investment writeup value: target 6.75

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Liquefied Natural Gas Ltd. (LNG AU, $0.90, 7/27/08) by gatsby892
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Description:
LNG Ltd. is an extraordinary off-the-radar opportunity to invest at the critical inflection point of a major Australian LNG liquefaction project. Shares offer dramatic upside opportunity as well as downside protection via long-term take-or-pay contracts. Conservatively assuming only $80 oil and aggressively doubling management’s capex guidance, we believe LNG will begin generating contracted revenues in 2011 and ramp to $0.45 of EPS annually from 2012 forward. Given that the Company will be providing LNG to an investment grade buyer under a 12 year contract (renewable to 25+ years), we believe such a steady earnings stream deserves a 15x multiple, in line with similar energy infrastructure operators. Our base case analysis results in a $6.75 share price, a 650% increase over the current.

While we believe a $6.75 stock price is completely realistic, we recognize that LNG’s earnings power will not be fully realized for a few years. To arrive at a fair value for the shares today, we have conservatively assumed that the project is delayed by one additional year and then applied a further cost of capital discount of 15% per annum over the next four years. The result is a $3.85 fair value for the shares today – a 325% increase over today’s stock price.

While these price targets are already clearly eye-popping, we believe they actually ignore additional significant upside optionality:

1) Earnings benefit greatly from higher energy prices. At $130 oil, LNG would earn over $0.70 of EPS, implying a share price of $10.50, a 12x return.

2) Potential exists to add another 2+ LNG trains to the project. This is highly likely as the resource base feeding LNG’s plant is extensive and estimated to support 25+ years of production. Adding 2 additional trains at $130 oil would yield EPS of $1.25 and a share price of $18.00, a 20x return.

3) The long-term upside lies in LNG’s ability to replicate its success in any of the hundreds of stranded gas fields across the globe. An additional 4 liquefaction projects at $130 oil would generate over $5.00 in earnings power during the latter half of the next decade, implying a $75 share price or 83x the current level.


The Story:
LNG Ltd. (LNG AU) is an early-stage developer and operator of mid scale liquefied natural gas (“LNG”) plants. The Company currently manages several projects across the globe that are in the early, prospective stages of development. However, its key project and greatest source of current value revolves around its proposed LNG liquefaction plant in Gladstone, Australia. Within the next 2 weeks, the Company expects to receive its official Site License Agreement to build a facility capable of running two 1.5 million tonne LNG trains. LNG has also already secured a Heads of Agreement (essentially an MOU) to source its gas feedstock from Arrow Energy (AOE AU) and is expected to announce an off-take agreement for its LNG supply in the next 1-2 months (which will include a majority stake investment by a multi-national off-taker). Concurrent with the signing of the off-take agreement, Arrow (the gas supplier) is expected to exercise its option to become a 20% owner in the project. With all interests aligned in the project, LNG shareholders stand to benefit the most.


Investment Thesis:

Completely Under-Followed
LNG is a micro-cap Australian listed equity only recently picked up by a single local Australian brokerage house (Bell Potter). Very few appreciate that this project is on the final cusp of becoming a significant reality. Furthermore, the entire Queensland coal bed gas field (the source of Arrow’s gas supply) is a recent phenomenon that has only recently gained any investor notice since British Gas Group made its hostile bid for Origin Energy in April. Yet, despite this headline grabbing news, the tremendous upside economics of the entire Queensland gas play remain virtually completely unknown outside of Australia. We believe many of these early stage Australian gas players (such as Arrow) represent extremely attractive investment opportunities. However, LNG provides an even more attractive payoff structure with greater leverage to the upside potential of this developing liquefied natural gas play.

First Mover = 1-3 Year Head Start
A bit of a visionary, Maurice Brand (LNG’s CEO) secured the current site 4 years ago when hardly anyone could contemplate the potential for a worldwide LNG market, much less the potential of the Queensland coal bed gas fields to become such a valuable resource base. After multiple years of permitting, LNG will very shortly receive its full Site License Agreement for the Gladstone site. For perspective on the significance of this Site License Agreement, the Curtis Island site currently being proposed by nearby Santos (STO AU) and Queensland Gas (QGC AU) is not yet zoned for building a liquefaction plant and it is estimated that the licensing process will take approximately two years, delaying final production until roughly 2014.

