OMCs: Going at attractive valuations

BPCL remains top pick of analysts, while HPCL's valuation, too, has become attractive after correction

Even as oil marketing companies (OMCs) reported strong performance in the quarter ending December ’15, beating analysts’ estimates, the stocks of Bharat Petroleum (BPC), Indian Oil (IOC) and Hindustan Petroleum (HPC) continue to decline. IOC hit a 52-week low of Rs  312.75 on Thursday; BPC and HPC are down 19 per cent and 24 per cent from mid-January levels.

Though part of this correction can be attributed to a fall in the broader indices, the buzz of an equity stake sale by the government in BPC and IOC has contributed. However, with the fundamentals looking healthy and the valuations reasonably attractive, it could be a good time to buy some of these companies.

The OMCs, which continue to benefit from benign oil prices and sector reforms, are also benefiting from the rebound of late in gross refining margins (GRMs), the difference between total value of petroleum products and the price of crude, on a per barrel basis. At the operating level, the companies saw strong performance in the December quarter. BPC's operating profit more than doubled to Rs  2,416 crore; HPC and IOC reported operating profit of Rs  2,240 crore and Rs  5,242 crore against losses in the year-ago quarter.

Lower interest costs due to declining working capital requirement further boosted profit. BPC saw these grow 170 per cent over a year; HPC and IOC reported profits against losses in the year-ago quarter.

Of late, while analysts had been expecting better performance due to lower oil prices, OMCs have performed better than expected, on the back of good GRMs. Inventory losses due to the fall in crude oil prices and foreign exchange losses thereby have been mitigated. Moving forward, analysts believe the benefits of reforms, benign oil prices and elevated GRMs will continue accruing.

Analysts at Credit Suisse say despite the near-term weakness in refining margins, "we continue to stay constructive on the refining sector, as we see refining surplus in Asia and the Middle East continuing to fall over 2016-18 ". Thus, analysts remain positive on the sector and see the correction in stock prices as an opportunity for investors.

They have BPC as the top pick. The expansion at its Kochi refinery by May is likely to help higher GRMs. Analysts at Edelweiss say the company’s inventory at around 30 days are much lower than IOC’s 55 days and, therefore, relatively more immune to oil price swings. They have a target price of Rs  984 for the stock, now trading at Rs  760, a 29.5 per cent upside. Credit Suisse analysts say BPC generates the strongest return on equity and remains their top pick.

HPC, most sensitive of the three to oil price reductions and fuel reforms, had seen stretched valuations. However, after the fall, the stock has become attractive, looking at the earnings growth estimated by analysts. Analysts at Prabhudas Lilladher expect its earnings to grow at a compounded annual rate of 35 per cent over FY15·18. They feel the refining margins will remain firm, there are no inventory losses expected, given stable crude oil prices, and also expect healthy marketing profits. They have a target price of Rs  1,047 for the stock, now priced at Rs  676.60.

IOC has seen some concern on profitability, due to commissioning of the Paradip refinery. However, the state-of-the-art refinery will start driving refining margins and profitability in the coming months. Also, the company has good rural penetration that can itself drive growth. Analysts at Edelweiss also highlight in their note that inventory losses will reduce in FY17, driving margins further. They have a target price of Rs  442 for IOC, which can see further upside as the Street gets comfortable on the mentioned concerns and some green shoots appear. The stock is trading at Rs  378.

On the flip side, if the government plans to sell its stake in BPC or IOC, the stocks can come under pressure in the interim. The government held 54.93 per cent stake in BPC and there has been a buzz from the start of the calendar year that it might divest three per cent. In IOC, the government already divested a 10 per cent stake in August last year and there is scope for some more, as it held 68.57 per cent before that.

The other worry stems from any sharp rise in oil prices. Though the government’s current policies are clear in allowing companies to pass on cost increases, it could lead to some pressure on working capital.