Vexing tax issue in hand

Updated: Feb 27 2012, 06:14am hrs
Downgrade to Neutral/High Risk:Our downgrade is on the back of heightened risks to the investment case post the adverse Supreme Court ruling, and the increased need for capital which could drive material dilution in the event of the review petition not eliciting a reversal of judgment. Given the unpredictable and binary nature of the outcome and based on the information we have, we find it extremely difficult to make a definitive recommendation and prefer to stay on the sidelines, especially following the 20% YTD (year-to-date) outperformance.

Uncertainties remainAs per management, the net liability of EOL (Essar Oil), after including the R18.9 billion assigned to an affiliate, would be R40 billion, which has been written off in the third quarter. The timelines of the payment, however, are yet to be decided. The company has decided to file a review petition (to be taken up by the same bench), which could take around 2-3 months. While EOL remains confident of exiting the CDR (corporate debt restructuring) by March 12 and believes a default event will not be triggered, its ability to raise the around R40 bn could be stretched.

Analyst meet takeaways (i) Gross debt = R153 bn as on Dec-11, equity = R29 bn; (ii) refinery expansion on track for completion by March 12; (iii) have requested parent Essar Energy to convert FCCBs (foreign currency convertible bonds) worth R13.96 bn; (iv) looking to raise equity of around R30 bn over the next 12-15 months.

Asian GRMs to continue to underperformWhile Singapore GRMs (gross refining margins) have recovered recently (from $6-7 in Nov-Dec to $9-10 currently), this is due to the late arrival of seasonal winter demand and refinery closures in the US/EU. We expect GRMs to see some pullback from the second quarter on new supply startups and spring a turnaround. Achieved GRMs of Asian refiners are expected to continue to underperform Singapore GRMs due to higher crude

premium (albeit moderating gradually).

Target Price cut to R69We have cut our target price to R69 and sharply revised down our FY12-13e estimates on the back of the following: (i) We have lowered our clean GRM assumptions from $9.5/10.0 for FY13/14e to $7.5 for both years to account for the moderated refining outlook, (ii) We also factor out the benefits from sales tax deferral in our forecasts.

As a result of the recent ruling, we factor in a repayment of around R40 bn (EOLs net liability to the government) in five equal installments over FY13-17e, (iii) Additionally, we have revised our INR/US$ assumptions given the depreciation of the rupee.

Our forecasts over FY12/ 13/14e are now R48.5/50.0/49.0 vs. R46/46/45 earlier, (iv) We have rolled forward our EV/Ebitda (enterprise value/ earnings before interest, taxes, depreciation and amortisation) multiple from 6x FY13e to 6.5x(times) FY14e (discounted back by one year) to account for the higher net debt in FY13e as a result of the repayment of the tax liability, while simultaneously giving the company the full benefit of its refinery expansion.

RisksWe assign a High Risk rating to Essar Oil. The key upside risks to our investment thesis on EOL are: (i) A positive result from Essars review petition in the Supreme Court regarding the sales tax deferment case; (ii) Significant improvement in the global refining environment and uptick in distillate demand; (iii) Timely and cost-efficient commissioning and ramp up of the expanded capacity; (iv) Signing of the Ratna PSC (production sharing contract).

Key downside risks to our thesis include (i) EOL being asked to pay the Gujarat government interest accrued of R17.5 bn on the sales tax deferred; (ii) An accelerated repayment schedule in case the review petition is rejected (currently assumed repayment over five years); (iii) A further deterioration in the global refining environment on the back of new supply/lower demand for distillates due to a global crisis; (iv) Delays in ramp-up of expanded capacity; (v) Refusal to allow EOL to exit the CDR; and (vi) Material equity dilution.