CFA Institute Research Challenge hosted by CFA Society of Pakistan Institute of Business Administration Karachi

Transcription

1 CFA Institute Research Challenge hosted by CFA Society of Pakistan Institute of Business Administration Karachi

2 This report is published for educational purposes only by Students competing in The CFA Institute Research Challenge. Institute of Business Administration (IBA) Student Research [Oil & Gas Sector, Oil Marketing Company] Pakistan Stock Exchange (PSX) Pakistan State Oil Date: 11/01/16 Current Price: PKR/share Recommendation: BUY (33% upside) Ticker: PSO (PSX) Ticker: PSO PA (Bloomberg) PKR/USD: 105 Target Price: 428 PKR/share (4.08 USD) Market Profile Closing price (PKR) week price range (PKR) Average daily volume (12M) 919,134 As a % of shares outstanding 0.34% Dividend yield (2015) 3% Shares outstanding Free-float shares (mn) Market capitalization 87 B P/E 8.28 P/BV 0.95 ROE 11.6% Figure 1: Team estimates, SCS trade PSO: Proxy for Pakistan s economic revival We issue a BUY recommendation on Pakistan State Oil (PSO) with a one-year target price of PKR 428 using the Discounted Free Cash Flow to Firm (FCFF) and Relative Valuation Method. This offers a 33% upside from its closing price of PKR 321 on January 11, PSO is one of the biggest and most liquid blue-chips on KSE with average daily volume being 0.34% of shares outstanding. Our investment thesis is based on PSO s earnings growth, backed by volumes growth, improving operating cash flows, and being a cheap blue-chip asset. PSO s earnings growth is primarily driven by its volumetric sales growth during FY16-21 (CAGR: 12%) due to a changing energy mix, lower financing costs which will reduce over the years due to lower borrowings and positive operating cash flows. PSO, as the national fuel supplier, is key in Pakistan s economic revival in the coming years. Economic growth depends primarily on self-sufficiency in energy, which we expect to be achieved through upcoming projects of gas, coal and nuclear, along with resolution of circular debt. PSO has a pivotal role to play in Pakistan s changing energy mix through its captive role in LNG supplies which will constitute 55% of PSO s sales by In addition, PSO will be the main beneficiary of circular debt resolution, as PSO s books contain 45% of the total CD (in FY15). Robust earnings growth Earnings growth will stem primarily from rising volumes of retail fuels: Motor Gasoline (MOGAS) with a CAGR of 11%, along with modest growth in High Speed Diesel (HSD) with a CAGR of 2.5%. We project strong earnings CAGR of 20% during FY16E-FY21E, as compared to 19% CAGR during FY10-14, due to introduction of LNG in PSO s product mix. Finance cost as a % of operating profit will decline to 41.5% in FY16, as compared to 48.6% in FY15. This will further reduce to 17% in FY18E-21E on back of repayment of short term borrowings as the company receives proceeds from retirement of PIB investments..coming from Volumes growth driven by MOGAS, HSD and LNG Valuation DCF Multiples Estimated price (PKR) Weights 50% 50% Final price (with inventory gains/losses) MOGAS and HSD sales will be driven by consumer demand, favorable macros as IMF expects GDP growth rate to increase in our forecast period, increase in economic activity due to CPEC, along with auto sales and unavailability of CNG. However, the decline in FO sales in PSO s book (CAGR: -15%) will be offset by the increase in LNG sales (CAGR: 89%). The decline in FO based electricity generation is due to the favorable energy generation mix, with a shift towards cheaper fuels, like gas and coal. Furthermore, we expect PSO s market share in all its products to remain the same, as it will continue to be the dominant market player due to its largest storage capacity and vast retail network, along with fuel contracts with major government entities. Improving operating cash flows due to resolution of circular debt We expect PSO s operating cash flows to improve and remain positive in FY Operating cash flows as a % of operating profit increased to 35% in FY16, from -88% in FY15. Improving cash flows are aided by a reduction in power sector receivables on PSO s books, which we believe is key for materialization of power projects under CPEC and for successful implementation of IMF conditions. Furthermore, reduction in oil prices in 2016 and slight increase thereafter, will make the payments affordable for the Independent Power Producers (IPPs) and a shift in energy mix from expensive fuels like FO, to cheaper fuels like LNG will ensure that PSO has less receivables from power sector. There will be slight receivables build-up from LNG, as the government will be stringent on the LNG deals, due to restrictions placed by international dealers like Qatar. Attractive valuation with P/E multiple converging to the market multiple We have derived an attractive valuation of this cheap asset, with a target price of PKR 428 and an upside of 45%. We expect that in future, PSO s stock is going to converge to the market multiple of 9.0x due to extraordinary earnings growth and improvement in risk profile. We foresee earnings growth to make market sentiments positive which will drive multiple reiterating. Main risks to valuation include: build-up of circular debt, rupee devaluation, volatility in oil prices, decrease in margins, increase in interest rates and threat to PSO s market share from new entrants. OMC 1

3 Business Description PSO's Strategic Investments 22% 22.50% 12% 49% 62% Joint Inst. Asia Petroleum PRL Pak-Greece Product Mix FY15 Mogas 18% HSD 29% Product Mix FY21 LNG 54% Furnace Oil 49% Furnac e Oil 9% HSD 18% Mogas 16% Shareholding Pattern Operating as a key player in Pakistan s changing energy mix and being the nation s biggest fuel supplier, Pakistan State Oil (PSO) is a state owned entity having dominant market share in POL Volumes of 56.8%. The company is involved in downstream oil business of storage, distribution and marketing of various POL products, comprising majorly of MOGAS, Furnace Oil (FO), and HSD, LNG, aviation fuel and lubricants. For the past 40 years, PSO has managed to establish reliable strategic partnerships with local customers and international suppliers. Currently, PSO has medium term contracts with various international suppliers such as Kuwait Petroleum and strategic investments in five local ventures: 62% Joint Installation of OMCs, 49% in Asia Petroleum, 22.5% in PRL, 22% in Pak Greece Manufacturing Company, 12% in PARCO White Oil Pipeline project. PSO s competitive edge of oil infrastructure PSO enjoys competitive advantage through its large customer base (3 million customers on daily basis), wide retail network of 3500 retail outlets, extensive storage capacity of over 1 million tons (74% of total storage capacity), 155 convenience stores (shop stops), 1786 New Vision Retail Outlets (NVROs), 24 Mobile quality testing units, 11 refueling facilities (9 at airports and 2 at seaports respectively), Unique Satellite tracking system (enabling monitoring of road movement). PSO s largest storage capacity enables it to earn commission through lending it to small players. PSO s product mix PSO s competitive advantage enables it to be the leading market player in most of the POL products. As of 2015, PSO has 67% market share in FO, 50% in HSD, 47% in Motor Gas, 100% in LNG, 50% in aviation fuel and 24% in lubricants. These products are majorly consumed by transport, power sectors and industry. The demand drivers for PSO sales are consumer demand, POL prices derived from international oil prices, auto sales, and energy mix and business activity. Being a national entity, PSO is busy in meeting total energy demand of country, but due to shortfall in supply from local refineries; the company has had to resort to import of both white and black oil in the past years. As of 2015, PSO purchased a total of Million Metric Tons (MMT) out of which it imported 9.8 MMT while the r est of 2.83 MMT was met by refineries. PSO s Shareholding Pattern- PSO is a Government owned entity with maximum shareholding of 40% held by Federal Government, NIT & ICP (25.51% and 15.60%). The other shareholders include Modaraba companies & Mutual funds, Individuals, Foreign Investors, Insurance Companies, Financial Institutions and Banks, Public Sector companies, and others. Current strategy of the company can be summed up under four main pillars: Network Expansion- In order to improve and retain customer experience, PSO is working towards updating retail outlets under its New Retail Vision. Under this strategy, the company will now provide premium services to its customers, as these outlets will encompass state of the art, latest machinery, updated technology and customer friendly staff. Backward Vertical Integration- According to one strategic objective i.e. Continue to create upstream synergy and evaluate diversification opportunities for growth, PSO is trying to get involved into backward vertical integration by acquiring Pakistan Refinery Limited. In FY 2015, PSO owned 22.5% shares of PRL but according to its Annual Report 2015, the company is trying to increase its ownership in this strategic venture by 55%. Diversifying sources of Revenues- PSO is a National entity that is involved in almost all downstream oil and gas products, with an annual net income of more than PKR 6.9 billion, the company is constantly trying to improve its efficiency along with increasing its customer base. In order to achieve one of its few objectives to increase market share, optimize supply chain network and to improve bottom line; PSO will enter into Lube & LNG Business lines Improved Cash Flows the Company has faced drawbacks of being leader in furnace oil market through huge circular debt. The blockage of cash flows from IPPs increases PSO s receivables that have detrimental effect on its after tax earnings as huge chunk is been absorbed by finance costs. Shifting product mix, maturity of PIBs in 2017, reduced receivables and higher sales of LNG will impact PSO s cash flow positively. Hence, we assume cash flow to improve by 14% in FY21 (PKR 35 Billion) as compared with FY16 (PKR 23 Billion). 17% 13% 14% 15% 41% Government Modaraba Individual FI Others Management & Corporate Governance PSO s Board was dismissed in February 2015, and has been reconstituted in November After the reconstitution, the company is trying to smoothen its operation and to inculcate an atmosphere of efficient culture, collaborative employees and excellence in operations. Moving forward, PSO is hopeful in Maintaining International HSE standards, improving retirement and benefits and introducing improved recruitment programs, these changes will help mitigate the negative brand image that circular debt has put on the face of corporation. Industry Overview and Competitive Positioning Pakistan State Oil is the largest oil marketing company in Pakistan. The structure of OMCs in Pakistan is oligopolistic, characterized by significant entry barriers, handful of players and low product differentiation (please refer to Appendix X ) along with prices regulated by government on the two major petroleum products HSD and MOGAS, which doesn t allow OMCs to be price setters and reap higher margins. PSO has a market share of 56.7%, with PSL and APL having 10% each and Hascol with 5% market share. PSO owns 68.4% of total storage capacity in country and provides storage services to smaller players in market as well. Price setting is restricted to only lubricant category where Shell Helix is currently the market leader with a 35% market share, PSO has a market share of 25% in Lubes market while Total PARCO stands at 29%. 2

