We expected 53-134% earnings growth, 26-53% ahead of the Street —actual growth was much higher at 66-227%. We now think the outlook is even brighter: our FY17F earnings are 10-35% ahead of consensus, while our TPs are 3-18% ahead.
Oil product demand has never been so strong. The ability to make marketing margins remains strong, and concerns on subsidies remain low. While refining margins have been weak recently, we expect recovery soon. We highlight that refining margins’ discount to Singapore complex have also narrowed. Also, inventory losses which again had an impact in FY16, are unlikely in FY17F.
Earnings have normalised for HP/BP; these may soon for IOC
Marketing: demand remains strong, and margins resilient
Refining: earnings sharply improved, JV/subsidiary refineries in profits
FY16 sets the base, but the best is yet to come; maintain buy
In our 2 July 2015 Anchor Report, The best is yet to come, we argued that FY16 would be a defining year for oil marketing companies (OMCs). We expected OMC earnings to grow 53-134% y-o-y. The actual growth was much higher at 66-227%. We now believe that FY16 has just set the base and the outlook is brighter.
* In marketing, Indian oil product demand growth has never been this strong. Also, the ability to maintain marketing margins remains, with no state interference and muted private sector growth.
* In refining, while regional margins have corrected recently, we remain positive on refining cycle, and expect margins to recover.
Consensus earnings estimates over the past 12 months have increased by 24-67% for FY17F and by 32-53% for FY18F for OMCs. Our revised earnings estimates are ahead of consensus by 10-35% for FY17F and 14-44% for FY18F.
Earnings normalised for HPCL/BPCL; IOC a laggard but could surprise
After steep earnings growth, HP’s and BP’s ROEs have consistently moved up from lows of 1.3-5.0% in FY12 to 31.0% in FY16, and have largely normalised. We model a 8-9% earnings CAGR for HP/BP over the next two years. Though IOC’s ROEs doubled last year to 15.5%, relatively it has been a laggard. But the earnings miss was driven by inventory losses, which we think will normalise in FY17F. While we lower our FY17-18F earnings estimates for IOC by 9-15%, we still expect a 19% earnings CAGR over FY16-18F.
Valuations yet to catch up with the sharp earnings growth
While OMCs have outperformed broader markets (HPCL +32%, BPCL +25%, IOC +18%, vs Sensex -1% in the past 12 months), stock prices have not fully reflected the sharp earnings growth. On FY18F P/E, HPCL is at 5.5x, IOC 6.3x and BPCL 7.7x, vs regional peers at c.10x. We think that as market confidence on the sustainability of earnings rises, valuations will catch up.
Move to EV/Ebitda valuations
With earnings normalising, we switch to EV/Ebitda-based valuations. For refining, we model a 6x multiple for HP/BP, but a lower 5x for IOC due to its relatively aged refineries and higher inventories. For marketing, we model a conservative 5x for OMCs. After steep growth (FY16 earnings c.50% ahead of our estimates), and the likely sustainability of strong ROEs, HPCL is now our top pick. Despite a strong run over the past three years, HPCL’s valuations look cheapest.
As we look back, FY16 was even better than our expectation
* The reported consolidated earnings were up a sharp 66-227% in FY16F. While IOC’s earnings were in line with our estimates, BPCL’s/HPCL’s earnings were 8%/44% ahead of our July 2015 estimates.
Apart from the strength in refining, OMCs also benefitted from the higher discounts from the Middle-East, lower fuel & loss (due to lower oil prices), and also improved refining processing abilities.