Existing Infrastructure = Lowest Cost
For a typical LNG liquefaction plant, approximately 50% of capital costs are usually for liquefaction equipment and the other 50% for site specific infrastructure build-out (utilities, storage tanks, loading jetties). However, the Gladstone project has secured an abandoned port site where jetties and land infrastructure is already in place (significantly reducing the costs). In comparison, the sites being proposed by Santos and Queensland are completely undeveloped and will require all of the necessary bridges, docks and jetties as well as channel dredging.

Significant Credible Insider Ownership
Arrow Energy owns 10% of the shares outstanding (which is separate from their option to become a 20% owner of the Gladstone project) and Golar LNG (GOL NO) owns an additional 16%. Golar is a $3 billion enterprise value LNG shipping company that is 45% owned by John Fredrickson – the visionary that turned Frontline (FRO) and SeaDrill (SDRL NO) into multi-billion dollar companies. The top 3 members of management and the Chairman of the Board own over 23% of the shares outstanding.

Impressive Management
Despite its micro-cap size, LNG has assembled an impressive set of Directors, proving that is not a ‘fly-by-night’ operation.

LNG Ltd. Board Members
1. Chairman – Phil Harvey – Former CEO of Alinta, Australia’s largest power and gas transmission company, which he sold to Singapore Power Limited for over $6 billion
2. Nick Davies – CEO of Arrow Energy
3. Gary Smith – CEO of Golar LNG
4. Bill Hornaday – COO of Niko Resources – a $4.5 billion oil and gas exploration and development company
5. Richard Beresford – Former Head of Gas Strategy and Development for China Light & Power

Superior Process Solution
LNG is proposing a modular approach using existing technologies (ie, standard turbines vs. custom built and concrete tanks vs. stainless steel) that will provide tangible cost savings with no adverse impact on quality. Further, providing an economically attractive liquefaction solution for mid-sized gas fields would be a game-changer in the energy industry.

Additional Projects not included in Valuation
• Indonesia – Mitsubishi originally had won a contract with Pertamina to provide an LNG terminal (LNG Ltd. had placed 2nd). However, the contract has just recently been terminated due to Mitsubishi’s inability to commit to its original submitted terms. LNG has been invited to reengage in conversations and a project team is currently on the ground in Indonesia.
• Others – Papua New Guinea, Iran


Compelling Valuation:

Upon project completion, Gladstone will produce a significant and stable earnings stream under a wide array of assumptions, with a contractual floor at $40 oil prices that provides considerable downside protection. Management estimates that the first train should be completed in 2011, with the second train coming online in the following year. The annual recurring earnings sensitivity analysis below assumes that the project only contains these two initial trains.

Annual EPS Potential
Oil Price
$40.00 $60.00 $80.00 $100.00 $120.00 $130.00 $150.00
$600 $0.30 $0.43 $0.56 $0.69 $0.81 $0.88 $1.01
$800 $0.27 $0.40 $0.52 $0.64 $0.76 $0.82 $0.94
$1,000 $0.25 $0.37 $0.48 $0.60 $0.71 $0.77 $0.89
$1,200 $0.23 $0.34 $0.45 $0.56 $0.67 $0.72 $0.83
CapEx $1,400 $0.21 $0.31 $0.42 $0.52 $0.63 $0.68 $0.79
$1,600 $0.19 $0.29 $0.39 $0.49 $0.59 $0.64 $0.74
$1,800 $0.17 $0.27 $0.36 $0.46 $0.56 $0.61 $0.70
$2,000 $0.15 $0.25 $0.34 $0.43 $0.53 $0.57 $0.67
$2,200 $0.14 $0.23 $0.32 $0.41 $0.50 $0.54 $0.63
$2,400 $0.12 $0.21 $0.30 $0.38 $0.47 $0.51 $0.60



Tremendous Upside:
The following sensitivity table represents the upside share price potential from current levels at various oil prices and under a range of capital expenditure assumptions (recall that management estimates a total cost of $600 million for the two train project we have analyzed and our base case has fully doubled their capex assumption for conservatism).

