CFA Institute Research Challenge

Hosted by Indian Association of Investment Professionals, India Indian Institute of Foreign Trade, Delhi Team - Andrei Marga

Andrei Marga Oil and Gas Andrei Marga Cairn India Ltd.

12th October 2012 Strong Fundamentals and Attractive Valuations

Industry: Oil and Gas Ticker: NSE/CAIRN Recommendation: BUY

Sector: Exploration & Production (Upstream) Current Price: Rs. 330.05 Strong 12 Month fundamentals Target Price: and lucrative Rs. 378.46 valuations

As on 11 th Oct 2012 (14.54% upside) Market Profile Highlights 52 Week Price Range (Rs.) 277.05 - 401.1 Average Daily Volume 2167449 Strong visibility for future produc tion growth: The de-bottlenecking of pipeline expected to Beta 0.83 be completed by Q1FY14 would increase production to 190kbpod. In addition, Aishwarya field Shares Outstanding 1,909 M is expected to produce 10kbpod from FY14 with production from Bhagyam field also likely to reach 40kbpod by FY15. Market Capitalization (Rs.) 630,066.1M Institutional Holdings 25.13% Deployment of cash presents upside: The Company plans to utilize its cash reserves by

Book Value per share (Rs.) incurring a net C apex of $2bn over the next two years to expand exploration and production of 252.97 oil and gas both in the country as well as abroad. This Capex will s upport the potential estimated Debt to Total Capital 2.30% oil production of 300kbpod as per revised management estimates. Return to Equity 16.40% Strong financial performance: The Company has maintained a healthy EBITDA margin with an average of 74% over the past three years which is better than global ave rage of 52% and other domestic peers. Currently the company ha s an OCF/PAT ratio of 89%. Over the period 2013-21, Company Grid Ratings OCF /PAT is expected to be in between 120-130%. Cairn is a zero-debt company with 16.44 % return on equity and cash reserves of $2bn . Low High Encouragin g discoveries in overseas and domestic blocks: Out of the 7 exploration blocks of 1 2 3 4 5 Cairn India, 3 blocks have registered successful discoveries. It plans to start the second Earnings Growth exploration phase in Sri Lanka in mid-2013. Furthermore, the KG basin Nagyalanka-SE block Cash Flow has in -place oil reserves estimates of 550mboe. In addition, Cairn India has also recently acquired a 60% stake in a deep sea gas discovery in South Africa. B/S Strength Low cost producer: Cairn India enjoys one of the lowest exploration and production costs i n Valuation Appeal world. The company had field direct operating cost of $2/boe. Risk Valuation: On the basis of Discounted Cash Flow valuation and Comparables Analysis, we

recommend a target price of 378.46 INR, offering a 1 4.54 % upside from current stock price. Our Stock Performance target pri ce is the weighted average of the two methods and is justified given the strong (as of 11/10/2012) 1m 3m 6m 1y fundamentals of the company. Absolute -2.9% 5.9% -4.8% 18.9% Key risks to the target price: Cairn India’s revenues largely depend upon crude oil prices and Nifty 5.9% 7.6% 9.2% 11.9% INR/USD exchange rate fluctuations. The other risks being delay in pipeline de-bottlenecking and government approvals for production increase.

Cairn India stock chart relative to index (rebased) Financial Snapshot INR FY 10 FY 11 FY 12 FY 13E FY 14E FY 15E FY 16E FY 17E Source: Bloomberg Revenue (mn) 16,230 102,779 118,607 208,017 233,032 248,351 238,364 219,196 EBITDA (mn) 9,874 84,211 95,533 120,619 129,294 138,449 127,016 111,111 Net Income (mn) 10,511 63,344 79,377 82,556 88,201 94,589 86,378 75,137 Earnings per Share 5.5 33.2 41.6 43.3 46.2 49.6 45.3 39.4 Book Value per Share 177.41 211.07 252.97 296.22 342.42 391.97 437.22 476.57 Return on Equity 3.10% 15.72% 16.44% 14.60% 13.49% 12.64% 10.35% 8.26% Return on Assets 2.99% 16.27% 18.90% 17.79% 18.79% 19.93% 18.05% 15.57%

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Business Description

One of the largest independent oil and gas exploration and production companies in India, Cairn India Limited was incorporated in 2006 as a subsidiary of UK-based Cairn Energy PLC. The Fig 1: Asset Base of Cairn India company was listed on the and the National Stock Exchange of India on 9 January 2007 and its IPO was the then largest IPO in the Indian primary equity markets. Cairn Rajasthan India and its JV partners account for more than 20 percent of India’s domestic crude oil RJ -ON -90/1* WI 70% production. The company participates in different blocks/fields through Production Sharing East Coast Contracts (PSC) entered into between the Company and and other venture KG-DWN-98/2 WI 10% partner. KG-ONN-2003/1 WI 49% PKGM-1 (Ravva)* WI 22.5% Production Units: Cairn India has a total of 10 blocks in its portfolio - one in Rajasthan, two on KG-OSN-2009/3 WI 100% the west coast, six on the east coast, including one in Sri Lanka, and one in South Africa. Of these, PR-OSN-2004/1 WI 35% three are currently producing hydrocarbons and are located in Rajasthan, Cambay and Ravva with West Coast Rajasthan being the most crucial block. CB/OS-2* WI 40% MB-DWN-2009/1 WI 100% Rajasthan (RJ-ON-90/1): The Company has made a total of 40 discoveries so far with 25 Sri Lanka SL 2007-01-001 WI 100% discoveries in the Rajasthan block alone. The Mangala, Bhagyam and Aishwariya (MBA) fields, South Africa (SA) among others, constitute Cairn India’s key assets in Rajasthan. The company is the operator in this Block 1 WI 60% block and has a 70:30 joint venture partnership with ONGC. At present, the block is producing * Producing Blocks 175,000 bopd, out of which 150,000 bopd is produced by Mangala field and 25,000 bopd by Bhagyam field. Aishwarya field is expected to commence production by end of FY2012-13. WI – Working Interest (Cairn) Source: Company Website Ravva (PKJM-1): Cairn India operates in the Krishna-Godavari Basin on the Ravva oil and gas field with 22.5% participating interest. It has partnerships with ONGC, Videocon and Ravva Oil and the average gross production from the field was 36,379 bopd in FY2012. Fig 2: Gross Production (bopd) Cambay (CB/OS-2): The Company’s operations in Cambay block are centered on the Lakshmi and Gauri oil and gas fields, and the CB-X development area. It is the operator in this area with a participating interest of 40% and has partnerships with ONGC and Tata Petrodyne Limited. The average gross production from the field in FY2012 was 8,242 bopd.

