Equity Analysis /

Pakistan State Oil: Easing cash-flow concerns amid improved earnings outlook; Buy

    Ahmed Raza
    Ahmed Raza

    Investment Analyst

    Intermarket Securities
    16 May 2019
    • We resume coverage on PSO with a Buy rating and Jun’20 TP of PKR230/sh. We believe PSO will see a considerable improvement in cash flows ahead of (i) an IMF program and power sector reforms, (ii) two more tranches of GoP Sukuk, and (iii) the inevitable phase-out of furnace oil. This in turn will help in ramping up cash for both inorganic growth opportunities and better payout regime in the medium term.
    • Additionally, near-term earnings are expected to recover strongly. In 4QFY19, seasonal uptick in FO sales and potentially large inventory gains should boost the bottom-line. Another positive trigger will be the revision in CPI-linked OMC margins by Jul’19 (assuming no delays). 
    • Recent poor earnings spell, market share decline and worsening circular debt, have together de-rated the stock significantly – trading at a FY20f P/E of 5.8x. But the market is presently overlooking the meaningful reduction in FO related receivables and the near-term turnaround in earnings and payout, in our view. 

    Resume coverage with Buy on improved cash-flows

    We resume coverage on Pakistan State Oil (PSO) with a Buy rating and Jun’20 TP of PKR230/sh. Our liking for PSO is based on an improving cash-flow situation and strong earnings outlook from 4QFY19 onwards. Pakistan’s entry into another IMF program, which has led to high-impact energy sector reforms in the past, elicits optimism that future buildup of circular debt will be limited (as during the 2013-16 EFF program). There is already the planned power tariff hikes, which may later be followed by privatization of discos, in our view. Additionally, GoP has already issued the first tranche of PKR200bn Sukuk in the energy sector, where PSO received a payment of PKR60bn; and it will likely follow up with two more tranches in 2019 to bring circular debt to PKR100bn (from current PKR600bn). For PSO, this will ensure a considerable reduction of the outstanding balance of the debt. We have conservatively built-in one more tranche of PKR200bn with similar payment to PSO.

    Poor earnings spell will reverse 4QFY19 onwards

    PSO posted 9MFY19 NPAT of PKR1,975mn (EPS: PKR15.15/sh), down 55% yoy due to inventory losses, lower volumes (FO in particular) and higher finance costs. However, we expect near-term results are likely to post a strong rebound. Rising petroleum prices (MS/HSD up 17%/10% since Mar’19) will result in potentially large inventory gains during 4QFY19, while FO sales will also recover seasonally due to peak electricity demand. We also estimate another dividend of PKR5/sh as we have built-in another circular debt payment in 4Q. Moreover, CPI-linked OMC margins are due to see an increase from Jul’19 (IMS estimates FY19 CPI to average at 7.5%). This will help to mitigate volumetric decline and market share loss, while also reduce the probability of minimum turnover tax.

    What can PSO do with the additional cash boost?

    While a sharp reduction in working capital is expected, what will PSO do with the additional cash? As a priority, PSO management can turn attention to the retail network and address its losing market share. Then it will invest in Pakistan Refinery (PRL) which is now a subsidiary (shareholding is up from 24% to 53%; will be consolidated post Jun’19). PRL is undertaking a US$1bn expansion and overhauling project as a turnaround strategy. Assuming a debt to equity ratio of 60:40, the share of PSO’s investment can go up to PKR30bn. Also, we expect payouts will likely improve meaningfully and be more regular (though remain <50%).

    Downside risks have adequate mitigating factors

    PSO’s market share will remain under threat from new players. It is worth noting, however, PSO can overcome the competition with the White oil pipeline project. Also, govt. regulations to require min. PKR6bn of capital investment by new OMCs will substantially dilute the threat, in our view. Another risk to our thesis is the continuous build-up of RLNG based circular debt (via SNGP). This will likely stall amid sharp gas tariff hikes for the Sui utilities (short term, summer based demand will improve their recoveries).

    Risks:(i) Inventory/exchange losses, (ii) slow-down in sales growth, and (iii) buildup in circular debt.