4 Key comparison ( ) PSO (2015) Shell (2014) APL (2015) Hascol (2014) Net Revenue (PKR Bn) , Net Profit (PKR Bn) Operating Profit (PKR Bn) Net Profit Margin % 0.76% % 1.60% 0.65% Operating Margin % 2.48% 0.18% 1.89% 1.25% Number of Retail Outlets 3, Market Capitalization (PKR Bn) EPS ROE 8.62% % 24% 20.65% Finance cost as a % of Operating Profit 48.60% 98.93% 3.40% 21.34% Relationship between Energy Demand & GDP affected by energy shortages Historical figures suggest that from , the relationship between energy consumption and GDP growth was ideal, (a ratio of 1.08). This was because till 2008, the only energy shortage that the economy faced was that of electricity, in form of load-shedding. During the period of 1990s 2005, there was surplus electricity in the economy (PIDE report). The current electricity crisis started from with a gradual widening gap in energy demand-supply. By 2011, the electricity shortfall had crossed the level of 5000 MW. Pakistan has been facing severe gas shortages since During , the demand for natural gas (4731 MMCFD) exceeded the available supply (4528 MMCFD). Thereafter, gas supply was suspended to the fertilizer sector and industries. Currently in 2015, gas shortfall is 2 billion cubic feet per day. Therefore, it can be safely concluded that after 2008, the final energy consumption/supply in the economy was less than the actual energy demand, the difference being pent-up or unmet demand. Upcoming energy projects The current political mandate of the democratic Government of Pakistan is to provide relief to the people through low -cost electricity using gas, coal, nuclear and hydel sources for Power generation. Essentially this means moving away from the expensive oil-based thermal power generation; the government believes that this shift from furnace oil to gas based power generation would lead up to USD billion savings each year. PSO, being the major and national fuel provider to the IPPs, has started being affected by the decline in furnace oil consumption GDP per unit of Energy India Pakistan China Bangladesh Paving way for LNG imports 9 LNG cargoes were imported between March-August 2015 and in future, LNG imports are only expected to increase, as can be reflected in the ongoing LNG deal between PSO and Qatargas, and the upcoming developments in LNG s storage and transportation. Pakistan s first LNG terminal was built by Engro s Elengy Terminal Pakistan Limited (ETPL) in a short period of 11 months in March The Elengy terminal is currently catering to around 200 MMCFD LNG in the national system. A contract for building a second LNG terminal at Port Qasim, with a capacity of 500 MMCFD has been awarded by the GoP to a Chinese state owned company. Transport capacity of the existing gas pipelines is 400 MMCFD. However, LNG pipeline contracts are being awarded to China (under CPEC) and Russia for Gwadar pipeline and North-South pipeline respectively. Apart from LNG, Iran-Pakistan gas pipeline project is up on the cards, through which Pakistan is expected to receive 750 million CFD from Iran which will be increased up to 1 billion CFD. Progress is slow due to tensions between Iran and major energy producers; however, we have assumed that this project would come on board by FY19. Another gas project in the news is TAPI (Turkmenistan- 3

5 FY04 FY06 FY08 FY10 FY12 FY14 FY16E FY18E FY20E CFA Institute Research Challenge % 20.00% 15.00% 10.00% 5.00% 0.00% -5.00% % % GDP & HSD Consumption GDP growth Rate LSM HSD Consumption MS Consumption & Autovehicle Growth 0% 10% 20% 30% Vehicles on road incremental % Mogas volumes change in transport, % Afghanistan-Pakistan-India); however, due to the project dates and security condition in Afghanistan, we have not considered this project to be coming any soon. Coal and nuclear are not far behind: 1320 MW imported coal based power projects at Qadirabad in District Sahiwal, 660 MW Thar coal based power project and 1320 MW imported coal based power project at Port Qasim Karachi. Upcoming nuclear projects include completion of Chasnupp-III and IV (adding a total of 680 MW). We have assumed that these projects would come on board with a 1 year lag, judging from the past performance of such projects. Pent-up demand to be met by LNG: We assume that, due to unmet energy demand in the economy, the upcoming energy projects (of gas, coal and nuclear) will firstly cater to the inoperative power plants and thus the energy crisis, implying that FO consumption might not be entirely substituted by LNG in the beginning years. As per our calculations, FO volumes exhibit negative growth of -4.7% in 2015, and continue to decline thereafter, with a sharp decline of 48% in FY20. Other economic highlights: GDP to grow by 4.5%: GDP growth is expected to increase to 4.5 percent in FY15/16 (from about 4.2 percent in FY 2014/15), sustained by current strength in services and construction, lower oil prices, expected improvements in the supply of gas and electricity, investment related to the China Pakistan Economic Corridor (CPEC), and an improving investment climate. Low oil prices have been the biggest factor in current strengthening of external stability. CPEC projects contributing to 3% & 7.35% growth in HSD & MOGAS respectively: HSD & MOGAS sales are assumed to increase due to greater economic activity amid ongoing CPEC projects. Modernized transport infrastructure; improved business activity, road density and road based trade route will lead to increased sales of heavy commercial vehicles which will contribute to the annual growth of 3% in HSD. GDP growth of 4.50%; accompanied by 5% increase in per capita GDP & 3.9% growth in household consumption for FY16-21E will continue to tune up MOGAS volumetric sales by 7.35%. Growth in LSM & HSD consumption: Large Scale Manufacturing (LSM) at 10.6 percent of GDP is assumed to contribute 0.5% to GDP growth for FY16-20E. LSM registered growth of 4.5% in Mar15 as compared to -1% in Mar14. With cumulative growth of 2.44% in next five years; LSM will contribute 3.5% growth to commercial transport on road in FY16E and 2% growth onwards till FY20E, consequently increasing HSD consumption. Vehicles growth, a strong driver for MOGAS & HSD: Growth in automobile sector contributes to increased consumption of POL products. In 2015 Trucks and tractors registered YOY growth of 53.9% and 44.6% respectively; production of trucks increased because Ghandhara Nissan Limited (GHNL) established its assembling plant in Pakistan. Tractors production plunged after cut in GST from 16% to 10% in the Federal Budget The demand for commercial vehicles increased on account of government schemes like Apna Rozgar and Kissan Package Scheme. However impending future threat of floods might be a cause of depressed demand of tractors in future, leading to decline in HSD consumption in Agriculture. Cars and LCVs registered YOY growth of 61% from Nov 14 to Nov 15. Taxi Scheme propelled Pak Suzuki volumes to 58,098 units in 5MFY16 in comparison to 29,456 units in 5MFY15 recording a tremendous jump of 97% YoY. Moreover, enhanced consumer sector dynamics, improving macros and an increase in car financing due to the 42-year low interest rate in the country overhauls the sales of automobile sector. MOGAS-CNG price differential to contribute growth in MOGAS sales: Lower price differential between MOGAS & CNG has compounded the effect of gas curtailment to CNG sector. With crude oil expected to plunge below 35; this differential will contribute to 13% growth in MOGAS in FY16 and 10% in FY17 hence stabilizing it to 5% YoY as oil prices are assumed to eventually break the bearish trend. CPEC Projects improving Energy & Transport infrastructure: The China Pakistan Economic Corridor (CPEC) will connect Western China (Kashgar) with the south of Pakistan (the port of Gwadar) through a series of infrastructure and energy projects. The initial prioritized pipeline of investments under CPEC envisages an overall investment of USD45 billion in ener gy (USD33.8 billion) and transport infrastructure (USD10.6 billion). All transport infrastructure projects are expected to be completed by Priority projects in the energy sector, which will create Independent Power Producers (IPPs), are scheduled to add about 10 GW of capacity by (by 2020 for hydro projects) while a further set of actively promoted projects is planned to add another 6.5 GW of capacity in due course. Dynamics of international oil prices: Over the last 6 months, Oil prices have plunged 28.5% from USD55.9 per barrel to USD32.59 per barrel experiencing its 11 year low. The reasons include dip in Chinese stock markets due to steep depreciation of the Chinese renminbi, huge sell-off in crude oil futures, oversupply in global oil markets, and US FED interest rate hike. Expectations that OPEC members will continue to ramp up oil production coupled with Iran s potential production will keep oil prices to be within USD40FY16E. However in the next 4 years oil prices are assumed to increase again because OPEC members cannot sustain distressed economic circumstance they are facing. OMCs: a major victim of ongoing circular debt crisis PSO, having major fuel supply agreements with national power entities, has born the maximum brunt of circular debt in its books, affecting its liquidity position the most. Having cash tied up in receivables limits an OMC s ability to procure fuel supplies, leading to late payable charges and further limits its ability to pay out dividends. Receivables from power sector entities pile up when oil prices are rising, as the payments in PKR terms become more expensive for IPPs to pay off. 4