The crude oil from Rajasthan fields is processed at Mangala Processing Terminal (MPT). Following the processing, the crude oil is transported to distant consumer refineries through Mangala Development Pipeline (MDP) with a current capacity of 175,000 bopd. MPT to Salaya section of the pipeline currently supply crude oil to IOCL’s Panipat and Koyali refineries, and to private refiners on the west coast of India. Going forward, the company plans to de-bottleneck and augment the MDP, which is expected to add around 10% extra capacity to the pipeline. Source: Company Filings Company Strategy: The Company’s strength lies in its low operating cost and high operational uptime – resulting in high EBITDA. The company witnessed an increase of 16% YoY in average Fig 3: Shareholding pattern daily gross production and 10.7% YoY increase in EBITDA in FY2012. The company aims to produce 300,000 barrels of oil per day, subject to further investments and approvals from its Joint Venture Partner ONGC and the Government of India. The company has estimated gross in-place resource of 7.3 bn boe in the Rajasthan block and has received positive results from the EOR polymer pilot project in Mangala field. Cairn India has also made two discoveries in Sri Lanka and has signed farm-in agreement with PetroSA for exploring crude oil and natural gas in South Africa.

Shareholding Pattern: Vedanta Group is the promoter of Cairn India and holds a stake of 58.85% in the company. Cairn UK Holdings Limited holds another 10.28% stake and 8.96% is occupied by other institutions. Foreign institutional investors have a holding of 16.17% and remaining 5.77% is occupied by other public shareholders.

Source: Company Website UK’s Cairn Plc. sold 8% stake in Cairn India for $910 million in September 2012 bringing down its stake to 10.28%.

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Fig 4: World Energy Basket World oil and gas market overview Global crude demand driven by emerging economies Oil is the most common source of energy around the world, notably accounting for 33% of the primary energy consumption basket (refer fig 4). The global demand for crude oil has increased by 14% in the last decade reaching 88.04million bopd in 2011. The major consumers being USA, China, Japan, and India. In India, however, oil accounts for 29% of the primary energy demand with coal fulfilling 53% of the primary energy demand in the country (refer fig 7). The demand for oil has been witnessing an increasing demand during the last decade especially from Non-OPEC countries like India and China. The oil demand in these two countries has grown at a CAGR of 4.3% and 7.2% respectively since 2001. Source: BP Statistical Review 2011 Increase in proven oil reserves The proven reserves of crude oil stood at 1652.6 billion barrels at the end of 2011, which reflect a 30% increase with respect to proven reserves of 1267.4billion barrels in 2001(refer fig 5). The Fig 5: World Crude Oil Reserves proven reserves grew 1.9% in 2011driven by a 24% increase in proven reserves in Iraq. Global oil and gas exploration spending on a rise Global upstream capital and operating expenditures (CAPEX and OPEX) are set to reach a combined record of $1.23 trillion for 2012 and expected to rise to $1.64 trillion in 2016, according the IHS estimates. The Asia-Pacific region follows North America ($392 billion) with $238 billion in total 2012 upstream spending. The high growth in upstream expenditures can also be attributed to increased exploration activity in Arctic and North Sea region. Crude oil supply surplus for the first time in last few years The global crude oil supply-demand scenario has witnessed a significant volatility in the past few Source: BP Statistical Review 2011 quarters. The global demand witnessed a decline in the first two quarters of 2012 due to a slowdown in the global economy. The demand increased 2% in the next quarter resulting in a push to the oil prices beyond $115/bbl. However, since then the global oil demand has seen a steady decline which is expected to continue to the next year due to expected slowdown in China. Nevertheless, Saudi Arabia and other OPEC countries have increased the crude production to compensate for the reduced Iranian oil supply and hence stabilize the crude prices near $100/bbl. Global oil supply-demand

Source: Short- term Energy Outlook, EIA, September 2012

Fig 6: Brent Crude V/S Global Global crude prices to stabilize at around $100/bbl till mid-2013 Demand-Supply deficit Brent crude oil spot prices have increased at a relatively steady pace from their 2012 low of $89/bbl in June to their recent high of $117/bbl in August driven by the seasonal tightening of oil markets and continuing unexpected production outages. The Brent crude oil prices are expected to fall from recent highs to below $110/bbl for the rest of 2012 at the back of a production increase by Saudi Arabia to stabilize the prices at around $100/bbl. The prices are more likely to go down with non ‐OPEC production expected to grow by 1.2 million bopd in 2013 compared with world consumption growth of 1.0 million bopd as per EIA estimates. Furthermore, the possibility of a deteriorating economic situation in the countries of the European Union and slowing growth in China adds significant downside risk to future prices, though supply disruptions and lower ‐than ‐expected supply growth could raise prices Hence, the crude oil prices are likely to hover around $100/bbl, though the market is expected to Source: Bloomberg, EIA loosen in the further months of 2013 mainly driven by economic and supply scenario.

