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Oil stocks: What to look at?

Oct 4, 2004

Following a previous article regarding the impact of high crude oil prices on the companies across the value chain of the energy sector, we believe that investors need to look beyond the price to earnings multiple to have a clear view of the most efficient company from a long-term perspective. Although all oil companies have been able to sustain such pressure in the past, with competition from the private players round the corner, times are likely to be tough going forward. In this article, we have analyzed IOC, HPCL and BPCL on the three parameters to see how strong the performance has been over the past five years. Let us study each parameter in detail.

Return on Assets (ROA): Knowing that these companies are ‘asset rich’ (with more than 50% of the domestic refining capacity and almost 100% of retail outlets), we believe that the ‘return on assets’ parameter would help get a clear view of the companies asset utilization. ROA is a function of Profit margins and Asset Turnover, and therefore any increase or decrease in one of these factors has a direct impact on ROA.

ROA = (EBIT * (1-Tax))/Total Fixed Assets

This can be further classified as ROA = (EBIT*(1-Tax))/Sales * (Sales/Total Fixed Assets)

Here, (EBIT (1-Tax))/Sales = Profit margin, and Sales/Total Fixed Assets = Asset turnover.

The above graph gives a clear indication as to how the oil-marketing majors have been able to lift their performance post deregulation. IOC, which has been an under-performer upto FY02, has been able to improve its performance since FY03 and this is largely due to the company’s diversified business, which includes petrochemicals and oil marketing. Refining business has also witnessed good times off late and IOC is riding high on the same. A closer look at the returns of the three majors suggests that higher the refining capacity (post-deregulation), higher has been the return on assets. This could be attributed to firm product prices in international markets. To put things in perspective, IOC controls nearly 42% of the country’s refining capacity while HPCL controls nearly 10%. On a standalone basis, BPCL’s refining capacity is lower than these two marketing majors (7%).

Return on Net worth (RONW): While ROA indicates the returns earned by a company on its fixed asset investments (including debt and equity funded assets), RONW gives an indication of the returns earned on shareholders’ funds. Over the last two years (post-deregulation), IOC has been able to successfully outperform the other two companies on this parameter. This is, again, due to the company’s well-diversified business model. Any price shock in the upstream segment (crude oil) could be captured at the refining level and thus passed on to the marketing division. Although petroleum product price hikes (at the retail level) were regulated, refining margins kept the profitability intact. Further, the high margin petrochemicals business has also supported the company’s earnings. On the other hand, BPCL’s strong marketing efforts have helped the company to overcome the refining drawback over its peer HPCL, which has been the under-performer among the three on this front.

Price to cash flows (P/CF): In order to value a company, the most usual parameter looked at by investors is the price to earnings ratio (P/E). However, we believe that since these companies are asset rich and need to provide a high depreciation for these capital intensive assets, which face the risk of obsolescence due to technological changes, price to cash flow gives a better perspective of the companies. This is because high depreciation costs often understate the earnings per share thereby making the stock seem expensive at times (on the P/E valuation parameter) when the company is actually expending for future benefits.

(x)FY04FY05*
HPCL 4.4 6.8
BPCL 4.9 9.1
IOC 5.8 6.6
* annualized

Given that the above indicators play a major role in the decision-making process, we would advice investors to also look at other factors like dividend yield, future growth in EPS and revenue growth prospects. From our interaction with these companies, we believe that they are heading in the right direction by way of expanding refining capacities and penetrating newer markets. To put things in perspective, IOC already has its presence in neighbouring countries while BPCL and HPCL are eyeing the Sri Lankan markets. This geographical diversification is likely to help these companies diversify their revenue sources. At the same time, expanding refining capacity would help reduce over-dependence on external sources for products thereby helping improve margins. However, at the current juncture, crude oil prices and government policies regarding pricing of products are a major negative for these companies. Investors need to keep this in mind before investing in these stocks.

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