Is this one of the cheapest stocks on the ASX 200?

Karoon Energy (ASX: KAR), an oil and gas producer, might be one of the most undervalued stocks in the ASX 200 but understandably so after over-raising equity to acquire a 30% interest in the Who Dat project and a recent production downgrade.

In May, Macquarie published a report citing expectations that Karoon could harvest its market cap in free cash flow over the next four years. This projection was based on conservative oil price assumptions for WTI crude: US$80.30 per barrel in 2024, US$68.70 in 2025, and US$65.70 in 2026.

In this educational piece, we're going explore:

1. What went wrong for Karoon

2. A closer look at Macquarie estimates

3. Near-term risks and opportunities

Dilution and downgrades

To recap, Karoon acquired a 30% interest in the Who Dat Project for US$747 million. This acquisition was funded through:

• A US$300 million equity raise

• US$274 million in debt

• US$171 million from cash reserves

This move aligns with Karoon's strategy to enter the US Gulf of Mexico as a non-operator in a producing asset. The Who Dat Project produces up to 33,000 barrels of oil per day (boepd) and is forecast to ramp up to 42,000 boepd through ongoing development.

Analysts were optimistic about the acquisition, with Citi projecting an 8-17% increase in free cash flow and 10-21% growth in EPS over the next three years. However, on April 19, Karoon revised its FY24 production guidance from 11.2-13.5 MMboe to 10.5-12.5 MMboe, representing a 6.8% reduction at the midpoint.

"This primarily reflects a downgrade in Who Dat production, with most of the reduction related to lower than expected deliverability and oil production being prioritised over gas," the company said in a statement.

The production downgrade, coupled with falling oil prices, triggered a substantial selloff of around 25% between April 18 and June 20.

"The Who Dat production downgrade so soon after Karoon over-raised equity for its acquisition is a difficult pill for investors to swallow," Citi analysts said in a note dated 19 April.

"The DCF impact of the deferral, under our conservative assumptions, is small so the equity looks cheap. Regardless, it’s the impact on investor trust that is more troublesome as management is already considering the next deal."

Looking ahead

Karoon has been heavily criticised by activist shareholders for its plans to do more M&A. These shareholders, including Samuel Terry Asset Management and Sandon Capital, have called to get Who Dat fully integrated and stabilised, and return capital to shareholders.

"Near field drilling was a big part of Karoon's acquisition case on Who Dat — and that is only just commencing ... could ultimately prove to be more important to valuation," says Macquarie.

"Karoon has flagged a dividend for some time. We now factor in a US$0.07 dividend and roughly ~30% payout ratio going forward — We believe this strikes a balance between rewarding investors (5-6% yield) and reinvesting in growth."

Risks and opportunities

Oil prices: Over the past two years, oil prices have remained relatively stable overall, but with significant volatility. This reflects an unpredictable macroeconomic environment and escalating geopolitical tensions. Should oil prices rise, Karoon could see increased earnings, potentially supporting a dividend or funding future M&A.

WTI crude oil price chart (Source: TradingView)

Clarification needed: Macquarie analysts expect a 10-11 cent per share dividend this year. However, the company has yet to confirm this. An official dividend announcement could spark a re-rate. Conversely, if Karoon disregards activist investor calls and pursues aggressive M&A instead, it may further erode investor confidence.

Confidence and track record: Karoon's recent history has been marked by some missteps and communication failures with shareholders. These factors are likely to continue weighing on the share price until the company can demonstrate improved performance and transparency.