Expectations vs ground realities

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SummaryThe ONGC stock’s sharp under-performance versus the Sensex reflects mismanaged expectations of volume growth, concerns about subsidies, a worrying decline in oil production and issues with OVL’s production.

Inexpensive valuations provide a big margin of safety for the stock

The ONGC stock’s sharp under-performance versus the Sensex reflects mismanaged expectations of volume growth, concerns about subsidies, a worrying decline in oil production and issues with OVL’s (ONGC Videsh ) production. However, the stock’s 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 ONGC’s 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 Street’s initial excitement about production growth on the basis of management guidance and subsequent disappointment on reduction in production targets. We highlight that ONGC’s actual production of crude oil has fallen short of MoU production targets historically. Besides, the decline in oil production from ONGC’s own fields accelerated from November 2011. Being conservative, we were skeptical of ONGC’s 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

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