6 Circular debt resolution strategy by GoP Till recently, the government had resorted to cash injections as a strategy for resolution of circular debt but the IMF for the first time, has set an indicative target on the accumulation of CD. The Government of Pakistan (GoP) and IMF have agreed on capping the circular debt at PKR 250 billion in The government intends to achieve this target through tariff rationalization, improvement in recovery and reduction in losses. In FY2015, this strategy has worked so far as collections improved in the range of 89-91%, compared with 87% recoveries in FY2014, and losses lessened by 0.5%. The current circular debt stock stands at PKR 314 billion (June-15) which the government plans to reduce till PKR 212 billion (June-18). Investment Summary We issue a BUY recommendation on Pakistan State Oil (PSO) with a target price of PKR 428 and an upside of 33.2% from its closing price of PKR 321 on January 11, Our investment case is based mainly on PSO s earnings growth, backed by volumes upsurge, improving operating cash flows and being attractively valued in the market. PSO s earnings growth is primarily driven by its volumetric sales growth during FY16-21 (CAGR: 10%) due to a changing energy mix involving LNG, lower financing costs due to repayment of short term borrowings and positive operating cash flows. Favorable bottom-line growth due to volumes growth and improved liquidity We are optimistic about PSO s earnings with the EPS reaching PKR75/share in FY20E-21E. We believe company s profitability to improve owing to a CAGR of 12% in volumetric sales, easing of power sector receivables and less reliance on cash blocking fuels (FO) leading to improved operating cash. We expect PSO s bottom-line to further benefit from reduced running financing from local and foreign banks, as the freed up cash from receivables will enable the company to cover its short-term borrowings, thus reducing finance cost to 17% of operating profit in FY PSO s earning will be driven mainly through increase in sales volumes and change in its product mix, with LNG constituting 54% of its volumetric sales in FY21E. Growth in MOGAS, HSD will be CAGR of 7% and 2.5% due to increasing consumer demand as POL prices become affordable in Pakistan, favorable macros as per IMF expectations, massive growth in automobiles sales, increased business activity due to CPEC and continued unavailability of CNG. Shifting energy mix highly favorable for PSO The GoP is committed to shift the energy mix as a part of their political mandate before the next national elections in 2018, as the current mix is highly expensive (per MMBTU cost of imported furnace oil USD vs USD 9.37 for R-LNG, at Brent of USD 50/barrel). The government further plans to establish 2400 megawatts (MW) LNG based power plants which will be supplemented by upcoming LNG terminal at Port Qasim and gas pipeline projects, leading to a rise in LNG imports. We expect the shift in energy mix to be immensely beneficial for PSO s product mix, acting as a cushion for decline in FO sales. As of now, PSO has the competitive advantage of being appointed as the sole contractor, on behalf of GoP, to import LNG and is under the process of striking a long-term LNG deal with Qatargas, with a very favorable LNG price. LNG imports to reduce PSO s reliance on FO and reduce build-up circular debt We underpin our rating for PSO s stock, owing to the surge in MS and HSD consumption and the shift towards cheaper fuels in energy mix which will increase LNG imports and reduce FO consumption by IPPs. Once the major inoperative power plants have been run on LNG, we expect the government to massively reduce electricity generation by oil, as much cheaper alternatives in form of gas, coal and hydel would be available. This will lead to a sharp decline in FO sales, however substituted by LNG imports on PSO s books. Our optimism of resolution in circular debt stems from the recent talks between GoP and IMF, in which they agreed to put a cap on circular debt, which is PKR 250 billion. The GoP has released its estimates of circular debt stock, which they expect to be lowered to PKR 211 billion by FY18E. We expect that the involvement of a multilateral organization and the ongoing economic developments with China under CPEC will ensure that the circular debt stays under manageable level for the government. PSO will be the main beneficiary of this resolution, as it has around 45% of the circular debt on its books. Where LNG receivables are concerned, we believe that it is highly unlikely that LNG receivables should meet the same fate as FO, due to the international nature of contract and the stringent conditions being put by Qatargas. However, being realistic, we have assumed that LNG sales would give rise to some level of receivables on PSO s books. Higher dividend payout amidst cash excess and manageable receivables We are optimistic about the company s cash flows, which will be in excess in FY20E-21. We expect the major improvement in PSO s cash flow position to be brought about by a massive plunge in FO sales of 48%, which will eventually lead to lower power sector receivables. This will improve PSO s liquidity position, thereby making its profile less risky. Furthermore, more distributable cash flows will most likely translate into higher dividend payout ratio, which we expect to increase up to 50% in FY20E-21E, from 15% in FY16E. Availability of excess cash means that the company can consider potential expansion, as PSO has plans to expand its lubes business, and lead to more organic growth. Attractive valuation and positive market sentiments We expect that in future, PSO s stock is going to converge to the market multiple of 9.0x, thus trading at a 0% discount. We expect the robust forecasted earnings growth and improvement in risk profile to make market sentiments positive which will drive multiple reiterating. Historically, PSO s stock had been trading at 8.07x with the market multiple of 8.5x, i.e. at a discount of 5% because of circular debt which gave out a negative market sentiment. Using DCF and relative valuation, we have arrived at a target price of PKR 428/share for this cheap asset, with a potential upside of 33%. 5

