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RBS:: Indian Oil Corporation – Mispriced
Negative sentiment on oil marketing has resulted in IOC's core business now being valued
virtually on a par with its peers (at 1x FY11 P/B) despite its ability to earn higher returns on the
same subsidy-sharing formula. A positive outlook on petchem margins is a bonus. Upgrade to
Buy; target price of Rs400 (from 410)
R&M business earnings unchanged
Our estimates assume status quo, ie some price hikes, no deregulation, that under-recoveries
continue and that Indian government (GOI) compensation is pegged at levels that ensure ongoing
ROE of 11-12% for the weakest player HPCL. We estimate that such a return for HPCL will result
in a 16-17% return for IOC, due to the latter’s higher contribution from refining, pipelines and now
petrochemicals. Given this assumption, we maintain our earnings estimates on the core refining
and marketing (R&M) operations, even though oil prices and resultant gross under-recoveries are
likely to end up higher than we were expecting.
Improved outlook for petrochemicals
We raise our FY12-13 EPS estimates by 6-9% on the back of improved petchem margin
expectations. PTA margins have improved in the last quarter, as rising cotton prices have pulled
up prices for polyester and its intermediates. Margins on ethylene and downstream products have
also been relatively firm and we expect them to bounce back. Petchem profit contribution has not
been evident in FY11 because the PX/PTA plant took a 90-day shutdown and the cracker has
taken time to stabilise post commissioning in March 2010.
We believe the stock offers value, even if status quo is maintained
IOC’s core business is currently being valued at 1x FY11F P/B, after valuing its investments in
ONGC and GAIL at a 20% discount to market prices (Rs70/share, down from Rs82/share earlier),
virtually on a par with core business valuations of peers BPCL/HPCL. We believe that IOC’s core
business valuation needs to be higher (we value at 1.4x FY11F P/B, 18-19% ROE), as the
subsidy-sharing mechanism should ensure that IOC’s ROE is far superior (as evidenced by
historical trends). We believe that most of the bad news is in the price, and at current valuations
investors need to Buy and wait patiently for the difficult-to-predict positive news flow to emerge
(any drop in global oil prices and/or the next round of domestic price hikes).
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