Chennai Petroleum: Buy

An optimistic outlook for the refining sector, expected improvement in the company's utilisation levels, and a sharp decline in the stock's price make Chennai Petroleum (CPCL)an attractive buy for investors with a long-term perspective. The stock has been a significant under-performer, losing around 28 per cent since the beginning of the fiscal, compared with the 3 per cent gain in the Sensex.

At its current price of Rs 211, the stock trades at around 23 times its trailing 12-month earnings. However, this multiple is exaggerated due to losses incurred in the March and June quarters last calendar, mainly a result of shutdown-induced under-utilisation. Excluding this (considering that the company is likely to continue on the recent profitability path), the stock trades at around 12.4 times earnings, cheaper than other refining peers such as MRPL and Essar Oil. Also, the current price is at a discount to the company's book value.

Refining margins up

With rising crude oil price, refining margins have seen an uptick in recent times. This is visible in CPCL's gross refining margin (GRM), which has improved from $1.8 per barrel in Q1 2011 to $4.1 in Q2 and further to $5.3 in the December quarter. Positive outlook for crude oil priceshould help refiners across the board, including CPCL. Besides, the company will benefit from its high complexity refineries which should help it capitalise better from increasing differential between light and heavy crude.

CPCL also has the advantage of being a pure refining play and not being subject to the vagaries of under-recoveries and subsidy sharing. The company markets most of its products through its parent company, Indian Oil.

Expected utilisation improvement

CPCL, which has refineries in two locations in Tamil Nadu — at Manali (with the bulk of the capacity) and at Cauvery Basin — has enhanced its installed capacity from 10.5 mmtpa to 11.5 mmtpa. The utilisation rate of the Manali refinery, which had declined in recent times due to upgrade-related shutdowns, is expected to improve. Also, with improved crude oil flows, utilisation levels of the Cauvery Basin refinery should improve.

Besides, CPCL has undertaken various initiatives such as residue upgradation project, auto fuel quality upgradation,and single-point mooring and crude oil terminal project. These projects are expected to improve the company's distillate yields and GRM. In addition, the company has initiated expansion of the refining capacity to 12.1 mmtpa in the near term. Going forward, CPCL plans to replace an old 2.8 mmtpa plant at Manali with a 9 mmtpa plant. This should significantly enhance overall capacity.

Improving Financials

CPCL returned to profitability in the Septemberquarter, after showing losses in the first quarter. The recent December quarter saw revenues grow by 22 per cent year-on-year to Rs 8,348 crore, while profits declined close to 30 per cent to Rs 155 crore. However, the fall in profit was mainly due to a tax credit in the previous period, excluding which bottomline growth in the December 2010 quarter would have been around 46 per cent. Operating margin (4.3 per cent) and adjusted net margin (1.9 per cent) too have improved. ROE (annualised) is healthy at around 17 per cent. We expect growth to continue, aided by healthy GRM and improved utilisation.

Reflecting increased reliance on borrowings to fund initiatives, CPCL's debt-to-equity increased to 0.8 times (as of September 2010) from 0.5 levels in 2009. Yet, there may still be headroom for more leverage.

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