Statutory warning – A long post with links to other analysis.

I have analysed the oil & gas industry and specifically refineries earlier (see here). In addition an analyis of the industry is also posted on my spreadsheet.

The oil majors have not been a part of the current bull run and the main reason is the convoluted pricing and subsidy structure. As a result the sector is not doing too well and may have some opportunities.

I have developed an investment thesis for HPCL which is given below

About
HPCL is one of the Oil majors with almost 13MMT refining capacity. It is engaged in the business of refining crude and marketing end products. In addition it is also integrating backwards into E&P, lube marketing via its Lube SBU and into the Gas distribution business.

The problem
The Oil & gas business in india has one of the worst economics possible. The pricing though supposed to be decontrolled, is still controlled by the government. As a result in a rising crude price scenario, where other Oil majors across the world are minting money, companies like HPCL, BPCL, IOC etc have been bleeding.

The typical Gross refining margins for companies like RPL has been around 10 usd per barrel. A company like HPCL should easily be able to make 6-7 usd / barrel. However in the last 1-2 years the Gross margins have been 3-4 and net margins have been around 1 usd/ barrel.

The above is due to subsidized sales of products such as Petrol, diesel and kerosene etc Due to the above situation, O&G companies have been beaten down and now sell below replacement value of their asset.

The opportunity and investment thesis
HPCL now sells at around 9000 crores. The EV is around 10000-11000 crores at best.

The replacement cost for the assets of HPCL can be calculated as follows

1.Refinery – 13MMT ( greefields projects cost around 1200-1800 Crs/ MMT) – 19000 (approximate)
2.Petrol pumps / retail outlets – 7313 (average cost atleast 1 cr/ outlet – 7000 Crs (approximate)
3.LPG distributors – 2202, customers 2.28 crores – ??
4.Other gas assets such as pipeline – 2000 Crs + (1700 crs invested in last 5 years), avantika gas, Bhagyanagar gas etc.
5.Other assets – some value
6. JV’s – MRP (17%) – 1200 Crs and other JV’s

The above assets can conservatively be valued at 25000 – 30000 Crs. So the company sells at 25-30 % of the replacement value of its assets.

The above discount is definitely not an abberation. It is mainly due to policies of the government. However I think the gap is higher than it should be and the main reason is that the market is assuming that the current state of affairs would continue as is.

I don’t believe the government is going to change its ways, however I think the bottom line of company should improve due to the following reasons

1. The company is currently engaged in diversifying its revenue streams via various initiatives and reduce the impact of the pig headed policies of the government. These initiatives are lube marketing, Gas distribution and retail initiatives and oil trading and risk management. The market is currently not valuing any of these real options.
2. The GRM and net refining margins are at their lowest. Going forward the worst case sceanrio is that they would remain at the same level. If that is the case, the bottom line should still improve as the various company intiatives take effect (see page 53 of Annual report)
3. The 9 MMT refinery and expansion of Vizag refinery to 15 MMT and export of the petro-products and E&P activities should help the company improve its margins going forward.

Conclusion
Although there exists a substantial discount to the assets value and possible cash flows, the gap is not likely to close any time soon. However even if the market reduces the gap to 50-60% of asset value, the returns should be reasonable. In addition the company is selling at a 5 year low in terms of its PE and P/B ratio. The key triggers to watch would be crude prices and the level to which the government compensates for the underrecoveries.

I saw the following post on torrent cables on ranjit kumar’s blog. In addition, I found this analysis on amit’s blog.

The fundamentals look enticing

– RONW – 30%+
– No debt
– A 25%+ growth in topline and bottomline
– Operates in the power cable industry which seems to be doing well and is a growth industry.
– Lower valuation than all its competitors

However I am concerned about the following

– Inventory and debtors has increased in the last few years (debtor days is at 60 from almost 20-25 a few years) back. As a result the company has a very low free cash flow. Most of the cash flow has been used up by the incremental working capital
– Cannot get the annual report for the company. As a result I have no idea on how the company is planning to reduce inventory and debtors.
– The company was in BIFR from 1999-2002 (not sure on dates). Why did the company land up in BIFR and why will it not land up in a similar position in the future?

Comments welcome on the above analysis (which is very superficial as of now)

PS: An apology to all who requested me for prof bakshi’s interview. He has however posted the interview on his website. I would strongly recommend reading the interview (I have done it twice and really learnt from it)

About
VST is involved in the manufacturing and marketing of cigarettes. It is the second largest cigarette-maker in India with 12 brands in its portfolio. The company is an affiliate of British American Tobacco (BAT), UK, which holds a 32.16% stake in the company. Some of the major brands of the company are Charminar, Charminar Special Filter, Charms Mini Kings and Charms Virginia Filter. Its products are targeted at the lower-end of the market and have dominance in the small sized (less than 60mm) micro segment. The company is dependent on ITC for the supply of tobacco. Though the major chunk of revenue comes from sale of cigarettes, it is also in the business of selling unmanufactured and cut tobacco.
In order to establish its presence in unrepresented geographies, the company has last year launched a new brand, ‘XL Filter’ in large parts of Tamil Nadu and the hill states of the North East. In 2005, the company also launched another new brand, ‘Shaan’, which has garnered 4% share in the micro segment.

Financials
The company is a debt free company with almost 200 Crs in cash and investments. The company has been consistently been profitable with net margins increasing from 5-6% to almost 15% now. The Return on capital is consistently above 25%+ and excluding the low yielding investment, the company enjoys very high return on tangible capital. The company has been working with Negative working capital for some time and this seems to be increasing too.

Positives
The company has strong competitive advantage due to the nature of the product for which users have a very high brand preference. Competition is limited to ITC and the unorganized sector at the low end. As a result the company has a strong free cash flow and high return on capital

Risks
Topline growth is low due to high excise and price sensitivity at the low end. Also the company is not clear of how it will use the excess cash and there is always a risk that the company may simply blow away the surplus cash.

Valuation
At 58Cr net profit and 200Cr cash on the books, the company can be conservatively valued at 1100-1200 Cr (at 15 times PE of Free cash flow) which is at 50% discount to the current market cap. The company can grow at a 4-5% topline via new product introductions and price increases. The net profit has grown at a much higher rate of almost 20% for the last 10 years and a 6-7% growth in the future should look achievable. This level of growth and the high ROC can easily justify a PE of 15.
In addition, the company has a dividend of almost 20 Rs / share which is almost a 50% payout ratio .

Relative valuation
ITC is the largest player, but it has several businesses and hence it is diffcult to compare the financials. However a segment based analysis shows that ITC has around 17% post tax margins and around 110% return on capital. In comparison VST has a 15% net margin and more than 100% return on capital. ITC is curently commanding a PE of 20.

Godfrey philips is the second largest cigarette manufacturer. It had a net profit of around 87 Crs and has an adjusted cash and equivalents of approximately 200 crs (net of debt). The company sells at a PE of around 15-16 (net of cash). In comparison VST sells at an adjusted PE of around 7 and this could mainly be due to the slightly lower growth rates than ITC and Godfrey philips.

Conclusion
The company is a slow grower and the unit volume are more or less stagnant. The free cash flow for the business is equal to the net profit and the return on capital is also high. The balance has a lot of surplus cash and this should increase in the coming years. The catalyst for unlocking value could be higher dividend, better growth rates in the topline or continued good performance of the topline and bottom line.