Share Price Upside from Current at 15x P/E
Oil Price
$40.00 $60.00 $80.00 $100.00 $120.00 $130.00 $150.00
$600 404% 617% 830% 1043% 1256% 1362% 1575%
$800 358% 560% 763% 965% 1167% 1268% 1470%
$1,000 316% 509% 702% 894% 1087% 1183% 1376%
$1,200 278% 462% 646% 830% 1014% 1106% 1290%
CapEx $1,400 244% 419% 595% 771% 947% 1035% 1211%
$1,600 212% 380% 549% 717% 886% 970% 1139%
$1,800 183% 344% 506% 668% 830% 911% 1072%
$2,000 155% 311% 467% 622% 778% 856% 1011%
$2,200 130% 280% 430% 580% 730% 805% 954%
$2,400 107% 252% 396% 541% 685% 757% 902%


Detailed Earnings Analysis
Below is a more detailed calculation of LNG Ltd.’s earnings potential (using $100 oil and management's capex estimates). The calculations of the revenue share between Gladstone and Arrow have been confirmed by the management teams of both LNG and Arrow as roughly correct. This analysis also assumes that the project is financed with 75% project debt, a reasonable assumption given that an investment grade off-taker will be the majority owner of the Gladstone project (we assume the Off-taker will own 50% and Arrow Energy will own 20% of Gladstone). Further, we have assumed that LNG is able to issue equity $1.50 after the final project terms have been announced to the market.

LNG Ltd. Economics

Number of LNG Trains at Gladstone 2
LNG Tonnes per Train 1.5
LNG Tonnes per mmBTU 51.5
Total mmBTUs 154.5

Oil Price $100

Gladstone % of price per bbl of Oil above $40 11%

Gladstone Revenue per mmBTU $13.10
Cost per mmBTU paid to Arrow for Feed Gas (8.24)
Gladstone Gross Margin per mmBTU $4.86
Liquefaction Costs (0.50)
Gladstone Pre-Tax Profit per mmBTU $4.36

x Total mmBTUs 154.5
Total Gladstone Revenue $673

x LNG Ltd. Ownership % 30%

LNG Ltd. Revenue $202
LNG Ltd. SG&A 5
LNG Ltd. Share of Debt Interest Cost 11
Pre-tax Earnings $186
Taxes (30%) 56
LNG Ltd. Net Income $130

Pro Forma Shares (post equity raise) 190
LNG Ltd. EPS $0.69


Risks:

Oil Prices
LNG’s revenues will be directly linked to global oil prices. The $40 contractual floor provides a significant level of downside protection.

Future CapEx Requirements
LNG liquefaction projects are notorious for going over budget and we believe this is the key risk to the LNG Ltd. story. Management’s current cost estimates for the project estimate $400 million for first train and $200 million for each incremental train (the above model depicts a two train solution – likely the initial configuration). However, for conservatism, we have assumed that the Gladstone project suffers from 100% cost overruns. It is also important to note that while some liquefaction projects will likely end up costing greater than $800/tonne, it is not accurate to draw a read-through to LNG Ltd. as many of these projects (such as the Gorgon and PNG projects) are located offshore in extremely remote locations with little to no access to existing infrastructure or skilled labor. Queensland, Australia is a major industrial center with a skilled labor pool and LNG is leveraging an existing port site for its project, greatly reducing the required capital investment.

Raising Project Financing
Despite the recent credit crisis, the market for infrastructure projects continues to be strong. We do not anticipate issues around financing as the Gladstone project will be led by an investment grade off-take partner who will also be the majority owner in the project.

Project Execution
LNG Ltd. is building a mid-sized LNG plant, which has never been attempted before. To date, major oil companies have only focused on building LNG plants for large natural gas fields and as such have been forced to custom build equipment to exact specifications that can support such large projects. LNG’s ability to successfully build an economically feasible mid-scale plant would be a real game changer for the industry as the number of medium-size stranded gas fields is substantially larger than the number of large stranded gas fields.

Arrow not Honoring its HOA with LNG Ltd.
We believe this to be an extremely remote possibility. We have spoken directly and extensively to both the CEO and the President of Australian Operations for Arrow and both have firmly stated their unwavering support for LNG’s Gladstone project. Arrow points to the fact that they just purchased a 10% stake in LNG Ltd. in December 2007 as tangible proof that they place great value in the Gladstone site as the best solution for the entire Queensland gas play. Finally, while a deal is never fully guaranteed until the money crosses the wire and the final contracts are signed, the HOA contains multiple provisions that would make it difficult for Arrow not to honor their intentions. Additionally, by their own admission, Arrow does not currently have a realistic alternative that would not require the Company to spend at least an additional 24 months finding and attempting to permit and develop another site.

