KMG EP: 9М2017 results overview

Raising the 12M TP to $13.3/GDR, keeping the HOLD recommendation.

Altynay IbraimovaNovember 30, 2017

The consequences of a favorable background in the oil market and more efficient operations after switching to the own processing scheme, in our view, strengthened the financial position of KMG EP, justifying the improvement of forecasts. The increase in forecasts for oil prices affected the increase in the target price by 19% to $13.3/GDR. At the same time, the risk of the cancellation of processing scheme and return to unprofitable oil sales to the domestic market in the current quarter has increased, which, coupled with the remaining uncertainty about the expected buyback by the parent company, restrains optimism, and therefore we keep our "Hold" recommendation for KMG EP shares.

Financial results are higher than expected. The Company's results for 9M2017 showed an increase in operating profit by 32% yoy due to high revenues (+ 29% yoy) and despite an increase in production costs by 39% yoy, explained by the increase in "oil" taxes due to the rise in price of oil. The largest (69%) share of export sales, accompanied by a relatively high oil price, profit from participation in joint ventures and a positive exchange rate difference, facilitated the acquisition already in 9M2017 net profit, commensurate with what we expected in 2017.

Regulatory risks remain. Transition to the processing scheme of oil in April 2016 allowed the Company to reach a profitable level for domestic supplies. Nevertheless, the margin of domestic supplies remains low, bearing in itself risks for profitability of sales - for 9M2017. The domestic supply margin was only 7%. Based on the current gasoline shortage in the domestic market in October, KMG EP notes the possibility of a forced cancellation processing scheme of oil and return to the previous model of oil supply to the refinery, which provides the government an opportunity to control fuel prices. We believe this risk is justified, given the importance for NC KMG to comply with the interests of the state. In addition, return to less profitable domestic supplies reduces the investment attractiveness of KMG EP. A low market valuation is beneficial for the parent company and will help to minimize the price for the repurchase of KMG EP shares, if necessary. Due to possible risks, we assume that deliveries to the domestic market in 2018-2022 may exceed the previously set 33%. We pledge a share of domestic supplies in 2018-2022 at 37%, which corresponds to the average value of the share of domestic supplies of KMG EP in 2015-2016 (33% and 41%, respectively).

Favorable conditions for paying dividends. Based on the high profitability for 9M2017, according to the results of this year, we expect a dividend above the level of last year at 15%. We expect dividend payout ratio of 20% of net profit for 2017. We justify our assumption by more favorable in comparison with 2014-2016 conjuncture in the oil market. In the following 2018-2022 we adhere to conservative expectations for dividend payments, noting that this issue is highly dependent on the financial position of the major shareholder.

Availability of "free" cash by KMG EP remains questionable. The opinion of KMG EP about more expedient use of funds in the amount of T1360bn has not yet been understood by the parent company, which, in turn, continues to experience the costs of a high debt load. The possibility of KMG EP to reinvest or use free money to pay dividends, in our view, is not considered by the parent company as an attractive alternative and continues to act as a risk for the share price.

Raising the 12M TP to $13.3/GDR, keeping the HOLD recommendation. We adjusted the forecast for 2017 taking into account the strong results of 9M2017 and improved expectations for the oil price in 2018-2022 based on the Bloomberg consensus forecast. Assessing the Company's ability to maintain free cash flows at the optimal level, provided that regulatory risks are minimized, we increase our 12M TP to $13.3/ GDR. In a view of the continuing uncertainty regarding buyouts and increased regulatory risks, we maintain the HOLD recommendation for KMG EP shares.

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