Elixir Securities Limited – Elixir Insight

Karachi, June 14, 2018 (PPI-OT): Pakistan State Oil Company Limited – Upwards Revision in LNG Margins to Raise Earnings

We update our investment case for PSO, revising up FY18/19 EPS by 15/18% largely owing to upward revision in LNG margins; we also roll-forward our PT to Jun-19 which now stands at PKR375/share (from PKR369/share) incorporating changes in margins and higher risk free rate assumption.

Owing to regulatory risk of revision in OMCs margins and deregulation of retail fuel prices, we haveassumed upward revision in margins based on 50% of CPI through the investment horizon. Certainty with regards to long term policy outlook on CPI linkage can significantly improve earnings profile and valuations.

The stock trades at cheap FY18F/FY19F PE of 6.2x/6.1x and offers decent FY19F dividend yield of 6.6%. We have a Buy stance on the scrip as it offers capital/total upside of 13%/20% where we maintain liking for the scrip due to improved earnings profile and potential reduction in circular debt (post IMF Program entry) unlocking its value.

Upside/Downside Risks Hang in Balance: We update our investment case for Pakistan State Oil (PSO), incorporating 1) revised up OMC margins for Motor Spirit (MS), High Speed Diesel (HSD) and Liquefied Natural Gas (LNG) and 2) increase in risk free-rate assumption to 9% from 8.5% due to higher interest rate projections on rising inflationary expectations on account of recent and expected spurts of PKR/USD depreciation. Finally, we have also rolled forward our Price Target to Jun-19, increasing the PT for the stock by 2% to PKR375/share from PKR369/share previously.

Increase in OMC Margins Largely In-line with Assumptions: The government has approved 3.5%/9.5% increase in margins for MS/HSD to PKR2.64/liter each for FY19 from PKR2.55/PKR2.41 per liter. The greater increase in HSD margin is attributable to no change in its margin in Oct-17 as it was deregulated. However given the loss of profits due to unenforced deregulation, the government decided to keep it at par with MS till GST recovery mechanism is finalized. This OMC margin for retail fuels was in line with our expectation of PKR2.65/liter. Going forward, owing to regulatory risk of revision in OMCs margins in line with CPI inflation and deregulation of retail fuel prices, we have continued to assume upward revision in margins based on 50% of CPI inflation throughout the investment horizon. Certainty with regards to long term policy outlook on CPI linkage can significantly improve earnings profile and valuations.

LNG Profits to Increase but Business Continuity Remains in Question: LNG margins saw a 50% increase to 3.75% from 2.5% earlier as Ministry of Energy sought increase due to FBR refusing to withdraw 1% withholding tax on import stage. We estimate it to raise EPS for PSO by PKR8.75 (for 600mmcfd volumes) for FY19F with the post-tax earnings growth in LNG core profits expected to stand at 83% compared with 50% growth in PBT due to no change in absolute amount in tax rate.

While this move comes as a huge positive for PSO’s near term earnings, the fate of LNG business staying with PSO remains in question as the government plans to shift this business eventually to PLL; thus we have assumed that this business shall transfer to Pakistan LNG Limited (PLL) after Dec-19. Resultantly, the incremental earnings impact does not translate into significant increase in valuations.

Valuations May Rally On Circular Debt Resolution: PSO trades at cheap FY18F/FY19F PE of 6.2x/6.1x and offers decent FY19F dividend yield of 6.6%. The potential resolution of circular debt (post IMF Program entry in 2H2018) can unlock value resulting in multiple re-rating similar to last seen in a lead up to clearance of circular debt in 2013. Our revised up Jun-19 PT of PKR375/share offers capital/total upside of 13%/20% from last close implying Buy stance.

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