Pakistan State Oil. PSO: Pessimism overplayed. WE Detailed Report

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1 1 KEY DATA KATS Code PSO Reuters Code PSO.KA Current Price (Rs) Year High, Low (Rs) , Market Cap (Rs' bn) 49 Market Cap (US$ mn) 496 Shares Outstanding (mn) 247 Free Float (%) 46 Source: KSE & Reuters Volume in ' Jan-12 Feb-12 Mar-12 Apr-12 May-12 Volume Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 PSO Dec-12 Source: KSE & WE Research Pakistan State Oil Jan-13 Feb-13 Mar-13 PKR Price per share PSO: Pessimism overplayed We continue our coverage for Pakistan State Oil with "BUY" recommendation having December'13 target price of Rs 235/share, currently offering an upside of 18%. Our optimism about the stock is mainly derived from surge in absolute margin on the back of stable oil prices along with higher furnace oil (FO) sales expected given the country's increasing dependence on thermal power generation. We admit that company is facing liquidity crunch but it would not hurt the investors from payout wise as company is now issuing bonus shares to compensate cash dividend. Trading at FY13E &FY14E PER of 3.9x and 4.15x respectively with ROE of 20.2% for the period FY13, we estimate stock to provide alpha for investors. The key risks to our thesis include lower International oil prices resulted into severe inventory losses, PKR depreciation by more than 5% annually, lingering circular debt and increase in discount rate. Higher margins and inventory gains to escalate earnings We expect company to post a PAT of Rs 12, 525 million (EPS: Rs 50.71), translating into an impressive increase of 38% compared to PAT of Rs 9,056 million (EPS: Rs 36.67) in CY11. Healthy earnings growth on YoY basis during FY13 is expected owing to improved product margins on HSD & MS, rise in product prices which would translate into inventory gains of around Rs 1,670 million (after tax) in FY13, lower exchange losses and fall in financing cost. Amid flattish YoY volumes expected, gross profit to surge 12.6% YoY, primarily driven by inventory gains coupled with higher absolute margins. PSO Financial Snapshot FY12A FY13E FY14F FY15F Net Sales (Rs mn) 1,024,424 1,085,414 1,144,971 1,208,414 Gross Profit (Rs mn) 34,323 38,638 36,418 37,858 Profit after Taxation (Rs mn) 9,056 12,525 11,831 13,542 EPS ( Rs) Book Value (Rs/share) DPS (Rs) P/E (x) P/BV(x) Dividend Yield (%) Payout (%) ROE (%) ROA (%) Source: Company Reports & WE Research WE RESEARCH IS AVAILABLE ON THOMSON REUTERS, BLOOMBERG, S & P CAPITAL IQ

2 2 Valuation: BUY with a Target Price of Rs 235 We have estimated a target price of Rs 235/share for PSO using DCF based valuation method. A discount rate of 18%, comprised of 12% risk free rate, 5.5% equity risk premium and a beta of 1.1 is used. The risk free rate is based on the secondary market yield on 10 year PIBs. PSO provides an upside of 31% to our DCF based December end 13 target price worth of Rs 235/share. Discounted Cashflow Model Trading at FY13E &FY14E PER of 3.9x and 4.1x respectively, PSO appears to be the cheapest stock on relative valuations basis with industry average PER of 6.2x. Rs in million FY13E FY14F FY15F Net Income 12,525 11,831 13,542 Non- Cash expenses 1,232 1,263 1,365 Change in working cap (5,183) (6,764) (5,629) Capex (1,433) (1,190) (1,262) Free Cash Flow to Equity 7,141 5,140 8,017 Discounted Free Cash Flow 7,141 4,731 6,253 Terminal Value 51,050 PV Terminal Value 39,818 Shares Outstanding Target Price Dec'13 (Rs) 235 Source: WE Estimates PSO misery overstated The stock of PSO has underperformed by 8% with KSE 100 Index since the start of the year CY13 mainly due to unresolved circular debt. However, we remain optimistic on the resolution of the issue once new government Relative performance PSO KSE 100 Index 75% takes charge. Trading at 60% FY13E &FY14E PER of 3.9x 45% and 4.1x respectively, PSO 30% appears to be the cheapest 15% stock on relative valuations 0% basis with industry average PER of 6.2x. Source: KSE & WE Research Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13

