  Management’s stated strategy is to create value through frontier exploration (opening new basins), monetize the assets, and return cash to shareholders to shrink the company to a level that they think they can double over the next 5 years.  This is very atypical for oil & gas management teams that generally are more focused on growing volumes at the expense of growing value.  In 2007 following the IPO of CAIR IN, management returned a substantial chunk of capital (~$1 billion) via a special dividend.  The best evidence of the value creation track record of the company is in the stock price performance -- the stock has been a 20x investment since 2000.  

Having just monetized its controlling stake in CAIR IN through a sale to Vedanta (VED LN), Cairn earlier this month announced a $3.5 billion special dividend (£1.60/share, or 62% of the current share price) that will occur in January 2012.  This will occur via a “B-share scheme” identical to what Cairn did in 2007 (allows UK taxable residents to elect either capital gains or ordinary income treatment).  If you hold your investment via swap, there should be no dividend withholding for non-UK taxable investors.  

At a minimum, we think it makes sense for the shares to trade at the value of the cash on the balance sheet and the market value of the CAIR IN stake, which alone provides c. 28% upside.  Further, we think that the exploration assets have a lot of positive optionality given management’s successful long-term exploration track record.  

A bit of background on Greenland:  As the ice caps recede and deepwater drilling technology gets better and better, there is a lot of jockeying amongst oil & gas majors for access to the deepwater Arctic plays.  This was seen most recently in the public fight between BP and XOM to joint venture with Rosneft to access the Russian arctic.  The arctic represents one of the last untapped virgin oil regions with the potential for large mega-field finds.  Cairn recognized this early and leased vast swaths of offshore Greenland in middle of last decade.  To date, they are the only oil & gas company that has drilled wells there.  In the last bid round (earlier this year), all of the major oils showed up (Exxon, Royal Dutch, Statoil, etc) and licensed acreage around Cairn.  So it’s clear that the region has real prospectivity despite Cairn’s lack of success to date.  

Following the special dividend, the company will pay out $3.5 billion (£1.60/share) and retain $1.2 billion (£0.53/share) in net cash which will likely be reinvested into M&A.  Management has committed to spend no more money in Greenland until they get a major oil partner (farm-out discussions under way, goal is to conclude a deal by summer 2012).  Overhead for the business is minimal at ~$30mm/yr.  The current stock price of £2.56/share implies an ex-dividend price of £0.96/share.  This compares to £1.15 /share for CAIR IN stake + £0.53/share in residual net cash = £1.68/share in core NAV before assigning any value to Cairn’s exploration assets.  Said another way, post-distribution the shares would need to appreciate 75% just to value the exploration assets at zero.  

Key risks:  
-       Reinvestment of $1.2 billion in capital
-       Downside to CAIR IN stock price (however we feel like the risks are to the upside on this one – CAIR IN has ~$1 billion in net cash, is on path to double its oil production over the next 2 years organically, trades at 6-7x 2012 P/E and 5x 2012 EBITDA, and sells its oil for Brent pricing with opex costs of <$5/barrel)

Special dividend in January that further highlights the substantial discount to cash and investments
Farm out agreement in Greenland