Raising target price and estimates

We are raising FY08-09 estimates by 19- 25% on the back of sustained strength in the refining cycle and reduced chances of subsidy burden. Introducing FY10E. The new target of Rs 360 is based on EV/EBITDA of 5.5x mid-FY09E, at the high end of its historical trading range but at a meaningful discount to peers (6.0-7.0x). Dividend yield of 5.6% provides downside support.

Robust 1Q reaffirms leverage

Company reported PAT of Rs 3.23 billion (EPS of Rs 21.7) during the quarter, slightly higher than expected but expectedly strong due to recent strength in GRMs. Reported GRM of USD 8.8/bbl was in-line with Singapore complex GRMs of USD 9.6/bbl. Adjusting for the subsidy payouts, CPCL has broadly tracked Singapore GRMs, apart from certain one-off quarters.

Sustained refining cycle to drive re-rating

New estimates are based on GRM of USD 6.5/bbl in FY08E and USD 6.0/bl in FY09E, though the gains are offset partially by the stronger rupee. We do not expect pure refiners to be included in the subsidy net as 1) duty protection is down to 1% and 2) major contribution from RIL’s refinery is unlikely given its EOU status now.

Replacement cost analysis suggests further hidden value

On a conservative EV/complexity bbl of USD 1500 (against replacement cost of USD 2000 and RIL/RPL’s current multiples of USD 1900-2200), CPCL could be worth Rs 490, 36% premium to target. The steep discount to replacement cost largely offsets the risks from a potential merger with IOC in the long term. Significant strategic stake (15%) of Iranian entity will likely block any merger moves near term.

Investment thesis

We maintain our Buy/Low Risk (1L) rating on CPCL with a target price of Rs 360. CPCL looks well positioned to capitalize on the sustained upturn in refining margins. In this context, CPCL's capacity expansion by 40% (up from 7.5MTPA to 10.5MTPA) and increased complexity appear timely. The company has improved its distillate yield and its heavy crude processing capacity now compares favorably with peers. Meanwhile, gross refining margins (GRMs) in the Asia-Pacific region have been on an uptrend, driven by strong demand growth from countries like China and India, and supply constraints due to years of underinvestment. Pure refiners have been relieved from bearing the marketing losses on cooking fuels. Though subsidy sharing, if re-introduced, is likely to remain within manageable limits, especially in relation to the strong GRMs, it would cap the upside potential in the stock from present levels. IOC has also been contemplating a merger of CPCL with itself. Any move toward a merger with IOC could impact the stock performance adversely.

Valuation

Our target price of Rs 360 is based on an EV/EBITDA of 5.5x mid-FY09E, meaningful discount to RIL/RPL (6.5-7.0x) to factor in smaller size, public sector status, risk of subsidies (though low in our opinion), and potential risk of merger with IOC. We base our valuation on the mid-point of FY08-09E to capture part of the decline in refining margins that we assume going forward. Though the target EV/EBITDA multiple is at the higher end of the company’s past five-year historical trading band of 2.0x-5.5x, we believe it is justified by the sustained strength in the refining outlook over next 3 years. While valuing the Indian refining and marketing companies, we tend to use EV/EBITDA numbers to compare companies across the regions, thereby avoiding the differences in accounting policies on depreciation and taxation. On conservative assumptions of EV/complexity bbl of USD 1500 (25% discount to the prevailing replacement cost), CPCL could be worth Rs 490 i.e. 36% premium to our target price. This coupled with dividend yield of 5.6% (FY08E) indicates the extent of hidden value in the stock.