Environmental Permits
LNG’s Environmental Impact Study (EIS) is more than 50% complete and the Company does not anticipate any problems finalizing it by the end of this year. The Gladstone site is located in a heavily industrialized area with a number of high pollutant factories (e.g. - smelters). Even in the remote chance that the EIS identifies an issue, it is highly likely that any deficiency could be quickly cured as the Queensland government continues to show its strong support for the various proposals to build LNG liquefaction plants in the region.


Catalyst:
1. Over the next 30-60 days, we anticipate that LNG Ltd. will announce an HOA for a 12 year off-take agreement with a major multi-national E&P player (e.g. - Shell) or directly with an end user (e.g. - a Japanese utility). The Company has already received four proposals and is currently waiting to receive a proposal from Shell before making a final decision.

2. Reaching Final Investment Decision by April 2009. After signing the off-take agreement, the remaining next steps will be:
December – Arrow Reserve Certification
December – Environmental Impact Study (EIS) finalized
December (following Arrow Reserve report and EIS) – Final Signing of Gas Sales Agreement with Arrow and LNG off-take agreement
Q1 2009 – Bankable Feasibility Study
April 2009 – Final Investment Decision and Financial Close





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10 gatsby892 08/08/2008 10:56am RE: Questions on model (Show Message...)


The calculation for these numbers were independently confirmed by both Arrow and LNG Ltd management as being roughly correct. Based upon the current proposals by the Off-takers, it appears that the Gladstone project will be guaranteed a minimum price per mm BTU of ~$6.50 at $40 oil prices or less. For every dollar that oil prices are above $40, the Gladstone project will receive an incremental ~$0.11. For providing the feed gas to the project, Arrow will receive ~63% of the Gladstone revenue.
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9 beep899 08/07/2008 14:17pm Questions on model (Show Message...)


In your "LNG Ltd. Economics" table you show Gladstone revenue per mmBTU at $13.10 with oil at $100 bbl and costs for feed gas at $8.24 per mmBTU. Could you explain how you arrived at those numbers.

Thanks for your interesting idea.
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8 gatsby892 07/29/2008 14:23pm Trader Contact Info. (Show Message...)


Given the limited Street coverage of LNG Ltd. (a significant source of the current opportunity), we have found that it is beneficial to go directly to the local axe in the name to secure sizeable trading volumes.

His contact information is below:

Mr. Athol White
Bell Potter Securities
[email protected]
+011 (61) 3-9235-1781
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7 gatsby892 07/29/2008 13:26pm RE: Shell Ownership (Show Message...)


1. "What do you think are the ramifications to LNG Ltd. if Shell (or another partner) comes in for less than 50%? The most Shell owns in any LNG project is 30%. Is it just that the additional financing burden must be born by LNG Ltd., or is there some other risk?"

The scenario you suggest would be a huge opportunity, rather than a “burden” or a “risk”. We are assuming a 50% stake for the off-taker in order to remain conservative (which we can very much afford to be given the upside potential here) and because conversations with Arrow indicate that Shell is interested in and will likely demand a stake of this magnitude. Obviously the shareholders of LNG Ltd. want the off-takers stake to be as small as possible so that the greatest profit leverage accrues directly to them. If, for instance, the off-taker were satisfied with just a 30% ownership stake and LNG Ltd. were to retain 50% (up from our base case assumption of just 30%), the EPS in our $80 oil base case would increase from $0.45 to $0.64 (even after accounting for the additional interest expense and equity dilution that would be required), implying an incremental 40%+ upside to all of the valuation targets we laid out in the initial write-up. The fact that Shell may not directly own more than 30% of any of its other LNG projects really has no bearing on this negotiation. There is no magic to that 30% number and no hesitation at Shell around taking significantly larger stakes.


2. "Is the gas definitely stranded without LNG Ltd?"