3 3 Circular debt - remains a hanging sword As key trigger for PSO remains the resolution of circular debt so we have made three assumptions. In our base case scenario, we expect circular debt to linger on and company would face liquidity problem resulted into lower operational efficiency. The company is going through liquidity issues due to massive receivables of over Rs 127 billion from various entities and needs some concrete steps by the government to resolve it. The company has gone through a number of technical defaults in the recent days. It should be noted that PSO's receivables include, Rs 53 billion from Hub Power Company (HUBCO), Rs 46 billion from Water and Power Development Authority (WAPDA), Rs 12 from Karachi Electric Supply Company (KESC), Rs 11 billion from Kot Addu Power Company (KAPCO), Rs 1.55 billion from Pakistan International Airline (PIA), Rs 1.30 billion from Pakistan Railways and Rs 1.14 billion from Independent Power Producers. On the other side, PSO has to pay Rs 73.5 billion to the international supplies and Rs 35 billion to refineries therefore any delay or non-payment from its receivables would certainly increase pressure to the company. However, government is releasing an amount of Rs10 billion but this amount can be called as next-to-nothing versus the huge size of receivables. While this would improve sentiments but a long-term solution includes elimination of power tariff subsidy, control on government financing and reduction in transmission & distribution losses. As key trigger for PSO remains the resolution of circular debt so we have made three assumptions. In our base case scenario, we expect circular debt to linger on and company would face liquidity problem resulted into lower operational efficiency. However we maintain buy stance in this scenario. Second and third scenarios would depend on new government. As we have mentioned, we value the stock using DCF Method, thus providing 3 scenarios with different target price in table below. Rs in million Best Scenario Base Scenario Worst Scenario Discounted Free Cash Flow 20,936 18,125 16,327 PV Terminal Value 57,713 39,818 28,367 Shares Outstanding Target Price Dec'13 (Rs) Source: WE Estimates

4 4 Margin revision to boost profits Recently, government has increased margins of Oil Marketing Companies for two major products i.e. Motor Gasoline (MS) and High Speed Diesel (HSD). PSO would be the major beneficiary of this margin revision as it enjoys the highest market share in both the products therefore it would get the major benefit and would increase its earnings. Recently, government has increased margins of Oil Marketing Companies for two major products i.e. Motor Gasoline (MS) and High Speed Diesel (HSD). The margins of Motor Gasoline are raised by Rs0.25/liter % while the margins of High Speed Diesel are raised by Rs0.10/liter - 5.7%. After the revision in margins, new margin of MS would be Rs2.23/liter and the new margin of HSD would be Rs1.86/liter. PSO would be the major beneficiary of this margin revision as it enjoys the highest market share in both the products therefore it would get the major benefit and would increase its earnings by 4% in FY14. Further, it would also take some pressure off circular debt. It is worth mentioning here that in December'11 the government had increased the OMC margin by around 30%. Rs/liter 11-Aug 11-Dec Chg 13-Apr Chg MS (Petrol) % % HSD (High Speed Diesel) % % Source: OGRA Bonus shares to Compensate Cash dividend Though PSO has bad history (last 5 years) of announcing handsome cash payouts and it rarely announced bonus shares especially on interim basis. However during the recent 1HFY13 it announced bonus issue of DPS 20% out-of-blue along with 20 20% bonus shares in FY12 15 also. This is positive for the 10 shareholders as company 5 compensate lower cash dividend with bonus share. 0 Source: KSE & We Research Stock Dividend FY09A FY10A FY11A FY12A 1HFY13A

5 5 Focusing on growth The company intends to acquire a 50% stake of EPL's holding in Sindh Engro Coal Mining Company Limited (SECMC). We expect FY14 would be relatively better year with previous two years as new government would improve efficiency in power generation. Although circular debt remains a concern for the company, recently company has shown interest in different ventures to focus on growth. We expect PSO to recognize its role and responsibility by investing in vertical and horizontal integration business in Oil & Gas. Three strategic plans that will be addressed growth story are: MoU signed with Engro on Thar Coal With an eye on diversification of its business line, company has signed a Memorandum of Understanding (MoU) with Engro Powergen Limited (EPL) to review technical and economical feasibility of the Thar Coal project. The MoU was signed keeping in view the fact that coal is available easily and cheaper as compared to other fuel sources thus become the fuel of choice for developed nations across the world. The company intends to acquire a 50% stake of EPL's holding in Sindh Engro Coal Mining Company Limited (SECMC). PSO to establish refinery in KP PSO signed MOU with KP government for the establishment of an oil refinery with a capacity of 40kbpd. Project cost is estimated around $800 million which would be financed with debt to equity ratio of 80:20. The project would be commissioned by FY17. PRL acquisition - a pipedream PSO has already showed its intention to increase its shareholding in Pakistan Refinery Limited (PRL) to 48% from current 18%. However, this is not the first time PSO has shown its interest in PRL. Previously, Shell holding 30% stake and Chevron 12% were not interested to divest their shareholding. We expect this acquisition would be good in the long-term where we estimate long term gross refinery margin would be around $4-5 per barrel. Furthermore, if this transaction materializes, PSO would increase the lubricants business by up-gradation of PRL. Offtake to improve in FY14 We expect FY14 would be relatively better year with previous two years as new government would improve efficiency in power generation by eliminating power tariff subsidy, control on government financing and reduction in transmission & distribution losses.