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Indian Oil and gas overview Fig 7: India Energy Basket India – Growing crude oil demand-supply deficit Oil accounts for 29% of the India’s primary energy consumption (refer fig 7), which has witnessed a growth of 4.3% annually since 2001. Although coal still accounts for 53% of the primary energy demand of the country, the share of oil has been increasing driven by strong economic growth. The oil demand grew by 3.9% in 2011 to 3.47million bopd as compared to 3.33million bopd in 2010. The demand is expected to grow by 2.8% annually till 2020 (refer fig 8). However, India fulfills only 24% of its demand by local production and depends primarily on imports for its crude oil supplies. Some of the key players in the oil and gas industry in India are ONGC, Cairn India, OIL, RIL, Essar and local OMCs Indian Oil, BPCL, and HPCL. Entry of private players accelerating oil and gas exploration in the country

Source: BP Statistical Review 2011 India has crude oil reserves of around 5.7billion barrels as of 2011 with a reserve to production ratio of 18.2. The oil and gas exploration sector in India is dominated by PSUs such as ONGC and OIL. Although, the upstream activity has seen an encouraging growth in the recent years due to Fig 8: India oil Production -Demand the emergence of private players such as Cairn India, RIL, and Essar, the private contribution is still around 27% of the total production. In 2011, operations were being carried out by national and private oil companies in 633

concessions, of which 263 are under Exploration Licence (PEL) and 370 under Mining Lease (ML) as compared to 203 PEL & 163 ML concessions in 1996 (refer fig 9). KBOPD Economy needs fuel to grow As the Indian economy has grown by more than 6% annually in the past decade, the demand for diesel has also grown by 8.5%. Diesel is a key fuel for transport sector, including trucks (which consume 37%), buses (12%), and railways (6%), while 10% of the diesel demand comes from Source: BP Statistical Review 2011, IEA and Infraline forecasts 2011 industry and 8% from power generation for agriculture. This demand is expected to grow by 7% annually for the next 5 years given the Indian economy maintains the growth pattern. Fig 9: PEL areas under operation High growth in auto sector Indian automobile sector has been one of the fastest growing in the world witnessing an annual growth of 12% in the last decade with total vehicle sales reaching 17.4 million in 2011-12. Out of this, passenger car sales accounted 2.6 million while two-wheeler sales accounted 13.4 million. Driven by this strong growth in auto sales, the petrol demand in the country has grown by 10.4% annually during the last decade. Need for securing strategic oil reserves for future India needs to secure strategic reserves of oil to support its economic growth and reduce its dependence on imports for its energy demand. Unlike China, India has been slower in securing strategic oil reserves. However, state-run ONGC-OVL has been active in this regard; the Source: Director General of Hydrocarbons, India participation of private players is yet to happen in the oil sector. Waning interest in new investments in the sector The exploration spending in NELP blocks has seen a drastic drop in India, falling from $4 billion Fig 10: NELP Allocation (last 5 yrs) in 2007 to $4.7 million in 2011. While 157 production sharing contracts were signed under No. of PSCs Wells different NELP rounds between 2005 and 2011, the number of exploration wells drilled has fallen Column1 blocks signed drilled from 60 in 2005 to nil in each of the four years between 2008 and 2011 (refer fig 10). NELP V 20 20 60 The reasons for the sharp fall in exploration drilling range from not getting permissions from NELP VI 55 52 12 defense and space agencies to environmental issues in the exploration region. Most importantly, NELP VII 57 41 0 many companies are put off by the lack of clarity in India's exploration and production policies as NELP VIII 32 31 0 seen in gas-pricing and tax-holiday concessions. NELP IX 34 13 0 PSC review and increase in Cess likely to affect future investments Source: Director General of Hydrocarbons, India The government has setup a review committee to review the Production Sharing Contracts (PSC) terms in order to modify the terms of cost recovery by contractor and government’s share. The government in the 2012 budget increased the cess on petroleum from Rs.2500/ton to Rs.4500/ton. This is likely to affect the major upstream players ONGC, OIL, and Cairn India significantly in terms of earnings.

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Fig 11: Oil production market Competitive positioning

Largest and most successful private player in India Cairn India produces around 20% of India’s total crude production making it the 2 nd largest player in the Indian market after ONGC. Cairn has enjoyed a very successful operation in India by starting production at the wells in record times. The production at Lakshmi field was started in a record time of 28months. The company also has a competitive reserve-replacement ratio (RRR) of 1.75 w.r.t. 1.79 for ONGC and 1.23 of OIL. Besides Cairn India, the other major player is RIL which has 29% of the PEL areas under operation and produces 3% of India’s production. RIL had achieved some initial success in KG basin but has currently put its new E&P investments on hold. Source: Director General of Hydrocarbons, India Low exploration and production cost translating to higher margins Fig 12: Field operating costs Cairn India has one of the lowest field direct operating costs of $1.9/boe as compared to an average of $7.3/boe spent by top IOCs in the world. The finding and development costs for the company at $7/boe are also around 60% lower than the global average of top players. This gives the company a strong advantage in terms of achieving higher margins. Own transportation pipeline offers more self-reliance Cain India’s 600Km long Mangala Development Pipeline is the world’s longest continuously heated and insulated pipeline. The pipeline carries 175,000bopd from Rajasthan fields to refiners in Gujrat. The pipeline gives a strong advantage to Cairn in terms of supply logistics and self- reliance in terms of its crude operations. *Ravva and Cambay have transportation costs included Source: JS Herold, Company Presentation Investment Summary Strong financial performance and valuation indicate a BUY On the basis of Discounted Cash Flow valuation and Comparables Analysis, we recommend a Target Price – Rs. 378.46 target price of 378.46 INR, offering a 14.54% upside from current stock price. Our target price is the weighted average of the two methods and is justified given the strong fundamentals of the Upside -14.54% company. The company has maintained a healthy EBITDA margin with an average of 74% over the past three years which is better than global average of 52% and other domestic peers. This strategy of being a low cost E&P company has helped it generate significant cash flow. Currently Current Price – Rs. 330.05 the company has an OCF/PAT of 89%. Over the period 2013-21, OCF/PAT is expected to be in between 120-130%. Current Stock Price – Last close 11 th Oct 12 Cairn is a zero-debt company and has a healthy balance sheet. The absence of interest burden, 16.44% return on equity and cash reserves of $2bn makes it one of the most promising E&P companies in the country. Fig 13: Cash Position of Cairn India Deployment of cash offers significant upside The company has announced its plans to utilize its cash reserves by making a Capex of $2bn in the next two years towards development of existing fields and new explorations. The management has guided for a gross Capex of up to $2bn till FY14, of which 60% is planned for the Rajasthan block pipeline and the remaining 40% for other exploration blocks. However, CIL is expected to generate strong net cash flows of Rs. 10,160Cr in the near term looking at its expected production growth and low operating costs. Strong visibility for future production growth The company continues its efforts to increase production from its key fields. With the de- bottlenecking of pipeline, the production is expected to rise by 10% to 190kbpod by Q1FY14. In addition, Aishwarya is also expected to commence production from end of FY13 with production rate of 10kbpd. The production from Bhagyam is also likely to reach 40kbpod by FY15. However, the production ramp-up is subjected to government approvals. The company has also pushed for approvals from the government in the non-development areas of the Barmer basin. Technology and Innovation driving the exploration success Cairn India improved its resource base from 6.6bn boe to 7.3bn boe in total in the Rajasthan asset in 2012. The company has initiated proven EOR (Enhanced Oil Recovery) method which is Source: Company Filings expected to increase the gross proved and probable (2P) reserves by around 300mm boe and

