Why you should be sceptical of Santos Ltd shares

Here at the Motley Fool, you’ll come across a lot of articles on the benefits of long-term investing, and for good reason.

The obvious benefits of taking a long-term view are many, but here are two for starters:

  1. the economics of your chosen company can shine after a number of good years and the share price should reflect that success where the effectiveness of the business model has been demonstrated, and
  2. assuming rising earnings, you may be able to count on a growing stream of dividends.

It was with some bemusement then that I read comments by Mr Kevin Gallagher, the newly-appointed Managing Director and Chief Executive Officer of Santos Ltd (ASX: STO) in the recently-disclosed First Quarter Activities Report for the period to 31 March 2016:

“We are focused on developing a business that is self-sustaining in a low oil price environment and well positioned to take full advantage of rising commodity prices in the future“.

And then there’s this …

“We will continue to look for opportunities to lift productivity and reduce costs to drive long-term value for shareholders” (emphasis added).

Am I missing the long-term earnings story here, or perhaps the downward move in the Santos share price over the last 2-3 years is an aberration?

The most recent annual report shows that Santos had a terrible year.

Not only had Santos reported a net loss for the year to 31 December 2015 of $2.698b, there was the not-so-minor matter of large amounts of net debt on the balance sheet (mostly priced in US dollars) amounting to a net debt/equity ratio of 75.6%.

With falls in the average realised oil price of 28% combined with an AUD/USD exchange rate trading 25% or so lower than it was two years ago, is it any wonder the market hasn’t taken kindly to Santos?

But surely Santos’ long-term record is okay … isn’t it?

For a capital-intensive, price-taker-type of business, the fully franked dividend yield of 4.3% barely compensates for the horror show that is Santos, and its record over the last 5, 10 and 15 years is where things look really ugly.

With a share price of $4.62 as at 22 April 2016 we can observe the following:

Number of years to 22 April 2016 Total shareholder return(% pa) AWOTE (% pa) *
1 (26.32) 1.56
5 (15.49) 2.82
10 (2.64) 3.71
15 4.98 4.07

* average weekly ordinary times earnings

I compare the total shareholder return (which is inclusive of dividends) to AWOTE as, I believe, it should be every investor’s goal to earn investment returns that grow at a faster rate than that of paid employment income.

Santos, over the last 5, 10 and 15 years, has been a disastrous investment for long-term shareholders (and the massive share issuance over the last 10 years hasn’t helped either).

Although the total shareholder return over the last 15 years of 4.98% pa was greater than AWOTE over the same period, it should be noted that this sort of return does not come close to compensating the shareholder for the risks they’re taking on by owning shares in this type of business.

So, when you hear a CEO of any commodity, capital-intensive business stating their desire to ‘drive long-term value for shareholders’, be sceptical.

If you’re betting on higher oil prices to turn around Santos’ fortunes, then you could be right in the short-term and Santos’ flagging share price may rise. However, I don’t believe Santos automatically becomes investment grade just because of an upward move in oil/LNG prices.

If I’m going to invest in a company long-term, it would look exactly the opposite of Santos.

I would want a company with low capital requirements, low to no debt on the balance sheet, and a competitive advantage in the market place that allows the company to raise its prices. Think along the lines of an Altium Limited (ASX: ALU)Technology One Limited (ASX: TNE), or Ltd (ASX: CAR).

None of the above companies are cheap, but if you’re patient, the market will reward you with opportunistic prices eventually. This is far preferable to buying cheap stocks like Santos that have a lot going against them.

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Motley Fool contributor Edward Vesely has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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