Stock Review: ESSAR OIL

 

   ESSAR OIL made robust profits in fiscal 2010-11, after years of losses. Its refinery expansion programme, scheduled to be completed by end of this year, will improve margins. Output from Raniganj coal bed methane block will start a steady stream of cash flow. Long-term investors will find value growth in Essar Oil.

BUSINESS:

The company runs a 14 million tonne per annum ( mtpa) petroleum refinery at Vadinar in Gujarat. It has 12 petroleum exploration blocks and five coal-bed methane blocks with estimated 10 trillion cubic feet (tcf) reserves. It runs 1,635 retail outlets and focuses on liquefied petroleum gas and compressed natural gas, besides non-fuel business. It has 50% controlling stake in a refinery in Kenya.

   Essar Oil sells about 60% of its output to domestic oil marketing companies -- Indian Oil, BPCL and HPCL. It exports one-third output and sells the rest to retail consumers. The company is eligible for sales tax deferral benefit worth $1.8 billion by August 2020 and a 7-year income tax holiday under section 80-IB. The ability to collect sales tax without requiring to deposit with the government has enabled the company to post higher refining margins than the one that would be typical for its current configuration.

GROWTH DRIVERS:

The company's refinery expansion will be complete by end of this year. Expansion will increase capacity to 18 mtpa and raise complexity to 11.8 from 6.1. Post expansion, the company will be able to process high sulphur, heavier types of crude oil, which is cheaper, and produce euro IV/V grades of fuels that command premium. It will boost gross refining margins. The company will further raise the capacity to 20 mtpa through debottlenecking by September 2012.

   The company's CBM block at Raniganj will soon begin natural gas production. Currently, at 0.35 million standard cubic metres per day (mmscmd), production is expected to rise to 3.5 mmscmd by FY14-end. The government approved a price of $5.25 per mmbtu plus a $1 per mmbtu as transportation charge for this block. At the current production level, this translates into an annualised turnover of around Rs 130 crore.Gross refining margins cycle has grown steadily after hitting a bottom in December 2009 quarter. During FY12, the GRM is expected to remain steady, if not improve. High oil prices and sales tax benefit that it enjoys will keep its GRM buoyant. Exploratory successes at its E&P blocks could be an added benefit.

FINANCIALS:

Essar Oil posted a net profit of 654 crore in FY11, which was a multi-fold jump from FY10. Prior to that, the company had been making heavy losses and had to undergo the pains of debt restructuring in FY05. Weakness in refining margins cycle meant that the company had to wait for a couple of years after its refinery was commissioned to show a respectable profit figure. The company ended FY11 with debt burden of 13,472 crore, which was more than twice its net worth. However, this debt-to-equity ratio is lowest in the last 10 years. The company paid 1,214 crore -- or nearly twice net profit --as interest cost in FY11.

VALUATION:

The scrip is trading at price-toearnings multiple of 30 based on profits for trailing 12 months, which is significantly higher than peers. However, Essar Oil is in a rampingup phase while all its peers are mature steady players. Essar Oil is expected to report a net profit of about 950 crore for FY12, which discounts the current market price by around 21 times. Considering the rise in profitability, thanks to expansion from FY13 onwards, the premium valuations appear justified. Long-term investors willing to wait for a couple of years will see further value growth in the scrip.

CONCERNS:

The company has time and again witnessed delays in its major projects, which could be a great cause of concern.