6 6 Volume to improve with ease in circular debt PSO's largest distribution network, with multi agreements of Fuel Supply would be the biggest recipient after easing circular debt resulted into increase in POL consumption. We expect company to post 3-year volume CAGR of 4% largely driven by FO sales. We expect industry FO volumetric sales to increase by 5% in next 3-year (FY14-16). PSO being the largest supplier of FO is currently enjoying market share of 75% is set to be a primary beneficiary of the expected increase in FO demand Furnace oil demand would surprise With a low level of water in dams and non availability of gas for multi-fired power generation, we expect demand for furnace oil (FO) would rise. With growing desire for power in the country, reliance on thermal power generation has been on the consistent rise, we expect industry FO volumetric sales to increase by 5% in next 3-year (FY14-16). PSO being the largest supplier of FO is currently enjoying market share of 75% is set to be a primary beneficiary of the expected increase in FO demand mainly on the back of its substantial market share, stable supply contracts and efficient inventory management. 80% 70% 60% 50% 40% 30% 20% 10% 0% Market Share - FO PSO SHEL APL Other Source: OCAC & WE Research Non-availability of CNG spurs petrol sales While the overall Petroleum sales remain flat in 8MFY13, the sales of MS (petrol) increased by 22% YoY to 1.1 million tons. This is mainly due to the CNG crisis as a transport fuel. During 8MFY13, the overall industry sales of MS increased by 18% YoY to 2.1 million tons. We believe MS Market Share - MS sales to increase by 3-60% year volume CAGR of 50% 40% 8% as country is facing huge shortage of 30% 20% gas which would 10% increase the usage of 0% gasoline in domestic PSO SHEL APL Other generators to cope Source: OCAC & WE Research with power shortages.

7 7 Company Introduction Pakistan State Oil is a public quoted company incorporated in Pakistan under the Companies Act, now Companies Ordinance, and is listed at all stock exchanges of Pakistan. The principal activities of the company are procurement, storage and marketing of petroleum and related products. It also blends and markets various kinds of lubricating oils. The primary shareholder of PSO is the government of Pakistan with 22.45% direct shareholding and 54% aggregate shareholding after adding the block shares in PICIC growth and Investment funds. The general public has 11.7% of shares, financial institutions own 23.62%, and public sector companies have 24.7% while foreign investors have 3.83% per cent of total shares. 3.83% Shareholding Structure 13.68% 22.45% 23.62% 11.70% 24.72% Govt of Pakistan General Public Public Sector Cos. Financial Instituution Foreign Investors Others Source: Company Report & WE Research

8 8 Valuation PSO - Financial Highlights FY12A FY13E FY14F FY15F EPS ( Rs) Book Value (Rs/share) DPS (Rs) P/E (x) P/BV(x) Dividend Yield (%) Payout (%) Key Ratios Analysis FY12A FY13E FY14F FY15F Current Ratio (x) ROE (%) ROA (%) Gross Margin (%) Net Margin (%) Sales Growth (%) PAT Growth (%) Income Statement Rs in million FY12A FY13E FY14F FY15F Net Sales 1,024,424 1,085,414 1,144,971 1,208,414 Cost of Products Sold 990,101 1,046,776 1,108,553 1,170,556 Gross Profit 34,323 38,638 36,418 37,858 Other Operating Income 2,134 2,244 2,360 2,483 Operating Expenses 19,143 18,404 17,610 17,329 Profit from operations 17,313 22,478 21,169 23,012 Other Income 7,551 7,752 6,332 7,638 Finance Costs 11,659 11,688 10,038 10,613 Share of Profit of Associates Profit before Taxation 13,674 19,036 17,980 20,580 Taxation 4,618 6,510 6,149 7,038 Profit for the Period 9,056 12,525 11,831 13,542 EPS (Rs)

9 9 Balance Sheet Rs in million FY12A FY13E FY14F FY15F Share Capital 1,715 2,470 2,470 2,470 Shareholder Equity 49,960 61,922 71,868 83,270 Non Current Liabilities 3,695 3,784 3,973 4,171 Current Liabilities 293, , , ,204 Total Liabilities 297, , , ,375 Non Current Assets 9,632 9,729 9,561 9,368 Current Assets 337, , , ,276 Total Assets 347, , , ,645 Cash Flow Statement Rs in million FY12A FY13E FY14F FY15F Cash from Operations 844 8,574 6,330 9,279 Cash from Investing activities (967) (1,329) (1,094) (1,173) Cash from Financing (562) (475) (1,696) (1,941) Net change in Cash (685) 6,770 3,540 6,165 Beginning Cash balance 2,309 1,624 8,394 11,933 Ending Cash balance 1,624 8,394 11,933 18,098 WE RESEARCH IS AVAILABLE ON THOMSON REUTERS, BLOOMBERG, S & P CAPITAL IQ WE Financial Services Corporate Office 506, Fifth Floor, Karachi Stock Exchange Building, Stock Exchange Road, Karachi , Pakistan URL: Disclaimer: All information contained in this publication has been researched and compiled from sources believed to be accurate and reliable at the time of publishing. However, we do not accept any responsibility for its accuracy & completeness and it is not intended to be an offer or a solicitation to buy or sell any securities. WE Financial Services & its employees will not be responsible for the consequence of reliance upon any opinion or statement herein or for any omission. All opinions and estimates contained herein constitute our judgment as of the date mentioned in the report and are subject to change without notice. For live markets, historical data, charts/graphs and investment/technical analysis tools, please visit our website URL: