CFA Institute Research Challenge · PDF fileStudents competing in The CFA Institute Research Challenge. ... PSO is one of the biggest and most ... Price setting is restricted to only

CFA Institute Research Challenge hosted by

CFA Society of Pakistan Institute of Business Administration

– Karachi

CFA Institute Research Challenge 2015-16

1

Institute of Business Administration (IBA) – Student Research This report is published for educational purposes only by [Oil & Gas Sector, Oil Marketing Company]

Students competing in The CFA Institute Research Challenge. Pakistan Stock Exchange (PSX)

Date: 11/01/16 Current Price: 321.27 PKR/share Recommendation: BUY (33% upside) Ticker: PSO (PSX) Ticker: PSO PA (Bloomberg) PKR/USD: 105 Target Price: 428 PKR/share (4.08 USD)

PSO: Proxy for Pakistan’s economic revival

We issue a BUY recommendation on Pakistan State Oil (PSO) with a one-year target price of PKR 428 using the Discounted Free Cash Flow to Firm (FCFF) and Relative Valuation Method. This offers a 33% upside from its closing price of PKR 321

on January 11, 2016. PSO is one of the biggest and most liquid blue-chips on KSE with average daily volume being 0.34% of shares outstanding. Our investment thesis is based on PSO’s earnings growth, backed by volumes growth,

improving operating cash flows, and being a cheap blue-chip asset. PSO’s earnings growth is primarily driven by its volumetric sales growth during FY16-21 (CAGR: 12%) due to a changing energy mix, lower financing costs which will

reduce over the years due to lower borrowings and positive operating cash flows.

PSO, as the national fuel supplier, is key in Pakistan’s economic revival in the coming years. Economic growth depends primarily on self-sufficiency in energy, which we expect to be achieved through upcoming projects of gas, coal and

nuclear, along with resolution of circular debt. PSO has a pivotal role to play in Pakistan’s changing energy mix through its captive role in LNG supplies which will constitute 55% of PSO’s sales by 2020-21. In addition, PSO will be the main

beneficiary of circular debt resolution, as PSO’s books contain 45% of the total CD (in FY15).

Robust earnings growth … Earnings growth will stem primarily from rising volumes of retail fuels: Motor Gasoline (MOGAS) with a CAGR of 11%,

along with modest growth in High Speed Diesel (HSD) with a CAGR of 2.5%. We project strong earnings CAGR of 20% during FY16E-FY21E, as compared to 19% CAGR during FY10-14, due to introduction of LNG in PSO’s product mix. Finance

cost as a % of operating profit will decline to 41.5% in FY16, as compared to 48.6% in FY15. This will further reduce to 17% in FY18E-21E on back of repayment of short term borrowings as the company receives proceeds from retirement of

PIB investments.

…….Coming from Volumes growth driven by MOGAS, HSD and LNG

MOGAS and HSD sales will be driven by consumer demand, favorable macros as IMF expects GDP growth rate to increase

in our forecast period, increase in economic activity due to CPEC, along with auto sales and unavailability of CNG. However, the decline in FO sales in PSO’s book (CAGR: -15%) will be offset by the increase in LNG sales (CAGR: 89%). The decline

in FO based electricity generation is due to the favorable energy generation mix, with a shift towards cheaper fuels, like gas and coal. Furthermore, we expect PSO’s market share in all its products to remain the same, as it will continue to be

the dominant market player due to its largest storage capacity and vast retail network, along with fuel contracts with major government entities.

Improving operating cash flows due to resolution of circular debt

We expect PSO’s operating cash flows to improve and remain positive in FY 2016-21. Operating cash flows as a % of

operating profit increased to 35% in FY16, from -88% in FY15. Improving cash flows are aided by a reduction in power sector receivables on PSO’s books, which we believe is key for materialization of power projects under CPEC and for

successful implementation of IMF conditions. Furthermore, reduction in oil prices in 2016 and slight increase thereafter, will make the payments affordable for the Independent Power Producers (IPPs) and a shift in energy mix from expensive

fuels like FO, to cheaper fuels like LNG will ensure that PSO has less receivables from power sector. There will be slight receivables build-up from LNG, as the government will be stringent on the LNG deals, due to restrictions placed by

international dealers like Qatar.

Attractive valuation with P/E multiple converging to the market multiple

We have derived an attractive valuation of this cheap asset, with a target price of PKR 428 and an upside of 45%. We expect that in future, PSO’s stock is going to converge to the market multiple of 9.0x due to extraordinary earnings growth

and improvement in risk profile. We foresee earnings growth to make market sentiments positive which will drive multiple reiterating.

Main risks to valuation include: build-up of circular debt, rupee devaluation, volatility in oil prices, decrease in OMC

margins, increase in interest rates and threat to PSO’s market share from new entrants.

Market Profile

Closing price (PKR) 321.27

52-week price

range (PKR)

283.75 -

415.40 Average daily

volume (12M) 919,134

As a % of shares outstanding 0.34%

Dividend yield (2015) 3% Shares

outstanding 271.69 Free-float shares

(mn) 126.19 Market

capitalization 87 B

P/E 8.28

P/BV 0.95

ROE 11.6%

Figure 1: Team estimates, SCS trade

Valuation DCF Multiples Estimated price (PKR) 438 417

Weights 50% 50%

Final price (with inventory gains/losses)

427.86

Pakistan State Oil


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Business Description

Operating as a key player in Pakistan’s changing energy mix and being the nation’s biggest fuel supplier, Pakistan State Oil (PSO) is a state owned entity having dominant market share in POL Volumes of 56.8%. The company is involved in downstream oil business of storage, distribution and marketing of various POL products, comprising majorly of MOGAS, Furnace Oil (FO), and HSD, LNG, aviation fuel and lubricants. For the past 40 years, PSO has managed to establish reliable strategic partnerships with local customers and international suppliers. Currently, PSO has medium term contracts with various international suppliers such as Kuwait Petroleum and strategic investments in five local ventures: 62% Joint Installation of OMCs, 49% in Asia Petroleum, 22.5% in PRL, 22% in Pak Greece Manufacturing Company, 12% in PARCO White Oil Pipeline project.

PSO’s competitive edge of oil infrastructure – PSO enjoys competitive advantage through its large customer base (3 million customers on daily basis), wide retail network of 3500 retail outlets, extensive storage capacity of over 1 million tons (74% of total storage capacity), 155 convenience stores (shop stops), 1786 New Vision Retail Outlets (NVROs), 24 Mobile quality testing units, 11 refueling facilities (9 at airports and 2 at seaports respectively), Unique Satellite tracking system (enabling monitoring of road movement). PSO’s largest storage capacity enables it to earn commission through lending it to small players.

PSO’s product mix – PSO’s competitive advantage enables it to be the leading market player in most of the POL products. As of 2015, PSO has 67% market share in FO, 50% in HSD, 47% in Motor Gas, 100% in LNG, 50% in aviation fuel and 24% in lubricants. These products are majorly consumed by transport, power sectors and industry. The demand drivers for PSO sales are consumer demand, POL prices derived from international oil prices, auto sales, and energy mix and business activity. Being a national entity, PSO is busy in meeting total energy demand of country, but due to shortfall in supply from local refineries; the company has had to resort to import of both white and black oil in the past years. As of 2015, PSO purchased a total of 12.627 Million Metric Tons (MMT) out of which it imported 9.8 MMT while the r est of 2.83 MMT was met by refineries.

