Equitymaster Agora Research Private Limited Independent Investment Research 10 April, 2010

Hindustan Petroleum Corp. Ltd.

Sell
Market data
Current price Market cap Face value FY09 DPS (Rs) BSE Code NSE symbol No. of shares Free float 52 week H/L Rs 309 (BSE) Rs 104,585 m Rs 10.0 6.3 500104 HINDPETRO 338.6 m 48.9% Rs 425 /242.5

Investment Concerns
The business destroys shareholder wealth: Public sector oil marketing companies such as Hindustan Petroleum Corporation Limited (HPCL) have unmatched physical assets-in-place. Refineries, pipelines and a vast distribution network. But they incur losses every single day that they operate. On the one hand, their inputs costs keep rising with higher crude oil prices. On the other hand, the government forces them to price their final output - auto and cooking fuels- at subsidised rates. As a result, from a shareholder's perspective, all that the wonderful assets succeed in doing is destroy wealth. We have all heard of the proverbial white elephant. The animal takes a fortune to maintain. But it earns precious little in return. Anyone looking at it is amazed by its size. What an asset it must be, they think. But only the owner knows how difficult it is to maintain this asset. Despite the recommendation of several committees, the latest one being the Kirit Parikh committee, the government continues to shield the consumer from high oil prices through a subsidy sharing mechanism involving downstream oil companies, the government and upstream oil companies. Cash flow problems and interest burden: The rise in the prices of crude oil, coupled with the inability to pass on the entire burden to the consumer, has put an enormous strain on the liquidity position of the refining and marketing companies. Although oil bonds from the government and discounts on crude oil prices by upstream companies have ensured that oil marketing companies remained profitable at the bottomline level, their cash flow position has been adversely affected. Consequently, their borrowing levels have increased, along with the corresponding rise in the interest outgo. This could pose serious challenges to HPCL which has drawn up major investment plans in the areas of refinery upgradation, building new capacities, development of distribution infrastructure and exploration and production. Complex refineries at a time when crude spreads narrow: Over the last few years, heavier and sour crude oils formed a higher proportion of the crude oil basket as the light/heavy crude differentials were quite high. Consequently, newer refineries with the latest facilities were opting for heavier crude oils to take advantage of the differentials. There has been a sharp reduction in the differential, with the average spread between Brent and Dubai crude coming down sharply. These changes are expected to have an impact on the refinery economics.
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Rs 100 invested is now worth

400 300
200
HPCL: Rs 97 Sensex: Rs 273

100 Apr-05 Sep-07 Mar-10

Stock price Performance

1-yr 3-yr 5-yr HPCL 17.7% 6.6% -0.9% Index* 66.0% 10.8% 22.6%

Returns over 1 year are compounded annual averages (CAGR) * BSE Sensex

Shareholding (Dec-2009)
Category Promoters Banks, FIs, MFs & UTI FIIs Public Others Total (%) 51.1 26.9 11.3 10.7 100.0

Report prepared by Equitymaster Agora Research Private Limited. www.equitymaster.com info@equitymaster.com

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Comparative
HPCL Operating ratios (FY09-FY12E) Sales CAGR Avg. EBDITA margin* Net profit CAGR Avg. net profit margin Other key ratios (FY12E) Return on equity Return on assets D/E ratio Valuations (FY12E) Current market price (Rs) Price to earnings Price to sales 309 5.9 0.1 505 11.0 0.1 12.1% 3.2% 1.7 9.8% 2.9% 1.7 6.6% -6.0% 32.0% 1.0% 6.0% 3.0% 37.7% 1.0% BPCL

Background
Hindustan Petroleum Corporation Limited (HPCL) is the third largest oil refining and marketing company in India. Apart from the 13 MTPA (million tonnes per annum) of refining capacity, it has strong retail presence with over 8,500 retail outlets spread across the country. The refineries at Mumbai and Visakhapatnam achieved a combined throughput of 15.8 MT during FY09.The company achieved market sales of 25.4 MT during the year. Further, the company has nearly 27 m customers in the fast growing LPG business. Going forward, the company plans to increase its refining capacity from the current 13.0 MTPA to nearly 16.2 MTPA.

Industry Prospects
India continues to be dependent on imports for meeting a major portion of its crude oil requirements. 128.16 m tonnes (MT) of crude oil were imported during the FY09, an increase of 6.49 MT over FY08. US$ 75.7 bn were spent on these imports as compared to US$ 68 bn in the previous year. The consumption of petroleum products in India stood at 133.4 MT in FY09, as compared to 128.95 MT in FY08, a YoY growth rate of 3.5%. However, the current pricing regime is shifting the energy use pattern in favour of transport fuels as seen in their growth rates. While consumption of petrol grew by 9% YoY, the consumption of diesel increased by 8.4% YoY in FY09. India's state owned oil marketing companies Indian Oil, BPCL and HPCL plan to invest over Rs 775 bn in adding 44.2 m tonnes of refining capacity by 2012.

