CFA Institute Research Challenge hosted by CFA Society of Pakistan Institute of Business Administration – Karachi CFA Institute Research Challenge 2015-16 Institute of Business Administration (IBA) – Student Research This report is published for educational purposes only by [Oil & Gas Sector, Oil Marketing Company] Students competing in The CFA Institute Research Challenge. Pakistan Stock Exchange (PSX) Pakistan State Oil Date: 11/01/16 Current Price: 321.27 PKR/share Recommendation: BUY (33% upside) Ticker: PSO (PSX) Ticker: PSO PA (Bloomberg) PKR/USD: 105 Target Price: 428 PKR/share (4.08 USD) Market Profile Closing price (PKR) 321.27 PSO: Proxy for Pakistan’s economic revival 52-week price 283.75 - range (PKR) 415.40 We issue a BUY recommendation on Pakistan State Oil (PSO) with a one-year target price of PKR 428 using the Discounted Average daily Free Cash Flow to Firm (FCFF) and Relative Valuation Method. This offers a 33% upside from its closing price of PKR 321 volume (12M) 919,134 on January 11, 2016. PSO is one of the biggest and most liquid blue-chips on KSE with average daily volume being 0.34% As a % of shares of shares outstanding. Our investment thesis is based on PSO’s earnings growth, backed by volumes growth, outstanding 0.34% improving operating cash flows, and being a cheap blue-chip asset. PSO’s earnings growth is primarily driven by its volumetric sales growth during FY16-21 (CAGR: 12%) due to a changing energy mix, lower financing costs which will Dividend yield reduce over the years due to lower borrowings and positive operating cash flows. (2015) 3% Shares PSO, as the national fuel supplier, is key in Pakistan’s economic revival in the coming years. Economic growth depends outstanding 271.69 primarily on self-sufficiency in energy, which we expect to be achieved through upcoming projects of gas, coal and Free-float shares nuclear, along with resolution of circular debt. PSO has a pivotal role to play in Pakistan’s changing energy mix through (mn) 126.19 its captive role in LNG supplies which will constitute 55% of PSO’s sales by 2020-21. In addition, PSO will be the main Market beneficiary of circular debt resolution, as PSO’s books contain 45% of the total CD (in FY15). capitalization 87 B Robust earnings growth … P/E 8.28 Earnings growth will stem primarily from rising volumes of retail fuels: Motor Gasoline (MOGAS) with a CAGR of 11%, P/BV 0.95 along with modest growth in High Speed Diesel (HSD) with a CAGR of 2.5%. We project strong earnings CAGR of 20% ROE 11.6% during FY16E-FY21E, as compared to 19% CAGR during FY10-14, due to introduction of LNG in PSO’s product mix. Finance cost as a % of operating profit will decline to 41.5% in FY16, as compared to 48.6% in FY15. This will further reduce to Figure 1: Team estimates, SCS trade 17% in FY18E-21E on back of repayment of short term borrowings as the company receives proceeds from retirement of PIB investments. …….Coming from Volumes growth driven by MOGAS, HSD and LNG MOGAS and HSD sales will be driven by consumer demand, favorable macros as IMF expects GDP growth rate to increase Valuation DCF Multiples in our forecast period, increase in economic activity due to CPEC, along with auto sales and unavailability of CNG. However, Estimated the decline in FO sales in PSO’s book (CAGR: -15%) will be offset by the increase in LNG sales (CAGR: 89%). The decline price (PKR) 438 417 in FO based electricity generation is due to the favorable energy generation mix, with a shift towards cheaper fuels, like Weights 50% 50% gas and coal. Furthermore, we expect PSO’s market share in all its products to remain the same, as it will continue to be Final price the dominant market player due to its largest storage capacity and vast retail network, along with fuel contracts with (with major government entities. inventory 427.86 gains/losses) Improving operating cash flows due to resolution of circular debt We expect PSO’s operating cash flows to improve and remain positive in FY 2016-21. Operating cash flows as a % of operating profit increased to 35% in FY16, from -88% in FY15. Improving cash flows are aided by a reduction in power sector receivables on PSO’s books, which we believe is key for materialization of power projects under CPEC and for successful implementation of IMF conditions. Furthermore, reduction in oil prices in 2016 and slight increase thereafter, will make the payments affordable for the Independent Power Producers (IPPs) and a shift in energy mix from expensive fuels like FO, to cheaper fuels like LNG will ensure that PSO has less receivables from power sector. There will be slight receivables build-up from LNG, as the government will be stringent on the LNG deals, due to restrictions placed by international dealers like Qatar. Attractive valuation with P/E multiple converging to the market multiple We have derived an attractive valuation of this cheap asset, with a target price of PKR 428 and an upside of 45%. We expect that in future, PSO’s stock is going to converge to the market multiple of 9.0x due to extraordinary earnings growth and improvement in risk profile. We foresee earnings growth to make market sentiments positive which will drive multiple reiterating. Main risks to valuation include: build-up of circular debt, rupee devaluation, volatility in oil prices, decrease in OMC margins, increase in interest rates and threat to PSO’s market share from new entrants. 