HPCL: BUY. HPCL: Refined and polished

Investors with a long-term perspective can buy the stock of public sector oil refiner and marketer HPCL. The company, along with its peer oil marketing companies (OMCs) Indian Oil and BPCL, have not had it this good in years.

The under-recovery monkey is finally off their backs. The rout of crude oil, diesel price decontrol last October and transfer of LPG subsidy to customers’ bank accounts have slashed under-recoveries of the OMCs from selling fuels below cost.

Next, the subsidy sharing mechanism for 2015-16 has been announced, and the OMCs will be fully compensated for the under-recoveries — their burden will be shared between the government and the upstream companies ONGC and Oil India.

The upshot: the borrowings of the OMCs (due to delays in getting government compensation) have come down sharply and so have their interest costs.

This, along with favourable gross refining margin — the difference between the cost of crude oil and the price of the refiners’ products — aided financial performance last year. HPCL’s borrowings reduced by ₹12,000 crore, its interest cost nearly halved and profit rose 58 per cent in 2014-15 to ₹2,733 crore, its highest ever.

In the June 2015 quarter, nil subsidy burden, inventory gains and high gross refining margin of $8.6 a barrel helped the company’s profit shoot up more than 34 times year-on-year. No surprise then that the run-up in the HPCL stock which began in late 2013 continued last year with a gain of 60 per cent. Over the past couple of months though, the stock has lost 20 per cent due to market volatility and concerns over weakening diesel margins.

This though, presents a good entry point for investors. At ₹775, the stock is at about six times the trailing 12-month earnings, lower than the average nine times it traded at in the past five years.

Also, there is good scope for earnings growth. In the near term, diesel refining margins may remain under pressure. But with diesel prices decontrolled, the company could earn higher margins on marketing the fuel.

Among the OMCs, HPCL has the highest marketing-to-refining ratio, that is, it markets much more fuel than it refines. While this made it more vulnerable to higher under-recovery in a controlled price scenario, it works in its favour now with decontrolled diesel prices.

Also, with crude oil unlikely to recover in a hurry from its current lows due to the global supply glut, the OMCs will suffer less fuel losses on refining.

In the long term, in addition to the structural pricing reforms, the significant expansion plans lined up by the company should add to its earnings.

Over the next few years, HPCL intends to invest in excess of ₹20,000 crore to increase the Visakhapatnam refinery capacity from 8.3 million tonnes per annum (mtpa) to 15 mtpa, and the Mumbai refinery capacity from 6.5 mtpa to 9.5 mtpa.

This will help reduce its supply dependence on other players. With debt levels under control, the company is well-positioned to fund the expansion. The nine-mtpa Bathinda refinery joint venture with Mittal Energy, in which HPCL has 49 per cent stake, is expected to turn profitable in a couple of years.

HPCL's current dividend yield is an attractive 3.2 per cent.

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