* For HPCL, subsidies excluded from operating results

Investment Rationale
GDP growth to drive off take and topline: The growth in consumption of petroleum products in India during FY09 was 3.5% YoY, lower than the 7% growth clocked last year. The average growth in the consumption of petroleum products over the FY02 to FY07 was 3.4%. Off take of petroleum products is closely linked to economic activity. Even cautious projections for the Indian GDP growth rate will translate into increased volumes for HPCL. Upswing in refining margins aids the beleaguered marketing side: Whenever there is buoyancy in refining margins, it contributes significantly in improving the bottom lines of the oil companies, thereby mitigating to some extent, the under-recoveries on the marketing side. Better margins are also the result of the refineries no longer having to contribute towards sharing the under recoveries of the marketing companies on the recommendation of the Rangarajan Committee. However, with the light heavy crude oil price differentials narrowing significantly in the recent past, the advantages arising out of the ability to process heavier crude could diminish.

Key management personnel

Mr. Arun Balakrishnan- Chairman & MD, is a Chemical Engineer from the Government College of Engineering, Trichur and a Post Graduate Management from the Indian Institute of Management, Bangalore. He has handled various portfolios in marketing, corporate and human resources of HPCL and possesses a rich experience in the oil sector. Prior to taking charge of his current responsibility on April 01, 2007, he held the position of director - human resources. He also had a 5 year stint with the erstwhile Oil Coordination Committee in the Petroleum Ministry as director - planning. Mr. S. Roy Choudhury- Director Marketing, is a Mechanical Engineer from the University of Assam. Prior to taking charge of his current responsibility in May 2004, he was executive director, the direct

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sales SBU of the company. Mr. Roy joined HPCL on 21st June, 1982 as a Construction Engineer. He began his career with the Assam Oil Company, Digboi. Risk Analysis
Please see Risk Matrix table on page 5 of this report

Sector: The Indian petroleum sector is heavily dependent on imports for meeting a major portion of its crude oil requirements. The state-owned oil marketing companies do not have the freedom to set the prices of petroleum products independently. As a result, they cannot recover their input costs. These under recoveries are only partly subsidised by upstream companies and the government. Hence, we assign a high risk rating to the company on this parameter. Companys standing: While HPCL is a large company in the overall scheme of things, in its industry it comes after Indian Oil and BPCL in terms of market share in most of the segments that it is present in. Hence, we assign a medium rating to the company on this parameter. Sales: HPCL generated average revenues to the tune of nearly Rs 878 bn (US$ 19.5 bn) each year over the last five years. Further, in the latest financial year (FY09), the company has generated over Rs 1.1 trillion. We, thus, assign a low-risk rating of 10 to the stock. Operating margin: Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as raw materials, wages, and sales and marketing costs. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt. The higher the margin, the better it is for the company as it indicates its operating efficiency. HPCLs average operating margins, on excluding subsidies, for the past three years have been -7% on a consolidated basis, which we do not expect to improve drastically during the next three, due to the governments policy to subsidise prices. As such, we assign a high risk rating of 1 to the stock on this parameter. Long term EPS growth: Given the wafer thin margins (after including subsidies) for HPCL, any improvement will lead to a strong growth rate due to the low base effect. We expect profit growth be 32% CAGR over the next three years. As such we assign a low risk rating of 9 to the stock on this parameter.

Return on capital invested (ROIC): ROIC is an important tool to assess a company's potential to be a quality investment by determining how well the management is able to allocate capital to its operations for future growth. A ROIC of above 15% is considered decent for companies that are in an expansionary phase. Considering HPCLs last three years average ROIC of 14%, we have assigned a high-risk rating of 2 to the stock on this parameter. Dividend payout: A stable dividend history inspires confidence in the management's intentions of rewarding shareholders. HPCLs average payout ratio has been a decent 28% over the past 3 fiscals. Thus, we have assigned a low-risk rating of 7. Promoter holding: A larger share of promoter holding indicates the confidence of the people who run it. We believe that a greater than 40% promoter holding indicates safety for retail investors. Promoter shareholding in HPCL at the end of December 2009 stood at 51%. As such, we assign a low risk rating of 8 to the stock on this parameter. FII holding: We believe that FII holding of greater than 14% can lead to high volatility in the stock price. The FII holding in HPCL at the end of December 2009 stood at 11%. Based on our parameters, the rating assigned is 5. Liquidity: The average daily trading volumes of HPCLs stock over the past 52 weeks stand at nearly 318,000 shares. This level of liquidity level is a matter of comfort, as this might protect the stock from undue volatility in case of exchange of large holdings among market participants/investors. The rating assigned is 9. Current ratio: HPCLs average current ratio during the period FY05 to FY09 has been 1.4 times. This indicates that the company is comfortably placed to pay off its short-term obligations, which gives comfort to its lenders. We assign a medium-risk rating of 5. Debt to equity ratio: A highly leveraged business is the first to get hit during times of economic downturn, as companies have to consistently pay interest costs, despite lower profitability. Although HPCLs average debt to equity ratio has been 1.4 over the past five fiscals, it is set to increase over the next three in order to fund its aggressive capital expenditure plan. We have assigned a high-risk rating of 1 to the stock.