Yes. The local Australian market is already oversupplied with conventional natural gas, keeping prices in the $3-$4/mmBtu range. Therefore, the only opportunity for monetizing an unconventional source such as the coal bed gas seams is to turn to the nearby international markets (where LNG is fetching closer to $20/mmBtu), which obviously requires liquefaction in order to facilitate transportation. There are currently 4 other liquefaction projects under development in the region, but as we discussed in the initial write-up, the Gladstone project has major advantages in terms of timing (2-3 year lead over the alternatives), costs (significantly lower capital requirements) and process (modular, off-the-shelf technology).
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5 gatsby892 07/29/2008 08:54am Confirmation Shell is Involved (Show Message...)


The following news article was written early this morning and we believe it has significant positive implications for LNG Ltd. Not only do the statements by Nick Davies (the CEO of the gas reserve owner, Arrow Energy, and a Board member of LNG Ltd.) confirm that Shell is actively involved in the bidding process for the Gladstone off-take agreement, but also that they are excited about the opportunity to participate in the project and that the Company has received other offers in a bidding competitive process. We believe that these statements are further confirmation that Gladstone is right on the cusp of having the final approvals and agreements in place to become a reality – a situation clearly not yet appreciated by the investment community with the shares still trading below $1.00. The full text of the article appears below:


Shell Is ‘Keen’ to Take Stake in Australian LNG, Partner Says
By Dinakar Sethuraman

July 29 (Bloomberg) -- Royal Dutch Shell Plc, Europe`s biggest oil company, is “keen” to acquire a stake and purchase the output from a coal-seam gas based fuel export project in Australia`s northeast, said Arrow Energy Ltd., a venture partner.
The venture, which is led by Liquefied Natural Gas Ltd. and includes Norway`s Golar LNG Ltd., may decide in the first half of 2009 to build the 1.5 million metric tons-a-year project, to start up by 2011, Nick Davies, chief executive officer of Brisbane-based Arrow, told a conference in Singapore. Shell has to offer the best price because there are other buyers competing for the fuel, he said.
Shell and Arrow in June signed a $700 million accord giving Shell a 30 percent stake in Arrow`s coal-seam gas licenses in Queensland and a 10 percent stake in Arrow`s international unit. Davies said then Shell would start negotiating with Perth-based LNG Ltd. to participate in the export project, which is one of five proposed for the Gladstone region based on coal-seam gas.
``You have to be absolutely low-cost in this business or your margins will get squeezed very quickly,`` Davies told reporters at the conference. ``Good gas prices are a
prerequisite.``
Arrow plans to use Shell`s expertise in gas from coal-seam areas to produce as much as 80 billion cubic feet a year of fuel by 2015 from China, India, Vietnam and Indonesia, Davies said. The company is drilling in three areas in India and plans to start drilling in China and Vietnam this year, he said.
``The main reason for the alliance with Shell is strategic,`` Davies said. ``The LNG is secondary.``
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4 gatsby892 07/29/2008 08:34am RE: Capital raise / balance sh (Show Message...)


"Can you provide more details regarding your capital raise and balance sheet assumptions?"

Management estimates that a 2 train Gladstone project will cost $400 million for the first train and an additional $200 million for the second train, for a total capex budget of $600 million. Our base case assumes for conservatism (and for no other reason) that this figure fully doubles to $1.2 billion on massive cost overruns.
Because LNG Ltd. is expected to own approximately 30% of the Gladstone project upon completion of final documentation (over the next 6 months), the Company would be responsible for financing $360 million (its pro rata share of the total). Despite recent credit market turbulence, projects of this type continue to receive favorable financing terms and we believe should be able to secure project debt financing for 75% of this figure ($270 million – fully payable to $0 by 2015 assuming the cash flows anticipated even under the minimum contracted $40 oil equivalent level) at a borrowing cost of roughly 8% (especially once the gas supply and multi-national off-taker agreements are finalized), leaving an equity requirement of just $90 million for LNG Ltd. (or just $45 million if management’s capex estimates prove correct).
Although shares currently trade for $0.90, management obviously will not seek to execute an equity offering until after the final investment documents have been secured by all parties and the project cash flows are essentially guaranteed (to a minimum $40 oil equivalent level as illustrated in the initial write-up). Given the substantial intrinsic values we’ve laid out for the Gladstone project, it is our view that the shares will have increased at least to the $3.00 level once the final project agreements have been announced. However, for conservatism (ie, maximum reasonable potential equity dilution), we have assumed that LNG Ltd. nevertheless continues to trade at an irrational discount to that intrinsic value and the Company is forced to issue equity at $1.50 per share (it is our view that at anything less than that – or perhaps even at this low level – either Arrow, Shell or any number of potential financial sponsors would step in to negotiate a private transaction for the remaining investment).
The Company currently has 144 million shares outstanding, or 160 million on a fully diluted basis. Assuming a $90 million equity offering at $1.50 share implies an additional 60 million shares are issued for a total of 220 million shares outstanding (or 190 million under management’s capex estimates or as few as 175 million if the offering is executed at $3.00 per share). The EPS estimates we have used for valuation and the sensitivity tables in the initial write-up include all such dilution as well as the interest expense burden related to the required project debt financing.
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3 rainman1080 07/28/2008 14:39pm Capital raise / balance sheet (Show Message...)