PSO’s Shareholding Pattern- PSO is a Government owned entity with maximum shareholding of 40% held by Federal Government, NIT & ICP (25.51% and 15.60%). The other shareholders include Modaraba companies & Mutual funds , Individuals, Foreign Investors, Insurance Companies, Financial Institutions and Banks, Public Sector companies, and others.

Current strategy of the company can be summed up under four main pillars:

Network Expansion- In order to improve and retain customer experience, PSO is working towards updating 1000+ retail outlets under its New Retail Vision. Under this strategy, the company will now provide premium services to its customers, as these outlets will encompass state of the art, latest machinery, updated technology and customer friendly staff.

Backward Vertical Integration- According to one strategic objective i.e. Continue to create upstream synergy and evaluate diversification opportunities for growth, PSO is trying to get involved into backward vertical integration by acquiring Pakistan Refinery Limited. In FY 2015, PSO owned 22.5% shares of PRL but according to its Annual Report 2015, the company is trying to increase its ownership in this strategic venture by 55%. Diversifying sources of Revenues- PSO is a National entity that is involved in almost all downstream oil and gas products, with an annual net income of more than PKR 6.9 billion, the company is constantly trying to improve its efficiency along with increasing its customer base. In order to achieve one of its few objectives to increase market share, optimize supply chain network and to improve bottom line; PSO will enter into Lube & LNG Business lines

Improved Cash Flows the Company has faced drawbacks of being leader in furnace oil market through huge circular debt. The blockage of cash flows from IPPs increases PSO’s receivables that have detrimental effect on its after tax earnings as huge chunk is been absorbed by finance costs. Shifting product mix, maturity of PIBs in 2017, reduced receivables and higher sales of LNG will impact PSO’s cash flow positively. Hence, we assume cash flow to improve by 14% in FY21 (PKR 35 Billion) as compared with FY16 (PKR 23 Billion).

Management & Corporate Governance

PSO’s Board was dismissed in February 2015, and has been reconstituted in November 2015. After the reconstitution, the company is trying to smoothen its operation and to inculcate an atmosphere of efficient culture, collaborative employees and excellence in operations. Moving forward, PSO is hopeful in Maintaining International HSE standards, improving retirement and benefits and introducing improved recruitment programs, these changes will help mitigate the negative brand image that circular debt has put on the face of corporation.

Industry Overview and Competitive Positioning

Pakistan State Oil is the largest oil marketing company in Pakistan. The structure of OMCs in Pakistan is oligopolistic, characterized by significant entry barriers, handful of players and low product differentiation (please refer to Appendix X ) along with prices regulated by government on the two major petroleum products HSD and MOGAS, which doesn’t allow OMCs to be price setters and reap higher margins. PSO has a market share of 56.7%, with PSL and APL having 10% each and Hascol with 5% market share. PSO owns 68.4% of total storage capacity in country and provides storage services to smaller players in market as well. Price setting is restricted to only lubricant category where Shell Helix is currently the market leader with a 35% market share, PSO has a market share of 25% in Lubes market while Total PARCO stands at 29%.

62%

49%

22.50%

22%

12%

PSO's Strategic Investments

Joint Inst. Asia Petroleum

PRL Pak-Greece

41%

15%

14%

13%

17%

Shareholding Pattern

Government

Modaraba

Individual

FI

Others

Furnace Oil

49%

HSD29%

Mogas18%

Product Mix FY15

Furnace Oil 9%

HSD18%

Mogas16%

LNG54%

Product Mix FY21


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Relationship between Energy Demand & GDP affected by energy shortages

Historical figures suggest that from 1994-2008, the relationship between energy consumption and GDP growth was ideal, (a ratio of 1.08). This was because till 2008, the only energy shortage that the economy faced was that of electricity, in form of

load-shedding. During the period of 1990s – 2005, there was surplus electricity in the economy (PIDE report). The current electricity crisis started from 2006-07 with a gradual widening gap in energy demand-supply. By 2011, the electricity shortfall

had crossed the level of 5000 MW.

Pakistan has been facing severe gas shortages since 2008. During 2008-09, the demand for natural gas (4731 MMCFD)

exceeded the available supply (4528 MMCFD). Thereafter, gas supply was suspended to the fertilizer sector and industries. Currently in 2015, gas shortfall is 2 billion cubic feet per day. Therefore, it can be safely concluded that after 2008, the final

energy consumption/supply in the economy was less than the actual energy demand, the difference being “pent-up” or unmet demand.

Upcoming energy projects

The current political mandate of the democratic Government of Pakistan is to provide relief to the people through low -cost electricity using gas, coal, nuclear and hydel sources for Power generation. Essentially this means moving away from the

expensive oil-based thermal power generation; the government believes that this shift from furnace oil to gas based power generation would lead up to USD 1-1.5 billion savings each year. PSO, being the major and national fuel provider to the IPPs,

has started being affected by the decline in furnace oil consumption.

Paving way for LNG imports

9 LNG cargoes were imported between March-August 2015 and in future, LNG imports are only expected to increase, as

can be reflected in the ongoing LNG deal between PSO and Qatargas, and the upcoming developments in LNG’s storage and

transportation. Pakistan’s first LNG terminal was built by Engro’s Elengy Terminal Pakistan Limited (ETPL) in a short period of 11 months in March 2015. The Elengy terminal is currently catering to around 200 MMCFD LNG in the national

system. A contract for building a second LNG terminal at Port Qasim, with a capacity of 500 MMCFD has been awarded by the GoP to a Chinese state owned company.

Transport capacity of the existing gas pipelines is 400 MMCFD. However, LNG pipeline contracts are being awarded to China

(under CPEC) and Russia for Gwadar pipeline and North-South pipeline respectively. Apart from LNG, Iran-Pakistan gas pipeline project is up on the cards, through which Pakistan is expected to receive 750 million CFD from Iran which will be

increased up to 1 billion CFD. Progress is slow due to tensions between Iran and major energy producers; however, we have assumed that this project would come on board by FY19. Another gas project in the news is TAPI (Turkmenistan-

Key comparison (2014-2015) PSO (2015) Shell (2014) APL (2015) Hascol (2014)

Net Revenue (PKR Bn) 913.09 250,785 205.715 99.0615

Net Profit (PKR Bn) 6.94 -1.067133 3.286 0.640

Operating Profit (PKR Bn) 22.67 451.94 3.886 1.237

Net Profit Margin % 0.76% -0.00043% 1.60% 0.65%

Operating Margin % 2.48% 0.18% 1.89% 1.25%

Number of Retail Outlets 3,795.00 783.00 469 383.00

Market Capitalization (PKR Bn) 87.73 24.93 38.52 16.87

EPS 25.53 -9.97 39.62 7.84

ROE 8.62% -18.10% 24% 20.65%

Finance cost as a % of Operating Profit 48.60% 98.93% 3.40% 21.34%

0

2

4

6

8

101214

2006 2007 2008 2009 2010 2011 2012

GDP per unit of Energy

India Pakistan

China Bangladesh


4

Afghanistan-Pakistan-India); however, due to the project dates and security condition in Afghanistan, we have not considered this project to be coming any soon.

Coal and nuclear are not far behind: 1320 MW imported coal based power projects at Qadirabad in District Sahiwal, 660 MW Thar coal based power project and 1320 MW imported coal based power project at Port Qasim Karachi. Upcoming

nuclear projects include completion of Chasnupp-III and IV (adding a total of 680 MW). We have assumed that these projects would come on board with a 1 year lag, judging from the past performance of such projects.

