India’s State Owned Refiners to grow 500% in 3 years

Ref: 10-005 of 12^th July, 2010

A golden opportunity struck a few days ago when Government of India changed its “Oil Price policy” drastically. I was expecting it to come in a few years, and it did. Just revisit my small article under NASA Ref: 0901-004-NASA dated 6-Jan-2009 Titled – Golden Era may arrive soon for Indian Oil Refiners. Click this link to read and download this article.

Compare the stock prices at the time of release of that article with present day stock price. The prices are extracted from Yahoo India.

We had mentioned very clearly in January 2009 that..

•        The era of low share prices of all SOE (State Owned Enterprises) will be gone forever…

•        My dream of SOE Refiners to multiply 5 to 10 times in less than 2 years is now a distinct possibility…..

•        …believe me if Government of India follows up with the deregulation of oil prices, the SOE Refiners will give over 500% return in less than 3 years.

The words have proved to be more than prophetic. The return is more than 80% in less than 18 months, but the real return will begin to accrue from now on. Sit down with these stocks in your portfolio, and you will find them growing even 5 times from current level (10 times from previous recommended level)

Why the SOE Refiners will give return over 500%?

This is purely a volume play. If the prices rise, those who have large volume (sales) will benefit most. Each liter or gallon of gas (petrol or diesel) will bring them additional return that will add straight to the bottom line. (Profit and Loss account). The EPS will rise tremendously.

By rough estimate, the current oil prices should have been at Rs. 75 to 80 level – about Rs 25 to 30 more (+ 47% or about). The Government of India was subsidizing to the extent of Rs 20/liter in case of Petrol/Diesel and ATF (used in Airlines). In other words, the profitability of these stocks have to rise by 47% per liter (less taxes) if the prices rise to that extent. If the Tax slab is 30%, the PAT (Profit After Taxes) have to rise by 33% per liter on increased income. (Not existing profit).

Take the example of BPCL (Bharat Petroleum). Now look at the following scenario with just about 6% increase in petrol prices recently. The company has total product sales of Rs 122,000 crores in 2010 of which almost 95% is refinery product sales or about Rs 115,000 crore. If the prices rise by 6% in petrol and diesel segment, the higher profit will be 6% of Rs 115,000 crores or Rs 6,900 crores before taxes or Rs 4,800 crores after taxes. (PAT). The company has only 36 crore shares outstanding. It means that the EPS may rise by massive Rs 135/share. If you assign PE ratio of about 10 (for growth stocks – it is no longer in non growth category), the stock price has to rise by Rs 1330 from current level. (To reach over Rs 2000)

Again, we have to reduce the subsidy level from higher profits. However, the past practices were to treat the subsidy as “investment” because they were in the form of bonds. They were not taken into account as “profit” for strange reasons. May be, they wanted to account for it on “realized cash flow basis”

NOW, this is the effect of just 6% rise in prices. What will be level of profit if the prices rise by full circle of 33% PAT? It means that the EPS has to rise by nearly 8 times or minimum Rs 1080 per shares. What will be the effect on share price in that case, after about 18 months? They will simply explode to the uppermost stratosphere.

There are many variables here. We do not know for certain how much price rise will be affected in 18 months. However, we are certain that the profits will grow much faster than historical standard. The earnings of these SOE Refiners will be in uncharted territory. Most analysts will be guided by charts, support and resistance level. They would not know that almost all of their calculations based on historical performance would fail.

Such huge rise in profit will be a distinct possibility – the only caveat is how much? There will be lot of opinions in this regard. My approach is just simple and arithmetic. Just increase profit by multiplying “revenue” by “% rise in oil or petrol prices” reduced by tax slab on increased profit. This is what happens in almost all commodity companies be they in steel, copper, aluminum or mining.

