We have been negative on the OMCs (oil and marketing companies) for some time. After the 28-47% stock fall YTD (year-to-date), we now take a more Neutral view of the space and upgrade Bharat Petroleum Corporation Ltd (BPCL) to Outperform.
*Dependent on overall losses. With the rise in rupee crude prices, under-recoveries are likely to remain high (R1,050-1,350 bn) in FY14/15 even if the government continues to deliver the promised diesel price increases and directed LPG payments. The government seems to have deferred the expected diesel price increase for now, but any efforts to reduce losses (which seems imperative) should be positive.
*Dependent on payment mechanism. Use of the export-parity pricing (EPP) mechanism is tantamount to under-funding of R130 bn (R113 bn ex-bulk diesel); in this case, OMC RoE (return on equity) could fall to 3-9%. Without EPP, the risk that the OMCs are not fully paid even at low levels of losses (like FY06/08) remains.
Hindustan Petroleum Corporation Ltd (HPCL) — have underperformed the market by 36%, 28% and 47%, respectively, since their Jan-13 peaks. We estimate these now trade at 0.20-0.26x core book, which we believe imply RoE the OMCs are likely to deliver under export-parity pricing. Under-recoveries remain high, and the prospect of diesel price increases looks low in the near term. FY14 (and beyond) subsidy payment mechanisms remain unclear. Nonetheless, we believe current valuations should limit further downside.
Valuations reflect under-compensation/ EPP: Stripping out the valuation of investments, E&P and pipeline businesses and other holdings, we estimate the core refining and marketing businesses of IOC/BPCL/HPCL are trading at 0.20/0.23/0.26x (times) core book. If the cost of equity was 15%, their current valuations would imply core RoE of about 3.0%/3.4%/3.9%. We think these are not too different from the levels the OMC could deliver if export-parity pricing was implemented fully.
If the OMCs delivered RoE of 4%—as implied by their stock prices currently— IOC/BPCL/ HPCL would generate PAT+depreciation less dividends (as a rough measure of cash flow) of about R78/24/25 billion. This would be less than the capex these companies have incurred historically, and perhaps the amounts they need to sustain their businesses. It is possible that the government—through lower compensation—reduces profitability and capex for these companies to the lower levels currently implied. Such low levels of cash generation, however, should not be sustained in the long run.
Differentiating among the three: BPCL has been able to sustain its RoE better than the other two OMCs—some of which may be due to its weighted average inventory accounting policy. We use net operating cash flow (as reported by the companies annually) per ton (of refining + marketing volumes) and the cash conversion cycle to assess the divergence in core operating performance. BPCL has been able to manage its businesses better. The cash flow per tonne as well as the cash conversion cycle for BPCL is better than both HPCL/IOC. Even on leverage metrics, BPCL appears less stressed. Its net debt to equity (1.8x) is lower than that for HPCL. Debt-to-Ebitda (FY13 actual, including other income at 3.7x) is lower than that for HPCL (8.6x) and IOC (5.1x).
Upgrade stocks: As we see limited potential downside to valuations, we upgrade BPCL to Outperform (target price to R376 from R283) and HPCL to Neutral (TP to R194 from R261). IOC has a proportionately higher refining capacity and the implementation of export parity could erode RoEs (return on equity) more than that for BPCL/HPCL; the new Paradip refinery could struggle to make reasonable margins as well. However, large investments/holdings and the pipeline business mean downside from current levels is limited.
Given its greatest leverage to the regulated business, HPCL has the most to gain from any regulatory improvement. The timing and form of regulations in the space are difficult to predict, and our upgrades are based on a valuation argument. Should the Barmer refinery project proceed, HPCL’s leverage would increase further. We, therefore, prefer BPCL—for which we estimate 90% of current market capitalisation is explained by its investment and E&P businesses.