Pent-up demand to be met by LNG: We assume that, due to unmet energy demand in the economy, the upcoming energy

projects (of gas, coal and nuclear) will firstly cater to the inoperative power plants and thus the energy crisis, implying that FO consumption might not be entirely substituted by LNG in the beginning years. As per our calculations, FO volumes exhibit

negative growth of -4.7% in 2015, and continue to decline thereafter, with a sharp decline of 48% in FY20.

Other economic highlights:

GDP to grow by 4.5%: GDP growth is expected to increase to 4.5 percent in FY15/16 (from about 4.2 percent in FY 2014/15),

sustained by current strength in services and construction, lower oil prices, expected improvements in the supply of gas and electricity, investment related to the China Pakistan Economic Corridor (CPEC), and an improving investment climate. Low

oil prices have been the biggest factor in current strengthening of external stability.

CPEC projects contributing to 3% & 7.35% growth in HSD & MOGAS respectively: HSD & MOGAS sales are assumed to increase due to greater economic activity amid ongoing CPEC projects. Modernized transport infrastructure; improved

business activity, road density and road based trade route will lead to increased sales of heavy commercial vehicles which will contribute to the annual growth of 3% in HSD. GDP growth of 4.50%; accompanied by 5% increase in per capita GDP &

3.9% growth in household consumption for FY16-21E will continue to tune up MOGAS volumetric sales by 7.35%.

Growth in LSM & HSD consumption: Large Scale Manufacturing (LSM) at 10.6 percent of GDP is assumed to contribute 0.5% to GDP growth for FY16-20E. LSM registered growth of 4.5% in Mar15 as compared to -1% in Mar14. With cumulative growth

of 2.44% in next five years; LSM will contribute 3.5% growth to commercial transport on road in FY16E and 2% growth onwards till FY20E, consequently increasing HSD consumption.

Vehicles growth, a strong driver for MOGAS & HSD: Growth in automobile sector contributes to increased consumption of POL products. In 2015 Trucks and tractors registered YOY growth of 53.9% and 44.6% respectively; production of trucks

increased because Ghandhara Nissan Limited (GHNL) established its assembling plant in Pakistan. Tractors production plunged after cut in GST from 16% to 10% in the Federal Budget 14-15. The demand for commercial vehicles increased on

account of government schemes like Apna Rozgar and Kissan Package Scheme. However impending future threat of floods might be a cause of depressed demand of tractors in future, leading to decline in HSD consumption in Agriculture.

Cars and LCVs registered YOY growth of 61% from Nov 14 to Nov 15 . Taxi Scheme propelled Pak Suzuki volumes to

58,098 units in 5MFY16 in comparison to 29,456 units in 5MFY15 recording a tremendous jump of 97% YoY. Moreover, enhanced consumer sector dynamics, improving macros and an increase in car financing due to the 42-year low interest rate

in the country overhauls the sales of automobile sector.

MOGAS-CNG price differential to contribute growth in MOGAS sales: Lower price differential between MOGAS & CNG has compounded the effect of gas curtailment to CNG sector. With crude oil expected to plunge below 35; this differential will

contribute to 13% growth in MOGAS in FY16 and 10% in FY17 hence stabilizing it to 5% YoY as oil prices are assumed to eventually break the bearish trend.

CPEC Projects improving Energy & Transport infrastructure: The China Pakistan Economic Corridor (CPEC) will connect

Western China (Kashgar) with the south of Pakistan (the port of Gwadar) through a series of infrastructure and energy projects. The initial prioritized pipeline of investments under CPEC envisages an overall investment of USD45 billion in ener gy

(USD33.8 billion) and transport infrastructure (USD10.6 billion). All transport infrastructure projects are expected to be completed by 2017–18. Priority projects in the energy sector, which will create Independent Power Producers (IPPs), are

scheduled to add about 10 GW of capacity by 2017–18 (by 2020 for hydro projects) while a further set of actively promoted projects is planned to add another 6.5 GW of capacity in due course.

Dynamics of international oil prices: Over the last 6 months, Oil prices have plunged 28.5% from USD55.9 per barrel to USD32.59 per barrel experiencing its 11 year low. The reasons include dip in Chinese stock markets due to steep depreciation

of the Chinese renminbi, huge sell-off in crude oil futures, oversupply in global oil markets, and US FED interest rate hike. Expectations that OPEC members will continue to ramp up oil production coupled with Iran’s potential production will keep

oil prices to be within USD40FY16E. However in the next 4 years oil prices are assumed to increase again because OPEC members cannot sustain distressed economic circumstance they are facing.

OMCs: a major victim of ongoing circular debt crisis

PSO, having major fuel supply agreements with national power entities, has born the maximum brunt of circular debt in its books, affecting its liquidity position the most. Having cash tied up in receivables limits an OMC’s ability to procure fuel supplies, leading to late payable charges and further limits its ability to pay out dividends. Receivables from power sector entities pile up when oil prices are rising, as the payments in PKR terms become more expensive for IPPs to pay off.

-1 5.00%

-1 0.00%

-5 .00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

FY0

4

FY0

6

FY0

8

FY1

0

FY1

2

FY1

4

FY1

6E

FY1

8E

FY2

0E

GDP & HSD Consumption

GDP growth Rate

LSM

HSD Con sumption

0% 10% 20% 30%

1

2

3

4

5

6

MS Consumption & Autovehicle Growth

Vehicles on road incremental %

Mogas volumes change in transport ,%


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Circular debt resolution strategy by GoP

Till recently, the government had resorted to cash injections as a strategy for resolution of circular debt but the IMF for the first time, has set an indicative target on the accumulation of CD. The Government of Pakistan (GoP) and IMF have agreed on capping the circular debt at PKR 250 billion in 2015-16. The government intends to achieve this target through tariff rationalization, improvement in recovery and reduction in losses. In FY2015, this strategy has worked so far as collections improved in the range of 89-91%, compared with 87% recoveries in FY2014, and losses lessened by 0.5%. The current circular debt stock stands at PKR 314 billion (June-15) which the government plans to reduce till PKR 212 billion (June-18).

