Indian markets have been the fancy of investors from early 2014 onwards. However, while this rally has stayed strong over the last four years, clouds over the public sector banks (PSBs) due to growing NPAs have resulted in a significant loss of value for the public sector undertakings (PSUs) sector at large, and this has precipitated in the last six months (see table). In FY18, PSBs reported a total loss of Rs 86,503 crore and saw market capitalisation drop by Rs 87,349 crore, year to date. The cascading impact of this on PSUs (ex-banks) is especially pronounced. With a total market capitalisation of Rs 15.5 lakh crore and profit-after-tax (PAT) of Rs 1.3 lakh crore, PSUs (ex-banks) are trading at a price-to-earnings ratio of 14 compared to that of the Nifty, which is trading at 25.9 as of FY18.
A critical analysis of the PSU basket shows that there is significant value to investors, especially in seven stocks—Mangalore Refinery and Petrochemicals, ONGC, Oil India, IOC, Chennai Petroleum, BPCL and HPCL—which are trading at a price-to-earnings ratio of 7.7, at a discount of almost 50% to the overall price-to-earnings ratio for PSU stocks, ex-banks and insurance. Clearly, these companies have had to deal with a double whammy as they faced headwinds resulting from rising crude prices. But four factors point to the hidden value in this basket, especially pertinent to oil marketing companies.
Robust business model: Such a low valuation of oil companies is a result of the market’s perception of the inverse relationship between crude oil prices and oil marketing companies. However, this perception, to say the least, is fallacious, given the business model of these companies. The fundamental role of these oil marketing companies is to buy, refine and market oil, for which they enjoy a gross margin of Rs 2-3 per litre, irrespective of the price of crude, given the decontrol of petrol and diesel prices. The price decontrol initiated by the UPA government has been actively followed through by the NDA government, with the decontrol of diesel prices and eliminated subsidies. Effectively, with this landmark reform, oil marketing companies are predominantly similar to traditional retail companies that cater to consumer demand. Today, retail stocks trade at a price-to-earnings ratio of over 50, whereas oil marketing companies trade in single digits. In this basket of oil marketing companies, HPCL stands out as a value buy, given the value of its plant and machinery is Rs 42,214 crore in FY18 and its market capitalisation, as of July 6, 2018, stood at Rs 40,866 crore. With a price-to-earnings ratio of 5.66, indicated gross dividend yield of 6.3% and an earnings yield of 17.6%, this company offers significant untapped value for investors.
Impending GST reform: Next, the strong intent of the government and opposition parties to bring petroleum products under the goods and services tax (GST) in a phased manner suggests the high taxes on petrol and diesel will begin to rescind. This, in turn, will further unlock consumer demand.
Strong growth potential: Equally, these companies are well-poised to capture the benefits of India’s demographic dividend. They continue to invest in capacity addition buoyed by strong consumer, aviation and industrial demand for petroleum products in India. For example, auto sales grew by 12% in FY18 and the sector is likely to continue this momentum in FY19, according to a study by the Society of Indian Automotive Manufacturers (SIAM). Another vector of growth is the Pradhan Mantri Ujjwala Yojana, which aims to provide 5 crore LPG connections to households. The sales of aviation turbine fuel have grown at 8% and are expected to sustain at these levels, as the economy gathers momentum. With the addition of 25,000 new fuel retail outlets over the next three to five years, the three companies—HPCL, IOC and BPCL—are poised to actively partake in India’s growth as their network expands to about 80,000 outlets. On the other hand, private sector players continue to slowly ramp up and have struggled to increase market share that continues to hover in high single digits.
Comparison with global peers: Finally, India’s oil marketing companies trade at a much lower price-to-earnings ratio compared to their global peers and this, once again, underscores the value offered by these stocks. Australia’s Caltex trades at 13.5, while America’s Valero Energy at 20.4 and the UK’s British Petroleum at 34.6.
In addition to these four factors, it is also important to address some unwarranted concerns. First, that all of the profits of oil marketing companies are exposed to margins of petrol and diesel. In reality, they account for only 25-30%. These companies also have a basket of other products like LPG, ATF, bitumen, petcoke and lubes, which account for a fair share of profits. A very stable but solid stream of revenue is pipelines, and more importantly refining, which is stable and expected to only increase, keeping in mind the International Maritime Organization (IMO) 2020 regulations that will strengthen diesel cracks sharply.
Another concern is the increasing capex. However, investments in capex will only increase the quality of earnings. Oil marketing companies generate about 20% of their market capitalisation as cash flow currently, hence a capex over five-year period is unlikely to increase debt-to-equity significantly.
In summary, the upside for investors in India’s oil companies is significant, especially as oil forms the backbone of the economy, given the high dependency on this commodity by virtually every industry, ranging from agriculture and mining to consumer goods manufacturing companies. And this dependency is here to stay for a long time, as about 80% of India’s freight moves across its roads, given the lack of a robust and well-networked railway infrastructure.
By Sumeet P Rohra