JPTXF - Japan Petroleum Exploration: Definitive Corporate Governance Demonstration

2023-12-13 03:19:53 ET

Summary

• Japan Petroleum Exploration posted a strong quarter driven by overseas E&P volumes growing offsetting price pressure.
• Management demonstrates responsiveness in its communications with shareholders and seems open to steadily growing payout ratios.
• The Toyota cross-shareholdings disposition could open the doors to value creation with JAPEX as it concerns their massive holding of Inpex.
• The Sakhalin-1 production resumption, where retaliations by Russia to sanctions target only American interests, sees massive increases in equity-method profits.
• Overall, a lot looks good with JAPEX. And we even think that after the reserve refills in the US, oil prices may come up again with further cuts.

Japan Petroleum Exploration ( JPTXF ), or JAPEX as we prefer to call it, posted a strong quarter driven by overseas E&P revenues. But the important thing to update investors on is the demonstration of good corporate governance. This is a key issue, as JAPEX has large non-operating assets and a very low P/B, which is somewhat more normal for an E&P company, but remains excessive and demands action as per the evolving TSE listing requirements. Management demonstrates not only clear capital allocation understanding, but also is beginning to open the door to more dividends, is doing buybacks, and is also not outright denying the possibility of unwinding their cross-holdings with Inpex ( IPXHY ) which would be a major catalyst for the company.

Earnings Discussion

First, we update our model based on forecasts for the coming FY. As usual, the ownership in Inpex, as well as very large cash balances, are what drives the valuation. It is being ignored as a resource to the company as markets continue to price JAPEX as if the Inpex stake doesn't exist. We will get back to this point and why new information suggests that this isn't a tenable position.

EBITDA is staying pretty resilient despite falling prices YoY, in particular, because of major increases in volumes coming from their Iraqi assets. This massive delta has had a large impact on overall results.

The Seagull project in the UK is also progressing well, having just started production this November. This is quite major because the E&P business in the UK is in current results contributing a substantial loss on the SG&A in addition to the capitalised development. This just means that next year when annual production is coming in about 1 billion JPY in losses will disappear and there will be incremental income.

Bottom Line

What investors should really be paying attention to is the statements the company is making around capital allocation. Firstly, the company is undertaking a 5.5% buyback , which is quite beefy for a Japanese company.

In the last Q&A around the 2022 management plan, the company had this to say about the payout ratio.

Although you consider the 30% not necessarily a high dividend payout ratio, as at a turning point in our business structure to achieve growth, we would like to start with a payout ratio of 30%.

Management Plan Q&A 2022

The buybacks are in response to higher-than-expected profits, and also we like to hear that they are thinking about the 30% payout as a starting point.

As for balance sheet efficiency, the company was asked about whether it plans on using leverage. While there may be sudden capital needs in E&P, and the business is highly commodity sensitive, it would still be good to source that cash from debt in good times of low Japanese rates and plenty of debt capacity due to the profitability of the business currently.

We are not referring to any particular project, but we think it is quite possible that, as we are looking for new projects both in E&P and non-E&P business areas, we will use interest-bearing debt to finance such investments.

Q2 2023 Q&A

Introducing leverage and expanding the scope of investment plans spell an end to overly-capitalised balance sheets and greater optionality, as well as securing debt at the current low Japanese rates.

Another major thing is the massive Inpex ownership. The company was asked about its plans for cross-shareholdings.

The reasonableness of cross-shareholdings has been repeatedly discussed by the Board of Directors from various perspectives, including cost and return on shareholding, as well as business relationships with the issuers and background of individual shareholdings. We will consider our future policy based on verifications and discussions by the Board of Directors.

What is important to note is that in the meantime, Toyota ( TM ) has undertaken dispositions of cross-shareholdings. Due to its leadership in Japanese markets, and conformist management teams, this could signal the beginning of more flexibility around cross-shareholdings, which have always been a big issue for international investors and a limit to capital efficiency. Freeing capital up from Inpex will likely result in more buybacks considering the company's relative willingness to do shareholder payouts, and the apparent pressure from shareholders as seen on these management calls.

We also liked in the Q&A the repeated mentions of IRR, and the openness to do more reporting around the targeted returns on projects as well as the optimal capital structure.

With the fact that oil has remained pretty resilient, and may see more supply pressure once the US has made their necessary refills of the strategic reserves which has taken some of the slack off the Saudis in removing supply from markets, we think the operating environment of JAPEX remains pretty good. They are earning in Sakhalin-1 again as production resumed since Exxon ( XOM ) got kicked out. The equity method income more than quadrupled with that resumption helping. Seagull has just come online, and growth in other assets, including electricity production in I/U, are all tailwinds. Net income is creeping up. With the corporate governance demonstrations and the continuous incisiveness of shareholders on these Q&As, we think there are also a lot of idiosyncratic gains to be made here as well.

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