Hindustan Petroleum - Hostage to policy reforms

Government policy on subsidy sharing remains ad-hoc, while declining refining margins pose an additional risk to HPCL's profits. We lower our target price to Rs250 (from Rs380) and downgrade from Buy to Hold.

1QFY09 results: impact of rising oil prices
HPCL reported 1QFY09 net loss of Rs8.8bn largely on higher net under-recoveries of Rs27.6bn and one-off provision of Rs1.6bn for staff costs. Inventory gains boosted refinery margins as well as marketing profits. We now forecast a steep fall in under-recoveries in subsequent quarters on declining crude prices, lower GRMs (gross refining margins) and full impact of price hike/duty cuts implemented on 4 June 2008.

Limited visibility on earnings
Final oil bonds quantum in FY08 turned out to be much lower than initial indications given by the government. The subsidy package for FY09 has been announced and it assumes gross underrecoveries of Rs2035bn, but there is no clarity on what adjustments will be made if actual underrecovery is higher or lower than this figure. Liquidity at least is no longer an issue, given that the central bank is now willing to absorb oil bonds and provide forex for crude imports. We estimate that Singapore GRMs will weaken (though HPCL's GRMs may benefit from the implementation of its modernisation capex) and that under-recoveries will drop in FY10-11 due to lower oil prices. Net net, we have cut our FY09-10 EPS by 18-45%.

Downgraded to Hold, clarity after next elections?
Our earlier positive view was based on expectations that the subsidy package the government announced in February 2008 would be maintained. These expectations have been belied and there is no firm policy on future subsidy sharing. Short-term, HPCL's share price is likely to be correlated with global oil prices. However, longer-term earnings and valuations are unlikely to improve unless there is clarity on government policy, and we believe this is unlikely till the term of the current government ends in May 2009. The government has appointed a high-powered committee to look at the subsidy issue and its final report is expected soon. There is an outside chance that the government provides policy clarity based on this report. We downgrade the stock from Sell to Hold and cut our target price from Rs380 (1.1x FY09F P/B) to Rs250 (0.7x FY09F P/B on 7% ROE) to reflect higher government policy risk.