Expectations vs ground realities

Updated: Dec 3 2012, 06:08am hrs
Inexpensive valuations provide a big margin of safety for the stock

The ONGC stocks sharp under-performance versus the Sensex reflects mismanaged expectations of volume growth, concerns about subsidies, a worrying decline in oil production and issues with OVLs (ONGC Videsh ) production. However, the stocks inexpensive valuations provide a big margin of safety. We upgrade ONGC to Buy from Add with a target price of R300, noting a favourable risk-reward balance. Catalysts include restart of production from South Sudan, steady share of subsidy similar to that over FY2011-12 and a hike in APM (administered pricing mechanism) gas price.

Concerns about subsidy, operations valid but not so much: We believe ONGCs inexpensive valuations reflect excessive concerns about volumes and subsidies, after a 15% under-performance versus the BSE Sensex over the past three months.

Assuming a mid-range P/E (price-to-earnings multiple of 10x(times), the stock is discounting 12-month forward EPS (earnings per share) of R25. This implies (i) 45% subsidy on upstream companies versus 39-40% over FY11-12, (ii) $35/bbl of net realised crude price for ONGC versus $54-56/bbl over FY10-12, and (iii) 6% decline in oil volumes from its own fields.

Our FY13e EPS of R30 for ONGC is based on (i) 40% subsidy sharing, (ii) $44/bbl of net realised crude price and (iii) 4.5% decline in oil volumes from its own fields.

Mismanaged expectations of volumes and ground realities: We are surprised by the Streets initial excitement about production growth on the basis of management guidance and subsequent disappointment on reduction in production targets. We highlight that ONGCs actual production of crude oil has fallen short of MoU production targets historically. Besides, the decline in oil production from ONGCs own fields accelerated from November 2011. Being conservative, we were skeptical of ONGCs volumes.

ONGC stock is a value-pick and valuations are compelling: We note that the market has never accorded growth multiples to the ONGC stock given the stable-to-declining (albeit modest) production historically. Hence, the recent de-rating of multiples due to production disappointment is rather exaggerated. The concerns of higher subsidy-sharing are valid but unlikely to surprise negatively versus our expectations. The ONGC stock trades at the lower end of its historical range and offers a dividend yield of 4%.

Improving profile of earnings led by growth in non-subsidy segments: We highlight that ONGCs mix of earnings improved over FY2010-13e (estimates) led by (i) growth in crude oil production from domestic JV fields due to a production ramp-up from the Rajasthan block, (ii) increase in natural gas production from its own fields, (iii) increase in natural gas prices in June 2010, (iv) higher realisations for non-subsidy segments led by increasing crude price and a depreciating rupee, and (v) resolution of a royalty issue with Cairn in FY12. This has more than offset the increasing subsidy burden and declining oil production from its own fields.

Catalysts for the stock performance

* Restart of oil production from South Sudan. OVL plans to restart production from oil fields in South Sudan by mid-December following the recent resolution of a dispute between South Sudan and Sudan over pipeline transit fees. We compute a benefit of R1 to consolidated EPS on an annualised basis at current levels of crude price and exchange rate, assuming production gradually reverts to pre-dispute levels.

* Favourable subsidy-sharing mechanism. The current valuations of ONGC reflect pessimism around subsidy sharing. A final subsidy sharing at 40% for upstream companies in FY13e, similar to FY11-12 levels, will be construed favourably by investors.

* Increase in domestic gas prices. We expect ONGC to benefit if the government were to increase the price of natural gas produced from nominated fields from FY2015e along with increase in gas price for RILs KG D-6 block. However, the EPS accretion may be restricted if the government increases royalty on gas production from nominated fields concurrently.

Kotak Institutional Equities