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Interest coverage ratio: It is used to determine how comfortably a company is placed in terms of payment of interest on outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense for a given period. The lower the ratio, the greater are the risks. HPCLs average interest coverage ratio has been 3 over the past three years and is expected to be 2 over the next three. We assign a high risk rating of 1 to the stock on this parameter. P/E Ratio: The P/E ratio (price-to-earnings ratio) of a stock is a measure of the price paid for a share relative to the per share income or profit earned by the company. This is one of the important metrics to judge the attractiveness of a stock and thus gets the highest weightage in our risk matrix. HPCLs consolidated P/E on earnings of FY09 stands at 14 times at a price of Rs 309 per share. As such, we have assigned a medium risk rating of 5 to the stock on this parameter. Considering the above analysis, the total ranking assigned to the company is 63 that, on a weighted basis, stands at 5.4. This makes the stock a medium-risk investment from a longterm perspective.

Valuations
The stock currently trades at Rs 309, implying a multiple of 0.7 times our estimated FY12 book value per share. We value HPCL on a book value basis. The key variables impacting the company's valuation are the volume of petroleum products sold, realisation rates (under recoveries, oil bonds & subsidy), capex and debt plans. It is important to note that, given the current lack of freedom on pricing, the performance of the company is extremely sensitive to its cost structure. So much so, that an increase of 1% in input costs (as a % of sales) from current levels can swing the bottomline into the red. In fact, much of the net profit is accounted by subsides which are unpredictable and can often leave investors on tenterhooks. On a book value multiple of 1x, HPCL should trade at Rs 452 from an FY12 perspective. This translates into a CAGR of 14%. However, there is a strong possibility that the price would remain at current levels or even fall from here if the company continues to bleed on account of unreasonable government policies. In light of this, we recommend a SELL on the stock. It should be noted that the stock presents a good buying opportunity for those who hope that the government will eventually take some rational decision. However, as far as we are concerned, we continue to remain negative and reiterate our SELL view on the stock.

Valuations
FY09 Revenue (Rs m) PAT (Rs m) EPS (Rs) Price to earnings (x) Price to sales (x) 1,136,797 7,573 22.4 13.8 0.1 FY10E 1,211,638 13,601 40.2 7.7 0.1 FY11E 1,291,791 15,429 45.6 6.8 0.1 FY12E 1,377,706 17,605 52.0 5.9 0.1

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Risk Matrix
Rating Sector risk Company's standing Performance parameters Sales (US$ m) Operating margins (%) Long term EPS growth (%) Return on invested capital (%) Technical parameters Dividend payout (%) Promoter holding (%) FII holding (%) Liquidity (Nos. '000) Safety parameters Current ratio (x) Debt to equity ratio (x) Interest coverage ratio (x) P/E ratio (x) Final Rating** Weightage* (A) 5.0% 5.0% 10.0% 10.0% 5.0% 10.0% 5.0% 10.0% 5.0% 10.0% 5.0% 20.0% Rating# (B) High Medium 10 1 9 2 7 8 5 9 5 1 1 5 63 Rating accorded Weighted (A*B) NA NA 0.5 0.1 0.9 0.2 0.4 0.8 0.3 0.9 0.3 0.1 0.1 1.0 5.4

# Rating has been assigned on the basis of the company's performance over the past five years and expected performance over the next 3 to 5 years. Rating is on a scale of 1 to 10, with 1 indicating highest risk and 10 indicating lowest risk. * 'Weightage' indicates the relative importance in percentage terms of the parameter. For instance, for an investor, given all the performance metrics, Return on Equity should be the foremost criteria for buying/not buying stocks. ** The final rating has been arrived at by multiplying the rating/points given on each parameter with the respective weightage

Financials at a glance
Consolidated (Rs m) Sales Sales growth (%) Operating profit* Operating profit margin (%) Net profit Net profit margin (%) No. of shares (m) EPS Balance Sheet Current assets Fixed assets Investments Total Assets Current liabilities Net worth Loan funds Total liabilities
* Subsidies excluded from operating results

FY09 1,136,797 11.3% (121,033) -10.6% 7,573 0.7% 338.6 22.4

FY10E 1,211,638 6.6% (49,391) -4.1% 13,601 1.1% 338.6 40.2

FY11E 1,291,791 6.6% (52,611) -4.1% 15,429 1.2% 338.6 45.6

FY12E 1,377,706 6.7% (56,062) -4.1% 17,605 1.3% 338.6 52.0

174,155 191,180 128,274 493,609 124,665 111,441 240,612 493,609

182,013 203,782 128,274 514,068 132,872 123,409 240,612 514,068

193,354 215,349 128,274 536,976 141,662 137,204 240,612 536,976

208,499 225,966 128,274 562,738 151,084 153,175 240,612 562,738

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