7 Concerns: The main risks to our investment thesis are volatility in oil prices thus leading to inventory losses and a worsening of circular debt pile-up, both of which can be detrimental to the bottom-line. Other risks include sluggish consumer demand in the economy, rupee devaluation and increase in interest rates. Valuation Valuation Target Price: PKR 428 Recommendation: BUY 120% 100% 80% 60% 40% 20% 0% Capital Structure We have arrived at our target price of PKR 428/share by assigning equal weights to Discounted Free Cash Flow to Firm (FCFF) and Relative Valuation using P/E. The price arrived from DCF is PKR 438, whereas that arrived from relative valuation is PKR 417. Discounted Cash Flow (DCF) Model We have discounted free cash flows available to firm (FCFF) from FY16E-21E. DCF is the most appropriate and reliable measure of PSO s intrinsic share value as it discounts FCFF which incorporates the company s future earnings growth. DCF also rightly captures PSO s improving cash position in the future. FCFF was derived by adding non-cash expenses (depreciation and amortization) and after-tax interest to Net Income, and subtracting Investment in working capital and Capex. Weighted Average Cost of Capital (WACC) We have used WACC to discount FCFF or the cash flows available to both common shareholders and debt, as WACC assigns a weighted average to cost of debt and equity. The only debt on PSO s books is that of short-term borrowings and we have taken PSO s cost of debt as KIBOR+1.5%, with the current KIBOR being 6%, and applied a tax rate of 32%, thus getting an after -tax cost of debt as 5.44%. We arrived at cost of equity through CAPM for which we assumed risk free rate on 10-year PIB, which is 9%, with market risk premium of 6%. We calculated beta using daily stock returns of PSO and KSE-100 Index (market index) from , and applied the covariance formula. The capital structure of debt-equity 0.53: 0.47, is that of From our calculation, WACC comes out to be 10.48%. Terminal Growth We have assumed PSO s terminal growth as 3%, as PSO is currently in its mature stage, which means that in the long-term, its revenue growth will be modest. Terminal growth rate is also linked to historical inflation and the historical GDP growth rate. Equity weight Debt weight PSO s CORE BUSINESS PSO s major business involves downstream marketing of POL products and recently, gas (LNG). Other sources of revenue include lending its biggest storage capacity to other small OMC players. Sales Revenue (volumes) Operating in an industry where the players don t have pricing power in their hand, PSO s revenue solely depends on its volumetric sales and in rare cases, on increase in OMC margins. We have assumed that in our forecast period, PSO s volumes in white oil category (MOGAS and HSD) will increase, while that in black oil (furnace oil) will fall drastically. The fall in FO sales is due to the shift in energy mix of the country and the introduction of the cheaper-alternative for electricity generation, namely LNG, as the government has a political mandate to provide relief to the people. Moving forward, we assume that LNG imports would make FO an unattractive fuel, thereby reducing its consumption, whereas PSO s diversification into LNG business would mean that increase in LNG sales would substitute for the fall in FO consumption by power producers. By FY2021E, we expect FO to constitute only 10% of PSO s 25 million tonnes sales, whereas LNG would form 54% of its sales. Sales Revenue (Pricing) The prices of local POL products are derived from international oil prices, namely OPEC-Reference Basket (ORB), which in turn is derived from Brent. We have assumed Brent to be USD 40/barrel in FY16E and thereafter to increase gradually till USD 55/barrel in FY19E. With Brent falling to USD 33/barrel in FY , the prices of POL products are not as low as they should be as GoP has been increasing the General Sales Tax (GST) rates to raise more tax revenues and to meet their fiscal deficit. We have assumed the current level of GST to remain the same in our forecast period, as the Bloomberg estimates Brent to increase from FY2016 onwards, and the GoP is unlikely to further increase GST on POL products as that would make the end-price very high for the consumers. Sales Revenue (OMC Margins) As OMCs do not have pricing power in the major POL products, their profits are determined by the margins on these products, fixed in PKR terms and percentage terms by the regulatory body, Oil & Gas Regulatory Authority (OGRA). Being conservative, we have assumed OMC margins to remain the same in our forecast period: PKR 2.35/liter on MOGAS and HSD; 3.5% of exrefinery price for FO, and 1.82% of Delivered Ex-Ship (DES) price for LNG. In case of rising oil prices, the final margins on FO and LNG would increase. However, margins on these two products are also affected by PKR depreciation against the USD. 6

8 Operating Expenses We have forecasted distribution and marketing expenses, and administration expenses by linking salaries and wages with inflation forecast taken from IMF documents, and by linking other expenses as a historical % of sales. We have forecasted depreciation expenses, divided into these two heads, by looking at the historical trend, which has given us a future rate of 5%. An important head in operating expenses is exchange losses, which have been an important item affecting PSO s profitability, as it was 2% of the gross profit in FY15. Moving forward, we have taken the assumption that exchange losses would be incurred on MOGAS and HSD, as exchange losses for FO are passed onto the end consumer. With an assumption of 4% depreciation of PKR against USD every year in our forecast period, we have applied this rate on 45% of PSO s total forecasted trade payables, thus conservatively assuming that 45% of the total payables would be those of retail fuels. CAPEX Capital expenditures (CAPEX) of PSO will increase in coming years as per major decisions announced by PSO s management including introduction of new retail stores, diversification in new business lines i.e. lubes as PSO has a manufacturing facility for its own lubes. These decisions will have an impact over CAPEX in upcoming years, which we expect to grow at a CAGR of around 14% for the period FY16E-FY21E. PRL acquisition We expect PSO s shareholding in PRL to increase up to 51% by FY18E. This is in line with PSO s latest move to purchase Chevron s share in PRL. Working Capital and inventory gains/losses We expect PSO s power sector receivables to decline over our forecast increase and LNG receivables to increase. We have assumed receivables days for power sector to reduce from 166 in FY15 to 125 in FY21E, and for LNG days to stabilize at 35 during FY20-21E. We have further assumed provision for impairment as % of gross trade debt in our forecast period, based on historical trends. For payables, we have assumed 25 local payables days and 35 foreign payables days. For inventory, we have assumed 14 inventory days for FO, 15 for MOGAS, 40 for HSD and 7 days in transit for LNG inventory. Furthermore we have assumed inventory losses to occur in FY16E, and thereafter inventory gains as Brent estimates are expected to increase as per Bloomberg s estimates. Improving cash flow position and increasing dividend payout We have assumed that as the company s operating cash flows improve and from the time it starts to repay its short term borrowings, it will increase its dividend payout ratio. The company has excess cash in FY20E and FY21E, while we expect its dividend payout to increase to 50% in these two years. We are optimistic that the company s cash flows will improve from FY20E, due to easing of circular debt, partly due to strategies devised by the IMF and GoP, and our expectation of massive drop in FO sales in FY20E. The company s cash flows will also ease due to maturity of PIB investment in Relative Valuation We have used relative valuation using a benchmark P/E of the market compared to PSO s P/E multiple. PSO traded at a 5% discount to the market in FY15 mainly because of the circular debt situation which increased the risk of PSO s stock. However, we expect the forward P/E multiple of PSO to converge to that of market in FY16E because of the following reasons: Improve in risk profile of PSO s stock as a result of our expectation of stable circular debt Extraordinary and sustainable earnings growth driving multiple reiterating Positive market sentiments making investment in PSO s stock attractive for investors We consider that the improvement in circular debt situation in the forecast period. This would reduce the uncertainty involving PSO s performance, enabling the investors to make more informed decisions hence, PSO s P/E multiple is likely to be trading close to the market. Moreover, sustained earnings growth in the forecast period is likely cause the investors to have positive market sentiments towards PSO and hence, they would now be willing to pay high price per earnings of PSO stock. Financial Analysis 2,000,000 1,800,000 1,600,000 1,400,000 1,200,000 1,000, , , , ,000 - Sales Revenue(PKR) Receivables to decline gradually: FO receivables situation is expected to recover mainly because of the falling global oil prices. This will improve PSO s receivables from IPPs. Although we assume that the international oil prices will modestly increase to around USD$55 per barrel in FY21E but the power; producers usually feel the pinch above USD$85 per barrel. Having said that, the piled up FO receivables are not going to disappear abruptly. FO days to receivable will fall to 125 days in FY21E from 210 days in FY16E. Additionally, LNG days to receivables are likely to drop to 35 days in FY21E from 105 days FY16E. Government has reiterated to keep control checks on its LNG receivables due to the involvement of Qatar Gas. In relation to this, PSO has opted for a conservative strategy which demands for advanced payments before the provision of services. Stagnant payables: Stringent conditions over the import of FO and LNG will make payables days to strict 35 days in the forecasted period. On the other hand, the local day s payable outstanding are expected to remain fixed. Improvement in Inventory Turnover: We expect an improvement in PSO s inventory turnover. Total days inventory outstanding are expected to fall to 16 days by FY21E. 7