Investment Summary

We issue a BUY recommendation on Pakistan State Oil (PSO) with a target price of PKR 428 and an upside of 33.2% from its closing price of PKR 321 on January 11, 2016. Our investment case is based mainly on PSO’s earnings growth, backed by volumes upsurge, improving operating cash flows and being attractively valued in the market. PSO’s earnings growth is primarily driven by its volumetric sales growth during FY16-21 (CAGR: 10%) due to a changing energy mix involving LNG, lower financing costs due to repayment of short term borrowings and positive operating cash flows. Favorable bottom-line growth due to volumes growth and improved liquidity We are optimistic about PSO’s earnings with the EPS reaching PKR75/share in FY20E-21E. We believe company’s profitability to improve owing to a CAGR of 12% in volumetric sales, easing of power sector receivables and less reliance on cash blocking fuels (FO) leading to improved operating cash. We expect PSO’s bottom-line to further benefit from reduced running financing from local and foreign banks, as the freed up cash from receivables will enable the company to cover its short-term borrowings, thus reducing finance cost to 17% of operating profit in FY18-21. PSO’s earning will be driven mainly through increase in sales volumes and change in its product mix, with LNG constituting 54% of its volumetric sales in FY21E. Growth in MOGAS, HSD will be CAGR of 7% and 2.5% due to increasing consumer demand as POL prices become affordable in Pakistan, favorable macros as per IMF expectations, massive growth in automobiles sales, increased business activity due to CPEC and continued unavailability of CNG. Shifting energy mix highly favorable for PSO The GoP is committed to shift the energy mix as a part of their political mandate before the next national elections in 2018, as the current mix is highly expensive (per MMBTU cost of imported furnace oil USD 10.62 vs USD 9.37 for R-LNG, at Brent of USD 50/barrel). The government further plans to establish 2400 megawatts (MW) LNG based power plants which will be supplemented by upcoming LNG terminal at Port Qasim and gas pipeline projects, leading to a rise in LNG imports. We expect the shift in energy mix to be immensely beneficial for PSO’s product mix, acting as a cushion for decline in FO sales. As of now, PSO has the competitive advantage of being appointed as the sole contractor, on behalf of GoP, to import LNG and is under the process of striking a long-term LNG deal with Qatargas, with a very favorable LNG price. LNG imports to reduce PSO’s reliance on FO and reduce build -up circular debt We underpin our rating for PSO’s stock, owing to the surge in MS and HSD consumption and the shift towards cheaper fuels in energy mix which will increase LNG imports and reduce FO consumption by IPPs. Once the major inoperative power plants have been run on LNG, we expect the government to massively reduce electricity generation by oil, as much cheaper alternatives in form of gas, coal and hydel would be available. This will lead to a sharp decline in FO sales, however substituted by LNG imports on PSO’s books. Our optimism of resolution in circular debt stems from the recent talks between GoP and IMF, in which they agreed to put a cap on circular debt, which is PKR 250 billion. The GoP has released its estimates of circular debt stock, which they expect to be lowered to PKR 211 billion by FY18E. We expect that the involvement of a multilateral organization and the ongoing economic developments with China under CPEC will ensure that the circular debt stays under manageable level for the government. PSO will be the main beneficiary of this resolution, as it has around 45% of the circular debt on its books. Where LNG receivables are concerned, we believe that it is highly unlikely that LNG receivables should meet the same fate as FO, due to the international nature of contract and the stringent conditions being put by Qatargas. However, being realistic, we have assumed that LNG sales would give rise to some level of receivables on PSO’s books. Higher dividend payout amidst cash excess and manageable receivables We are optimistic about the company’s cash flows, which will be in excess in FY20E-21. We expect the major improvement in PSO’s cash flow position to be brought about by a massive plunge in FO sales of 48%, which will eventually lead to lower power sector receivables. This will improve PSO’s liquidity position, thereby making its profile less risky. Furthermore, more distributable cash flows will most likely translate into higher dividend payout ratio, which we expect to increase up to 50% in FY20E-21E, from 15% in FY16E. Availability of excess cash means that the company can consider potential expansion, as PSO has plans to expand its lubes business, and lead to more organic growth. Attractive valuation and positive market sentiments We expect that in future, PSO’s stock is going to converge to the market multiple of 9.0x, thus trading at a 0% discount. We expect the robust forecasted earnings growth and improvement in risk profile to make market sentiments positive which will drive multiple reiterating. Historically, PSO’s stock had been trading at 8.07x with the market multiple of 8.5x, i.e. at a discount of 5% because of circular debt which gave out a negative market sentiment. Using DCF and relative valuation, we have arrived at a target price of PKR 428/share for this cheap asset, with a potential upside of 33%.


6

Concerns: The main risks to our investment thesis are volatility in oil prices thus leading to inventory losses and a worsening of circular debt pile-up, both of which can be detrimental to the bottom-line. Other risks include sluggish consumer demand in the economy, rupee devaluation and increase in interest rates.

Valuation

Valuation Target Price: PKR 428 Recommendation: BUY

We have arrived at our target price of PKR 428/share by assigning equal weights to Discounted Free Cash Flow to Firm (FCFF) and Relative Valuation using P/E. The price arrived from DCF is PKR 438, whereas that arrived from relative valuation is PKR

417.

Discounted Cash Flow (DCF) Model

We have discounted free cash flows available to firm (FCFF) from FY16E-21E. DCF is the most appropriate and reliable measure of PSO’s intrinsic share value as it discounts FCFF which incorporates the company’s future earnings growth. DCF

also rightly captures PSO’s improving cash position in the future. FCFF was derived by adding non-cash expenses (depreciation and amortization) and after-tax interest to Net Income, and subtracting Investment in working capital and

Capex. Weighted Average Cost of Capital (WACC)

We have used WACC to discount FCFF or the cash flows available to both common shareholders and debt, as WACC assigns a weighted average to cost of debt and equity. The only debt on PSO’s books is that of short-term borrowings and we have taken

PSO’s cost of debt as KIBOR+1.5%, with the current KIBOR being 6%, and applied a tax rate of 32%, thus getting an after -tax cost of debt as 5.44%. We arrived at cost of equity through CAPM for which we assumed risk free rate on 10-year PIB, which

is 9%, with market risk premium of 6%. We calculated beta using daily stock returns of PSO and KSE-100 Index (market index) from 2009-2015, and applied the covariance formula. The capital structure of debt-equity 0.53: 0.47, is that of 2016.

From our calculation, WACC comes out to be 10.48%.

Terminal Growth We have assumed PSO’s terminal growth as 3%, as PSO is currently in its mature stage, which means that in the long-term,

its revenue growth will be modest. Terminal growth rate is also linked to historical inflation and the historical GDP growth rate.

PSO’s CORE BUSINESS

PSO’s major business involves downstream marketing of POL products and recently, gas (LNG). Other sources of revenue include lending its biggest storage capacity to other small OMC players.

Sales Revenue (volumes)

Operating in an industry where the players don’t have pricing power in their hand, PSO’s revenue solely depends on its volumetric sales and in rare cases, on increase in OMC margins. We have assumed that in our forecast period, PSO’s volumes

in white oil category (MOGAS and HSD) will increase, while that in black oil (furnace oil) will fall drastically. The fall in FO sales is due to the shift in energy mix of the country and the introduction of the cheaper-alternative for electricity generation,

namely LNG, as the government has a political mandate to provide relief to the people. Moving forward, we assume that LNG imports would make FO an unattractive fuel, thereby reducing its consumption, whereas PSO’s diversification into LNG

business would mean that increase in LNG sales would substitute for the fall in FO consumption by power producers. By FY2021E, we expect FO to constitute only 10% of PSO’s 25 million tonnes sales, whereas LNG would form 54% of its sales.

Sales Revenue (Pricing)

The prices of local POL products are derived from international oil prices, namely OPEC-Reference Basket (ORB), which in turn is derived from Brent. We have assumed Brent to be USD 40/barrel in FY16E and thereafter to increase gradually till

USD 55/barrel in FY19E.

With Brent falling to USD 33/barrel in FY2015-16, the prices of POL products are not as low as they should be as GoP has been increasing the General Sales Tax (GST) rates to raise more tax revenues and to meet their fiscal deficit. We have assumed

the current level of GST to remain the same in our forecast period, as the Bloomberg estimates Brent to increase from FY2016 onwards, and the GoP is unlikely to further increase GST on POL products as that would make the end-price very high for the

consumers.

Sales Revenue (OMC Margins) As OMCs do not have pricing power in the major POL products, their profits are determined by the margins on these products,

fixed in PKR terms and percentage terms by the regulatory body, Oil & Gas Regulatory Authority (OGRA). Being conservative, we have assumed OMC margins to remain the same in our forecast period: PKR 2.35/liter on MOGAS and HSD; 3.5% of ex-

refinery price for FO, and 1.82% of Delivered Ex-Ship (DES) price for LNG. In case of rising oil prices, the final margins on FO and LNG would increase. However, margins on these two products are also affected by PKR depreciation against the USD.

