Achieving the positive value of KMG EP's free cash flows, as well as an increase in the consensus forecast for Brent crude oil (up to $56/bbl in 2017), allow us to increase our 12M target price to $11.2/GDR. At the same time, the low profitability of domestic supplies, the relationships of independent directors of KMG EP with the management of NC KMG and the uncertainty regarding the repurchase of KMG EP shares by the parent company in case of IPO, as part of the privatization program are the main risks, in connection with which we retain the "Hold" recommendation.
Strong financial results, supported by the improved operating performance. We positively evaluate the Company's financial results for 2016. The shift to the profitable level in operations with supplies to the domestic market as a result of processing, a partial VAT refund, the growth of operating cash flow from T70bn to T159bn yoy and the increase in net cash by 7% fully reflect our opinion. The company managed to significantly increase revenues (+39% yoy), while limiting itself to a slight increase in costs (+3%).
Low profitability of domestic sales. The share of export supplies in 2016 increased by 4 pp up to 56%, domestic supplies showed a similar increase, which amounted to 44%. Despite the fact that the main factor in the growth of income was the weakening of tenge, we believe, that the transition to independent oil processing, albeit partially, but still had a positive impact on the increase in revenues. At the same time, we note a lower profitability of domestic sales compared to export sales. So, according to our calculations, in 2016, the export margin was 52%, while the supply to the domestic market in 1Q2016 was unprofitable (-79%), and only after the transition to a new implementation scheme in 2-4 quarters there was a positive margin of 15%, which is why we note a rather low profitability of domestic supplies and believe, that if the share of domestic supplies increases, the risk of a decline in overall profitability remains.
Mutual relations with NC KMG are the main risk. The high probability of KMG EP's stock repurchase by the parent company NC KMG remains in the light of the planned IPO of the latter under the Privatization program. Given NC KMG’s shortage of cash with a high debt burden, we note a high risk of the repurchase of KMG EP shares against the interests of minority shareholders of KMG EP. The repeated attempt of NC KMG to neglect the interests of minority shareholders over the past three years, in our view, fully determines this risk.
The minimum dividend payout ratio despite the high monetary position. We assume that the net monetary position of T1.2 trillion ($3.5 billion) allows the Company to consider the possibility of paying dividends. However, given the financial position of the parent company and the importance of maintaining liquidity for the latter, we expect the minimum threshold of dividend payout ratio of 15%.
Increase of the 12M TP to $11.2/GDR, “Hold” recommendation. An increase of the consensus forecast of oil prices and strong annual results of KMG EP allow us to increase our 12M TP to $11.2/GDR. Taking into account the current price of $10.1, the target price implies a potential of growth by 8.8% and due to the remaining risks related to the relationships with NC KMG, which involve a buyback, we maintain our “Hold” recommendation for KMG EP shares.