Energy - downstream PSUs: When the tide turns - Kotak

We remain wary of the Street's assumption of robust increase in marketing profitability for downstream PSUs noting risks from rising participation of the private players in fuel retailing business. Weaker-than-expected marketing margins could pose material downside risks to consensus estimates for HPCL>BPCL>IOCL. We recommend investors to switch from HPCL and BPCL to IOCL given relative margin of safety or move to GAIL, RIL and ONGC, given favorable reward-risk balance.

OMCs' marketing profitability remains flat in past four years, even as overall EBITDA doubles

We would like to highlight that normalized marketing segment profitability for PSU OMCs has remained largely unchanged in FY2013-17, even as cumulative EBITDA doubled in the same period driven by a sharp increase in contribution from refining and petchem segments. Our normalized computations, excluding one-offs, inventory-related gains and losses for the marketing segment and forex-related losses, suggest that the marketing segment EBITDA for the OMCs have remained flat around Rs240 bn in FY2013-17, contrary to the Street's much anticipated benefits from deregulation of auto fuels and robust 5.5% CAGR growth in petroleum consumption during the past four years. Overall normalized EBITDA has indeed doubled to Rs550 bn in FY2017 from Rs289 bn in FY2013, entirely driven by a strong refining cycle in subdued crude environment and incremental contribution from IOCL's petchem unit.

Risks exist to marketing profitability due to rising competition from private players and MNCs

We see downside risks to marketing profitability of OMCs in the medium term, with private players indicating plans to expand their presence significantly, which may impact volumes due to accelerated loss of market share and/or marketing margins. Auto fuel margins have not expanded at all over the past two years post deregulation despite a marginal presence of the private players, who are now firming up plans to expand retail network over the next 2-3 years—(1) RIL plans to open up to 3,000 outlets from 1,221 as on March 31, 2017, (2) Essar Oil is on track to open 5,600 outlets from 3,500 currently, (3) BP has recently secured license to open up to 3,500 outlets and (4) Shell, MRPL and NRL also have limited presence, while Haldia Petrochemicals has also been approved to open up its own outlets. In our view, implementation of daily fuel pricing may further act as a blessing in disguise for private players, as it may deter policy interventions in auto fuel pricing henceforth.

12-15% below consensus estimates for BPCL and HPCL; low valuation multiples justified

We see material downside risks to consensus estimates from any disappointment on marketing segment profitability—our estimates are 12-15% below consensus for BPCL and HPCL and around 2% for IOCL. We see HPCL as the most vulnerable, as marketing segment accounts ~55% of its FY2019E EBITDA, as compared to ~40% for BPCL and ~25% for IOCL A Rs0.25/liter reduction in marketing margins on auto fuels can impact FY2019E EPS of HPCL by 12%, BPCL by 8% and IOCL by 5.5%. We highlight that OMCs may look optically inexpensive trading at 10-12X P/E multiples or 6-67X EV/EBITDA; however, it may be justified as a significant portion of the business is cyclical and it also requires meaningful amount of capex for upgradation and modernization, let alone to raise capacities. Operating cash flows of OMCs have fallen short of capex over the years and capex has not necessarily driven earnings growth, as the latter has been more influenced by policies earlier and cycles now. It is worth noting that significant capex planned by OMCs in refining, petchem and upstream projects will likely generate lower returns as compared to the extant marketing segment, while the capex in marketing segment is essentially required to meet the growing demand and/or replace old infrastructure, which may not necessarily drive earnings growth.

Source : Equity Bulls

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