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Morningstar | Sinopec’s Capex Increase a Dampener; Our FVE at HKD 6.20 With Spin-Offs to Boost Cash Flow

China Petroleum & Chemical, or Sinopec, guided for a 15.5% jump in capital expenditures for 2019 that is a dampener on sentiment. After reducing our profit forecast by an average 20% over the next five years, we are lowering our fair value estimate to HKD 6.20 (USD 71 per ADR) from HKD 6.50 (USD 84) to reflect reduced free cash flow expectations. However, we still believe that impending spin-off of its marketing and pipeline assets will lead to lower cash flow needs. Sinopec’s 2018 dividend payout at 83% remains attractive, and we expect the forward dividend yield of 7.6% alongside the potential spin-off gains to provide support for the shares.

Sinopec’s fourth-quarter income was negligible, with a 25% year-over-year drop in revenue on lower average oil and gas and product prices further impeded by one-off charges, including its derivatives trading loss of over CNY 4 billion and a CNY 4.3 billion upstream impairment charge. However, Sinopec’s lifting cost was well contained at USD 16.41 per barrel and refining margin of USD 9.64 per barrel held up well. Given our assumptions for the Brent oil price to decline 7% in 2019 and easing to our midcycle forecast of USD 60 per barrel, we expect Sinopec’s upstream segment to continue recording operating losses for the foreseeable future. What could mitigate this would be for China to revamp its natural gas pricing mechanism such that gas selling prices better reflect costs. We think this is possible over time especially as the government would like to see Sinopec and PetroChina expand their shale gas output.

The company’s capital expenditure, or capex, jumped 79% in 2018 as profit recovered. However, Sinopec’s guidance to spend 15.5% more this year was still surprising as although the company is in a net cash position, we see limited upstream investment opportunities. Overall, we still think that capex is likely to be around the CNY 110 billion range over the midterm, particularly with softer crude oil prices.

The company’s 2019 capex budget includes spending on a new gas pipeline. However, if a national pipeline company is formed as widely as expected, this new pipeline should be taken over by the new pipeline company. If so, the new company will assume responsibilities for building the new pipeline and Sinopec’s capex should decline in the absence of new projects.

We note that the spin-offs of the pipeline and marketing businesses will dampen earnings and cash flow contributions from these two segments. However, we think we are likely to see a net improvement in free cash flow from the reduced capex obligations. Our fair value estimate partly reflects some of the estimated gain. Of our HKD 6.20 fair value estimate, 7% or HKD 0.44 consists of projected spin-off gains.

We believe that Sinopec’s second-half 2018 earnings was also negatively affected by falling product prices that led to inventory markdowns. Since we think prices will continue to ease over the next five years, we have factored in some continued inventory mark-to-market losses. This leads in part to our earnings revision down for Sinopec but as they are non-cash-flow costs, it has limited impact on our DCF-based fair value estimate.