0%

20%

40%

60%

80%

100%

120%

Capital Structure

Equity weight Debt weight


7

Operating Expenses We have forecasted distribution and marketing expenses, and administration expenses by linking salaries and wages with

inflation forecast taken from IMF documents, and by linking other expenses as a historical % of sales. We have forecasted depreciation expenses, divided into these two heads, by looking at the historical trend, which has given us a future rate of 5%.

An important head in operating expenses is exchange losses, which have been an important item affecting PSO’s profitability, as it was 2% of the gross profit in FY15. Moving forward, we have taken the assumption that exchange losses would be

incurred on MOGAS and HSD, as exchange losses for FO are passed onto the end consumer. With an assumption of 4% depreciation of PKR against USD every year in our forecast period, we have applied this rate on 45% of PSO’s total forecasted

trade payables, thus conservatively assuming that 45% of the total payables would be those of retail fuels.

CAPEX

Capital expenditures (CAPEX) of PSO will increase in coming years as per major decisions announced by PSO’s management including introduction of new retail stores, diversification in new business lines i.e. lubes as PSO has a manufacturing facility

for its own lubes. These decisions will have an impact over CAPEX in upcoming years, which we expect to grow at a CAGR of around 14% for the period FY16E-FY21E.

PRL acquisition

We expect PSO’s shareholding in PRL to increase up to 51% by FY18E. This is in line with PSO’s latest move to purchase Chevron’s share in PRL.

Working Capital and inventory gains/losses

We expect PSO’s power sector receivables to decline over our forecast increase and LNG receivables to increase. We have assumed receivables days for power sector to reduce from 166 in FY15 to 125 in FY21E, and for LNG days to stabilize at 35

during FY20-21E. We have further assumed provision for impairment as 2.5 – 2.7% of gross trade debt in our forecast period, based on historical trends. For payables, we have assumed 25 local payables days and 35 foreign payables days. For inventory,

we have assumed 14 inventory days for FO, 15 for MOGAS, 40 for HSD and 7 days in transit for LNG inventory. Furthermore we have assumed inventory losses to occur in FY16E, and thereafter inventory gains as Brent estimates are expected to

increase as per Bloomberg’s estimates.

Improving cash flow position and increasing dividend payout We have assumed that as the company’s operating cash flows improve and from the time it starts to repay its short term borrowings, it will increase its dividend payout ratio. The company has excess cash in FY20E and FY21E, while we expect its

dividend payout to increase to 50% in these two years. We are optimistic that the company’s cash flows will improve from FY20E, due to easing of circular debt, partly due to strategies devised by the IMF and GoP, and our expectation of massive

drop in FO sales in FY20E. The company’s cash flows w ill also ease due to maturity of PIB investment in 2017.

Relative Valuation We have used relative valuation using a benchmark P/E of the market compared to PSO’s P/E multiple. PSO traded at a 5%

discount to the market in FY15 mainly because of the circular debt situation which increased the risk of PSO’s stock. However, we expect the forward P/E multiple of PSO to converge to that of market in FY16E because of the following reasons:

· Improve in risk profile of PSO’s stock as a result of our expectation of stable circular debt · Extraordinary and sustainable earnings growth driving multiple reiterating

· Positive market sentiments making investment in PSO’s stock attractive for investors We consider that the improvement in circular debt situation in the forecast period. This would reduce the uncertainty

involving PSO’s performance, enabling the investors to make more informed decisions hence, PSO’s P/E multiple is likely to be trading close to the market. Moreover, sustained earnings growth in the forecast period is likely cause the investors to

have positive market sentiments towards PSO and hence, they would now be willing to pay high price per earnings of PSO’ stock.

Financial Analysis

Receivables to decline gradually: FO receivables’ situation is expected to recover mainly because of the falling global oil prices. This will improve PSO’s receivables from IPPs. Although we assume that the international oil prices will modestly

increase to around USD$55 per barrel in FY21E but the power; producers usually feel the pinch above USD$85 per barrel. Having said that, the piled up FO receivables are not going to disappear abruptly. FO days to receivable will fall to 125 days

in FY21E from 210 days in FY16E.

Additionally, LNG days to receivables are likely to drop to 35 days in FY21E from 105 days FY16E. Government has reiterated to keep control checks on its LNG receivables due to the involvement of Qatar Gas. In relation to this, PSO has opted for a

conservative strategy which demands for advanced payments before the provision of services.

Stagnant payables: Stringent conditions over the import of FO and LNG will make payables days to strict 35 days in the forecasted period. On the other hand, the local day’s payable outstanding are expected to remain fixed.

Improvement in Inventory Turnover: We expect an improvement in PSO’s inventory turnover. Total days inventory outstanding are expected to fall to 16 days by FY21E.

-

200,000

400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

1,600,000

1,800,000

2,000,000

Sales Revenue(PKR)


8

Strong Cash Generation We expect the cash flow from operations to improve in the forecasted period mainly because of the improved working capital situation. This is reinforced by the improving cash conversion cycle in the forecasted period. While

in the historical trends analyzed, CFO was negative because of the drags in liquidity of PSO. CFI is largely to remain negative due to increasing CAPEX except for FY18E when PSO plans to retire the PIB investments of PKR47 billion. Consequently, PSO

will be able to generate sufficient cash to cover all its investments (except for FY16E where the deficit will be financed by borrowing).

Liquidity Situation- The liquidity position of PSO also looks rosy as the current ratio is well above 1 in the forecasted years

(Current Ratio 2016E: 1.13x, 2021E: 1.46x) which is in congruence with the historical period (Current Ratio 2014: 1.08x, 2015: 1.10x)

CFO/CAPEX confirms the fact that PSO will be able to cover its investments in the future with the ratio being significantly higher than 1 in the forecasted years (2016E: 5.11x, 2021E: 4.77x) However, earnings quality calculated by the cash

realization ratio (CFO/PAT) showed that it will maintain around 1 in the forecasted periods indicating that the cash would be sufficient to satisfy its financial commitments as well.

Dividend payout upturn- We expect the dividend payout to increase (FY16E: 15%, FY21E: 50%) because of the enriched

cash situation of PSO and the excess cash available from retirement of PIBs worth 47 billion in FY18E.

DU PONT- We expect improved ROE forecasts to around 15% in FY21E from 12% in FY16E, mainly due to high asset turnover and significant equity multiplier. Historically, PSO showcased high return on equity (FY12 ROE 21%, FY13 ROE 19% and FY14

ROE 32%) with an exception to FY15 when ROE was low because of adverse profitability.

DuPont analysis recommends the most important driver for sustaining future level of return on equity to be high asset turnover, which indicates better utilization of PSO’s resources. Along with it, we have concluded that equity multiplier is ought

to be the second most important driver hence, an increase in PSO’s financial leverage position would contribute to profitability in the forecasted years.

Revenues and earnings optimism- We expect revenues CAGR in FY16-21E to be 12%. An increase in automobile sales,

resurgence of large scale manufacturing, high expected LNG consumption and PSO’s penetration in lubes business would upsurge revenue drastically. Furthermore, we expect EPS to grow from 38.8/share in FY16E to 75.5/share in FY21E. The

gradual revival of oil prices and anticipated white oil demand would contribute to high future.

Finance cost to ease-off- We expect PSO’s finance cost situation to improve in the forecasted period. This is because of the PIB proceeds of PKR47billionin FY18E which will provide PSO with excessive cash hence, reducing the need for borrowing.

The capital structure which currently stands at 0.55:0.45 debt to equity is expected to be 0.03:0.97 debt to equity in FY18E. This is reiterated by the interest cover multiple which will increase from 2.4x in FY16E to 5.82x in FY21E. Net finance

cost is also likely to be positive as a result which suggests lower burden of finance cost on PSO in the forecasted period FY16E-FY21E.