9 Target price sensitivity Risk free rate 8.5% 9.0% 9.5% 10.0% 10.5% 11.0% 11.5% 12.0% Terminal rate 1.5% % % % % % PKR Billion (10) (30) (50) (70) (90) CFO CFI CFF Strong Cash Generation We expect the cash flow from operations to improve in the forecasted period mainly because of the improved working capital situation. This is reinforced by the improving cash conversion cycle in the forecasted period. While in the historical trends analyzed, CFO was negative because of the drags in liquidity of PSO. CFI is largely to remain negative due to increasing CAPEX except for FY18E when PSO plans to retire the PIB investments of PKR47 billion. Consequently, PSO will be able to generate sufficient cash to cover all its investments (except for FY16E where the deficit will be financed by borrowing). Liquidity Situation- The liquidity position of PSO also looks rosy as the current ratio is well above 1 in the forecasted years (Current Ratio 2016E: 1.13x, 2021E: 1.46x) which is in congruence with the historical period (Current Ratio 2014: 1.08x, 2015: 1.10x) CFO/CAPEX confirms the fact that PSO will be able to cover its investments in the future with the ratio being significantly higher than 1 in the forecasted years (2016E: 5.11x, 2021E: 4.77x) However, earnings quality calculated by the cash realization ratio (CFO/PAT) showed that it will maintain around 1 in the forecasted periods indicating that the cash would be sufficient to satisfy its financial commitments as well. 60% 50% 40% 30% 20% 10% 0% Payout ratio Dividend payout upturn- We expect the dividend payout to increase (FY16E: 15%, FY21E: 50%) because of the enriched cash situation of PSO and the excess cash available from retirement of PIBs worth 47 billion in FY18E. DU PONT- We expect improved ROE forecasts to around 15% in FY21E from 12% in FY16E, mainly due to high asset turnover and significant equity multiplier. Historically, PSO showcased high return on equity (FY12 ROE 21%, FY13 ROE 19% and FY14 ROE 32%) with an exception to FY15 when ROE was low because of adverse profitability. DuPont analysis recommends the most important driver for sustaining future level of return on equity to be high asset turnover, which indicates better utilization of PSO s resources. Along with it, we have concluded that equity multiplier is ought to be the second most important driver hence, an increase in PSO s financial leverage position would contribute to profitability in the forecasted years. Revenues and earnings optimism- We expect revenues CAGR in FY16-21E to be 12%. An increase in automobile sales, resurgence of large scale manufacturing, high expected LNG consumption and PSO s penetration in lubes business would upsurge revenue drastically. Furthermore, we expect EPS to grow from 38.8/share in FY16E to 75.5/share in FY21E. The gradual revival of oil prices and anticipated white oil demand would contribute to high future. Finance cost to ease-off- We expect PSO s finance cost situation to improve in the forecasted period. This is because of the PIB proceeds of PKR47billionin FY18E which will provide PSO with excessive cash hence, reducing the need for borrowing. The capital structure which currently stands at 0.55:0.45 debt to equity is expected to be 0.03:0.97 debt to equity in FY18E. This is reiterated by the interest cover multiple which will increase from 2.4x in FY16E to 5.82x in FY21E. Net finance cost is also likely to be positive as a result which suggests lower burden of finance cost on PSO in the forecasted period FY16E- FY21E. Sensitivity Analysis Conditional upside to target price: Increase in OMC margins We have assumed that OMC margin on LNG imports would remain at 1.82% of DES price during our forecast period. However, PSO had demanded the margin on LNG to be 4%, approved by the Economic Coordination Committee, to which OGRA did not agree. With the current assumption of oil prices and LNG volumetric sales, if LNG margins were to increase to 4%, we expect a target price of PKR 625/share, a massive (conditional) upside of 95% from the current share price of PKR

10 USD/barrel CFA Institute Research Challenge PROBABILITY Low Medium High Market share threat Interest rates; Exchange rates; GDP growth Volatility in oil prices (Brent) Circular debt ; Volatility in oil prices OMC Margins; CNG availability Low Medium High IMPACT Investment Risks Regulatory risk Margins on POL products Operating in an industry in which margins for 47% of its total sales (on HSD & MS) are currently fixed at PKR 2.35/liter, and determined by OGRA, there is always the risk that margins could fall. From the regulatory history, the only time that OGRA reduced margins was in Aug However, we believe it s highly unlikely that margins would fall as OMCs are always pressurizing the government to increase the margins. We can safely expect margins on OMC products to remain constant moving forward, with a conditional upside if OGRA agrees on raising margins. The government is usually reluctant to increase margins when the oil prices are rising. Macroeconomic risk GDP growth rate Unfavorable macroeconomic conditions such as low GDP growth will reduce the business activity in the economy, thus leading to lower consumption of POL products, affecting diesel consumption the most. However, moving forward we expect IMF forecasts to be realized due to ongoing economic activity with regional neighbors (China Pakistan Economic Corridor) and government s political willingness to make Pakistan energy self-sufficient. Macroeconomic risk Rupee devaluation against USD As opposed to smaller OMCs, PSO relies on imports for 75-80% of its product supply, thus being most affected by rupee devaluation. Longer day s payables and a worsening PKR against USD translate into high exchange losses for the company. Macroeconomic risk Volatility in oil prices Sharp volatility in oil prices could lead to inventory gains and losses, with the most dangerous form of volatility incurring due to falling oil prices. We have assumed that oil prices would fall in FY16E, and thereafter would modestly increase up to 55 USD/barrel. While Bloomberg has forecasted much higher Brent prices, our conservative estimates have helped us trim inventory gains to a minimum. Macroeconomic risk Rising interest rate If interest rates rise beyond our estimates, this would lead to higher finance costs for PSO, thus affecting its profitability. However, recently central bank kept the policy rate constant at 6% and moving forward, IMF expectations of inflation are 5% for the long-term. With a real interest rate of 2%, we don t expect the policy rate to exceed beyond 9-10%. Industry risk Circular debt The government had been making promises to resolve the circular debt in the last couple of years, which makes this issue all the more critical as it greatly impacts PSO s profitability. We are highly optimistic where resolution of circular debt is concerned, due to the involvement of a multilateral agency, IMF, in capping the circular debt stock. We expect that the government might use another financial instrument to settle its outstanding balance with PSO, just as it did in 2013, which would add interest income in other financial income. Industry risk Availability of gas for transport If All Pakistan CNG Association (APCNGA) imports LNG on its own or if the government allocat es gas to transport sector, petrol sales could be threatened. However, imported LNG would be more costly than local gas, thus making this an expensive decision for APCNGA. CNG prices would have to be increased, which will make this substitute fuel unattractive in front of petrol. Industry risk Threat to market share from new, smaller OMCs Our assumption is that PSO will retain its market share, due to its competitive edge over storage capacity and vast retail network. However, in the latest fiscal year, PSO has lost its market share slightly in FO, HSD and MOGAS and there is always a risk that the new, smaller OMCs may jeopardize PSO s market share in retail fuels (MOGAS & HSD). We expect this risk to be mitigated in the future as PSO will remain the major contractor, on behalf of government, where LNG is concerned and it is the beneficiary of some major fuel supply arrangements in the country. As for its consumer business, PSO is revamping all of its petrol pumps through new vision retail stores and has plans to expand its lubes business. Operational risk Inventory management With cash being tied up in power sector receivables, PSO has been facing a liquidity crunch which had affected its ability to procure fuel from international suppliers on time. This led to a petrol crisis in the country in Jan-Feb However moving forward, we expect PSO s receivables and cash flows to be in a better position, thus enabling it to engage in better inventory management. Firm-specific risk PRL acquisition We have assumed that PSO would go ahead with the PRL acquisition and increase its shareholding up to 51%, thereby becoming a parent company of PRL. Cash flows would be affected in medium term due to the investment outlay. In the beginning, this might not prove to be profitable, as PRL is currently a loss-making entity, with PKR 1.18 billion losses in 2015, and PSO would have to incur huge capex in order to make this venture a profitable one. 9

11 Appendices Core F inancials Sum m ary F Y14 F Y15 F Y16E F Y17E F Y18E F Y19E F Y20E F Y 21E Sales (mn tonnes) Net Revenue (PKR bn) Net Profit (PKR bn) EPS (PKR/share) Net Profit Margin % 1.84% 0.76% 1.49% 1.56% 1.52% 1.44% 1.48% 1.45% Finance cost (PKR bn) (9.5) (11.0) (11.0) (11.0) (5.7) (5.6) (5.7) (5.9) ST borrowings (PKR bn) Operating cash flows (PKR bn) (53.30) (20.02) Receivables from Govt & other aut. bodies (PKR bn) Cash Conversion Cycle Return on Equity 32% 8% 12% 13% 14% 15% 16% 15% Dividend payout 7% 39% 15% 25% 35% 40% 50% 50% DPS (PKR/share) Effective tax rate 34% 42% 32% 31% 30% 30% 30% 30% Source: Team Estimates Core assum ptions Volum es ( m n tonnes): F Y14 F Y15 F Y16E F Y17E F Y18E F Y19E F Y20E F Y 21E MOGAS HSD Furnace Oil LNG Volum es growth %: F Y14 F Y15 F Y16E F Y17E F Y18E F Y19E F Y20E F Y 21E MOGAS 14% 23% 23% 14% 9% 7% 6% 5% HSD 0% 8% 4% 3% 3% 3% 3% 3% Furnace Oil 13% -5% -11% -6% -5% -6% -48% 0% LNG 505% 100% 90% 47% 34% 0% 10

