Sector Update | 22 January 2018
Oil & Gas
It’s a spade after all!
ONGC to buy government’s stake in HPCL
Since the announcement of the creation of mega oil and gas companies in the last
budget, ONGC’s acquisition of the government’s stake in HPCL has been a trending
subject. Several confusing news articles on the modalities and valuations flooded
the street. ONGC’s following announcement finally calls a spade a spade:
In a cash transaction, ONGC will acquire the government’s entire stake in HPCL
at INR473.97/share, implying 13.7% premium to its six month average price.
SEBI has exempted ONGC from the regulatory requirement of an open offer.
The deal is to be closed by the end of January 2018.
No further regulatory approval is necessary.
Please refer to our report
dated 18 July 2017
Win-win for minority shareholders of both companies
In our report on the potential ONGC-HPCL merger, July 2017, we had ascribed a
valuation of INR350-470/share for the acquisition of HPCL, based on multiple
methodologies. Our target price for HPCL was INR427 then, which we
subsequently raised to INR576 on account of increased efficiencies and better
outlook on refining margins.
Amid lack of significant cost efficiencies/synergies, valuation has been tricky –
the street would ascribe a holding company discount to ONGC's stake in HPCL.
We believe the current purchase price, though below our target price for HPCL,
is a win-win situation for the minority shareholders of both companies. While
ONGC would not be penalized through unwarranted premium, HPCL’s minority
shareholders would continue to benefit from earnings upside in the stock.
Assuming ONGC funds the transaction of INR369b fully through debt, it would
witness an increase of INR30b in its interest cost at 8%. This would decrease its
PAT by INR19b. Against this, acquiring stake in HPCL would add INR16b to its
PAT, an increase of 6% in FY19E PAT.
The impact on return ratios would also be positive, though only 40-60bp. Also,
the street’s concern that ONGC would be a sacrificial goat would vanish.
ONGC would now be able to focus more on its ongoing capex. Recent cost
controls, increase in gas production, and expected increase in gas price
realization aided by spurt in oil prices make ONGC a lucrative investment
candidate. It may also benefit from the upcoming policy initiatives for enhanced
oil recovery. Valuing the stock at 10x average FY19-20E EPS, adjusting for
dividend income and adding value of investments, we reiterate our
Buy
rating
on ONGC with a target of INR234. An increase of USD5/bbl in oil price realization
boosts EPS by ~10%.
We also remain positive on HPCL, although we have been highlighting its high
capex as a reason for concern. We value HPCL using SOTP, valuing refining at 6x
EV/EBITDA, marketing at 8x EV/EBITDA and pipeline at 7.5x EV/EBITDA. We
reiterate our
Buy
rating with a target of INR576.
EPS accretive for ONGC
Remain positive on both names
Motilal Oswal research is available on www.motilaloswal.com/Institutional-Equities, Bloomberg, Thomson Reuters, Factset and S&P Capital.
Investors
2016
advised to refer through important disclosures made at the last page of the Research Report.
are
8 August
Swarnendu Bhushan – Research Analyst
(Swarnendu.Bhushan@MotilalOswal.com); +91 22 6129 1529
Abhinil Dahiwale – Research Analyst
(Abhinil.Dahiwale@motilaloswal.com); +91 22 3980 4309
1

Oil & Gas
Budget 2017: Creation of oil and gas majors, a flashback
Lack of progress with domestic E&P amid rising domestic demand has resulted
in growing import dependence. India imports ~80% of its crude requirements
and ~50% of its gas requirements.
Due to lack of sufficient domestic prospects so far, the emphasis has also been
on faster acquisition of overseas assets. However, Indian companies have faced
several disappointments in the past in terms of severe competition from larger
players across the globe. Much smaller balance sheet of Indian companies
restricts them from taking on larger projects.
For the same reason, the finance minister in the last budget had announced
possible merger of oil and gas PSUs, thereby creating vertically-integrated large
companies. On the one hand, while such consolidation would help result in
lesser earnings volatility, on the other, it would create larger balance sheets,
helping to take on larger projects overseas.
The ongoing consolidation of ONGC and HPCL is the result of the same exercise.
This would further pave the way for similar consolidation in the sector, the
contours of which are not yet clear.
ONGC+HPCL: A good strategy?
Higher oil prices adversely impact refining margins, all other factors remaining
the same, and vice versa. The consolidation would reduce volatility in the
earnings of ONGC to some extent.
ONGC would get access to ~23% market share of petroleum products in the
country. Post deregulation of auto fuels (petrol and diesel), net marketing
margins on auto fuels have expanded from INR0.7-0.8p/liter to INR1.2-1.3/liter,
barring the past few weeks of high crude oil prices. Marketing margins are much
lower than in other countries, as mentioned in our thematic report,
OMCs
finally on the yellow brick road,
September 2017. We believe that as marketing
margins improve, so would the profitability of the consolidated entity.
HPCL has had little presence in upstream and the consolidation would not really
bring any operational synergies in this regard.
On a standalone basis, HPCL is likely to generate negative free cash flow of
INR82b in FY18-20E. We believe that access to a larger balance sheet of ONGC
would help it in funding its projects properly.
ONGC has already gained some expertise in the petrochemicals segment
through commissioning of ONGC Petro Additions Limited (OPaL). HPCL is also
coming up with petrochemicals projects. The consolidation would help HPCL in
executing those projects well.
22 January 2018
2

