Share sale could act as next catalyst
New Delhi   22-Nov-2010

The government's decision to sell shares of state-owned IndianOil (IOC) in early CY11 should speed up the process of providing more clarity to the subsidy system that takes a big bite out of the company's profits.

Price controls mean IOC sells diesel, kerosene and cooking gas below cost to help the government curb inflation and these losses are only partially reimbursed by the government (known as under-recovery). While this cost IOC up to 75% of its net profit in previous years, it still has a clear advantage over peers---its broad business portfolio means its earnings are hurt less by the subsidy system than other oil marketing companies (OMCs).We estimate 40% of FY12 Ebitda (earnings before interest, taxes, depreciation and amortisation) will come from non-refinery and non-retail businesses vs 20% for other OMCs. IOC is also expanding its petrochemical capacity, which should increase earnings 10% over FY 11-12e.

OMC share prices have risen around 30% after June 2010 when the government deregulated petrol prices and announced one-off price increases for diesel, LPG and kerosene. The rally reflects market expectations of further deregulation but we believe political and inflationary pressure will make further reform difficult. We think the government is likely to replace ad hoc increases with a partial pass-through system based on the crude oil price by January 2011 (before the share sale). While this would institutionalise under-recovery for companies like IOC, it would also add visibility to earnings forecasts.

We value IOC based on 10x(times) PE (price-to earnings) multiple for FY12e core earnings and investment on actual. Catalysts include clarity on the subsidy system, further deregulation of fuel pricing and material discoveries in its exploration blocks.

IOC is the country's largest company by sales, the biggest oil marketing company and has also just become the country's leading refiner. At No 125, it is the highest ranked Fortune 500 company in India. As with the other OMCs, the company's shares have suffered in recent years because it has to sell products below market price and the government only reimburses a percentage of the under-recovery. To put this in context, IOC's net profit would have been about 75% higher in the last few years if its losses had been fully reimbursed.

OMC stocks have rallied after June 2010, and it reflects market expectations of further deregulation but we continue to believe this optimism is misplaced as state elections, political opposition and inflationary pressure will make further reform difficult. Petrol deregulation was relatively easy to implement as India's petrol consumption is less than a quarter of diesel consumption. Petrol users are also perceived to be well-off as most own their own cars. We continue to expect OMCs to share 17% for FY12e of under-recovery while the market expects their contribution to be only marginal.

With the Sensex hitting new highs this month, Prime Minister Manmohan Singh's administration plans to sell equity in IOC in the quarter ending March. The government, which holds a 79% stake in the company, plans to sell a 10% stake. Bloomberg reported the share sale may raise as much as Rs 195.5bn ($4.4bn).

IOC dominates fuel marketing with a 52% market share and owns 40% of domestic refining capacity (excluding export-oriented refineries). The company's petrochemical and lubricants businesses, along with its large pipeline network, means its earnings suffer less from under-recovery than other OMCs. Its petrochemical plant at Panipat in northern India that has just commenced operations following an expansion will boost earnings by 10% over FY11-12e.

The northern part of the country is a large market for petrochemicals but the bulk of production is in western Indian.

IOC, whose refineries are spread out geographically, is also constructing a 15 million metric tonnes a year (mtpa) refinery in the eastern part of the country, which will mean it will save on the refinery margins it currently has to pay to private refiners. When complete, IOC's market share in the eastern region should rise to74%.

We expect IOC's net profit to decline in FY11 as the company will have to bear 17% of gross under-recovery and may not get the benefit of inventory gains as it did in FY10. We expect 15% EPS growth in FY12 over FY11 based on lower under-recovery, higher refining margin and the contribution from the Panipat cracker. We value the company as its core business comprising refining, marketing and petrochemicals and value of investments. We value its core business at 10x FY12e earnings which is in line with its peers.

A large part of IOC's value comes from its holdings in other companies. We value the listed holdings at market price and listed investments held as promoters-Petronet LNG, Chennai Petroleum, Lanka Oil--at a 10% discount to market value. The total investments constitute about 30% of its market value. Key risk to our target price is materially different refining and petrochemical margins, different share of under-recovery or announcement of oil gas discoveries.

HSBC Global Research