Published last week the offer of NC KMG to KMG EP regarding the potential share buyback resulted in share price appreciation of KMG EP by 12.9% in spite of decline in crude oil prices. In their letter, NC KMG fixed the base average price of $7/GDR, and we estimate that a redemption price of a common share will not exceed $8/GDR (the premium will be defined on the EGM in January, 2016 in case of agreement between NC KMG and KMG EP).
NC KMG is interested in the purchase of common shares of KMG EP in order to resume a complete control over KMG EP and reduce operating expenses of both KMG NC and KMG EP urged by low oil prices and declining profitability. The repurchase price and the premium would be indirectly affected by the debt covenants of NC KMG (debt of $14.8 bln). NC KMG is required to maintain the leverage ratio (net debt/EBITDA) below 3,5 (previously, we mentioned that sale of 50% stake of Kashagan by NC KMG to NBK this year was driven by the risk of breaching the debt covenant as leverage ratio reached 2,9). Cash receipts of $4.7 bln from sale of 50% stake in Kashagan, redemption of $3,4 bln of outstanding bonds, buyback of KMG EP shares for $1,1-$1,3 bln will raise the leverage ratio to 2,8 at the end of 1H2016 from estimated 2,2 at the end of 2H2015. We believe that amid low oil prices such debt leverage ratio is highly unsustainable; therefore with redemption price above $8/GDR, the company may run the risk of breaching debt covenants.
To offset the significant premium, NC KMG offers an option of priority share allocation in the upcoming IPO of NC KMG. We believe that the IPO itself is motivated by the reduction of debt burden of $14.8 bln.
In spite of the relatively low fixed basis price in the current offer vs the previous one of $18.5/GDR, this offer is attractive for minority shareholders of KMG EP as it includes an option to buy shares of NC KMG (further delisting of KMG EP shares). In case if NC KMG fails to get approval from KMG EP BOD, the main risk shareholders will face is a decline of stock prices amid low oil prices ($45-$50/barrel), regulatory risks, cost inefficiency of KMG EP, maturity of oil fields and high capital expenditures.
Our previously estimated price of $11/GDR and the premium of $4/GDR (reported last week) reflected a regulatory discount that is included in the current market price.
In our base scenario we exclude a possibility of preferred shares buyback due to depressed profitability and risk of breach of debt covenants. However, we acknowledge the chance of preferred shares buyback due to the relatively low price of securities vs common shares (the spread widened by 42.4 pp to 54.6% YoY). According to our estimates, the spread may increase above 60% due to low expected dividends (T433/share) based on 2015 results and low future dividends (guaranteed dividend is only T25/share) should low crude oil prices prevail.
Despite the fact that NC KMG has already fixed the base price at $7/GDR we present our fundamental valuation based on “as is” scenario and analysis of the 3Q2015 results of KMG EP (without an offer).