Woodside vs Santos: Which ASX energy giant is the better buy?

Equity markets lit up earlier this year when the two largest energy companies on the Australian bourses announced they were looking into consolidation options. The original plan would have involved the two entities merging. The deal was called off after the two parties failed to agree on a price, despite the slick opportunity to create an $80 billion company - and one of the world's largest commodities companies to boot.

But now that the dust has settled, Citi has released a fascinating pitch deck which analyses the two companies from a range of metrics including balance sheet strength, dividend yield, operating expenses (OpEx), and earnings margins.

And in all cases bar one, Santos (ASX: STO) proved to be the stand out of the two major energy firms. In this article, we'll go through Citi's case for why Santos is the better pick despite one key measure swinging clearly in favour of Woodside (ASX: WDS).

Being catalyst-poor is not a bad thing

Although revenue growth and return on invested capital (ROIC) expansion profiles are not dissimilar, a look at the dividend yield and the profit-to-net asset value metrics demonstrates that, in its judgment, "Santos looks superior". Not only that, Woodside's dividend may actually continue to contract for as many as three more years under Citi's base case.

"While Santos isn't necessarily catalyst rich, when Woodside's negative DPS momentum and portfolio issues become better understood, the relative valuation gap may close from funds switching," analysts led by Citi's Head of Australian Energy James Byrne wrote in a slide deck to clients today.

Present versus future performance

On its existing track record and its balance sheet, Woodside edges out Santos as the favourite. The reason, Byrne's team said, comes down to "Woodside’s levered P&L on 1P unit of depreciation methodology" - meaning its ROIC expansion is slightly stronger.

"Both companies have very healthy balance sheets after a few periods of de-gearing, but we believe Woodside is stronger for now," Byrne and his team wrote.

But add in any future plans that are currently in the pipeline (confirmed or speculated) and Santos takes line honours.

"The pipeline is far stronger for Santos in our view. We would also contend that the risk weighting we should ascribe for STO’s unsanctioned growth - Papua LNG and Pikka ph2 in particular - is higher than WDS’s Calypso and the untested Sangomar upper sands. On all measures, we believe Santos is significantly more compelling with unsanctioned growth," Byrne's team wrote.

4 charts that matter (for Santos bulls)

Byrne's team also spelled out some charts - with attached reasoning for why they believe Santos is superior. And as is with any company, we start with its product - in this case - energy production.

"Woodside is spending US$20 billion in CAPEX to achieve a flat outcome for production ... this should underpin an 80% payout ratio. But if equity markets want to invest in growing businesses –which is a key area of debate – then Woodside will be capital hungry. On the other hand, Santos is self-funding a stronger pipeline of growth" Citi wrote.

Source: Citi

On earnings margins, declining production at Woodside's flagship assets will have a much more lasting impact on its balance sheet than at Santos where production is projected to remain steady.

Source: Citi

As with all commodities companies, higher costs are the norm. But as for which energy giant has more capacity to put a lid on those costs, Santos wins because Woodside will likely have lower EBITDAX margins, higher rehabilitation costs, higher exploration expenditure and a declining production profile. As Byrne's team put it, "the difference in quality of cash flows is not well understood in our view."

Source: Citi

Finally, energy companies are much like mining companies in that many people invest in them for the cash they could potentially pay out to investors. The free cash flow growth, crucial to this part of the investment case, is much higher at Santos. That leads to a much higher forecast dividend yield for Santos as supposed to its larger competitor.

Source: Citi

The caveats (in favour of Woodside bulls)

Both trades have become overcrowded in recent months, Citi notes, but Santos is more overcrowded on its metrics than Woodside. The other problem for Santos is key person risk. While Meg O'Neill is likely to stay around for a while longer, Santos MD and CEO Kevin Gallagher may retire sooner than the market expects (Gallagher has been atop at Santos for more than 8 years now).

In Conclusion

In most cases, Santos is the better of the two bets. But as you can see, there are some caveats and arguments that shift the balance slightly in favour of Woodside - making Citi's Santos call a near but not definitely better bet.

Here is one last graphic you may want to see - a table which analyses both stocks with respect to the different kinds of fund strategies and investing styles that exist in the market. The next time you hear a fund manager talking up one stock or the other, there's every chance they might be drawing notes from a table like this.

Source: Citi