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Fig 14: Rajasthan Resource Potential extend the plateau production in Rajasthan. Following positive results from the EOR polymer pilot Gross in Place (mmboe) in Mangala field, 70 mm bbls have been booked as 2P reserves. Going forward, the company also Under Development intends to implement EOR in Bhagyam and Aishwariya fields. We believe that extensive use of MBARS 2168 latest technology and EOR methods is likely to extend the recovery potential from existing fields. Future Development and Prospective Encouraging result on discoveries front in overseas and domestic blocks Resource Balmer Hills+19 districts 2010 Out of the 7 exploration blocks of Cairn India, 3 blocks have registered successful discoveries. Exploration 3100 After the completion of phase 1 of deep water exploration in Sri Lanka, CIL will start the second Total 7278 exploration phase in mid-2013. Furthermore, the KG basin Nagyalanka-SE block has in-place oil reserves estimates of 550m boe. In addition, CIL has also recently acquired a 60% stake in a deep Source: Company Presentation sea gas discovery in South Africa. We believe incremental results from these discoveries and new explorations will lead to higher production and earnings estimates. Fig 15: USD/INR Exchange Rate Rupee appreciation may affect earnings Movement A depreciating rupee and invoicing in US dollars, have contributed towards forex gain of Rs 866 Cr in Q1FY13. For every, US$5/bbl rise in crude prices Cairn’s EPS for FY13 will rise by 5.8%, while every Re1/US$ depreciation in INR EPS increases by 2.26%. INR has seen an appreciation in the past few weeks after it hit record low of 57.09 in June’12. However, the company has guided to invoice the revenues in rupee to the extent of asset transferred under Cairn India. Hence, even if there is an appreciation in rupee, the loss would be limited. Correlation between Brent Crude and Cairn India Equity Cairn India has historically traded at a premium to crude and saw a strong correlation with crude prices but over the last 18 months this correlation has wrecked. With the likelihood of Vedanta Source: Bloomberg coming on board, Cairn India’s shares traded at a discount to crude prices and its peers for a year. However the correlation has shown recovery in last couple of months and we believe this to continue given the company’s strong asset base and successful discoveries. Notably, the recent corrections in Brent Crude prices were also reflected directly on CILs stock price which also witnessed a decline correspondingly and then has improved in past weeks driven by oil prices.

Cairn India Equity correlation with Brent Crude suffered following Vedanta’s acquisition plans

Key Developments and Stock Price movements

Source: Bloomberg Page 6

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Valuation

Assumptions Fig 16: Gross Oil Prod (bopd): Production Rajasthan Block Rajasthan Block As per management guidance, the estimated economic life of the Rajasthan Block is assumed to be till FYE 2041 with an average daily gross oil production of 175,500 bopd in FY 2013. This will be supported by debottlenecking of MPT pipeline & the renewed sales agreement with buyers for volumes in excess of 175,000 bopd. Due to uncertainty in getting further regulatory approvals, the block is assumed to achieve a peak production of 230,375 bopd by FY 2016, around 20% lower than the upside expected of 300000 bopd. Mangala field is projected to reach its peak production of 150,000 bbpd (upto current GoI approval) by FY 2014 without EOR deployment. Bhagyam which commenced production in Jan 2012 is expected to gradually increase its production capacity and achieve its peak production of 60,000 bopd by FY 2018. Aishwarya field which is expected to commence production in the current year is estimated to reach the maximum production level of 25000 bopd by FY 2020. Source : Student Research Besides the MBA fields, Rageshwari, Saraswati and other marginal oil fields in the Rajasthan block are expected to contribute to the blocks’ production from this year onwards at around Fig 17: Forecasted Production 500bopd , with maximum production level of 800 bopd being reached by FY 2016. (mmbbls) Following positive results from the EOR polymer pilot at Mangala field which led to booking 2P reserves of 70 mn bbls, an EOR potential of 15% of STOIIP (Total recovery ~ 305 mn bbls) is considered for the valuation purpose with effect from FYE 2014. Ravva & Cambay Ravva field which is already on decline is expected to continue till FYE 2028, assuming 10 years extension from current PSC expiration. Cambay field is assumed to contribute to ~ 1 to 3% of total production till FYE 2023 when its PSC with the government ends. Statutory levies It is assumed that Cess at the rate of Rs. 4500/ton along with a Royalty of 15% of its share of Source : Student Research revenue from Rajasthan Block is paid by Cairn India to the GoI for all forward years. Fig 18: Forecasted Production For Ravva field, current Cess at Rs 900/ ton and Royalty of Rs. 481/ ton is projected to be paid by (mmbbls) Cairn India to the GoI for the whole economic life of the field. Furthermore the terms of PSC for Profit sharing with government are considered for calculating Investment multiples and PTRR (Post Tax Rate of Return) for deciding JV’s share of profits. Other Assumptions: (Base case)

