Not there yet. The recent correction in OMCs led by weakness in marketing margins has not made the valuations compelling enough for us to revisit our negative thesis on these stocks. We continue to see downside risks to consensus estimates for OMCs, given our concerns on Street’s generous assumptions for the marketing segment. We remain cautious on (1) intermittent curtailment of marketing margins, (2) sustained loss of market share and (3) significant capex plans, which may limit FCF generation.
Sharp decline in margins on auto fuels; lack of increase in dealer price of LPG/kerosene
Marketing margins on diesel and gasoline have declined sharply to about `1/liter currently from `3.1/liter in 2QFY18, led by lack of commensurate increase in domestic retail prices since the first week of November despite a sharp uptick in global crude and product prices during the same period. The dealer prices of LPG and kerosene have not changed since September 2017, putting an intermittent halt to the phased reduction in cooking fuel subsidies, which was implemented by allowing OMCs to gradually increase the effective price for end-consumers.
Rule out expansion of marketing margins on auto fuels given multiple headwinds
In our view, it may be a bit difficult for OMCs to earn steady margins as earlier, leave aside any possibility of increase in margins, under an environment of (1) elevated crude prices of US$55-65/bbl, (2) upcoming prolonged election cycle over the next 12-18 months, and (3) sustained competitive pressure from private players. Any cut in excise duties will be difficult for the government to manage given fiscal constraints and even if it happens, it is unlikely that OMCs can gain out of it by expanding margins. Besides, the companies have not been able to recover additional burden from MDR costs, digital discounts and GST-related stranded taxes yet, despite such burden being effective for PSUs and private players alike.
Sustained loss of market share in auto fuels to private players
PSU OMCs continue to lose market share in auto fuels despite a rather restrained expansion of retail outlet networks by the private players. Our computation suggests that private players have garnered 7.9% market share in diesel and 5.5% in gasoline in 1HFY18 as compared to 5.9% and 4.9% respectively in FY2017, implying no respite in the pace of loss in market share.
Significant downside risks to consensus estimates from disappointment on marketing profits
We see downside risks to FY2018 consensus forecasts, as our 2HFY18E EPS for OMCs, factoring in (1) steady refining and marketing margins at 1HFY18 levels and (2) reversal of inventory loss, are still 12-18% below consensus. QTD marketing margins on diesel and gasoline have declined to `1.9-2.3/liter from around `2.8/liter in 1HFY18. QTD Singapore complex refining margin, albeit robust, has declined by US$1/bbl qoq from 2QFY18 and is flat compared to 1HFY18 levels. Our FY2019-20E EPS are 8-13% below consensus, as we factor in modest improvement in marketing profits, contrary to the Street’s optimism. A `0.25/liter reduction in auto fuels margins can impact FY2019E EPS of HPCL by 10%, BPCL by 7.5% and IOCL by 5.6%.
Growth multiples may be difficult to justify given cyclical nature and low FCF conversion
We highlight that OMCs may look optically inexpensive trading at 9-11X P/E multiples or 6-7X EV/EBITDA. However, it is difficult to justify growth multiples for OMCs, as a significant portion of the business (entire refining and a part of marketing) is cyclical and requires meaningful amount of capex for upgradation and modernization, let alone to raise capacities. A significant portion of operating cash flows may be utilized on planned capex in refining, petchem and upstream projects, which will likely generate lower returns as compared to the extant marketing segment, while the capex in the marketing segment is essentially required to meet the growing demand and/or replace old infrastructure, which may not necessarily drive earnings growth.
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