According to the 1H2015 financial results of KMG EP published on August 14, revenue declined by 48.1% YoY, and net profit slumped by 98.3%. The main reasons of decline of revenue and profitability are drop of oil prices by 49.5% YoY to $54.5/barrel and increase of non-tax operating cost by 17.9% YoY to T162.7bln.
New FX rate of KZT/USD is calling for another challenge for KMG EP with regard to keeping its operating cost in line with inflation. In our analysis we acknowledge the importance of increasing profitability that currently opened to the company through a door of depreciated tenge. We noted that cost saving benefits associated with tenge devaluation would be offset in 2018 with increased inflation. We also note that company profitability ratio (ROE) declined to the historical low level of 3.5% in 2014 and would increase to 6.1% in 2015.
Company`s free cash flow (FCF) from its core business (OMG, EMG) is negative and expected to be negative for foreseeable future. However, FCF from associates and joint ventures is positive (KGM, PKI, CCEL) and cash pile of T682.3 bln provide a downside buffer. Current oil prices are volatile with 2016 Brent price in the range of $45-$65/barrel, and while we do not see a turning point in oil prices to reach $60 in the next year, we topped Brent price/barrel to $70 in 2022 in our valuation model.
Based on this analysis, we upgraded our rating from Sell to Hold on expectation of dividends stemming from tenge devaluation, slightly improved profitability within next two years, and cash resources that provide some flexibility to the company.
We reduced our 12M TP from $10/GDR to $9.1/GDR (previous report was based on market price of $12/GDR, target price was $10/GDR) which is in our expectation provide 9% upside to the current price. We estimate a dividend of T777 per common share, or dividend yield of 6.5% per GDR mostly owing to foreign exchange gain on cash assets after devaluation of tenge. Our total expected return for shareholders is 15.6% per GDR, 20.7% per common stock and preferred stock. Our difference in total expected return per GDR and common share is explained by lower liquidity on KASE and inefficiency in exchange rate that is currently available, but should be eliminated as arbitrage opportunities of price difference between LSE and KASE would bring the prices to the equilibrium level (buy common stock on KASE, sell GDR on LSE).