12 Core assum ptions ( W orking Capital) Receivables: F Y14 F Y15 F Y16E F Y17E F Y18E F Y19E F Y20E F Y21E Receivables days - Power sector Receivables days - LNG Receivables days - Other customers Receivables days - total Payables: F Y14 F Y15 F Y16E F Y17E F Y18E F Y19E F Y20E F Y21E Payables days - local Payables days - foreign Payables days - total Inventory: F Y14 F Y15 F Y16E F Y17E F Y18E F Y19E F Y20E F Y21E Inventory days - MOGAS Inventory days - HSD Inventory days - FO Inventory days - LNG Inventory days - total Core Assum ptions: F Y14 F Y15 F Y16E F Y17E F Y18E F Y19E F Y20E F Y21E ST borrowing markup (KIBOR + 1.5%) 6.5% 9.1% 8.5% 9.6% 9.6% 9.6% 9.6% 9.6% Late payment surcharge (KIBOR + 3%) 12.8% 10.4% 10.0% 11.1% 11.1% 11.1% 11.1% 11.1% Bank deposit rate 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% Penal Income (PKR bn) Inventory losses/gains 4.1 (7.90) (0.22) Exchange losses (1.04) (0.66) (1.32) (1.48) (1.99) (2.44) (2.72) (2.87) 11

13 Macroeconomic Indicators G D P G R O W TH R ATE 5.50% 5.20% 5.20% 5.20% 5.20% 5.00% 4.50% 4.00% 4.03% 4.24% 4.50% 4.50% 3.50% 3.00% F Y1 4 F Y1 5 F Y1 6 E F Y1 7 E F Y1 8 E F Y1 9 E F Y2 0 E F Y2 1 E 12.0% 9.0% 8.6% I N F LATI O N 6.0% 4.4% 4.7% 5.5% 5.0% 5.0% 5.0% 5.0% 3.0% 0.0% F Y1 4 F Y1 5 F Y1 6 EF Y1 7 EF Y1 8 EF Y1 9 EF Y2 0 EF Y2 1 E 12.0% D I SC O U N T R ATE/ K I B O R 10.0% 8.0% 9.8% 7.4% 7.0% 8.1% 8.1% 8.1% 8.1% 8.1% 6.0% 4.0% F Y1 4 F Y1 5 F Y1 6 EF Y1 7 EF Y1 8 EF Y1 9 EF Y2 0 EF Y2 1 E 12

14 PKR million CFA Institute Research Challenge Exchange Rate Assum ption E X C H A N GE RA T E ( P KR/USD) F Y1 4 F Y1 5 F Y1 6 E F Y1 7 E F Y1 8 E F Y1 9 E F Y2 0 E F Y2 1 E Exchange losses to be incurred only on HSD and MOG AS - (500) FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E (1,000) (1,500) (2,000) (2,500) (3,000) (3,500) 13

15 Balance Sheet ( Assets) PKR millions Historical Balance Sheet Projected Balance Sheet As at June 30th FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E ASSETS Property Plant and Equipment 6,085 5,832 5,525 5,855 6,333 6,966 7,647 9,102 10,702 12,462 14,398 Intangibles Long Term Investment 2,314 1,968 48,253 45,789 50,681 52,522 57,255 10,716 10,688 10,714 10,741 Long Term Loans Advance and Other Receivables Long Term Deposits and Prepayments Deffered tax 957 2,130 3,292 6,464 8,011 9,332 10,555 11,689 12,587 13,162 13,304 NON CURRENT ASSETS 9,859 10,469 57,593 58,637 65,559 69,358 76,009 32,077 34,576 36,965 39,106 Stores Spare Parts and Loose Tools Stock in Trade (Inventory) 95,378 88, ,089 86,297 58,492 62,409 66,465 79,636 90,341 95, ,592 Trade Debts 124, ,022 76, , , , , , , , ,907 Loans and Advances , Deposits and Short term Prepayments 1,027 2,528 2,406 2,511 1,903 2,075 2,285 2,236 2,202 2,140 2,188 Mark-up/ Interest Receivables on Investments - - 2,251 2,251 2,237 2,247 2, Other Receivables 22,520 21,122 26,571 21,108 19,550 19,299 19,496 19,696 19,900 20,108 20,321 Taxation - Net 6,312 5,315 4,586 4,673 8,132 7,584 7,732 9,824 12,221 14,330 14,364 Cash and Bank balances 2,309 1,624 5,227 20,607 2,312 2,000 2,000 2,000 2,000 31,942 35,540 CURRENT ASSETS 252, , , , , , , , , , ,787 Net Assets in Bangladesh TOTAL ASSETS 262, , , , , , , , , , ,892 14

16 Balance Sheet ( Equity & Liabilities ) PKR millions Historical Balance Sheet Projected Balance Sheet As at June 30th FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E LIABILITIES & EQUITY Issued Subscribed and paid-up 1,715 1,715 2,470 2,717 2,717 2,717 2,717 2,717 2,717 2,717 2,717 Reserves 40,188 46,619 58,173 75,904 79,593 88,556 98, , , , ,590 TOTAL EQUITY 41,903 48,334 60,643 78,621 82,310 91, , , , , ,307 Retirement and Other Service Benefits 2,234 4,982 4,271 5,184 8,321 9,014 9,708 10,401 11,094 11,788 12,481 Long term deposits 1,024 1,176 1, Deferred Liabilities NON-CURRENT LIABILITIES 3,257 6,158 5,614 5,184 8,321 9,014 9,708 10,401 11,094 11,788 12,481 Trade and other Payables 191, , , , , , , , , , ,023 Provisions Accrued Interest / Markup , ,176 1,417 1,388 1,392 1,392 1,392 Short Term Borrowings 24,542 45,773 17,270 92, ,076 98,935 80,366 15,217 5, Taxes Payable CURRENT LIABILITIES 217, , , , , , , , , , ,104 TOTAL LIABILITIES 220, , , , , , , , , , ,585 TOTAL EQUITY AND LIABILITIES 262, , , , , , , , , , ,892 15

17 Incom e Statem ent PKR millions Historical P&L Projected P&L For the year ended June 30th FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E Sales 974,917 1,199,928 1,294,503 1,409,574 1,114, ,089 1,073,799 1,387,934 1,659,951 1,814,172 1,891,211 Less: Sales Tax (137,969) (163,861) (178,505) (204,360) (183,891) (221,789) (242,524) (309,214) (370,456) (409,292) (433,047) Less: IFEM (16,418) (11,643) (15,876) (17,575) (17,423) (24,745) (25,693) (31,115) (35,423) (38,362) (41,452) Net Sales 820,530 1,024,424 1,100,122 1,187, , , ,582 1,047,605 1,254,072 1,366,518 1,416,712 Cost of Product Sold (786,250) (990,101) (1,065,961) (1,150,815) (889,515) (679,256) (773,276) (1,009,754) (1,211,484) (1,321,946) (1,370,351) Gross Profit 34,280 34,323 34,161 36,824 23,579 28,299 32,305 37,851 42,588 44,571 46,362 Other Income 5,960 9,685 5,939 19,518 14,024 12,365 12,518 8,530 8,972 10,633 10,908 Operating Costs: Distribution & Marketing Expenses (5,986) (7,069) (7,317) - (8,118) (8,611) (9,399) (10,555) (11,700) (12,401) (12,782) Administrative Expenses (1,515) (1,660) (1,730) (2,003) (2,300) (2,281) (2,449) (2,666) (2,885) (3,045) (3,164) Other Operating Expenses (2,240) (9,272) (3,664) (3,890) (3,513) (2,495) (3,088) (4,120) (4,942) (4,385) (5,247) Total Operating Cost (9,740) (18,000) (12,711) (13,316) (13,931) (13,387) (14,936) (17,342) (19,526) (19,831) (21,194) EBITDA 30,500 26,007 27,390 43,026 23,672 27,277 29,887 29,040 32,034 35,373 36,076 Depreciation & Amortization 1,139 1,143 1,160 1,054 1,001 1,043 1,118 1,199 1,324 1,463 1,613 EBIT 29,361 24,864 26,230 41,972 22,671 26,234 28,770 27,840 30,710 33,911 34,463 Finance Cost (11,903) (11,659) (7,591) (9,544) (11,017) (11,040) (11,002) (5,747) (5,639) (5,668) (5,926) Share of Profit from Associates Profit Before tax 17,974 13,674 19,210 32,969 12,034 15,506 18,264 22,754 25,770 28,982 29,321 Taxation (3,195) (4,618) (6,572) (11,151) (5,097) (4,962) (5,662) (6,826) (7,731) (8,695) (8,796) Profit After tax 14,779 9,056 12,638 21,818 6,936 10,544 12,602 15,928 18,039 20,288 20,525 16