Crude Price Realization Brent crude Price US$ 100/bbl Discount to Brent crude 10% (Management guidance of 10-15% for Raj Block) Pricing Premium from Brent US$ 2/bbl (For Ravva & Cambay) Exchange Rate Rs 52/US$ Capex US$ 2bn in FY 2012-14 (60% Rajasthan, 40% Others) FY 2015 onwards- Average Capex/Sales for past yrs Source: Student Research Opex Rajasthan Block Direct Field Opex US$ 3.5/bbl ; Pipeline Opex US$ 1.5/bbl Ravva US$ 2.9/bbl (Direct Field Opex incl Pipeline costs) Cambay US$ 4.7/bbl (Direct Field Opex incl Pipeline costs) WACC 11.08% Tax rate 33.9%

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Fig 19: Scenario Analysis Discounted Cash Flow (DCF) Valuation Cairn India has been valued by projecting the revenues of Rajasthan Block, Ravva field &Cambay Base Case Best Case Worst case field separately, and then carrying out a Sum-of-the-parts Discounted Cash Flow analysis using Exploratory Upside 10% 20% 5% the combined revenues. Using the implied EV/bbl ratio for these 3 fields, exploratory upside is Oil recovery (mn bbls) 1,190.05 1,701.05 934.55 valued at INR 229,484mn. EV (Rs mn) 644,473 873,957 529,730 The Free cash flows to the firm are projected for the entire life of the fields (maximum till EV (Rs/ share) 337.88 458.19 277.72 FYE2041) with a target Debt-Equity of 0% as per management guidance of net-cash company Share Price 374.65 494.96 314.49 position. Upside/ (Downside)% 0% 32% -16% These cash flows are discounted at a weighted average cost of capital (WACC) of 11.08% to Source: Student Research arrive at the enterprise value of Rs. 644,473mn. Then by adding the net cash of Rs. 70,135 mn, we arrive at an equity value of Rs. 714,608mn, translating into a share price of INR374.65 . Please refer Appendix for WACC calculation and Enterprise value calculation. Fig 20: Football Field Analysis SOTP Valuation: Cumulative FCFF Net 2P Reserves Block (Rs mn) (mm bbl) EV/bbl ($) Rs/ Share Rajasthan Block 403,816 658.15 16.73 211.71 Ravva 7,256 16.16 12.24 3.80 Cambay 3,916 4.74 22.51 2.05 Exploratory Upside 229,484 511.00 12.24 120.31 Total 644,473 1,190.05 337.88 Rs. 330.05 Current Share Price Net cash 70,135 36.77 Rs. 378.46 Target Share Price Cairn India 714,608 374.65 Source: Student Research Sensitivity Analysis:

Fig 21: Currency v/s Crude oil prices Fig 22: WACC v/s Crude oil prices

Crude Oil Prices Crude Oil Prices 374.65 90.00 95.00 100.00 105.00 110.00 374.65 90.00 95.00 100.00 105.00 110.00

48.00 281.68 318.30 348.00 379.68 411.98 9.08% 326.12 361.85 399.38 434.52 461.09 50.00 293.98 330.01 361.43 396.77 419.16 10.08% 315.51 350.16 386.59 420.63 446.38 52.00 305.61 339.25 374.65 407.66 432.66 11.08% 305.61 339.25 374.65 407.66 432.66

Rs./US$ 54.00 317.57 349.25 387.78 413.17 442.43 WACC 12.08% 296.36 329.05 363.49 395.55 419.86 56.00 323.63 363.36 397.92 425.03 459.83 13.08% 287.70 319.50 353.05 384.22 407.88

Fig 23: Comparables Analysis Valuation by Comparables A sample set comprising of the major players in E&P segment of Indian oil Industry (ONGC, OIL, Essar Oil) has been taken as the comparables in absence of close peers to Cairn India. Forward looking multiples 2013E (P/E, EV/EBITDA & P/FCF) are calculated for these companies and their average is taken as the trading multiple of Cairn India, wherein equal weightage is assigned to all 3 valuation ratios. Accordingly a share price of INR 387.34 is determined which is 3.4% more than the DCF valuation. Target Price The target Price has been arrived at, by giving a 70% weightage to DCF analysis and a 30% Source: Bloomberg, Student Research weightage to comparables to arrive at a target share price of INR 378.46. A higher weightage to DCF method is justified on the ground of fundamental valuation being more appropriate for valuing the company which is functioning in a volatile economic environment presently.

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Risks to our Price target The DCF model is affected largely by 3 factors- Brent crude price, Rs/$ Exchange rate & WACC of the company. Out of the three the major impacting factor is the Brent crude price as reflected in figure 22. Please see the Monte Carlo simulation in the Risks section for a more detailed analysis on the sensitivity of Crude oil prices on valuation of the company.

Financial Analysis Source: Student Research A Sharp fall in EBITDA and PAT margins expected in FY13 Fig 25: Performance Cairn India through out the years has maintained a healthy EBITDA margin keeping in line with its core strategy of being a low cost E&P company. CIL has an average margin of 74% with the margin stabilising to 80% over the past two years. It has Performed better than global peers and outperformed major domestic players. The high margin has helped post a much higher PAT margins than its peers and helped generate a significant cash flow for acquiring oil & gas blocks and even debt pay offs. We expect the margin to drop on account of increased statuatory levies. PAT margin is expected to drop from the current level of 67% on account of levies and ending of tax holiday. Return ratios to come under stress Company has shown excellent growth of 25% y-o-y as of FY12. EPS for the FY13 is expected at 43.4 with y-o-y growth of 4% owing to levies and increased taxes. The higher margins has helped Source: Student Research the company maintain a healthy EPS uptil now. ROE was seen at 16.5% in FY12 is expected to drop by 200bps. Cash Flow generation to remain strong Cairn has a healthy cash flow which is expected to improve considerably over the next decade. Currently the company has an OCF/PAT of 89%. Over the period 2013-21,OCF/PAT is expected to be in between 120-130% which is in line with domestic peers. The strong cash flow has resulted Fig 26: Profitability in a cash balance of $1.3bn on its books as of Mar 31 2012 and will help the company acquire oil & gas blocks along with other future investments. Absence of debt burden and strong cash reserves strengthen the balance sheet Cairn has a healthy balance sheet has become a zero debt company during FY12. The absence of interest burden, 16.44% return on equity and a healthy cash flow has helped company create a strong asset base. The company recorded a growth of 13% in the last financial year and is expected to grow 14-16% y-o-y over FY13-FY15. Key Financial Ratios FY 10 FY 11 FY 12 FY 13E FY 14E FY 15E FY 16E FY 17E FY 18E Source: Student Research EBITDA Margin 61% 82% 81% 58% 55% 56% 53% 51% 51%

