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Event update: Oil & gas - ONGC to acquire 51% stake in HPCL at 14% premium to CMP

EVENT – Final price revealed for ONGC’s HPCL buy

A press release by ONGC to the stock exchanges indicates that the ONGC Board has cleared the decision to acquire Government of India’s (GoI) 51.1% stake in HPCL at Rs369.15bn, which implies a price of Rs473.97/sh. This price is at 14% premium to HPCL’s last closing price of Rs416/sh (as on 19 Jan 2018) and at 11% premium to the last average price in last 60 days. Both interested parties, GoI and ONGC expect to close the transaction by end of January 2018.

IMPACT – Lower premium a key positive, but does little to achieve scale

Premium lower than earlier reports: Initial market reports had indicated that the Finance Ministry was looking at about 40% premium to current market price as consideration for the sale, which implied a payout of about Rs453bn vs Rs369bn declared now. While we see little reason for any premium to be paid in this transaction, as this is a stake sale without any change in ownership with no Open offer on the table, the premium is still much lower than the 52- week high of Rs493/sh for HPCL.

No open offer needed as this is a related party transaction: ONGC has stated that as this transaction is between GoI (promoter of ONGC holding 67.7%) and HPCL (Government holds 51.1%), it pertains to a transaction between the government and a government company as per SEBI definition. As this is a related party transaction, it would not require an open offer to be made to HPCL minority shareholders. Effectively, while the transaction would be a non-event for HPCL stock, the two companies (HPCL and ONGC) would require shareholder approval in which may see minority shareholders questioning the need to pay a premium for the stake between same owners.

Further transactions could be in the offing: We believe this transaction could spur further consolidation in the PSU oil & gas space, as the deal could be followed by the merger of HPCL and MRPL (ONGC owns 74% of MRPL, HPCL 17%). IOCL could also merge its subsidiary, CPCL, and/or buy the government stake in OIL India.

EPS accretive deal for ONGC but leverage to increase: With a 14% premium for the 51% HPCL stake, even if the open offer clause is not triggered, we believe the price would set a benchmark as fair value for HPCL, which we believe is a positive for the stock. ONGC too will also see an EPS upside from the deal (assuming it borrows ~70% or ~Rs258bn needed for the stake at 14% premium) but is likely to be saddled with additional leverage, albeit rising realisations, production growth visibility and marginally higher domestic gas would offset the leverage, in our view.

On the other hand, if ONGC chooses to (and is allowed to) monetise part or all of its 14% stake in IOCL to fund the deal, IOCL stock could become an unintended victim of this transaction, causing likely pressure in the stock price in the near term, as a large tranche could be offloaded in the market.

VIEW: Leverage to increase in the near term; long term prospects for ONGC remain robust

With the obvious financial stress on the balance sheet with this transaction, in addition to the payout for GSPC and Vankor acquisitions, debt on ONGC’s consolidated Balance Sheet is likely to exceed Rs1trn by FY19E. However, we believe the company will be on a surer footing from an operational standpoint and estimate 5.2% CAGR in oil and gas output over FY17-21E, 4-20% below the company’s guidance (FY19-21E), which more than covers for any real or perceived delays in execution. We estimate 17% consolidated EPS CAGR over FY17-20E (based on our conservative numbers), which we believe is underappreciated by the street, given the material payout for buying HPCL and resultant increase in leverage.

For HPCL, specifically, the transaction changes little on ground, with the company retaining its independent identity and only direct ownership changing hands. If the common promoter (ONGC) allows HPCL to absorb MRPL, the overall refining complexity of HPCL would see a sharp improvement, supporting earnings over FY18-19E. We reiterate our Outperformer rating on HPCL and ONGC, with ONGC stock likely to see some near-term pressure, unless it decides to monetise its stake in IOCL to fund the HPCL acquisition.