1 CFA Institute Research Challenge 2015-16 Business Description PSO's Strategic Investments Operating as a key player in Pakistan’s changing energy mix and being the nation’s biggest fuel supplier, Pakistan State Oil (PSO) is a state owned entity having dominant market share in POL Volumes of 56.8%. The company is involved in 12% downstream oil business of storage, distribution and marketing of various POL products, comprising majorly of MOGAS, 22% Furnace Oil (FO), and HSD, LNG, aviation fuel and lubricants. For the past 40 years, PSO has managed to establish reliable 62% strategic partnerships with local customers and international suppliers. Currently, PSO has medium term contracts with various international suppliers such as Kuwait Petroleum and strategic investments in five local ventures: 62% Joint Installation of OMCs, 49% in Asia Petroleum, 22.5% in PRL, 22% in Pak Greece Manufacturing Company, 12% in PARCO 22.50% White Oil Pipeline project. PSO’s competitive edge of oil infrastructure – PSO enjoys competitive advantage through its large customer base (3 million customers on daily basis), wide retail network of 3500 retail outlets, extensive storage capacity of over 1 million tons 49% (74% of total storage capacity), 155 convenience stores (shop stops), 1786 New Vision Retail Outlets (NVROs), 24 Mobile quality testing units, 11 refueling facilities (9 at airports and 2 at seaports respectively), Unique Satellite tracking system Joint Inst. Asia Petroleum (enabling monitoring of road movement). PSO’s largest storage capacity enables it to earn commission through lending it to PRL Pak-Greece small players. Product Mix FY15 PSO’s product mix – PSO’s competitive advantage enables it to be the leading market player in most of the POL products. As of 2015, PSO has 67% market share in FO, 50% in HSD, 47% in Motor Gas, 100% in LNG, 50% in aviation fuel and 24% in lubricants. These products are majorly consumed by transport, power sectors and industry. The demand drivers for PSO sales Mogas are consumer demand, POL prices derived from international oil prices, auto sales, and energy mix and business activity. 18% Being a national entity, PSO is busy in meeting total energy demand of country, but due to shortfall in supply from local refineries; the company has had to resort to import of both white and black oil in the past years. As of 2015, PSO purchased Furnace Oil a total of 12.627 Million Metric Tons (MMT) out of which it imported 9.8 MMT while the rest of 2.83 MMT was met by 49% refineries. HSD PSO’s Shareholding Pattern- PSO is a Government owned entity with maximum shareholding of 40% held by Federal 29% Government, NIT & ICP (25.51% and 15.60%). The other shareholders include Modaraba companies & Mutual funds, Individuals, Foreign Investors, Insurance Companies, Financial Institutions and Banks, Public Sector companies, and others. Current strategy of the company can be summed up under four main pillars: Product Mix FY21 Network Expansion- In order to improve and retain customer experience, PSO is working towards updating 1000+ retail outlets under its New Retail Vision. Under this strategy, the company will now provide premium services to its customers, as Furnac these outlets will encompass state of the art, latest machinery, updated technology and customer friendly staff. e Oil 9% HSD Backward Vertical Integration- According to one strategic objective i.e. Continue to create upstream synergy and evaluate 18% diversification opportunities for growth, PSO is trying to get involved into backward vertical integration by acquiring Pakistan Refinery Limited. In FY 2015, PSO owned 22.5% shares of PRL but according to its Annual Report 2015, the company is trying LNG to increase its ownership in this strategic venture by 55%. 54% Mogas Diversifying sources of Revenues- PSO is a National entity that is involved in almost all downstream oil and gas products, 16% with an annual net income of more than PKR 6.9 billion, the company is constantly trying to improve its efficiency along with increasing its customer base.