ONGC Rating: Sell; Kotak Institutional Equities says lacklustre output trajectory a dampener

We retain our negative stance on ONGC noting (i) lacklustre volume trajectory despite sustained large capex; (ii) generally rising cost structure with the current year being an exception; and (iii) deteriorating return ratios given inefficient capital allocation. We believe valuation multiple for the stock needs to be lower as dividend is the only takeaway for shareholders with retained earnings failing to generate incremental growth or value. Sell stays with a revised FV of Rs 90, now based on $55/bbl crude price. Near-term elevated crude price is the only risk to our stance.

Volume trajectory has remained lacklustre despite sustained increase in capex and reserves: ONGC’s domestic production has remained lacklustre with volumes generally declining over the whole of past decade despite (i) sustained increase in capex and (ii) even a rising reserves base. Annual capex outlay has more than doubled since FY2010, while total production has declined steadily perhaps reflecting a combination of (i) inherent decline in mature fields and (ii) lack of commensurate addition from new fields due to weak execution and techno-commercial issues. 2P reserve base has increased steadily, but there has been limited success in conversion of reserves to production. OVL’s production, ex-Vankor, has also remained steady over a decade despite acquisition of several other producing assets reflecting meaningful decline inherently.

Rising cost structure and inefficient capital allocation have led to deteriorating returns profile: We highlight that ONGC’s overall cost of domestic production has increased over the past five years effectively requiring higher oil and gas prices to generate same level of returns from its underlying business; the costs in FYTD21 are lower due to Covid-impacted activities and hence, not comparable. Further, increase in capex and inorganic transactions including high-priced acquisition of HPCL and overseas assets have led to deterioration of return ratios for ONGC—we expect return ratios in FY2022 to be materially lower than FY2018 despite assuming same average oil price; even if we adjust for higher gas price, RoAE will still be lower by ~120 bps.

Valuation multiple has to account for dividends only given lack of inherent value creation: ONGC’s consistent dividend payout has been the only takeaway for shareholders given lack of incremental value creation by the company through the activities in its control. Hence, we believe the valuation multiple on earnings has to be lower as retained earnings after paying out dividends has failed to generate any incremental growth or returns for the company.

Revise earnings to reflect higher crude prices for FY2022-23; reiterate SELL : We revise consolidated EPS estimates to Rs 14.7 in FY2022 and Rs 15.3 in FY2023 from Rs 10.3 and Rs 12.4, factoring in Dated Brent crude price of $57.5/bbl and $55/bbl, respectively, versus $50/bbl earlier and other minor changes. We reiterate Sell with a revised FV of Rs 90, based on 6.5X FY2023E EPS instead of 7X earlier. In our view, recovery in crude price is the only play for the stock; however, we doubt if the current elevated levels could sustain for long, as gradual easing of curtailed supplies will mitigate the anticipated rebound in demand.