Return on Equity 3.10% 15.72% 16.44% 14.60% 13.49% 12.64% 10.35% 8.26% 7.57%

Return on Assets 2.99% 16.27% 18.90% 17.79% 18.79% 19.93% 18.05% 15.57% 15.31% OCF/Sales 6.76% 61.59% 59.62% 47.38% 45.93% 46.04% 44.66% 43.22% 43.18% OCF/EBITDA 11.11% 75.18% 74.02% 81.71% 82.79% 82.58% 83.82% 85.27% 85.25% EPS 5.5 33.2 41.6 43.3 46.2 49.6 45.3 39.4 39.1 Book Value per Share 177.41 211.07 252.97 296.22 342.42 391.97 437.22 476.57 515.60

Investment Risks External Risks Crude oil price volatility : Revenues generated by the company are directly linked to the prices of the crude oil. As per our sensitivity analysis a $5/bbl change in our long-term oil price assumption would impact CIL’s SoTP valuation by approximately Rs. 35/share. Exchange rate risk: The realizations of CIL in both gas and oil are reported in dollar terms. Thus, an expected Rupee appreciation will affect the revenues going forward.

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Interest Rate risk: Company has almost zero debt. Thus, interest rate risk is not too high. But if the money is borrowed in the coming years for exploration and operation, interest rates will affect the profitability. Regulatory uncertainty: Political developments by the Centre, state, local laws and regulations such as production restrictions, changes in taxes, royalties and other amount payable to the various government or other agencies will affect the business.

Internal Risks Exploratory upside may be lower The estimation of underground accumulations of reserves is a judgmental phenomenon and actual recoveries can vary significantly. The reserves measurement is a function of the quality of the available data and the engineering and geological interpretation. Hence, the results of further drilling, testing, and production may significantly change the reserve estimates. This may in turn affect the future production and revenue estimates. Delay in de-bottlenecking of pipeline Debottlenecking of the pipelines is expected to provide a further upside to production by 10%, which is expected to be completed by March 2013. A further delay in the de-bottlenecking may restrict the production from Rajasthan block. Government Approvals a key bottleneck CIL requires approvals for revised FDP for higher MBA production. The current approved FDP is for 200kbpd (150/40/10 kbpd for Mangala, Bhagyam & Aishwariya fields). It would also require approvals from the JV partners and Government of India. These approvals can be delayed or denied by any of the concerned parties resulting in lower than estimated production. Pipeline extension key for future expansion There could be delay and higher than estimated cost of construction of the Salaya to Bhogat section of the pipeline and the Bhogat terminal. The construction, installation and commissioning of the pipeline can take longer than planned due to unforeseen project delays. Dividends might not come this year Although, the Company has announced a dividend of 20%, the payment of dividend is subject to the discretion of Board of Directors. Cairn India is waiting for a corporate reorganization, which is a prerequisite for dividend payments. Regulatory authorities have not approved this reorganization yet. Thus, there is a risk towards dividend payout coming in near future. CEO exit might delay government approvals Rahul Dhir stepped down as the MD and CEO of Cairn India on Aug 31, 2012. The new CEO will have to start the process of building relationships right from the scratch. This might also lead to delays in several approvals for the company. Other Concerns Vedanta may be looking for Cairn’s Cash There are serious concerns that the debt ridden ($10.1 bn as on March 2012) parent, Vedanta, might see cash rich Cairn India as a source to improve its own balance sheet. The concerns arise from the fact that Sesa Goa, which was acquired by Vedanta and a subsidiary currently, bought 18.5% in Cairn India via the Open Offer. Sesa Goa funded the $3bn required for this deal mainly through its cash reserves. Thus, we believe that the management, in a similar fashion, might also use the cash reserve of Cairn India Limited to add more companies to its portfolio. Seeking of approval to sell crude to RIL SEZ poses a dilemma Cairn India is trying hard to seek permission to sell its Rajasthan crude oil to ' SEZ refinery at Jamnagar in Gujarat to ensure uninterrupted production from its fields. The reason given by Cairn is that it can sell oil only to RIL because an 80-km stretch of its Barmer-Bhogat pipeline, which is meant to transport crude oil to west coast for supplies to oil refineries across India, is struck due to ROU problems. This presents a potential upside for CIL, however, it could hamper CIL’s chances to get approvals to raise production from its Rajasthan fields. The government might require Cairn to first complete construction of its pipeline because selling crude to SEZ refinery is equivalent to exporting it and government does not permit the export of domestically produced crude oil without special permit from IOC.

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Appendix:

Appendix 1: WACC Calculation

Assumptions:

Risk Free rate 8.2% 10 year Government of India Bond Yield Beta 0.83 Regression of stock returns (CAIRN) with market returns (NSE) for past year (26 September 2011 to 25 September 2012) Market Risk Premium 3.5% Average of 1) Market Risk Premium through Extrinsic method used by Aswath Damodaran: India 2012 (Local Currency Rating Baa3, Adj. Default Spread 200, Country Risk premium at 4%) 2) Bloomberg (Equity Risk Premium at 2.75%) Cost of Debt 9.1% YTM of its NCDs listed in WDM segment of NSE (LTY% as on 25 September 2012) Target Debt-Equity ratio 0.0% Management guidance of Zero-debt target Tax Rate 33.9% Indian corporate tax rate including surcharge and education cess

Calculation: Cost of Equity for Cairn India is calculated using Capital Asset Pricing Model (CAPM) as the company does not pay out dividends yet and hence cannot apply dividend growth model.

