Wednesday, 20 December 2017

Analysing Hengyuan’s discount to Petron

Edge Weekly
Analysing Hengyuan’s discount to Petron
Ben Shane Lim

The Edge Malaysia

December 19, 2017 16:00 pm +08

This article first appeared in The Edge Malaysia Weekly, on December 11, 2017 - December 17, 2017.

THE broader oil and gas industry may be in the doldrums but refiners like Hengyuan Refining Co Bhd and Petron Malaysia Refining & Marketing Bhd have enjoyed a stellar run.

At its close of RM11.28 last Friday, Hengyuan’s share price had shot up 403% year on year while Petron’s share price closed at a near-record high of RM12.46, gaining 205% year on year.

Their share price performance was matched by an equally impressive surge in the earnings of the two companies. Petron’s earnings spiked 144% year on year to RM305.61 million for the nine months ended Sept 30 while Hengyuan saw a 469% year-on-year improvement from a lower base to RM725.67 million.

A key driver of the refiners’ earnings has been better margins arising from improved spreads between crude oil prices and their refined finished products, primarily RON92 and RON95 gasoline or motor gasoline (mogas).

Against this backdrop, it is interesting to note that Hengyuan is priced at a substantial discount to Petron in terms of earnings — only 3.5 times annualised 2017 earnings (9M2017 earnings per share came to RM2.42). In contrast, Petron is being valued at 8.26 times earnings on the same basis.

The difference in valuation is even starker, considering that Hengyuan’s 2Q2017 earnings were weighed down by a RM76 million swing in “other operating gains/(losses)” during the quarter. Adjusted for this, Hengyuan’s historical valuation would be even more attractive.

Of course, there are some major differences between the two companies. The most obvious is the fact that Hengyuan is a pure refinery play while Petron also distributes petrol via several hundred stations in the country.

A less obvious difference is the fact that Hengyuan has kept a relatively low profile since its new major shareholder, China’s Shandong Hengyuan Petrochemical Co, took over Shell Refining Co’s 51% stake late last year.

Channel checks reveal that both fund managers and analysts alike have not been granted meaningful access to management. In contrast to Petron, which is tracked by two local research houses, there is little to no marketing of the stock from the sell-side.

This also means that investors have to rely strictly on Hengyuan’s quarterly financial reports to evaluate its prospects. This can be tricky. Some details, for example, the cause of the RM76 million swing, were not explained in the 2Q2017 report.

Furthermore, it would be difficult to anticipate the company’s capital expenditure plans. Recall that one of the key reasons oil major Shell exited the market was its reluctance to invest additional capex in expanding, reconstructing and upgrading Hengyuan’s refining capacity.

Hengyuan has broadly indicated that it plans to upgrade existing facilities to meet Euro 4 and Euro 5 fuel standards. In its quarterly financial reports, Hengyuan states that it has capital commitments totalling RM790.07 million, 24.1% of which has been contracted while the balance has not.

What is not clear, however, is the timeline for the capital expenditure.

The good news is that Hengyuan has lots of cash — RM897.77 million as at Sept 30, which was more than double its cash holding a year ago. However, the group also carries a lot of debt — RM1.31 billion in total. While net gearing has improved to a healthy 9.87% from 34.47% last year, aggressive capital expenditure could put pressure on the group’s balance sheet.

Nevertheless, the company has not been paying dividends, which gives its capex plans more leverage and reduces the need for a cash call.

In contrast, Petron is now a zero-debt company with RM113.64 million cash on its books or 42 sen per share. Generating RM320 million in net cash from operating activities and with no debts to service, Petron is in a much better position to pay dividends. The group only had capital commitments of RM170 million as at Sept 30.

Better earnings in 4Q

While Petron’s balance sheet may look stronger, Hengyuan boasts better gross and net margins of 14.5% and 12.2% respectively. Petron’s net and gross margins in the third quarter were 8.5% and 4.14%.

Again, without further elaboration from management, it is difficult to ascertain why Hengyuan has been able to enjoy such good margins compared with Petron.

In its latest financial report, Hengyuan attributes the better margins to “an unforeseen spike in the average price of market-traded refined products, following unplanned production outages caused by hurricanes in the Gulf of Mexico and a fire incident reported in a world-scale European refinery”.

The group notes that revenue was further boosted by a 600,000 barrel increase in sales (from the previous year) during the quarter. Unlike Petron, however, Hengyuan does not disclose exact sales volume each quarter.

Coupled with big fluctuations in the US dollar and ringgit exchange rate and the steady uptick in crude oil prices this year, it is difficult to ascertain what is driving Hengyuan’s margins.

Sure, mogas spreads picked up in the second half of the year. Bloomberg data shows that the Singapore Mogas 92 ICE Brent Crack Spread for December expanded to US$9.885 per barrel last week, about 65% higher than the two-year average of six points. The index is an indication of the spread between crude oil prices and refined mogas, a general indicator of refiners’ margins.

Based on forward indices, however, the spreads are expected to peak in the fourth quarter. The 2Q2018 forwards show spreads easing 11.6% to US$8.9 per barrel.

In other words, both Petron and Hengyuan can expect better margins in the fourth quarter. However, margins should begin to normalise next year, although they will remain higher than this year’s.

This, of course, assumes that foreign exchange movements do not distort the companies’ earnings. Both employ a myriad of hedging and derivative instruments to protect themselves from forex movements.

As the dollar weakened against the ringgit, Hengyuan booked a RM67.3 million realised forex loss in the third quarter (and a RM17.8 million unrealised forex gain). In contrast, Petron only booked a RM6.5 million realised forex loss in the same period.

Another difference between the two companies is that Petron is also an exporter while Hengyuan is focused purely on the domestic market. About 9% of Petron’s revenue comes from exports.

Adding to the forex conundrum is the fact that the bulk of Hengyuan’s debt is denominated in US dollars — two separate term loans of US$350 million, some US$200 million of which has to be repaid (or refinanced) by 2022 while the balance will be run until 2024.

In the final analysis, it may be justified that Hengyuan is valued at a discount to Petron. However, the discount may be a little deep at the moment, approaching the low single digits. Barring unforeseen circumstances, Hengyuan could be considered Petron’s cheaper peer.

That said, the outlook for both companies is not without risk, given the difficulty in anticipating what crude oil price volatility will do to spreads going forward.

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