I am giving you tool. Use your common sense and arithmetic skill to work out the possible scenario. Further, the SOE normally declare higher dividend – almost 35% of their profits. If the profits rise by Rs 420 per share as PAT, the 35% of PAT will be Rs 147 per share – that will be dividend payout. In other words, the dividend yields will be nearly 21% when the prices clock full circle. Most of the dividend will go to the Government of India who owns 54% of total equity as per latest filing with NSE.

Following factors will fuel further stock price rise:

– The company will have higher cash flow for expansion

– Debt will reduce that will reduce the interest cost

– there will be much higher expectation on earnings due to expansion.

– If global prices go down, the local prices will go down less than expected because the company will use this opportunity to raise under recovered subsidy from past actions.

It all depends how speedily the prices are raised by these corporations. Although the prices will be decontrolled, the government with controlling stake in these companies will have greater say how much the prices to rise having regard to public sentiment.

Who will benefit most?

Use peer comparison in Moneycontrol.com with reference to Sale volume. If a company has larger sales than others, its profit will rise faster than other competitors. The State Owned Refiners are having sales of over Rs 122000 (BPCL) to Rs 300,000 crores (IOC). Naturally, IOC has to gain more. Those who sell more liters of petrol or diesel, will earn more – it is as simple as that.

See the following table. We considered only 6% rise in petrol prices as announced by these companies. (Annualized). Last column takes only 70% of extra profits as PAT and then divided by number of shares outstanding. This is Additional earnings due to rise in petrol prices alone – other volume increases due to higher incoming capacity is not considered.

SOE Refiner	Shares	Gross Sales 2010	Qualified Revenue for Price Rise	6% of QR 10	Extra EPS – PAT
Indian Oil Corp (IOC)	125 Cr.	234,933 Cr	223,186 Cr	13,391 Cr	74.98
Bharat Petroleum (BPCL)	36 Cr	122,276 Cr	116,162 Cr	6,969 Cr	135.50
Hindustan Petroleum (HPCL)	34 Cr	111,467 Cr	105,893 Cr	6,353 Cr	130.79
Mangalore Refinery (MRPL)	175 Cr	31,885 Cr	30,291 Cr	1,817 Cr	7.27

It will be observed that –

1.       BPCL is largest beneficiary in terms of EPS. Its stock price is Rs 708 now.

2.       HPCL is most valuable because its stock price is at Rs 489 – 32% less than BPCL with almost same profits and number of shares

3.       IOC earns most but its EPS is less due to large number of shares – almost 3.5 times that of BPCL and HPCL. It is however trading at just < 400 – about 57% of BPCL and 80% of HPCL. It will earn most when the price rise completes full circle. It is poised to grow most. Its market cap will grow so much that it may become leading BSE/NIFTY Index Stock, outstripping even ONGC. Most Index Tracking Funds will have to buy this beauty whether they like it or not.

4.       Private Refiners like RIL or Essar Oil Ltd are not considered here. They are already trading at much high PE ratio – almost 3 times of SOE Refiners. So they will underperform compared to SOE Refiners.

5.       See the market cap existing and future based on price projections after about 3 years.

Market Cap of SOE Refiners – Present and Future (after 3 years)

SOE Refiner	Shares	CMP (9Jul10)	Market Cap	Projected Price (> 3Y)	Projected Market Cap
Indian Oil Corp (IOC)	125 Cr.	400	50,000 Cr	3,000	375,000 Cr
Bharat Petroleum (BPCL)	36 Cr	709	25,524 Cr	5,400	194,400 Cr
Hindustan Petroleum (HPCL)	34 Cr	488	16,592 Cr	5,400	183,600 Cr
Mangalore Refinery (MRPL)	175 Cr	84	14,700 Cr	360	63,000 Cr.

Current Market Cap of top leader – ONGC is about Rs 278,000 crores. IOC is therefore poised to overtake even ONGC in just under 3 years to become top ranking stock in India. Almost all funds will have to buy this stock to track BSE/NIFTY Indices.

