A recent JP Morgan Cazenove analysis claiming that BG Group’s share price is undervalued focuses primarily on a large capital intensive LNG project that BG Group has undertaken in Australia. The project pay-out is underpinned primarily, among other things, by a long-term supply contract with CNOOC. The report cites the reasons for BG Group’s undervaluation as:
1. Typical market reaction to negative free cash flow, regardless of whether the subject company has undertaken a capital intensive project; and
2. A recent increase in the capital budget that investors did not expect.
In our opinion, however, the report appears to rely too heavily on the assumptions:
1. That the capital budget increase won’t happen again; and
2. The BG Group will realise the benefits of the long-term CNOOC contract.
Our Firm often assists in the analysis as to whether assumptions like those cited in the JP Morgan analysis are justified for a particular project. We employ the latest technology to analyse risks for budget overruns (and schedule delays and quality lapses for that matter). Our tools can also assess the risks of the relevant economic factors to the overall pay-out of the project. We have found that many projects fail when the owner or investors have not properly assessed the underlying assumptions.
In the light of our experience, the problem with the first assumption is obvious. Capital intensive projects often run over-budget. The JP Morgan report evinces no analysis of why budget increases will not occur in future and instead appears to rely on BG Group’s announcement that they will not further increase the budget.
The problem with the second assumption is less obvious, but potentially more devastating. China is fitfully moving to develop its own shale gas resources, which some estimate as the largest in the world. Technical and underinvestment issues currently beset the Chinese efforts on shale development, and its population is ageing and growth in manufacturing is slowing. Nevertheless, if the Chinese speed shale development or if its domestic market slows significantly, CNOOC’s uptake on the contract with BG will be increasingly unlikely.
Apparently, investors have already considered factors other than those cited in JP Morgan analysis. Which makes the current valuation more reasonable and should caution potential investors in BG Group. Maybe the investment will pay off big, but other factors could cause a less optimal result. Judicious use of the tools we offer would offer an investor less risk of a disastrous outcome and a higher assurance of success.