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ONGC: Heavy shoulders! - Views on News from Equitymaster
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ONGC: Heavy shoulders!
Jan 31, 2006

Performance Summary
Despite a challenging policy environment and production disruptions, ONGC's third quarter performance has been commendable. While operating margins have improved considerably, a higher subsidy share in terms of discounts on crude oil and natural gas to oil marketing companies, resulted in a relatively subdued bottomline growth. Amidst these developments, net profit in 9mFY06 is higher by 24% YoY.

(Rs m) 3QFY05 3QFY06 Change 9mFY05 9mFY06 Change
Net sales 121,035 124,761 3.1% 342,140 360,256 5.3%
Expenditure 58,172 51,150 -12.1% 164,162 154,041 -6.2%
Operating profit (EBDITA) 62,864 73,611 17.1% 177,978 206,215 15.9%
EBDITA margin (%) 51.9% 59.0%   52.0% 57.2%  
Other income 4,616 5,619 21.7% 12,367 17,240 39.4%
Interest 170 70 -59.1% 275 147 -46.7%
Depreciation 12,863 20,118 56.4% 44,432 52,999 19.3%
Profit before tax 54,446 59,042 8.4% 145,639 170,310 16.9%
Tax 19,513 20,165 3.3% 53,785 56,861 5.7%
Profit after tax/(loss) 34,933 38,878 11.3% 91,854 113,449 23.5%
Net profit margin (%) 28.9% 31.2%   26.8% 31.5%  
No. of shares (m) 1,425.9 1,425.9   1,425.9 1,425.9  
Diluted earnings per share (Rs)*         106.2  
Price to earnings ratio (x)         11.8  
(*trailing twelve-month earnings)

What is the company's business?
ONGC is the country’s largest oil exploration and production (E&P) company accounting for nearly 90% of India’s proven oil and gas reserves. At the current rate of production, the company accounts for over 80% of oil and gas production. Apart from E&P, the company also produces value-added petroleum products such as LPG, kerosene, naphtha and diesel. While LPG is sold to the PSU marketing companies, a major chunk of naphtha is exported and diesel is used for captive consumption. ONGC also has a 72% stake in MRPL, a stand-alone refinery with a capacity of nearly 9.7 MMT (million metric tonnes). Together with MRPL, ONGC has planned its downstream fuel-retailing venture and has a license to set up nearly 1,600 retail outlets.

What has driven performance in 3QFY06?
Output down, but prices higher: Crude oil production in 3QFY06 was lower by 10.2% YoY and this could be attributed to the fire in July 2005 that engulfed the Bombay High oil field. The company has stated that production has recovered of late and further increases are expected in the next three months. The fire also had a negative impact on natural gas volumes (down 2% YoY in 3QFY06). For the first nine months of the fiscal year, while crude oil production was down 8% YoY, natural gas volumes were marginally lower (2% YoY). But firm crude prices have enabled ONGC to report a 3% YoY growth in sales in 3QFY06. But if one excludes the subsidy share of ONGC at the topline level in both the quarters, sales growth is higher at 14% YoY.

Subsidy subdues margins: While operating margins have improved significantly in 3QFY06 and 9mFY06, margins could have been higher but for the higher subsidy share. The subsidy burden was Rs 85 bn in 9mFY06 (19% of sales) as compared to Rs 31 bn (9% of sales) in the corresponding period last year. Margins were also suppressed owing to fact that the Bombay High field is not operating at full capacity for reasons mentioned earlier.

Segmental contribution…
(Rs m) 3QFY05 3QFY06 Change 9mFY05 9mFY06 Change
Offshore 84,460 94,962 12.4% 235,466 261,587 11.1%
EBIT margin 54.6% 51.8%   52.0% 53.9%  
Onshore 38,984 34,203 -12.3% 113,022 107,405 -5.0%
EBIT margin 17.2% 26.0%   16.1% 21.3%  
Overall EBIT margin 42.7% 45.0%   40.3% 44.4%  

Net profit growth slows: Even though depreciation charges increased by 56% YoY in 3QFY06, the net profit growth of 11% YoY is commendable considering the production disruptions and higher subsidy sharing. To put things in perspective, the profit before tax could have been higher by 44% YoY but for the subsidy share. As is evident from the graph, the topline growth has slowed down substantially since 3QFY05, which we expect to recover as production in the Bombay High field gathers momentum. Despite this and the higher subsidy share, operating margins have been on an uptrend and considering the firm price scenario, we expect margins to remain firm in the near term.

What to expect?
At Rs 1,248, the stock is trading at a price to earnings multiple of 11.8 times trailing twelve-month earnings. We believe that there is a need to upgrade our earnings estimate for FY06 and beyond. We also expect a stronger performance on a consolidated basis (considering the fact that production in the Sakhalin field has already started in October 2005 and ONGC's share of production in the first three months stands at 0.15 MT). We suggest a HOLD on the stock.

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