18 Cash F low Statem ent Cash flow statement FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E Net Income 21,818 6,936 10,544 12,787 15,046 16,091 17,530 17,960 Depreciation & Amortization 1,054 1,001 1,043 1,118 1,199 1,324 1,463 1,613 Change in Working Capital (76,177) (27,954) (3,028) 34,321 21,432 7,422 15,240 (1,907) CFO (53,304) (20,017) 8,559 48,226 37,677 24,837 34,232 17,666 Capex (1,384) (1,479) (1,675) (1,799) (2,654) (2,924) (3,223) (3,549) Investments 2,464 (4,892) (1,841) (4,733) 46, (26) (28) Change in other LT Assets (3,177) (1,552) (1,326) (1,254) (1,090) (829) (525) (160) CFI (2,098) (7,922) (4,842) (7,787) 42,795 (3,725) (3,774) (3,736) Other changes in Equity (3,840) (3,247) (1,581.65) (3,196.79) (5,266.16) (6,436.28) (8,764.98) (8,980.10) Change in Borrowing 73,709 9,754 (3,140) (37,936) (61,000) Change in other LT Liabilities 912 3, CFF 70,782 9,644 (4,028) (40,439) (65,572) (5,743) (8,072) (8,287) Net Cashflow 15,379 (18,295) (312) 0 14,900 15,369 22,387 5,643 Beginning Cashflow 5,227 20,607 2, , , , , , Ending Cashflow 20,607 2,312 2, , , , , , Actual on BS 20,607 2,312 2, , , , , ,

19 Financial ratio FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E PROFITABILTY: ROE 32% 8% 12% 13% 14% 15% 16% 15% Profit margin 2% 1% 1.49% 1.56% 1.52% 1.44% 1.48% 1.45% Asset Turnov er Lev erage ROA 7% 2% 3% 4% 5% 5% 5% 5% LIQUIDITY: Current ratio 1.08x 1.10x 1.13x 1.14x 1.40x 1.41x 1.44x 1.46x Quick ratio 0.79x 0.87x 0.87x 0.87x 1.04x 1.03x 1.05x 1.06x CFO/CAPEX ACTIVITY: LNG Receivables Turnover Pow er sector receivables turnover Day s Pow er sector receivables Day s LNG receivables Inv entory Turnover Day s in inv entory (without stock in transit) Cash Conversion Cycle FINANCIAL LEVERAGE: Total Debt to Equity 3.73x 3.15x 2.77x 2.55x 2.08x 2.08x 1.94x 1.85x Interest Cov erage 4.40x 2.06x 2.38x 2.62x 4.84x 5.45x 5.98x 5.82x SHAREHOLDER RATIO: Earning per share Div idend per share Div idend pay out ratio 7% 39% 15% 25% 35% 40% 50% 50% 18

20 Common Size Analysis Balance Sheet As at June 30th FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E ASSETS Property Plant and Equipment 2.32% 1.67% 1.96% 1.57% 1.86% 2.02% 2.14% 2.66% 2.85% 3.21% 3.55% Intangibles 0.01% 0.01% 0.02% 0.01% 0.02% 0.02% 0.02% 0.03% 0.03% 0.04% 0.00% Long Term Investment 0.88% 0.57% 17.11% 12.30% 14.85% 15.24% 16.02% 3.13% 2.85% 2.76% 2.65% Long Term Loans Adv ance and Other Receivables 0.12% 0.11% 0.13% 0.09% 0.09% 0.09% 0.08% 0.08% 0.07% 0.06% 0.06% Long Term Deposits and Prepayments 0.05% 0.03% 0.05% 0.04% 0.05% 0.05% 0.06% 0.07% 0.07% 0.07% 0.00% Deffered tax 0.36% 0.61% 1.17% 1.74% 2.35% 2.71% 2.95% 3.41% 3.35% 3.39% 3.28% NON CURRENT ASSETS 3.75% 3.01% 20.43% 15.76% 19.21% 20.13% 21.27% 9.36% 9.20% 9.52% 9.63% Stores Spare Parts and Loose Tools 0.04% 0.04% 0.05% 0.05% 0.06% 0.05% 0.05% 0.07% 0.08% 0.08% 0.08% Stock in Trade (Inventory ) 36.31% 25.42% 37.63% 23.19% 17.14% 18.11% 18.60% 23.24% 24.05% 24.51% 24.78% Trade Debts 47.48% 62.60% 27.17% 47.13% 52.97% 51.93% 50.50% 57.32% 56.86% 48.12% 47.53% Loans and Adv ances 0.16% 0.15% 0.17% 0.13% 0.63% 0.15% 0.14% 0.15% 0.14% 0.14% 0.14% Deposits and Short term Prepay ments 0.39% 0.73% 0.85% 0.67% 0.56% 0.60% 0.64% 0.65% 0.59% 0.55% 0.54% Mark-up/ Interest Receiv ables on Inv estments 0.00% 0.00% 0.80% 0.60% 0.66% 0.65% 0.63% 0.00% 0.00% 0.00% 0.00% Other Receivables 8.57% 6.06% 9.42% 5.67% 5.73% 5.60% 5.45% 5.75% 5.30% 5.18% 5.01% Taxation - Net 2.40% 1.53% 1.63% 1.26% 2.38% 2.20% 2.16% 2.87% 3.25% 3.69% 3.54% Cash and Bank balances 0.88% 0.47% 1.85% 5.54% 0.68% 0.58% 0.56% 0.58% 0.53% 8.22% 8.76% CURRENT ASSETS 96.25% 96.99% 79.57% 84.24% 80.79% 80% 78.73% 90.64% 90.80% 90.48% 90.37% Net Assets in Bangladesh 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% TOTAL ASSETS 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% LIABILITIES & EQUITY Issued Subscribed and paid-up 1% 0% 1% 1% 1% 1% 1% 1% 1% 1% 1% Reserv es 15% 13% 21% 20% 23% 26% 27% 32% 32% 33% 34% TOTAL EQUITY 16% 14% 22% 21% 24% 26% 28% 32% 32% 34% 35% Retirement and Other Serv ice Benefits 1% 1% 2% 1% 2% 3% 3% 3% 3% 3% 3% Long term deposits 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% Deferred Liabilities 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% NON-CURRENT LIABILITIES 1% 2% 2% 1% 2% 3% 3% 3% 3% 3% 3% Trade and other Pay ables 73% 71% 70% 52% 43% 42% 46% 59% 63% 62% 61% Prov isions 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% Accrued Interest / Markup 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% Short Term Borrow ings 9% 13% 6% 25% 30% 29% 22% 4% 1% 0% 0% Taxes Payable 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% CURRENT LIABILITIES 83% 84% 77% 77% 73% 71% 69% 65% 65% 63% 62% TOTAL LIABILITIES 84% 86% 78% 79% 76% 74% 72% 68% 68% 66% 65% TOTAL EQUITY AND LIABILITIES 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 19

21 Common Size Analysis P&L FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E Sales 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% Less: Sales Tax -14% -14% -14% -14% -17% -23% -23% -22% -22% -23% -23% Less: IFEM -1.7% -1.0% -1.2% -1.2% -1.6% -2.6% -2.4% -2.2% -2.1% -2.1% -2.2% Net Sales 84% 85% 85% 84% 82% 74% 75% 75% 76% 75% 75% Cost of Product Sold -81% -83% -82% -82% -80% -71% -72% -73% -73% -73% -72% Gross Profit 3.5% 2.9% 2.6% 2.6% 2.1% 3.0% 3.0% 2.7% 2.6% 2.5% 2.5% Other Income 0.6% 0.8% 0.5% 1.4% 1.3% 1.3% 1.2% 0.6% 0.5% 0.6% 0.6% Operating Costs: 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Distribution & Marketing Expenses -0.6% -0.6% -0.6% 0.0% -0.7% -0.9% -0.9% -0.8% -0.7% -0.7% -0.7% Administrative Expenses -0.2% -0.1% -0.1% -0.1% -0.2% -0.2% -0.2% -0.2% -0.2% -0.2% -0.2% Other Operating Expenses -0.2% -0.8% -0.3% -0.3% -0.3% -0.3% -0.3% -0.3% -0.3% -0.2% -0.3% Total Operating Cost -1.0% -1.5% -1.0% -0.9% -1.3% -1.4% -1.4% -1.2% -1.2% -1.1% -1.1% EBITDA 3.1% 2.2% 2.1% 3.1% 2.1% 2.9% 2.8% 2.1% 1.9% 1.9% 1.9% Depreciation & Amortization 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% EBIT 3.0% 2.1% 2.0% 3.0% 2.0% 2.7% 2.7% 2.0% 1.9% 1.9% 1.8% Finance Cost -1.2% -1.0% -0.6% -0.7% -1.0% -1.2% -1.0% -0.4% -0.3% -0.3% -0.3% Share of Profit from Associates 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Profit Before tax 1.84% 1.14% 1.48% 2.34% 1.08% 1.63% 1.70% 1.64% 1.55% 1.60% 1.55% Tax ation -0.3% -0.4% -0.5% -0.8% -0.5% -0.5% -0.5% -0.5% -0.5% -0.5% -0.5% Profit After tax 1.5% 0.8% 1.0% 1.5% 0.6% 1.1% 1.2% 1.1% 1.1% 1.1% 1.1% 20

