Why I’m Avoiding Santos (ASX:STO) Shares

Shares of Santos Ltd (ASX: STO) are trading near their 12-month high after the company delivered a drastically improved half-year result earlier this week. However, it wasn’t enough to change my skeptical view.

Santos is one of Australia’s largest oil and gas companies. Established in 1954, Santos owns and operates one of Australia’s largest portfolios of oil and gas fields, connected by extensive pipelines and complementary facilities.

Santos’ 2019 Half-Year Report

Santos recorded a sizeable improvement in most key financial metrics. Total product sales for the period grew by 18% to US$1.97 billion, supported by a 32% increase in production as well as lower production costs.

Net profit after tax (NPAT) jumped a mammoth 273% to US$388 million for the first half. The company said underlying profit was up 89% to US$411 million, which gives a more meaningful comparison as it strips out one-off or non-recurring items from the results.

Santos also reported a 74% rise in free cash flow to US$638 million, which helped to support an interim dividend of US$0.06 per share. This represents a 71% increase on the previous corresponding period.

Balance Sheet Concerns

Santos’ balance sheet has often given me cause for concern. During the half, this was exacerbated with net debt increasing by 38% to reach US$3.4 billion as of 30 June 2019.

The capital intensive nature of Santos’ business operations means that it is always susceptible to racking up large amounts of debt. In lean years when the oil price is low, this can lead to ballooning debt right at a time when profits are falling.

If I were a shareholder in Santos, I would have much preferred that management not pay a dividend at all, instead using the cash to pay down debt. Long-term shareholders will remember the all too painful implosion of the share price in 2015 as the oil price went into free fall. A heavily indebted Santos was forced to sell assets, lay off workers and raise capital in order to stay afloat

Although I am not predicting a repeat of this scenario anytime soon, the risk of such a calamity occurring again intensifies as the debt burden grows.

What Now?

Santos is a company that can do very well in periods where the oil price is high. The problem is, I never know when these periods will be. As is the case with most companies that make money from selling commodities, Santos will inevitably go through periods of boom and bust.

Therefore, I’d rather invest in a high quality company signified by a durable competitive advantage and an ability to generate high returns on equity in all economic conditions.

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Disclaimer: Any information contained in this article is limited to general financial information only. The information should NOT be considered as financial advice of ANY kind. The information should not be acted on because it may not be correct and it has not taken into account your specific needs, goals or objectives. Please, consider consulting a licenced and trusted financial adviser before acting on the information. By reading this website, you acknowledge this warning and agree to our terms & conditions available here. This article is authorised by Owen Raszkiewicz of The Rask Group Pty Ltd.

At the time of publishing, Luke has no financial interest in any companies mentioned.

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