Indian Oil Corporation - Tougher environment ahead

Government policy on subsidy sharing remains ad hoc, while declining refining margins pose an additional risk to IOC's profits. We lower our P/B-based target price to Rs450 (from Rs680) and downgrade from Buy to Hold.

1QFY09 results: impact of rising oil prices
IOC reported 1QFY09 net profit of Rs4.15bn, largely on higher net under-recoveries of Rs73.2bn on retail products and a one-off Rs9.2bn provision for staff costs. Inventory gains boosted refinery margins and marketing profits. We now forecast a steep fall in under-recoveries in subsequent quarters as a result of declining crude prices, lower gross refining margins (GRMs) and the full impact of price hikes/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 Rs2,035bn, 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 the central bank is now willing to absorb oil bonds and provide forex for crude imports. We estimate GRMs will weaken and assume under-recoveries will drop in FY10-11 due to lower oil prices. Net/net, we have cut our FY09-10 EPS forecasts by 29-30%.

Downgraded to Hold; clarity after next elections?
Our previous positive view was based on our expectations that the subsidy package announced in February 2008 would be maintained. These expectations have been belied and there is no firm policy on future subsidy sharing. Short term, IOC's share price is likely to correlate 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 next election (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 of the government providing policy clarity based on this report. We downgrade our rating on IOC from Sell to Hold. We continue to value IOC's holdings in ONGC/GAIL (Rs118/IOC share) separately. Valuation for the core business is now down to 0.9x FY09F P/B (11% ROE) from 1.3x FY09F P/B earlier.