We upgrade FY18-19ii EPS for OMCs by 10-25% on the back of: 1) firm GRMs; 2) sustained product sales; and 3) strong outlook for marketing margins. OMCs trade inexpensively, offering earnings yield of 10-11% and dividend yield of 3.5-5% on FY18ii, assuming 40% payout (>45% in FY17). We maintain ‘buy’ on all the three OMCs. HPCL is our top pick, given its net long marketing portfolio and lowest embedded value in SoTP.
We think that investor concerns on regulation on marketing margins seem unwarranted, given favourable policy changes and recent actions from the state and central governments such as the cut in VAT and excise duty respectively. OMCs should also gain from other products, including lubes and LPG. BPCL has the highest earnings upgrade over FY18ii/19ii. The company is adding 6 million MT capacity at Kochi and is expected to clock the highest earnings growth at 16-17% pa over FY18-20ii.
We expect OMCs to maintain dividend payouts on the back of healthy cash flows and relatively underleveraged balance sheets through FY18-20ii. At CMP, a 40% payout implies dividend yield of 3.5- 5% for OMCs on FY18ii. Furthermore, on headline PE basis the stocks offer an average 10-11% earnings yield on FY18ii; valuations are compelling. We envisage rerating for the stocks, driven by consistent performance of the marketing division and as street acknowledges the pricing power of OMCs. We like all the three OMCs, and retain Buy.
We like all the three OMCs, but we like HPCL the most because: 1) it earns 60% of its Ebitda from marketing (highest across the OMC pack), and remains less vulnerable to swings in crude – product cracks; 2) embedded value in SoTP is the least, which offers the highest leverage to changes in valuation multiples for the marketing business, across which we see undervaluation. Moreover, dividend yield of 4.2% offers good downside support. However, the stock is expected to be more volatile than others, considering news flow on acquisition by ONGC.