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ONGC: A risky proposition - Views on News from Equitymaster
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ONGC: A risky proposition
Jul 26, 2006

Performance summary
Exploration and production giant, ONGC, declared its 1QFY07 results. For the quarter ended June 2006, topline and bottomline grew by 34% and 24% respectively (YoY). Operating margins dwindled by 70 basis points due to higher revenue contribution from the trading business (a lower margin business). Lower growth in profitability was primarily on account of higher depreciation charges.

Standalone financial snapshot
(Rs m) 1QFY06 1QFY07 Change
Net sales 108,697 146,028 34.3%
Expenditure 47,646 64,933 36.3%
Operating profit (EBDITA) 61,051 81,094 32.8%
EBDITA margin (%) 56.2% 55.5%
Other income 2,986 4,200 40.7%
Interest 22 33 50.5%
Depreciation 13,517 22,309 65.0%
Profit before tax 50,498 62,952 24.7%
Tax 17,309 21,763 25.7%
Net profit 33,189 41,190 24.1%
Net profit margin (%) 30.5% 28.2%
No. of shares (m) 1,425.9 1,425.9
Diluted Annualised earnings per share (Rs) 23.28 28.89
Price to earnings ratio (x)* 10.7
* Based on trailing twelve months earnings.

What has driven the performance in 1QFY07?
Realisation driven growth: ONGC registered a growth of 34% YoY in its topline during 1QFY07. Crude oil production remained stagnant at 6.48 million metric tonnes (MMTPA) compared to 6.49 MMTPA in 1QFY06. Gas production went up by 1.4% to 5.78 billion cubic metres (BCM) as against 5.70 BCM in the previous quarter. The natural gas sales went up by 3.5% during the quarter from 4.58 BCM to 4.74 BCM. Based on these facts, we conclude that the sales were primarily driven by the increase in realisation (on the sale of crude oil, natural gas and Naphtha).

The graphs here indicate the movement in crude and natural gas prices since 1QFY06. As is known, every US$ 1 per barrel increase in crude prices translates into Rs 9.0 bn of incremental gross revenues for ONGC. Given the fact that the average Brent crude prices are higher by US$ 18 per barrel in 1QFY07 as compared to 1QFY06. The fact that the Rupee has depreciated against the US$ has also helped matters. Given the fact that crude prices are trading firm (in fact, higher on a YoY basis), ONGC is likely to post robust numbers at the gross level for the rest of the fiscal year.

Segmental analysis
Particulars 1QFY06 1QFY07 % change
Offshore revenues 78,328.4 104,388.4 33.3%
Onshore revenues 32,076.0 43,814.4 36.6%
Total 110,404.4 148,202.8 34.2%
Offshore PBIT 45,165.2 58,010.3 28.4%
Onshore PBIT 3,438.4 4,403.9 28.1%
Total 48,603.6 62,414.2 28.4%
Business mix and accounting policies hurts margins: Operating profits during the quarter grew by 33% YoY. Margins declined marginally from 56.2% to 55.5%, due to the change in the business mix of the company. Trading business (margins of less than 1%) increased its share in the net sales from 8.6% to 11.5% during the quarter. However, excluding the trading business, operating margins would have stood at 62.7% as against 61.5% (130 basis point increase). The sales figure of 1QFY06 was inclusive of Value Added Tax (VAT), while for the current quarter (as per the change in the accounting guidelines), the same was excluded while arriving at the sales figure. Thus, if we include the VAT in the current quarter sales, margins would increase by 120 basis points to 57.4%. Subsidy burden for the company during the quarter was Rs 51.2 bn (35% of net sales) as compared to 26.5% of net sales in 1QFY06 resulting in revenue loss. To put things in perspective, the gross billing rate for ONGC during FY06 was US$ 59.66, while the realisation were US$ 42.34 per barrel, thus translating into the discounts of US$ 17.32 per barrel. The subsidy impact on PBT and PAT was as much as Rs 47 bn (32% of the net sales during the quarter).

Expenditure break up…
(%) of sales 1QFY06 1QFY07
Consumption of raw materials 0.3% 0.7%
Purchases(trading) 8.6% 11.5%
Staff cost 2.6% 2.0%
Other expenditure 32.4% 30.3%
Total expenditure as % of sales 43.8% 44.4%

Higher depreciation deflates net profits: Depreciation (contributing 15% of the net sales) increased 65% YoY. ONGC has changed its depreciation policy during the previous fiscal. The rate of depreciation on all trunk pipelines and onshore flow lines (assets below ground) was increased from 27.82% to 100%. Other income during the quarter increased by 41% YoY on the back of strong cash flows.

Performance over the recent past
Particulars 1QFY06 2QFY06 3QFY06 4QFY06 1QFY07
Net Sales growth (%, YoY) 5.60% 7.30% 3.10% -2.10% 34.3%
Operating profits growth (%, YoY) 18.50% 12.50% 17.10% 5.50% 55.5%
Net profits growth (%, YoY) 43.80% 22.30% 11.30% -35.60% 24.1%
Operating profit margins 56.20% 56.40% 59.00% 56.50% 55.5%
*Net profit and net profit growth is based on profit before extraordinary items

What to expect?
At the current market price of Rs 1,138, ONGC’s stock is trading at a price to earnings multiple of 10.7 times trailing twelve months earnings and 2.8 times book value. The board has declared a bonus issue of 1:2 (one share for every two share held), which will further enhance the liquidity of the stock (at the same time, diluting earnings). ONGC has not gained significantly from favorable crude oil prices. Even if crude prices are to soften from here, it is insulated from the same. This is due to the fact that current net realisation of US$ 42.34 per barrel (FY06) is well below the international prices of crude. In fact, if prices soften, the subsidy burden will reduce.

In our view, ONGC’s growth prospects are closely linked to crude prices and government policies, both of which are not predictable. Given the energy needs of the country from a long-term standpoint, ONGC is well placed to service the need (from India as well as through its international presence). But it will continue to be governed by the whims and fancies of the government. At around 4% dividend yield, valuations do not look unreasonable. But the risks associated with the company are on the higher side.

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