22 Ratio Analysis Financial ratio FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E PROFITABILTY: ROE 32% 8% 12% 13% 14% 15% 16% 15% Profit margin 2% 1% 1.49% 1.56% 1.52% 1.44% 1.48% 1.45% Asset Turnover Leverage ROA 7% 2% 3% 4% 5% 5% 5% 5% LIQUIDITY: Current ratio 1.08x 1.10x 1.13x 1.14x 1.40x 1.41x 1.44x 1.46x Quick ratio 0.79x 0.87x 0.87x 0.87x 1.04x 1.03x 1.05x 1.06x CFO/CAPEX Financial ratio FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E ACTIVITY: LNG Receivables Turnover Power sector receivables turnover Days Power sector receivables Days LNG receivables Inventory Turnover Days in inventory (without stock in transit) Cash Conversion Cycle FINANCIAL LEVERAGE: Total Debt to Equity 3.73x 3.15x 2.77x 2.55x 2.08x 2.08x 1.94x 1.85x Interest Coverage 4.40x 2.06x 2.38x 2.62x 4.84x 5.45x 5.98x 5.82x SHAREHOLDER RATIO: Earning per share Dividend per share Dividend payout ratio 7% 39% 15% 25% 35% 40% 50% 50% 21

23 Valuation using Core business and noncore business FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E EBITDA w ithout penal income & markup on PIBs 26,094 12,271 16,943 19,554 23,206 26,200 29,540 30,243 Less: Taxation (11,151) (5,097) (4,962) (5,662) (6,826) (7,731) (8,695) (8,796) Add: WC Change (76,177) (27,954) (3,028) 15,075 10,170 1,170 26,523 (5,217) Less: Capex (1,384) (1,479) (1,675) (1,799) (2,654) (2,924) (3,223) (3,549) FCFF (62,619) (22,260) 7,278 27,168 23,896 16,715 44,146 12, NPV of FCFF 100,996 7,278 24,574 19,550 12,369 29,548 7,677 Terminal Value 104,621 PV of Terminal Value 63,338 Enterprise v alue 164,334 Less: Net Debt 96,935 Equity Value 67,399 Core share Price Non-core share Price Target Price

24 23

25 PKR/share CFA Institute Research Challenge Jan-10 4-Jan-11 4-Jan-12 4-Jan-13 4-Jan-14 4-Jan-15 5X 4X 3X 2X 24

26 Sensitivity factor Current price PKR/USD depreciation Target price Upside Decision 4.0% % Buy 6.0% % Buy 7.7% % Hold 8.0% % Hold Circular debt LNG receivables days Constant at 70 (from ) 330 3% Sell Constant at 65 (from ) 347 8% Sell Constant at 50 (from ) % Buy Rise in interest rates (increase from our assumptions) Kibor = 10.1% % Buy Kibor = 12.1% % Hold Kibor = 14.1% 345 8% Sell Kibor = 14.6% 338 5% Sell Brent (w/o incorporating inv. Losses & gains) 10% increase ev ery year (from 40 USD in 2016) 339 5% Sell 10% decrease ev ery year % Buy Constant at % Buy 5 USD increase ev ery year from % Sell 7 USD increase ev ery year from % Sell Inventory losses/gains Assumption for volatility of USD/barrel: -5 ev ery year 332 3% Sell +5 ev ery year % Buy -10 ev ery year % Sell -5 in % Buy -10 in % Sell Increase in LNG margins from 1.82 to 4% % Buy 25

27 Porter's Five Forces Threat of new entrant 5 4 Bargaining Power of 3 2 Threat of Substitutes Customers 1 0 Competition in industry Bargaining Power of Suppliers Bargaining Power of Customers - LOW: Since prices are regulated by OGRA customers doesn t have any bargaining power for regulated products such as HSD, MOGAS, LNG or FO. There is low switching cost. No particular group carries a significant weight. Since prices are fixed, end users of HSD & MOGAS make their purchase according to their convenience and proximity of dealer. FO end users are bound to buy from PSO according to long term Fuel Supply Agreements (FSA) signed by them therefore no bargaining power lies with them either. However, only 1 out of 6 Power plants according to power policy of 2002 purchase FO from PSO. Moving forward, LNG is also solely imported a nd sold by PSO thus this situation is not looking to change very soon. Many B2B consumers are given PSO cards which makes it necessary for them to buy from PSO further limiting their bargaining power. Intensity of Competitive Rivalry - MODERATE: PSO is the market leader in white & black oil but Pakistan Shell Limited (PSL) is leader in lubricants. Competition is limited to few companies but has been increasing gradually in recent years. The biggest competition it faces comes from PSL. Regulated prices for most of the products make it even more difficult for firms to compete. Deregulation in prices and product differentiation exists only in lubricant category where Shell Helix is currently the market leader with a 35% market share, PSO has a market share of 25% while Chevron stands at 29%. PSO being a government organization enjoys a lot of securities that others players do not, for example it provides FO to most of the Power plants in the country due to long term fuel supply agreements. PSO s plans of acquir ing controlling share in PRL and vertical integration will further improve its competitive position. PSO has storage facilities all over Pakistan i.e. at 36 locations with a capacity of 552,000 tons. SPL only has 65,000 tons storage capacity. Bargaining Power of Suppliers - LOW: PSO imports Black Oil from Kuwait Petroleum and Qatar Petroleum via supplier contract which is usually valid for 1-2 years. Suppliers deliver in high volumes based on pre-contract agreement hence, there is low bargaining power of suppliers internationally. Locally, PARCO, NRL and PRL are the fuel suppliers to PSO. The local refineries supply fuel throug h long-term contracts according to which, fuel supply is matched to the market share of the OMC. The one with the highest market share ge ts to meet its fuel requirements first and the rest is distributed to the OMCs in accordance with their respective market share s. As of now, PSO has the largest market share in both Black Oil & White Oil Markets hence, the bargaining of local supplier is also low. Threat of Substitutes - MODERATE: Due to the energy crisis prevalent in the country, there exist moderate threat of new substitutes in both white and black oil markets. Product substitutes are natural gas, coal, solar power and renewable energy. Substitutes in Black Oil Market such as, coal & LNG can be a threat to PSO but since PSO is the sole importer of LNG as well, it faces threat of cannibalization and not losing its share to some other competitor. Barriers to Entry - HIGH: There are high barriers to entry for OMCs in the industry. To start as an OMC you need capital in billions (Total investment capacity of PKR 500 million or more over an initial period of three years, with minimum upfront equity of PKR100 million based on the criteria of 60:40 debt/ equity ratio, supported by a due diligence certificate from a scheduled bank or financial inst itution), storage facilities, license from the government and have an initial retail network. Very less product differentiation & regularized prices also make it difficult to enter the industry. Recently, some small OMCs have emerged in the industry such as, Hascol Petroleum and Admore Gas and some other small companies are operating in Punjab. 26

28 Macroeconomic variables FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E GDP grow th rate 4.03% 4.24% 4.50% 4.50% 5.20% 5.20% 5.20% 5.20% Inflation 8.6% 4.4% 4.7% 5.5% 5.0% 5.0% 5.0% 5.0% Ex change rate (PKR/USD) Discount rate/ Kibor 10% 7% 7.00% 8.10% 8.10% 8.10% 8.10% 8.10% Circular debt stock (FY2012) Total Tariff & Subsidy Issues CPPA Receivables from KESC Total (DISCOs Receivables) Stock of Debt - Beginning of the Year PKR billion Mogas vs CNG consumption in transport 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E Mogas % CNG % 27

29 Cost, PKR/km million TOE CFA Institute Research Challenge CNG consumption in transport CNG used in transport sector Share of natural gas allocated to transport % 10% 8% 6% 4% 2% 0% Petrol-CNG price parity Petrol CNG 28

30 FY15 FY16E FY17E FY18E FY19E FY20E FY21E Brent (USD/barrel) LNG margin (PKR/ton) FO margin (PKR/ton) 1, ,072 1,195 1,243 1,293 LNG sales (mn tonnes) FO sales (mn tonnes) LNG contribution to core profits 0.7% 4.7% 8.6% 16.1% 22.9% 30.5% 30.5% FO contribution to core profits 32.2% 16.7% 13.9% 13.7% 12.7% 6.6% 6.6% Source: Team estimates 29