July 19, 2007

Graham idea – Selling below replacement cost – HPCL

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

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.

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.


alok said...

This is a good analysis of HPCL.
My opinion is as under:--

- While Asset values are much higher than market value, Mr Market has a tendency to value a company based on current quarterly earnings.
With crude prices going up, margins could be further under pressure for HPCL in the short term.

- Current price of HPCL reflects the Govt controls which are unlikely to change in near future.

- In the long run, either Govt policies could change or there might be privatisation. In either case, earnings would improve drastically. In case of privatisation, the valuations will obviously be done on asset values which.(I presume thats what happened in IPCL's case)

- Hence with a time horizon of 3 years plus, this investment could prove to be a gold mine.


Rohit Chauhan said...

Hi alok
completely agree with you. Also crude has touched almost 76 dollars/ bl and could increase. so the near term prospects for hpcl and other oil companies is awful.
very likely hpcl and other O&G companies may show bad results in the near future and the stock price could go down still further.
so a lot of patience and complete contrarian view is required to invest in any such company.

khali_pili_lafda said...

This is specific to HPCL but I'm trying to generalize
Assuming the assets are valued at ~25,000 Crores, should we subtract the Total Debt comprising of
a. ~6,500 Crore (Secured and Unsecured)
b. Preferred Stock (0 for HPCL)
c. Minority Interest if any (don't know), etc
to ascertain the residual claims of equity holders on the replacement value of the assets.
I'm assuming a potential acquirer would subtract liabilities before paying for the assets.
For HPCL, should equity holders claim 25,000-6500=19,500Crores as its intrinsic market cap? Or am I misunderstanding something here.

Rohit Chauhan said...

Hi niraj
your overall math is correct
however to calculate the net asset value the following formulae would give a more accurate result

fixed asset+ net working capital + investments - long term debt - anyother liability

so in case of hpcl i think the net debt (net of investment) is around 2500 crs
so a very rough math would be

25000 (rough) -2500 = 22500
compare that with 9000 crs value of equity
hope the above clarifies

Ranjit kumar said...

Hi rohit,

My personal opinion is that until the government regulations are lifted the companies assets are worth little just because there will be no buyer. My opinion is that we should only calculate the value of assets of businesses which are not controlled by external forces. And i also strongly believe the point that a contrarian can be made to wait till death when he enters a trade too early. Pls can you let me know your thoughts on the above.

Ranjit kumar

Gaurav said...

I bought HPCL 2 years ago on the same theory. It hasnt worked out. I dont think it will work till government goes out of pricing in this sector, which doesn't seem likely till at least 2009 (next election). The day government policies change, it is unlikely stock will double, and that would be a better entry point.

Rohit Chauhan said...

i dont think the goverment is planning to change its attitude towards oil companies any time soon. My thesis is not based on that trigger ..if that were to happen then this stock could be 2-3 bagger. however fuel pricing is too political to get fixed and become market driven anytime soon.
my thesis is based on the following key points
- the underlying business of HPCL is undergoing a shift to non - goverment interference streams such as gas, exports , retail etc. That should enhance earnings in future
- HPCL has sold at higher valuation in the past inspite of goverment interference. the key difference was lower oil prices. i do not expect or have a view on oil prices. however over the next couple of years i think the GRM could improve providing an additional kicker
- finally it can be a reversion to mean idea too. HPCL is selling at one of highest discount to cash flows and asset value . the market is valuing it below bankruptcy value. i expect the the discount to reduce in time.

mohnish pabrai is a great investor. i recently read his book 'dhando investor' where he discusses ideas with high uncertainity and low risk. I think HPCL/BPCL and other oil companies fit that definition

however all or any other above is not happening anytime soon and may play out in a couple of years at the earliest

Gaurav said...

I don't know how the minister who allocates this subsidy burden thinks and how he allocates the subsidy burden across various players. If HPCL starts making profit in gas, exports, retail etc, then maybe the government will also ask it to carry a higher subsidy burden. My guess is that RIL and ONGC have more political muscle than HPCL. This is a multibagger stock - I agree. Question is - how long will it take to get that return - 3 years, 5 years, 10 years?.

sandy said...

hi rohit

how would b the value unlocked and when? one can wait for seven yrs to get a a decent return.

read from the maquarie research report that the cost of constructing new refineries is rising and to remain feasible the gross refining margin must b around 11 usd/ barrel.
how this mite affect hpcl in the coming yrs.

sandy said...

wat about buying the stock for the next 7 yrs and if luckily the value gets unlocked maybe due to privatisation?
one mite get a decent compunded annual growth of about 22%