WACC Calculation Risk free rate 8.2% Equity risk premium 3.5%

Beta 0.83 Cost of Equity 11.1%

Cost of debt 9.1% Tax rate 33.9% Post tax cost of debt 6.0%

Debt/Equity 0% WACC 11.08%

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Appendix 2: Projected Average daily Oil Production (bopd)

FY 10 FY 11 FY 12 FY 13E FY 14E FY 15E FY 16E FY 17E FY 18E

Rajasthan Block Mangala 14,861 100,993 125,000 150,000 150,000 142,500 128,250 109,013 92,661 Bhagyam - - 3,267 25,000 25,000 40,000 50,000 60,000 60,000 Aishwarya - - - - 10,000 10,000 15,000 15,000 25,000 Rageshwari/Saraswati/Others - - - 500 500 800 800 760 684 EOR production - - - - 26,325 31,325 36,325 41,325 46,325 Rajasthan Total 14,861 100,993 128,267 175,500 211,825 224,625 230,375 226,098 224,670 Ravva 40,783 36,947 36,329 31,243 26,869 23,107 19,872 17,090 14,697 Cambay 13,392 11,168 8,203 6,726 5,516 4,523 3,709 3,041 2,433 Total 69,036 149,108 172,799 213,469 244,209 252,255 253,956 246,229 241,800

Appendix 3: Projected Income Statement (Rs. mn)

FY 10 FY 11 FY 12 FY 13E FY 14E FY 15E FY 16E FY 17E FY 18E Gross Revenue 16,230 102,779 118,607 208,017 233,032 248,351 238,364 219,196 217,417 % growth 533% 15% 75% 12% 7% -4% -8% -1% Production cost 2,492 4,753 6,038 12,285 14,601 15,369 15,682 15,340 15,194 Statutory levies 1,390 9,757 13,076 59,489 71,635 75,880 77,763 76,282 75,765 Employee benefit & others 2,474 4,058 3,961 15,623 17,502 18,652 17,902 16,463 16,329 EBITDA 9,874 84,211 95,533 120,619 129,294 138,449 127,016 111,111 110,130 % margin 61% 82% 81% 58% 55% 56% 53% 51% 51% Dep., Depletion & Amortisation 1,485 11,930 14,403 25,078 29,530 30,944 31,474 30,724 30,371 EBIT 8,389 72,281 81,130 95,541 99,765 107,505 95,542 80,387 79,759 % margin 52% 70% 68% 46% 43% 43% 40% 37% 37% Other Income/(Expense) 3,929 (1,715) 7,122 29,354 33,670 35,595 35,136 33,285 32,958 Exceptional items (2,154) (1,667) (4,017) ------PBT 10,163 68,900 84,235 124,895 133,435 143,100 130,677 113,672 112,717 Tax (348) 5,556 4,857 42,340 45,234 48,511 44,300 38,535 38,211 PAT 10,511 63,344 79,377 82,556 88,201 94,589 86,378 75,137 74,506 % growth 503% 25% 4% 7% 7% -9% -13% -1% EPS 5.5 33.2 41.6 43.3 46.2 49.6 45.3 39.4 39.1 % growth 503% 25% 4% 7% 7% -9% -13% -1%

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Appendix 4: Projected Balance Sheet (Rs. mn)

FY 10 FY 11 FY 12 FY 13E FY 14E FY 15E FY 16E FY 17E FY 18E Sources of funds: Share Capital 19,434 19,019 19,074 19,074 19,074 19,074 19,074 19,074 19,074 Reserves & Surplus 319,250 383,913 463,847 546,403 634,603 729,192 815,570 890,707 965,213 Net Worth 338,683 402,932 482,921 565,477 653,677 748,266 834,644 909,781 984,287 Long -term Borrowings 34,007 26,738 ------Provisions & other LT liabilities 4,619 19,458 25,581 25,581 25,581 25,581 25,581 25,581 25,581 Long term liabilities 38,627 46,196 25,581 25,581 25,581 25,581 25,581 25,581 25,581

Total 377,310 449,128 508,502 591,058 679,258 773,847 860,225 935,363 1,009,868

Application of funds: Net Assets incl Capital WIP 351,258 389,277 420,086 463,973 469,478 474,679 478,620 482,691 486,575 Net working capital excl. cash 16,758 15,581 18,281 27,357 38,045 49,244 60,635 71,755 82,747 Cash & Bank balance 9,294 44,270 70,135 99,728 171,735 249,924 320,970 380,916 440,547

Total 377,310 449,128 508,502 591,058 679,258 773,847 860,225 935,363 1,009,868

Appendix 5: Projected Cash Flow Statement (Rs. mn)

FY 10 FY 11 FY 12 FY 13E FY 14E FY 15E FY 16E FY 17E FY 18E EBIT (1-tax) (388) 51,377 56,307 73,480 77,513 83,390 74,987 64,018 63,514 Dep., Depletion & Amortisation 1,485 11,930 14,403 25,078 29,530 30,944 31,474 30,724 30,371 Operating Cashflows 1,097 63,306 70,710 98,558 107,043 114,334 106,461 94,742 93,885 Capex (33,662) (25,648) (29,558) (68,965) (35,035) (36,145) (35,416) (34,795) (34,254) Debt/Equity raised (6,785) (6,348) (13,574) ------Dividend paid ------Others 25,795 3,665 (1,712) ------Net cash flows (13,555) 34,976 25,865 29,593 72,008 78,189 71,045 59,947 59,630 Opening Cash balance 65,271 9,294 44,270 70,135 99,728 171,735 249,924 320,970 380,916 Closing cash balance 9,294 44,270 70,135 99,728 171,735 249,924 320,970 380,916 440,547

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Appendix 6: Peer Comparison

Stock Returns

Source: Bloomberg

Cairn has outperformed its peers in stock performance which can be attributed to the high margins and higher growth of the company. ONGC has particularly seen low returns on account of the subsidy sharing burden. Earnings quality has also been better as compared to its peers as Cairn has reported a much higher effective depreciation which is at least 2-3 times its domestic competitors.