Sensitivity Analysis Conditional upside to target price: Increase in OMC margins We have assumed that OMC margin on LNG imports would remain at 1.82% of DES price during our forecast period. However,

PSO had demanded the margin on LNG to be 4%, approved by the Economic Coordination Committee, to which OGRA did not agree. With the current assumption of oil prices and LNG volumetric sales, if LNG margins were to increase to 4%, we expect

a target price of PKR 625/share, a massive (conditional) upside of 95% from the current share price of PKR 321.

Ter

min

al r

ate

Target price sensitivity

Risk free rate

8.5% 9.0% 9.5% 10.0% 10.5% 11.0% 11.5% 12.0%

1.5% 407.07

399.24

391.82

384.79

378.12

371.77

365.74

359.98

2.0%

416.16

407.66

399.65

392.08

384.91

378.11

371.66

365.52

2.5%

426.40

417.14

408.43

400.22

392.47

385.15

378.22

371.65

3.0% 438.04

427.86

418.33

409.38

400.96

393.02

385.53

378.45

3.5% 451.39

440.11

429.59

419.75

410.53

401.87

393.73

386.06

4.0% 466.86

454.22

442.50

431.59

421.41

411.90

402.98

394.61

(90)

(70)

(50)

(30)

(10)

10

30

50

70

90

PKR Billion

CFO CFI CFF

0%

10%

20%

30%

40%

50%

60%

Payout ratio


9

Investment Risks

Regulatory risk | Margins on POL products Operating in an industry in which margins for 47% of its total sales (on HSD & MS) are currently fixed at PKR 2.35/liter,

and determined by OGRA, there is always the risk that margins could fall. From the regulatory history, the only time that OGRA reduced margins was in Aug-2008.

However, we believe it’s highly unlikely that margins would fall as OMCs are always pressurizing the government to

increase the margins. We can safely expect margins on OMC products to remain constant moving forward, with a conditional upside if OGRA agrees on raising margins. The government is usually reluctant to increase margins when the

oil prices are rising.

Macroeconomic risk | GDP growth rate Unfavorable macroeconomic conditions such as low GDP growth will reduce the business activity in the economy, thus

leading to lower consumption of POL products, affecting diesel consumption the most. However, moving forward we expect IMF forecasts to be realized due to ongoing economic activity with regional neighbors (China Pakistan Economic Corridor)

and government’s political willingness to make Pakistan energy self-sufficient.

Macroeconomic risk | Rupee devaluation against USD As opposed to smaller OMCs, PSO relies on imports for 75-80% of its product supply, thus being most affected by rupee

devaluation. Longer day’s payables and a worsening PKR against USD translate into high exchange losses for the company. Macroeconomic risk | Volatility in oil prices

Sharp volatility in oil prices could lead to inventory gains and losses, with the most dangerous form of volatility incurring due to falling oil prices. We have assumed that oil prices would fall in FY16E, and thereafter would modestly increase up

to 55 USD/barrel. While Bloomberg has forecasted much higher Brent prices, our conservative estimates have helped us trim inventory gains to a minimum.

Macroeconomic risk | Rising interest rate

If interest rates rise beyond our estimates, this would lead to higher finance costs for PSO, thus affecting its profitability. However, recently central bank kept the policy rate constant at 6% and moving forward, IMF expectations of inflation are

5% for the long-term. With a real interest rate of 2%, we don’t expect the policy rate to exceed beyond 9-10%.

Industry risk | Circular debt The government had been making promises to resolve the circular debt in the last couple of years, which makes this issue

all the more critical as it greatly impacts PSO’s profitability. We are highly optimistic where resolution of circular debt is concerned, due to the involvement of a multilateral agency, IMF, in capping the circular debt stock. We expect that the

government might use another financial instrument to settle its outstanding balance with PSO, just as it did in 2013, which would add interest income in other financial income.

Industry risk | Availability of gas for transport

If All Pakistan CNG Association (APCNGA) imports LNG on its own or if the government allocat es gas to transport sector, petrol sales could be threatened. However, imported LNG would be more costly than local gas, thus making this an

expensive decision for APCNGA. CNG prices would have to be increased, which will make this substitute fuel unattractive in front of petrol.

Industry risk | Threat to market share from new, smaller OMCs

Our assumption is that PSO will retain its market share, due to its competitive edge over storage capacity and vast retail network. However, in the latest fiscal year, PSO has lost its market share slightly in FO, HSD and MOGAS and there is always

a risk that the new, smaller OMCs may jeopardize PSO’s market share in retail fuels (MOGAS & HSD). We expect this risk to be mitigated in the future as PSO will remain the major contractor, on behalf of government, where LNG is concerned and

it is the beneficiary of some major fuel supply arrangements in the country. As for its consumer business, PSO is revamping all of its petrol pumps through new vision retail stores and has plans to expand its lubes business.

Operational risk | Inventory management

With cash being tied up in power sector receivables, PSO has been facing a liquidity crunch which had affected its ability to procure fuel from international suppliers on time. This led to a petrol crisis in the country in Jan-Feb 2015. However

moving forward, we expect PSO’s receivables and cash flows to be in a better position, thus enabling it to engage in better inventory management.

Firm-specific risk | PRL acquisition

We have assumed that PSO would go ahead with the PRL acquisition and increase its shareholding up to 51%, thereby becoming a parent company of PRL. Cash flows would be affected in medium term due to the investment outlay. In the

beginning, this might not prove to be profitable, as PRL is currently a loss-making entity, with PKR 1.18 billion losses in 2015, and PSO would have to incur huge capex in order to make this venture a profitable one.

-5

-4

-3

-2

-1

0

1

2

3

4

USD

/bar

rel

Volatility in oil prices (Brent)

Hig

h

Me

diu

m

Market share

threat

Circular debt ;

Volatility in oil

prices

Lo

w

Interest rates;

Exchange rates;

GDP growth

OMC Margins;

CNG

availability

Low Medium High

IMPACT

PR

OB

AB

ILIT

Y


10

Appendices

Core F inancia l s Sum m ary F Y14 F Y15 F Y16E F Y17E F Y18E F Y19E F Y20E F Y21E

Sales (mn tonnes) 13.02 12.58 14.39 16.37 19.77 23.08 24.67 25.00

Net Revenue (PKR bn) 1188 913 708 806 1048 1254 1367 1417

Net Profit (PKR bn) 21.82 6.94 10.54 12.60 15.93 18.04 20.29 20.52

EPS (PKR/share) 80.31 25.53 38.81 46.38 58.63 66.40 74.67 75.55

Net Profit Margin % 1.84% 0.76% 1.49% 1.56% 1.52% 1.44% 1.48% 1.45%

Finance cost (PKR bn) (9.5) (11.0) (11.0) (11.0) (5.7) (5.6) (5.7) (5.9)

ST borrowings (PKR bn) 92.32 102.08 98.94 80.37 15.22 5.03 - -

Operating cash flows (PKR bn) (53.30) (20.02) 8.56 28.80 27.30 20.53 48.27 16.92

Receivables from Govt & other aut. bodies (PKR bn) 108.4 126.9 121.4 120.3 125.8 134.8 102.4 102.4