Can you provide more details regarding your capital raise and balance sheet assumptions? Thanks.
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2 gatsby892 07/28/2008 12:20pm RE: questions (Show Message...)


1) "Why are they benchmarking to oil and not gas?"

This practice conforms with the industry standard.

2) "You say it would be difficult for Arrow to break their supply agreement, but you could explain this further?"

Breaking the terms of the HOA would not be difficult in a legal sense, but would be extremely problematic for Arrow in a practical sense as they are currently not even contemplating an alternative to the Gladstone project with LNG Ltd. to deliver their gas. As the write-up discusses, choosing any other alternative at this stage would delay revenue generation at least 2-3 years while simultaneously increasing the capital expense budget, dramatically impairing the NPV of the project relative to the currently anticipated economics. We know of no reason that Arrow would even consider this -- and they have stated as much to us.

3) "It’s not clear why you assume it’s inevitable that LNG Ltd. becomes a minority owner in the Gladstone facility? It seems like a pretty big leap of faith to say that an off-taker (which hasn`t been found) will decide to own half of the entire facility. What does it say about LNG Ltd. that this assumption has to be made?"

Although the exact terms of the ongoing negotiations are still confidential, the general economic assumptions we’re using (including ownership splits) have been roughly confirmed for us as appropriate by both LNG and Arrow (who also holds a Board seat at LNG Ltd. and has just recently partnered with Shell for the development of its coal-seam gas reserves). The off-taker (recall that there are already 4 offers on the table to fill this role and a fifth expected shortly from Shell -- the likely frontrunner given their new interest in Arrow`s reserves) plays a critical role in a project like this and it is not at all unusual for them to take a majority position (ownership economics are also an indication of the relative capex responsibility and as you have pointed out, the off-taker will bring significantly greater access to capital than LNG Ltd. has on its own). Although LNG Ltd. is giving up 70% of the economics in order to make this project a reality, they will most certainly be able to negotiate more favorable terms on future projects once they have proven themselves with Gladstone.

4) "It seems like an awful lot needs to go right in order for this to work, and if it doesn’t, the downside is substantial."

We very much disagree with this statement. A lot has already gone right and we’re now sitting on the cusp of a series of announcements that will formally finalize these terms and events that have been developed and negotiated over the preceding months and years.

Furthermore, LNG Ltd. has traded fairly tightly around a $0.60 average share price for the last 5 years – before the Queensland coal bed gas reserves were well understood, even locally; before signing the HOA with Arrow for the gas supply; when gas averaged less than $7.50 (20% lower than current and nearly half of recent levels); before Shell`s strategic stake in Arrow made them an extremely credible off-taker; when the site licensing was still years away; etc. These shares have and always will price in some option value for the many global development projects under consideration. And energy prices (in all forms) have moved dramatically higher. In other words, we think the downside is roughly 33% or less if this project gets killed entirely (despite the fact that we have every indication that progress is being made weekly on all final approvals).

These shares are simply not appropriately pricing in the upside – just look at where the shares have traded for years prior to this deal and compare that to the valuation analyses we presented in the write-up – the probability weighted expected outcome under even our most conservative scenarios is multiples of the current share price. The payoff structure is highly asymmetric to the upside.
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