EV/EBITDAX multiple Analysis

Global average for E&P companies is ~7.0x. Cairn India with its FY12 multiple of 5.76x trades at discount of 20% to global peers. ONGC has a particularly low multiple (4.75x) owing to the issues related to subsidy burden. Even though Cairn has reported a higher growth as compared to Reliance but still Reliance trades at a higher multiple (8.72x) than Cairn. Enterprise value of Cairn reduced over last year owing to debt payments which has made the company debt free.

Transaction comparables on EV/EBITDAX: Cairn as a whole is worth over $500mn and should fetch 8.8x EV/EBITDAX valuation. This is after accounting for around 20% discount as compared to the transactions entered into by similar global companies in 2012.

Source: Economist Report 2012- Energy M&A EV/EBITDA multiples

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Price Earnings to Growth Analysis

Cairn has the lowest PEG ratio among both domestic and international peers. The low PEG ratio indicates that the stock is comparatively undervalued.

Source: Bloomberg

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CFA Institute Research Challenge October 12, 2012

Appendix 7: Risk Matrix

Risk matrix identifies certain risks which will have significant impact for Cairn India and also have a high probability to occur. These risks are Price of Crude, Production risks and Approvals. Other important risks are exchange rate risk and operational risk.

Risks like Price of Crude and production risks are difficult to control. Risks in getting approvals can be mitigated by the company management, which can try and build strong relations with Government and JV partners. This might ensure quick approvals for its business.

Cairn India needs to have mitigation plans in place to overcome these risks. Exchange rate risks can be hedged by entering into forward contracts. At present Cairn India only has 3 months currency forwards. Longer term forward contracts can be undertaken to mitigate risk in longer run. Operational risks can be mitigated by taking appropriate measures to ensure health and safety of labors. The company can enter into contracts with local landowners for prior approval to access the land for construction of pipelines. Thus, the probability of delays can be reduced significantly by undertaking such measures.

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Appendix 8: Crude Oil Prices

Crude Oil performance (25th September 2012)

Brent Crude and West Texas Intermediate Oil Prices Brent Crude (USD) and Brent Crude (Rs.)

Source: Bloomberg

Brent –WTI Crude Price Spreads

Source: Bloomberg Crude prices have seen a significant decline in the past 6 months where they declined by almost 18% from $121/bbl levels to $95/bbl levels. The prices are currently hovering around $110/bbl, but are expected to see a decline to $100/bbl levels driven by lower demand and higher supplies.

The WTI-Brent spread has been above $15/bbl in the last few months showing a lower US demand while the Brent prices were mainly driven by higher Asian demand and uncertainty arising in the Middle-East due to Iran-US tensions.

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Appendix 9: OPEC fiscal budget would keep the oil prices near $100/bbl

An important factor for oil prices is the "fiscal breakeven price" of oil for national oil companies. Many oil exporting nations depend directly upon revenues from national oil companies to finance government budgets. If oil prices are not high enough to balance the government budget, the government is driven into deficit spending.

Total Government expenditure of Gulf countries Average oil price at which the Gulf governments ($ billion ) breakeven ( Brent crude, $/bbl) Forecast 2003 600 UAE 2012 E

500 Saudi Arabia

400 Qatar Oman 300 Kuwait 200 Bahrain 100 Algeria 0 2000 2002 2004 2006 2008 2010 2012 $0 $25 $50 $75 $100 $125

Source: Institute of International Finance Source: Wall Street Journal

Endowed with about 70% of the world's proven oil reserves and 50% of proven gas reserves, MENA oil-exporters play a critical role in the world energy market. Earnings from oil and gas account for about 70% of total exports, and 75% of budget revenues. The global financial crisis and recession affected mainly the oil exporters (as oil prices peaked and then dropped sharply) and the more globalized jurisdictions such as Dubai where the financial sector and the property market suffered severe setbacks. Massive step-up in government spending along with central bank liquidity support and capital injections into the banking sector helped mitigate the impact of the crisis on economic activity. Many governments in the region remain on a path of strong fiscal expansion, especially in the GCC, where real GDP growth in 2010-11 is projected to average 4.2% annually, still below the annual average growth of 8.0% in 2002-2008.

WTI prices in the $80 to $90 range and Brent prices in the $90 to $100 range, provide oil producers with profitable returns -- in terms of costs of production -- although governments which depend upon higher oil prices than that to balance their budgets (fiscal breakeven) may be forced to pay a price on global financial markets in order to finance budget deficits.

All these factors reinforce the fact stated by Saudi Arabia that they see Brent Crude at $100/bbl levels and would see that maintained over the coming months.

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Appendix 10: Monte Carlo Simulation

Using Brent Crude Price from the DCF Model as the Sensitive Variable:

Our DCF model is affected largely by 3 factors- Brent crude price, Rs/$ Exchange rate & WACC of the company. Out of the three the major impacting factor is the Brent crude price. This Monte Carlo simulation is performed to judge the sensitivity of Crude oil prices on the target price given. We assumed that Brent crude Price is normally distributed with a confidence interval of 3 sigma (95.45%).

The Monte Carlo simulation concluded that there is only 3% chance that our recommended rating will change from Buy to Sell and a 23% chance of it changing to Hold.

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Disclosures:

Ownership and material conflicts of interest: The author(s), or a member of their household, of this report does not hold a financial interest in the securities of this company. The author(s), or a member of their household, of this report does not know of the existence of any conflicts of interest that might bias the content or publication of this report.

Receipt of compensation: Compensation of the author(s) of this report is not based on investment banking revenue.

Position as a officer or director: The author(s), or a member of their household, does not serve as an officer, director or advisory board member of the subject company.

Market making: The author(s) does not act as a market maker in the subject company’s securities.

Disclaimer: The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable, but the author(s) does not make any representation or warranty, express or implied, as to its accuracy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any security. This report should not be considered to be a recommendation by any individual affiliated with IAIP, CFA Institute or the CFA Institute Research Challenge with regard to this company’s stock.

CFA Institute Research Challenge