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Sector update: Oil & Gas - Buy the uncertainty!

The last 6 months (6M) have been a perfect storm for oil marketing companies (OMC), which have buffeted prospects of the OMC stocks (IOCL, BPCL, HPCL) under our coverage. A combination of rising oil prices, aspersions cast on political interference in fuel pricing (impacting marketing margins) and subsequent pressure on the INR, along with a muted GRM environment has led to 20/24/39% underperformance in IOCL/BPCL/HPCL versus the Sensex, respectively, over last 6 months. We submit, however, that the correction is overdone, despite a persisting challenging environment in crude prices and uncertainty around marketing margins of retail fuels. A reverse valuation exercise for the OMCs implies that the entire marketing business of the companies is available at abysmal valuations to investors, with even a worst-case valuation implying 25-30% upside from CMP. IOCL is our top pick in the current environment, with the reverse valuation implying marketing is valued at NIL at CMP.

Marketing businesses of OMCs trade at abysmal levels: After valuing the refining/pipeline/petchem business + listed investments of OMCs, we believe their marketing business is valued at implied EV/EBITDA of (2.3x)/3.4x/1x, respectively, for IOCL/BPCL/HPCL, which more than factors in the relatively muted prospects for the segment over FY19-20E. Even after factoring retail margins at lower-than-normalised levels (we assume average gross margins of Rs2.6/ltr for FY20E versus normalised target levels of Rs2.7/ltr), we believe valuations look undemanding. We see this as an opportunity to add to positions in the stocks, near term uncertainties notwithstanding.

Balance sheets unlikely to go out of whack: The much improved working capital environment for OMCs and higher profitability over FY17-18 imply ~1.4x leverage for IOCL/BPCL despite markedly higher capex over FY19-20E. Also, we do not expect HPCL to surpass a leverage of 1.6x, even if the company meets its stated investment aims (Rs650bn capex over next 4 years). We have built in annualised run rates of only ~Rs100bn p.a. for HPCL instead of Rs150bn guided by management, given historical trends and the timelines for the various projects proposed.

Valuations & View - Buy into weakness: Net of listed investments (at 20% discount to CMP), IOCL/BPCL/HPCL trade at 6.1/6.9/4.9x FY20E consolidated EPS, respectively. With EV/EBITDA discounting the marketing business materially (exhibit 14), we believe valuations appear extremely attractive. On EV/EBITDA, we value OMC’s refining business at 6x, pipelines at 6.5x, petchem at 6.5x and marketing at 6x FY20E EBITDA, to arrive at a target price of Rs233/473/400 for IOCL/BPCL/HPCL, respectively, implying 47/26/55% upsides from the current level. IOCL and HPCL are our preferred picks given their cheapest valuations.