Government of India will become Trillionaire if all PSU are combined and its stake recalculated. It will be the richest government in the world.

How the stocks will move and what will boost and hurt them?

I have always mentioned that the stock has 4 strengths – its own, industry’s, country’s and international. The SOE Refiners will have strength of their own, Industry’s (oil sector), Country’s (India due to its growing status and higher GDP expected over 9%). The only remaining and uncertain effect will be Global Stock Market, dictated by United States which is in perilous state. Add the strength of 3 factors and deduct or add the weakness or strength of fourth factor.

Each quarter will show better and better performance because the SOE Refiners will steadily raise the prices in order not to rock the boats, and avoid discomfort to government.

Rise in oil prices will also fuel protest. At the same time, the intended practice to change Gas Station prices every fortnight will also ensure that in the days of steep correction in oil prices abroad caused by stronger dollar, the prices could go down. Once the people understand that the prices could go higher or lower, the protests would begin to disappear. Until now, Indian consumers were looking at only local prices in Rupees – in future they will see the international prices as guide. They would not blame government if the world prices move higher.

Higher consumption will also move the stocks higher due to higher demand. First is the value growth and then volume growth caused by expansion will drive SOE Refiners prices higher.

Higher Rupee will bring down the oil prices. Rupee is the only major commodity which is still under the control of the government and RBI. When the artificial intervention ends, and free market is allowed to play role, Rupee could rise to 26/$ from current 47/$. In that case, the oil prices could drop by over 50% from current level. However, the margin of the companies would be protected. The refining margin determines the profit, not the actual sale or purchase of the commodity.

If the international oil prices begin to climb again, then only the government will come under pressure to roll back on decontrol. If that happens, then my above targets will be severely affected. I do not think that GOI would roll back on decontrol. It has two choices – either free market determines the prices or it has to offer massive subsidy that would strain its budget.

India’s Debt rating will improve due to removal of major obstacle to deficit – Subsidy. It will bring down interest cost internationally. FII may pump in more money into the market, especially SOE Refiners stock that will propel the prices higher.

The credit rating of SOE Refiners will get back to AAA level domestically and their foreign currency bonds rating too may improve. That will reduce their interest cost boosting their existing profits.

If any of these refiners decide to float ADR or GDR, they will be most sought after. They will attain premium to domestic price and also higher rupee could boost the prices of GDR/ADR. They will be the best to invest. Return on future ADR/GDR will be 50% higher than domestic stocks. All NRIs should seize this opportunity when presented.

Some of the stocks, notably Indian Oil Corporation, may achieve cult status and propel into BSE/NIFTY indices due to its sheer size and rise in market cap. It will become almost Number 1 index stock, outstripping even ONGC and Reliance. Those stocks may suffer due to their index dilution. They will have to work much harder to retain even existing prices.

Uncertain global monetary conditions will hurt these stocks in normal course. That is only market related weakness.

Due to weaker dollar and unwillingness of Arabs to oblige United States, it is likely that oil prices will have upward bias. That will ensure higher and higher profits for the SOE Refiners.

Is my forecast accurate or reliable?

I use common sense and project the prices. I have given the reasons as above. If you agree to the reasoning, you may buy into these stocks on long term basis. One should reduce their reliance on bank’s FD and also draw loans from Provident Fund account to buy these stocks only. This is one of the safest investment bet in the world.

The global market is very risky. By my assessment, United States is almost bankrupt and it is also following bankrupt policies. All actions so far by Obama Administration are going to work in opposite directions. He should read my book “SUB PRIME RESOLVED” to direct his future economic policies to resolve the impasse.

If you are losing over 20% in leading index stocks, switch to these SOE Refiners. Do not be afraid that they have risen already by 20% recently. They have lot to go higher as mentioned above. However, buy only if you are convinced.

Anil Selarka (Kalidas)

Hong Kong

Ref: 10-005 dated 12^th July, 2010

©Copyrighted by Anil Selarka (Kalidas)

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