Cash Conversion Cycle 25 42 49 39 26 18 6 6

Return on Equity 32% 8% 12% 13% 14% 15% 16% 15%

Dividend payout 7% 39% 15% 25% 35% 40% 50% 50%

DPS (PKR/share) 5.91 10.00 5.82 11.60 20.52 26.56 37.34 37.77

Effective tax rate 34% 42% 32% 31% 30% 30% 30% 30%

Source: Team Estimates

Core assum ptions

Volum es ( m n tonnes ) : F Y14 F Y15 F Y16E F Y17E F Y18E F Y19E F Y20E F Y21E

MOGAS 3.83 4.70 5.78 6.58 7.19 7.69 8.15 8.58

HSD 6.85 7.38 7.68 7.92 8.16 8.41 8.64 8.88

Furnace Oil 9.55 9.11 8.13 7.62 7.22 6.76 3.51 3.51

LNG - 0.30 1.80 3.61 6.86 10.10 13.53 13.53

Volum es growth %: F Y14 F Y15 F Y16E F Y17E F Y18E F Y19E F Y20E F Y21E

MOGAS 14% 23% 23% 14% 9% 7% 6% 5%

HSD 0% 8% 4% 3% 3% 3% 3% 3%

Furnace Oil 13% -5% -11% -6% -5% -6% -48% 0%

LNG 505% 100% 90% 47% 34% 0%


11

Core assum ptions ( W orking Capi ta l )

Receivables : F Y14 F Y15 F Y16E F Y17E F Y18E F Y19E F Y20E F Y21E

Receivables days - Power sector 66 166 210 190 165 150 130 125

Receivables days - LNG - 203 105 75 45 40 35 35

Receivables days - Other customers 34 33 30 30 30 30 30 30

Receivables days - total 45 59 68 61 52 47 38 37

Payables : F Y14 F Y15 F Y16E F Y17E F Y18E F Y19E F Y20E F Y21E

Payables days - local 22 39 25 25 25 25 25 25

Payables days - foreign 47 33 35 35 35 35 35 35

Payables days - total 42 36 47 46 46 46 47 47

Inventory: F Y14 F Y15 F Y16E F Y17E F Y18E F Y19E F Y20E F Y21E

Inventory days - MOGAS 15 15 15 15 15 15

Inventory days - HSD 40 40 40 40 40 40

Inventory days - FO 14 14 14 14 14 14

Inventory days - LNG 7 7 7 7 7 7

Inventory days - total 22 19 27 24 20 18 16 16

Core Assum ptions : F Y14 F Y15 F Y16E F Y17E F Y18E F Y19E F Y20E F Y21E

ST borrowing markup (KIBOR + 1.5%) 6.5% 9.1% 8.5% 9.6% 9.6% 9.6% 9.6% 9.6%

Late payment surcharge (KIBOR + 3%) 12.8% 10.4% 10.0% 11.1% 11.1% 11.1% 11.1% 11.1%

Bank deposit rate 4.5% 4.5% 4.5% 4.5% 4.5% 4.5%

Penal Income (PKR bn) 12.38 6.89 5.83 5.83 5.83 5.83 5.83 5.83

Inventory losses/gains 4.1 (7.90) (0.22) 0.94 0.98 0.51 - -

Exchange losses (1.04) (0.66) (1.32) (1.48) (1.99) (2.44) (2.72) (2.87)


12

Macroeconomic Indicators

4.03%

4.24%

4.50% 4.50%

5.20% 5.20% 5.20% 5.20%

3.00%

3.50%

4.00%

4.50%

5.00%

5.50%

F Y1 4 FY1 5 FY1 6 E F Y1 7 E FY1 8 E FY1 9 E F Y2 0 E FY2 1 E

G DP G RO WTH RATE

8.6%

4.4% 4.7%5.5%

5.0% 5.0% 5.0% 5.0%

0.0%

3.0%

6.0%

9.0%

12.0%

F Y1 4 FY1 5 F Y1 6 EFY1 7 EFY1 8 EF Y1 9 EFY2 0 EF Y2 1 E

I NF LATI O N

9.8%

7.4%7.0%

8.1% 8.1% 8.1% 8.1% 8.1%

4.0%

6.0%

8.0%

10.0%

12.0%

FY1 4 FY1 5 FY1 6 EFY1 7 EFY1 8 EFY1 9 EFY2 0 EFY2 1 E

DI SCO UNT RATE/ K I BO R


13

Exchange Rate Assum ption

Exchange losses to be incurred only on HSD and MOG AS…

102.9 101.3105.3

109.6

113.9

118.5

123.2

128.2

70.0

80.0

90.0

100.0

110.0

120.0

130.0

140.0

F Y1 4 F Y1 5 F Y1 6 E F Y1 7 E F Y1 8 E F Y1 9 E F Y2 0 E F Y2 1 E

E X C H A NGE RA T E ( P KR/USD)

(3,500)

(3,000)

(2,500)

(2,000)

(1,500)

(1,000)

(500)

-

FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E

PK

R m

illio

n


14

Ba lance Sheet ( Assets )

PKR millions Historical Balance Sheet Projected Balance Sheet As at June 30th FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E ASSETS Property Plant and Equipment 6,085 5,832 5,525 5,855 6,333 6,966 7,647 9,102 10,702

12,462 14,398

Intangibles 30 30 48 54 61 71 86 107 126 149 - Long Term Investment 2,314 1,968 48,253 45,789 50,681 52,522 57,255 10,716 10,688

10,714 10,741

Long Term Loans Advance and Other Receivables 325 385 380 341 323 306 291 277 263 250 237 Long Term Deposits and Prepayments 124 113 139 156 172 189 208 229 251 277 - Deffered tax 957 2,130 3,292 6,464 8,011 9,332 10,555 11,689 12,587

13,162 13,304

NON CURRENT ASSETS 9,859

10,469 57,593

58,637 65,559

69,358 76,009

32,077 34,576

36,965 39,106

Stores Spare Parts and Loose Tools 115 134 139 189 208 161 183 238 285 311 322 Stock in Trade (Inventory) 95,378 88,524 106,089 86,297 58,492 62,409 66,465 79,636 90,341

95,215 100,592

Trade Debts 124,722

218,022 76,596 175,386 180,778

178,904 180,496

196,376 213,577

186,917 192,907

Loans and Advances 431 526 491 491 2,135 501 511 521 531 542 553 Deposits and Short term Prepayments 1,027 2,528 2,406 2,511 1,903 2,075 2,285 2,236 2,202 2,140 2,188 Mark-up/ Interest Receivables on Investments - - 2,251 2,251 2,237 2,247 2,245 - - - - Other Receivables 22,520 21,122 26,571 21,108 19,550 19,299 19,496 19,696 19,900

20,108 20,321

Taxation - Net 6,312 5,315 4,586 4,673 8,132 7,584 7,732 9,824 12,221 14,330

14,364 Cash and Bank balances 2,309 1,624 5,227 20,607 2,312 2,000 2,000 2,000 2,000

31,942 35,540

CURRENT ASSETS 252,815

337,796 224,356

313,514 275,749

275,180 281,412

310,527 341,057

351,505 366,787

Net Assets in Bangladesh - - - - - - - - - - - TOTAL ASSETS

262,673 348,265

281,950 372,151

341,307 344,538

357,422 342,605

375,632 388,470

405,892


15

Ba lance Sheet ( Equi ty & Liabi l i t ies )

PKR millions Historical Balance Sheet Projected Balance Sheet As at June 30th FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E LIABILITIES & EQUITY Issued Subscribed and paid-up 1,715 1,715 2,470 2,717 2,717 2,717 2,717 2,717 2,717 2,717 2,717 Reserves 40,188 46,619 58,173 75,904 79,593 88,556 98,008 108,361 119,184 129,328 139,590 TOTAL EQUITY 41,903 48,334 60,643 78,621 82,310 91,273 100,725

