No gamble this: Despite doubling, OMC stks may run further

A: The title of a report actually very aptly is ‘Double, But No Quits!’ Essentially as you know, this sector in the past was akin to playing poker when reforms had not taken place. In poker, as they say, you are doubled or you quit. Now with reforms being firmly in place, we believe that although the stocks have doubled we think that there is significantly greater scope from here.

There are essentially three reasons for this. We believe that the profits of these companies over the next three years will roughly double. Firstly, working capital requirements are down nearly 70 percent as the subsidy burden has declined on the back of not only crude prices declining but diesel (which was 60 percent of the subsidy burden) now firmly de-regulated. So reforms are structural and hence is not playing poker any more.

On the back of diesel de-regulation we believe margins there are poised to double as well. Essentially on a replacement cost basis, for new entrants to come in to this sector, the new players will require a margin of at least Rs 1.5 a litre versus 71 paisa earlier. That results in significant growth in earnings as well.

Notably for the first five months of reforms, margins are already up by about 50 percent in that space. So that is our first argument.

The second argument-- which is more a concern that the market voices -- is competition. We believe that competition while being inevitable is not going to play party-pooper because the entry barriers are much higher and to make a reasonable return, they will also have to earn higher margin.

Otherwise it just does not make business sense for them to enter the sector. If you also go back to the 2002-2004 period, when you did have these reforms, competition did not fight on margins and allowed margins to go because it is still going to be a five-player oligopoly.

We have in fact done case studies of even very mature markets such as USA and we have also done a case study of South Korea which is a similar four-player industry. What we find is that in fact in the longer term, margins could be even much higher than what even we are anticipating.

Finally when it comes to valuations, despite these stocks having doubled the valuations are not particularly stretched. So as headline numbers, valuations are still at roughly about 20 percent EV/EBITDA discount to, for example, the PSU basket. Again looking at 2002 -2004 period, in those days these stocks had been 3-7 baggers. So as compared to that, doubling is still not significant.

Putting all these three together, we are fairly bullish on this space because reforms are structural and it is not playing poker any more.

Sumaira: Your point is taken, but one of the other points that you note is that it is the heavy inventory losses that have so far suppressed the benefits post the de-regulation. So, when do you actually expect the full benefits to go through or for the OMCs to start trimming their inventories?

A: In fact that we have cited as an opportunity because the market does not recognise that. So, inventory losses are really a trajectory of oil prices. And as long as oil prices are declining, you will get inventory losses. But that is purely technical. It is not fundamental and in fact because of those technical losses so to speak, this year’s earnings -- March 2015 earnings -- we believe are going to be significantly lower even though, fundamentally the business from the retail perspective is actually doing much better.

So, actually the enhanced turnings are going to be massed as a result of that. We expect oil prices to remain actually weak roughly till the middle of this time of the year and recover in the second half of next calendar year. To that extent, you will potentially get not only higher fundamental recovery and earnings from retail margins but also inventory gains potentially into the next year basically.

Reema: We have already seen about a 50 percent increase in the diesel retail margins. You indicated that you do not expect competition from private players like Reliance or perhaps even Essar to play spoilsport. And diesel retail margins can actually go up; something that we have even seen the global landscape. So, give us a sense, how much can the retail margins go up from here in the next one year, two years, three years?

A: Essentially prior to deregulation, the margins were 71 paise a litre. And, in the last five months the margin is roughly about Rs 1.10 a litre. Given essentially what the new players, competition needs to earn assuming a projectile of about 11 percent, we believe that they will need to earn margins of about Rs 1.60 a litre. That is what we have assumed that margins will settle down in the next three years.

But, if you take the Korea example, margins could be another rupee higher in the longer term. Of course at this stage we are assuming margins in about three years being about Rs 1.50-1.60 a litre. But margins could be even beyond that essentially.

Competition essentially has set up 1,700 gas stations. This compares with HPCL, BPCL and IOCL, which have got 50,000 gas stations. By the end of this year, competition gas stations would be probably in the region of about 2,800 or so. But that again is not going to be very significant.

So, typically the nature of this industry is that, the nature of any business generally is that the marginal player sets the price and in this case, the marginal player are the new entrants whose cost of setting up these outlets is going to be higher.

Sumaira: Do you see foreign institutional investor (FII) interest now picking up in this pace given the earnings upside that you project and what would be your top-pick in the sector?

A: Very sharply. If you look at the FI interest, even in the December quarter, just after de-regulation, the FI holding in HPCL roughly has gone up by 6 percent, if I remember correctly. That has ever happened before and I would not be surprised in this quarter March, it has gone up even further.

Now, why has that happened? This is one of the few large sectors that the government has opened up. If you think of an analyst on the buy side who has got to pitch internally to his portfolio team as investment committee. In the earlier days of control, you could model or forecast their earnings, it was a difficult pitch to your investment committee. And therefore difficult for fund managers among the FIs especially to buy these stocks.

Now that we have got reforms in place and progressively as these companies become model-able, they become like any regular business and therefore they become significantly investable. And, hence we see FI interest only going up.

Now, we do have a buy on the entire space that includes HPCL, BPCL and IOCL. To answer your question, HPCL in the near term will be the largest beneficiary because its retail ratio to its refined ratio is the highest. BPCL otherwise has got generally greater efficiencies and in the longer term will be a winner. So, we would essentially say in the shorter term HPCL will perhaps give you better returns and longer term BPCL.

Reema: You have a price target of Rs 935 for BPCL, Rs 816 for HPCL and Rs 429 for IOC. We have already seen structural reforms in the oil and gas space as you pointed out. In the next 12 months any more that we can expect in terms of reforms?

A: The other set of reforms which is ongoing is LPG subsidy being brought down. The entire under-recovery in the oil sector was Rs 1.69 lakh crore couple of years back and now it is down to we estimate about Rs 42,000 crore by next year.

Within that chunk LPG now accounts for 60 percent of the subsidy burden. With the rollout of the direct transfer scheme, the target for the government is about another Rs 10,000 crore reductions in subsidy. That further enhances profitability of these companies. That is a significant reform.

Interestingly a bulk of the reform is in the downstream space, which one would have thought would have been more difficult to do but actually that has been managed very well. The area of reforms where reforms are signify required is actually upstream. We have seen global oil prices declining and with the lag equipment cost crashing, the service suppliers for example deep water rigs, and India has got a lot of deep water areas to explore.

So deep water rigs are coming down from USD 0.5 million a day, USD 0.6 million to USD 0.3 to 0.35 million a day. It would be actually a very apt moment to do reforms there so that the country can take advantage of low services cost and boost the upstream sector requirements.

Notably by far India imports 80 percent of its oil requirements which is the largest portion of its import bill. So that is an area of reform which the government would do well to kick of now.