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Morningstar | Lowering Sinopec's FVE to HKD 7.50 (USD 96/ADR), Reflects Slightly Lower Income and Renminbi. See Updated Analyst Note from 24 Jul 2018

We lower our profit projections on Sinopec by 3%-5% in 2018-2019 and by an average 10% in the midterm leading to a slight cut in our fair value estimate to HKD 7.50 (USD 96 per ADR) from HKD 7.70 (USD 99/ADR). The change also incorporates a 7.5% reduction in our renminbi exchange rate versus the Hong Kong dollar. Because Sinopec's revenue is largely U.S.-dollar denominated, the company does benefit slightly from the weaker renminbi. The lowered earnings mainly reflect softer marketing and chemicals margin assumptions. The market should not be surprised by Sinopec's positive profit warning for interim profit growth of 50% given the uptick in crude oil prices to USD 74 per barrel, up 50% year on year, during the second quarter. This should lead to a sharp improvement in upstream oil & gas segment earnings. We believe Sinopec is fairly valued but expect a relatively attractive dividend yield in excess of 8% in 2018, as well as the promise of gains from its marketing unit and pipelines spin offs to support its share price. At our midcycle forecast, we expect Sinopec's returns to fall just short of its cost of capital, which reinforces our no-moat rating.

Sinopec reports its interim earnings at end-August. The 50% positive profit growth warning implies an interim net profit of around CNY 42 billion, or 45% of our full-year 2018 profit estimate. We also see refining margins staying strong as it benefits from inventory gains on rising prices. However, the higher product prices have encouraged teapot refineries to resume operations leading to lower retail prices. As a result, we factor in marketing segment earnings to decline. The higher input costs should also eat into chemical segment earnings margins in 2018. However, the improved upstream income should lift group operating margin to 4.7% in 2018 from 3.0% in 2017, especially in the absence of impairment charges that totaled over CNY 21 billion in 2017.

Given our view that the global oil & gas market remains in an excess supply situation, we maintain our forecast for lower crude oil prices post 2018 meaning that we expect this year's profit to represent peak profit for the company. We assume the Brent oil price to decline to USD 60 per barrel in 2022 from USD 73 in 2018. As a result, our 2018-2022 EPS CAGR is negative 8%. We also factor in refining margins to normalize to USD 6.50 per barrel from USD 9.00 estimate in 2018. Our midcycle operating margin for Sinopec is 3.7%, in line with its historical 10-year average.

We are hearing conflicting views as to the timing of the creation of a national pipeline company to incorporate the oil & gas pipelines that belong to PetroChina and Sinopec, and other pipeline companies presently. Both PetroChina and Sinopec do not expect this to happen in the near term given the complex task of pricing and introducing various supply and delivery contracts. However, we also understand that there is strong motivation by the government to establish the national pipeline company so that all importers of LNG are able to transport gas nationally more efficiently. This is part of the country's aim to increase reliance on natural gas.

In 2016, Sinopec sold a 50% stake in its Sichuan to East China pipeline for CNY 22.8 billion. The sale valued the entity at around 2.2 times assets. Sinopec recorded a gain of CNY 20.6 billion on the sale. Hence, we believe the sale of the remaining pipelines would present a significant one-off gain to Sinopec. Given a lack of detailed information, it is difficult to calculate an exact value to the pipeline assets but reports have indicated that Sinopec's portion of the new national pipeline company should be around 30%. Based on this, we estimate a value of around CNY 147 billion. We factor in a 25% revaluation gain, excluding any addition in value for the previously reflected Sichuan-East China pipeline, into our valuation of Sinopec but note that this will depend on the book value of the assets. Given the uncertainty of the timing and value, we prefer to be cautious. Also, some of the gain to Sinopec’s fair value would be offset by reduced income from its pipeline assets. At the same time, we prefer to represent some of this value into our fair value estimate as we expect the spin-off of the pipelines to occur within the next five years.

While there is no timing tabled for its marketing division spin-off, we would not be surprised to see Sinopec list out a 10% stake in Hong Kong in 2019. We estimate a one-off gain of around CNY 9.9 billion assuming the assets are listed at 8.0 times average 2018-2019 EBITDA. Similar to the pipelines spin-off, we reflect a potential gain in our fair value of Sinopec but have not included it into our earnings forecast.

Despite our declining profit forecast on lower oil prices, we think Sinopec will be able to comfortably maintain a dividend payout in excess of 60%, particularly if it were to offload its pipelines. We expect its capital expenditure to hover around CNY 110 billion with limited acquisition opportunities. Hence, emphasis will be on improving the recovery at its existing oilfields and on gasfield exploration and development. With slowing growth in China, we see downstream investment focused mainly on moving up the chemicals value chain. And if the pipelines are spun off, Sinopec would not need to allocate funds to grow its pipeline network. As a result, we see Sinopec in an increasing net cash position going forward.