Buy on weakness

Mariyam Zhumadil, CFAOctober 30, 2014

After the company guided for a 34% YoY decline in consolidated earnings selling pressure on KTO’s shares rose notably. This took the market by surprise and increased uncertainty over the size of 2014 dividends. We attribute the slump in consolidated earnings mainly to an T18.1bn decline in the contribution of associates income (HF estimate) due to a devaluation related loss (largely one-time) and the changes to the oil supply agreement with Russia (largely permanent). The agreement resulted in displacement of regulated volumes (export and domestic) by non-regulated transit volumes. Core KTO earnings have not been significantly affected by the changes to the agreement. But KCP’s high value export volumes were substituted by transit volumes where the tariffs are four times lower. As a result, we cut our 12-month target price by 22.4% to T1047 per share, which at the current share price translates into a 24.7% upside to the current market price, in addition to the 13.3% expected dividend yield. We recommend investors to take advantage of the current share price weakness. The main risks to our valuation are the withdrawal of government support for the People’s IPO program, regulatory and corporate governance risks.

2014 guidance surprises the market

After the company guided for a 34% YoY decline in consolidated earnings selling pressure on KTO’s shares rose notably. This took the market by surprise and increased uncertainty over the size of 2014 dividends. We attribute the slump in consolidated earnings mainly to an T18.1bn decline in the contribution of associates income (HF estimate) due to a devaluation related loss (largely one-time) and the changes to the oil supply agreement with Russia (largely permanent). The agreement resulted in displacement of regulated volumes (export and domestic) by non-regulated transit volumes. Core KTO earnings have not been significantly affected by the changes to the agreement. But KCP’s high value export volumes were substituted by transit volumes where the tariffs are four times lower.

Fears over dividends are exaggerated, we believe

Firstly, the company’s dividend policy states that the dividend payment is determined off the consolidated net income or core net income, whichever is greater. Based on the 9M2014 unconsolidated financial results the company’s net income is already T50.1bn, which implies that FY2014 core net income will be approximately on par with the 2013 earnings. Secondly, the contribution of associates is mostly a non-cash item. Thirdly, we believe that 2014 dividends will be not less than the previous year distribution as the company’s major shareholder, NC KMG remains cash hungry. We expect 2014 dividend to be T111 per share, which implies a 110% payout ratio and a dividend yield of 13.3% off the last close price.

Performance relative to KASE

KTO share price fell by 24.3% over the past month, while KASE index declined by 18.5%. We explain the decline of the index by the falling market cap of commodity exporters’, which account for large share of the index. We believe that the sell-off of KTO shares prior to the earnings guidance downgrade by the company was related to the closure by the large retail investors of their long positions in tenge-denominated assets due to concerns over tenge weakening. In our view, this was not quite rational as the tariff regulation allows preserving the real value of the company in the long-term.

Valuation 

We have updated our model to reflect 1) the actual 9M2014 operating results; 2) downward revision of 2014 volume growth assumptions; 3) revision of revenue forecasts for KTO and KKT; 4) revision of dividend assumptions. As a result, we cut our 12-month target price by 22.4% to T1047 per share, which at the current share price translates into a 24.7% upside to the current market price, in addition to the 13.3% expected dividend yield.

Recommendation

KTO shares remain our top pick among the publicly listed Kazakh stocks. The company generates stable and predictable cash flows, and is capable of paying out stable dividends. We recommend investors to take advantage of the current share price weakness. The main risks to our valuation are the withdrawal of government support for the People’s IPO program, regulatory and corporate governance risks.

Full report can be downloaded in the PDF version.

Other reports