We upgrade our rating on ONGC to ‘outperform’ (from Neutral), raising TP to Rs 220 (19% upside). We see the stock doing well as the market begins to fully appreciate the improving outlook on subsidies; government price increases are cutting retail losses by $1 bn/year (30% of FY18E). At $50/bbl oil, losses on kerosene/LPG could fall to zero by Dec-19 (vs $4.3 billion in FY16). Despite delivery of reform, ONGC trades at a 25% discount to global peers on P/CF, higher than historical average (16%). Fundamentals continue to improve, with rising domestic gas/oil production.
Higher overseas output (on acquisitions) helps EPS too. Continued demonstration of subsidy reduction is the key catalyst, which helps: Lower multiple discounts — as the magnitude of subsidy losses falls and cash flows become more predictable, raising maximum net realisations every year — more so in the back end of our field DCFs. Following 50% cumulative price cuts in domestic gas prices, we see momentum turning — and expect a 45% increase in the next two years, adding 15% to EPS.
Multiple domestic projects are also ramping-up, and ONGC’s volume trajectory (both gas and oil) has begun to turn. The delivery of ~10% gas volume growth over FY17-19 can help the stock as well. While ONGC has historically not been a crude play (realisations capped by subsidy), falling losses on LPG / Kerosene increases this leverage. In our base case ($65/bbl oil in FY19), we expect a 25% EPS CAGR.
If oil were to remain flat at $50/bbl, the stock would deliver an 8% EPS CAGR nonetheless; combined with inexpensive valuations and a 4+% dividend yield, we see risk reward as favourable. Given ONGC’s alternative for cash deployment (overseas M&A) and our positive outlook on HPCL’s core refining and marketing business, we don’t see potential investments in HPCL as a negative. We update models for falling subsidies, KG-basin volumes/capex (with a year delay) and overseas business outlook. FY18/19 EPS up 4%.