Oil & Gas
Exhibit 1:
Synergies for ONGC+HPCL
Reduced
volatility
of earnings
Better equipped
to take on
private players in
marketing of
auto fuels
ONGC+HPCL
Larger balance
sheet would
help HPCL fund
larger projects
Better
equipped to
take larger
E&P projects
overseas
ONGC's
expertise in
petrochem
would help in
executing future
projects of HPCL
Source: Company, MOSL
FCFF of HPCL expected to
remain –ve during FY18-20;
access to larger balance
sheet of ONGC would help
HPCL with better funding of
its projects
Exhibit 2: Free cash flow of HPCL (consolidated)
INR m
PAT
Depr
Capex
Others (Bhatinda/MRPL)
FCFF excld working cap changes
FY18E
68,534
27,392
109,090
10,000
-13,163
FY19E
FY20E
79,765
79,994
28,214
28,214
109,090
175,690
10,000
10,000
-1,111
-67,482
Source: Company, MOSL
Calling a spade a spade
In our report on the potential
ONGC-HPCL merger,
July 2017, we had analyzed
various methods of valuing HPCL. We concluded a valuation of INR350-
470/share for the acquisition based on multiple methodologies. We had
increased our valuation of HPCL to INR576 subsequently, on account of
increased efficiencies and better outlook on refining margins.
Amid news articles mentioning 9-70% premium for valuing the government’s
stake in HPCL, the street was concerned that a large premium would be a
double whammy for ONGC – the street would ascribe a holding company
discount for ONGC’s stake in HPCL.
However, the current valuation of INR473.97/share reduces the leakage to
INR11b only.
We also estimate that there would be an improvement in the return ratios of
ONGC, although limited.
22 January 2018
3

Oil & Gas
Exhibit 3: Value leakage was a concern
No significant change in
valuation of ONGC
Remarks
HPCL's 6m average stock price
Assumed premium (%)
Outflow from ONGC (INR b)
Our target price for HPCL
(INR/share)
Our target market cap for HPCL
(INR b)
Holding company discount (%)
Our valuation of ONGC's stake
in HPCL (INR b)
Value leakage (INR b)
417
70
559
576
888
20
363
196
Leakage reduces to INR6b at current valuation,
hence no significant change in valuation of ONGC
Source: Company, MOSL
News articles suggested 9-70% premium
Exhibit 4: Improvement in return ratios of ONGC
ONGC pre-merger
EBIT (INRb)
PAT (INRb)
Shareholder equity (INRb)
Capital employed (INRb)
ROE (%)
ROCE (%)
ONGC post-merger
EBIT (INRb)
PAT (INRb)
Shareholder equity (INRb)
Capital employed (INRb)
ROE (%)
ROCE (%)
FY18E
377
246
2,298
3,084
10.9
9.5
448
267
2,388
3,291
11.6
10.8
FY19E
468
300
2,403
3,255
12.8
10.7
562
320
2,600
3,581
13.1
11.5
FY20E
479
313
2,513
3,571
12.7
10.5
579
329
2,817
4,015
12.6
10.9
Source: Company, MOSL
Exhibit 5: Improvement in EPS of ONGC
Acquisition cost (INRb)
Rise in debt if fully funded through debt
Rise in interest cost at 8% interest
Decrease in PAT (INRb)
Increase in PAT due to stake purchase (INRb)
Net increase in PAT (INRb)
% increase in EPS (INRb)
369
369
30
19
35
16
6
Will a merger eventually happen? We believe so.
Currently, the government has clarified that HPCL would remain a Central Public
Sector Enterprise. It is likely to remain listed as just another subsidiary of ONGC,
like MRPL. However, we see a possibility of merger, eventually.
So far, we have not witnessed any major onslaught from private players in
petroleum marketing. However, India is away from both crude producing
countries as well as import markets of refined products. Private players would
eventually find it difficult to compete with players in the Middle East amid
decreasing need of imports with rising domestic refining capacities there.
With much better refining margins, private players may pose a threat to the
dominance of the Oil Marketing Companies (OMCs) if they focus on Indian
markets to maintain high utilization of their refining assets. In that case, they
may offer discounts and threaten marketing margins of the OMCs.
22 January 2018
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Oil & Gas
A merger of HPCL with ONGC would give the merged entity a much better ability
to survive in such a scenario.
Will valuations of either company change? We do not think so.
There is no reason for change in valuation of HPCL. We continue to value the
company using SOTP. Valuing refining at 6x EV/EBITDA, marketing at 8x
EV/EBITDA and pipeline at 7.5x EV/EBITDA, we value HPCL at INR576 and
reiterate our
Buy
recommendation on the stock.
There was still some expectation on the street that an open offer could
come. In absence of the same, there could be some negative reaction.
However, we believe this should be viewed as a buying opportunity in the
stock.
We value ONGC at 10x average FY19-20E EPS adjusted for other income. For
investments in listed entities, we use a holding company discount of 20%. As per
our calculation (refer following exhibit), we don’t see any change in valuation for
ONGC.
Exhibit 5: No change in ONGC’s valuation
Outflow from ONGC (INRb)
Our target price for HPCL (INR/share)
Our target market cap for HPCL (INRb)
Holding company discount (%)
Our valuation of ONGC's stake in HPCL (INRb)
Value leakage (INRb)
Value leakage (INR/share)
Value
369.2
576
888.2
20
363.2
6
0.5
Source: Company, MOSL
22 January 2018
5

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22 January 2018
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