Brownfield expansion to up refinery capacity by ~65%; expect stable GRM: HPCL plans capex of R558 billion over FY16-21, which includes R257 billion for refineries, R262 billion for marketing, and the remaining for renewables, R&D and JV projects. For the next two years, capex will be funded through internal accruals; it could take loan in later years as refinery capex will be back-ended.
Refinery capex of Rs 257 billion includes R42 billion for Euro VI upgrade and brownfield expansions (i) at Vizag from 8.3 to 15mmt (Rs 200 billion, up from Rs 170 billion) along with upgrade, (b) at Mumbai from 6.5 to 9.5mmt (Rs 42 billion) and JV Bhatinda refinery from 9 to 11.3mmt (Rs 24 billion). Expects overall GRM to improve by $1.5-2/bbl: Vizag to complete by April 2020 and expand GRM by $4-5/bbl, (ii) Mumbai to complete in three years and expand GRM by $1-1.5/bbl and Bhatinda by Jun-17. Expects GRM to remain stable in the medium term (FY16 GRM: $6.7/bbl), at $5-7/bbl helped by higher distillate yields.
Bhatinda refinery clocking double-digit GRM; to be profitable in FY17: Bhatinda refinery (HPCL stake 49%) is expected to continue posting profits in FY17 (FY16 PAT was R18 billion) even at the current petroleum product cracks,and GRM is expected to be in double-digits.
Marketing capex increased significantly; margins above regulated era: Updated capex plans place high emphasis on marketing; five-year marketing capex significantly high at R262 billion (47% of total capex). Management announced plans to set up 3 new LPG plants, 3 POL depots and Lube Blending Plants at Mumbai and Kasna (UP).
Mktg. margins remain strong at R1.7/1.6/ltr for petrol/diesel (v/s regulated era of R1.4/ltr). Volumes remain strong with FY16 POL growth at 9.3%.
Already started dynamic pricing; marketing, lubes give earnings stability: Dynamic pricing (based on location, demand and competition) is already under way in some test markets, and could be rolled out on a pan-India basis.
Dynamic/ differential pricing will help the company to sweat the marketing assets better and improve profitability further. While refining will continue to be cyclical, marketing (including pipelines) gives earnings stability and lubes business also contributes meaningfully (10-20%).
Valuation and view
On SA basis, HPCL trades at 7.3x FY18e EPS of R140.6 and 1.4.x FY18e BV. On a consol. basis, HPCL trades at 6.1x FY18 EPS of Rs 169. We value HPCL at 5.5x for refining and 8x for marketing to arrive at a fair value of Rs 1,359, implying a 32% upside. Dividend yield is attractive at ~3-4%. Maintain buy.
Other key takeaways
Management expects GRMs to be range bound within $5-7/bbl in FY17 (excluding GRM movements). FY17 capex plans stand at R68.6 bn (five year capex at R558 bn). This includes Rs 14 bn for refining, Rs 46 bn for marketing,R2.9 bn for renewables, R4.8 bn for joint ventures (refining, gas including LNG and E&P) and remaining for R&D.
Capex financing: Management guided that for the next 1-2 years, the capex plans of Rs 550 bn will be funded through internal accruals and eventually borrowings could be increased.
Mega refinery plans: Currently, the mega refinery is being planned in two phases with Phase I capacity of 40MMT and remaining 20MMT capacity in Phase II. Management highlighted that land acquisition remains the biggest challenge for the refinery and OMCs are currently scouting for locations.
Management reiterated that Rajasthan refinery plans haven’t been shelved and are under review. Management also highlighted that its subsidiary Prize Petroleum is currently screening E&P opportunities.
DBT in kerosene is expected to lead to reduction of kerosene subsidies, as usually DBT leads to reduction in bogus accounts. HPCL has upgraded its lubes production capacity to produce better grade Group III base oils. Management re-emphasised focus on R&D as a long-term business driver. Post six years of formulation, HPCL started supply of winter diesel to the Indian army.
Five years R&D spend is planned at R5 billion. The PSU pay revision is currently expected in December 2016, and post that the employee expenses could increase. FII limit currently stands at 24% and will be increased shortly to 40%. HPCL’s standalone debt stands at R212 bn (vs R203 bn in March-15) and subsidy receivables at R40 bn.
Valuation and view
Widening Moat: OMCs’ economic moat is widening, led by scope for meaningful increase in marketing margins and profitability, slower ramp-up by private marketers, high volume growth, aided by expected GDP boost, and improving balance sheet with increasing cash flow.
OMCs profit normalisation was delayed for a decade: OMC’s deregulation and in turn their profit normalisation had been derailed for a decade after an earlier brief de-regulation period in 2004-06. However, this time around we believe government will stay put with its deregulation decision given the hard lessons of financial stress of the last decade.
Increased excise duties offer some flexibility to moderate prices in the event of spike in oil prices, but huge and growing India consumption volumes will make it practically impossible to again revisit the price control model.
Marketing division to drive profitability: Post de-regulation, we expect marketing division profitability to grow rapidly, and hence should also command a higher valuation. An R0.5/ltr increase in petrol and diesel marketing margins increases HPCL’s FY18e EPS by 27%. We model gross per litre diesel margin of 1.6/2.0 in FY17/FY18.
Pure play marketing companies trade at higher valuations: Pure play petroleum marketing companies—US based CST Brands (CST US; M Cap: $ 2.4 billion) and New Zealand based Z Energy (ZEL NZ; M Cap: $1.5 billion) trade (1 year forward basis) at 10x EV/Ebitda. These valuations (in-line with the underlying business dynamics) are more similar to consumer business than refining or oil & gas. Of the three OMCs, HPCL’s earnings are more sensitive to a change in the marketing margin-given its higher ratio of marketing-to-refining volume. Hence, it would be the largest beneficiary of higher auto fuel margins.
On SA basis, HPCL trades at 7.3x FY18E EPS of R140.6 and 1.4.x FY18E BV. We value HPCL at 5.5x for refining and 8x for marketing to arrive at a fair value of R1,359, implying a 32% upside. Dividend yield is attractive at 3-4%. HPCL had a payout of 30% of standalone profits last year and the same is likely to continue.
