As oil prices declined, the stock became cheaper for the obvious reason that it reduces the operating margin, but it also becomes a lot riskier for the less obvious reasons which we discuss in this note. In our analysis we explicitly acknowledge the fact that lower prices affect not only the Company itself, but also its operating environment. The most important mechanisms that transmit oil price shock to the shareholder value through the environment are of fiscal, quasi-fiscal, regulatory and corporate governance nature. Based on this analysis, we revise our expectations for the environmental parameters. The scenarios which were low probability even three month ago have by now come to the fore of our attention.
As a result, we downgrade the stock to a Sell, in expectation of the risks stemming from regulation, corporate governance, and fiscal pressure translating onto lower revenues, reduced flexibility in cutting spending, more restrictive payout policy, and the growing but still low probability of conversion of USD-denominated cash pile into KZT. In our baseline scenario domestic prices for 2015 will be cut by 15%, which among other factors translates into a 12M TP of $10.1/GDR, 16% below the current market price.
Implications of lower oil prices for earnings. Lower oil prices will have a negative impact on KMG EP’s earnings and cash flows due to its relatively high operating costs and tax base. With lower oil prices (2015E- $66.2/bbl), tax adjustment, and rising domestic supplies we estimate that EBITDA will decline by approximately 63% to $506mn in 2015, and that FCFFs will drop to $154mn. We believe the company’s regular dividends appear unsustainable in the long-run due to its deteriorating cash flow generation capacity. To maintain the current payouts KMG EP will need to fund from its cash pile. Furthermore, we expect cash discount to widen in the near future. At the enlarged government meeting President Nazarbayev suggested that state-run companies support tenge by keeping their cash balances in the local currency. Later, the head of Samruk-Kazyna said that in line with the agreement reached with the NBK, the foreign currency needs of every company in the Fund will be studied and that they will try to gradually convert foreign currency deposits into tenge. We believe above statements are effectively putting KMG EP’s cash balance, 88% of which was held in USD as of 9M2014-end, at risk. The company’s operating costs (50%) and majority of capex (70-80%) is spent in tenge, which leaves it virtually no arguments to keep excess cash in USD.
Risks for minority shareholders on the rise. KMG EP is the second most important source of regular dividends for the parent company, generates approximately half of consolidated KMG Group EBITDA and is the largest contributor to KMG Group’s consolidated cash balance. The slump in oil prices effectively will serve as a double hit for NC KMG. It is set to weaken dividend income coverage of its capex spend and debt service costs. On the other hand, deteriorating fiscal environment and government’s political decision to keep tenge exchange rate fixed will come at a cost to the state-run companies, which we expect to bear the social and economic costs of this decision. In this environment, the highly leveraged parent shareholder with declining cash inflows, high capex and social commitments is clearly the largest risk factor for KMG EP equity.
Higher domestic supplies amid lower prices. The government effectively subsidizes domestic gasoline prices by mandating sales to refineries at below market prices. This discretionary practice translates into low predictability of returns and essentially serves to divert value from shareholders. We see several risks stemming from domestic supplies. Firstly, in 2009-2013, domestic sales accounted for 7-10% of the total revenue, but this is expected to increase as supply requirements rise to 50% by 2018 due to substitution of falling supplies from the other producers and rising demand after commissioning of the fourth refinery. Secondly, we believe government has high propensity to cut domestic prices for 2015 and after. KMG EP’s 2015 domestic price of T54,000/t ($40/bbl) was set when oil was trading at $110/bbl. Due to supply of cheap gasoline from Russia local refineries and intermediary traders have already accumulated high stocks of gasoline, and are now pushing the Ministry to lower domestic prices. Additionally, we note that the Ministry has started to cut domestic prices for smaller producers. We believe the maximum cut could be at 40% (sufficient to breakeven at opex+SG&A of T33,500/t) and would imply a 12M TP of $6.8/GDR. The reduction of the domestic sale price by 15% in 2015 and further maintenance of a 50% spread to the export price (lower than the historically observed 65-75% spread), would result in a 16% drop in the equity value ($10.1/GDR). In the meantime, we adopt the 15% cut scenario as our base case.