111,078 121,901

132,045 142,307

Retirement and Other Service Benefits 2,234 4,982 4,271 5,184 8,321 9,014 9,708 10,401 11,094 11,788 12,481 Long term deposits 1,024 1,176 1,342 - - - - - - - - Deferred Liabilities - - - - - - - - - - - NON-CURRENT LIABILITIES 3,257 6,158 5,614 5,184 8,321 9,014 9,708 10,401 11,094

11,788 12,481

Trade and other Payables 191,851 246,767 197,303 194,008 147,045 143,451 164,518 203,833 235,527 242,556 249,023 Provisions 689 689 689 689 689 689 689 689 689 689 689 Accrued Interest / Markup 432 544 432 1,328 867 1,176 1,417 1,388 1,392 1,392 1,392 Short Term Borrowings 24,542 45,773 17,270 92,321 102,076 98,935 80,366 15,217 5,029 0 0 Taxes Payable - - - - - - - - - - - CURRENT LIABILITIES

217,513 293,773

215,693 288,346

250,676 244,251

246,989 221,126

242,637 244,637

251,104 TOTAL LIABILITIES

220,770 299,931

221,307 293,530

258,997 253,265

256,697 231,527

253,731 256,425

263,585 TOTAL EQUITY AND LIABILITIES

262,673 348,265

281,950 372,151

341,307 344,538

357,422 342,605

375,632 388,470

405,892


16

Incom e Statem ent

PKR millions Historical P&L Projected P&L For the year ended June 30th FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E Sales 974,917 1,199,928 1,294,503 1,409,574 1,114,409 954,089 1,073,799 1,387,934 1,659,951 1,814,172

1,891,211 Less: Sales Tax

(137,969) (163,861) (178,505) (204,360)

(183,891) (221,789)

(242,524) (309,214) (370,456) (409,292)

(433,047) Less: IFEM

(16,418) (11,643) (15,876) (17,575) (17,423) (24,745) (25,693) (31,115) (35,423)

(38,362) (41,452)

Net Sales 820,530 1,024,424 1,100,122 1,187,639 913,094 707,554 805,582 1,047,605 1,254,072 1,366,518 1,416,712 Cost of Product Sold

(786,250) (990,101)

(1,065,961) (1,150,815)

(889,515) (679,256)

(773,276) (1,009,754)

(1,211,484) (1,321,946)

(1,370,351) Gross Profit 34,280 34,323 34,161 36,824 23,579 28,299 32,305 37,851 42,588 44,571 46,362 Other Income 5,960 9,685 5,939 19,518 14,024 12,365 12,518 8,530 8,972 10,633 10,908 Operating Costs: Distribution & Marketing Expenses

(5,986) (7,069) (7,317) - (8,118) (8,611) (9,399) (10,555) (11,700) (12,401)

(12,782) Administrative Expenses

(1,515) (1,660) (1,730) (2,003) (2,300) (2,281) (2,449) (2,666) (2,885) (3,045) (3,164) Other Operating Expenses

(2,240) (9,272) (3,664) (3,890) (3,513) (2,495) (3,088) (4,120) (4,942) (4,385) (5,247) Total Operating Cost

(9,740) (18,000)

(12,711) (13,316)

(13,931) (13,387)

(14,936) (17,342)

(19,526) (19,831)

(21,194) EBITDA 30,500 26,007 27,390 43,026 23,672 27,277 29,887 29,040 32,034 35,373 36,076 Depreciation & Amortization 1,139 1,143 1,160 1,054 1,001 1,043 1,118 1,199 1,324 1,463 1,613 EBIT 29,361 24,864 26,230 41,972 22,671 26,234 28,770 27,840 30,710 33,911 34,463 Finance Cost

(11,903) (11,659) (7,591) (9,544) (11,017) (11,040) (11,002) (5,747) (5,639) (5,668) (5,926)

Share of Profit from Associates 517 469 571 542 379 313 496 661 699 740 784 Profit Before tax 17,974 13,674 19,210 32,969 12,034 15,506 18,264 22,754 25,770 28,982 29,321 Taxation

(3,195) (4,618) (6,572) (11,151) (5,097) (4,962) (5,662) (6,826) (7,731) (8,695) (8,796) Profit After tax 14,779 9,056 12,638 21,818 6,936 10,544 12,602 15,928 18,039 20,288 20,525


17

Cash F low Statem ent

Cash flow statement FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E Net Income

21,818 6,936

10,544 12,787 15,046 16,091 17,530 17,960

Depreciation & Amortization

1,054 1,001

1,043 1,118 1,199 1,324 1,463 1,613

Change in Working Capital

(76,177)

(27,954)

(3,028)

34,321 21,432 7,422

15,240

(1,907)

CFO (53,304)

(20,017) 8,559

48,226 37,677

24,837 34,232

17,666 Capex

(1,384)

(1,479)

(1,675)

(1,799)

(2,654)

(2,924)

(3,223)

(3,549)

Investments 2,464

(4,892)

(1,841)

(4,733) 46,539 28

(26) (28)

Change in other LT Assets

(3,177)

(1,552)

(1,326)

(1,254)

(1,090)

(829)

(525)

(160)

CFI (2,098)

(7,922)

(4,842)

(7,787)

42,795

(3,725)

(3,774)

(3,736)

Other changes in Equity

(3,840) (3,247)

(1,581.65) (3,196.79)

(5,266.16) (6,436.28)

(8,764.98) (8,980.10)

Change in Borrowing 73,709

9,754 (3,140)

(37,936) (61,000) - - -

Change in other LT Liabilities

912 3,137 693 693 693 693 693 693

CFF 70,782

9,644 (4,028)

(40,439) (65,572)

(5,743) (8,072)

(8,287) Net Cashflow

15,379

(18,295)

(312) 0

14,900

15,369

22,387 5,643

Beginning Cashflow 5,227

20,607 2,311.884

2,000.000 2,000.000

16,899.961 32,268.935

54,656.061 Ending Cashflow

20,607 2,312

2,000.000 2,000.000

16,899.961 32,268.935

54,656.061 60,298.774

Actual on BS 20,607

2,312

2,000.000

2,000.000

16,899.961

32,268.935

54,656.061

60,298.774


18

Financial ratio FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E

PROFITABILTY:

ROE 32% 8% 12% 13% 14% 15% 16% 15%

Profit margin 2% 1% 1.49% 1.56% 1.52% 1.44% 1.48% 1.45%

Asset Turnov er 3.63 2.56 2.06 2.30 2.99 3.49 3.58 3.57

Lev erage 4.73 4.15 3.77 3.55 3.08 3.08 2.94 2.85

ROA 7% 2% 3% 4% 5% 5% 5% 5%

LIQUIDITY:

Current ratio 1.08x 1.10x 1.13x 1.14x 1.40x 1.41x 1.44x 1.46x

Quick ratio 0.79x 0.87x 0.87x 0.87x 1.04x 1.03x 1.05x 1.06x

CFO/CAPEX -38.50 -13.53 5.11 16.00 10.29 7.02 14.98 4.77

ACTIVITY:

LNG Receivables Turnover - 1.80 3.49 4.87 8.11 9.13 10.43 10.43

Pow er sector receivables turnover 5.53 2.35 1.74 1.92 2.21 2.43 2.81 2.92

Day s Pow er sector receivables 66 166 210 190 165 150 130 125

Day s LNG receivables - 203 105 75 45 40 35 35

Inv entory Turnover 13.76 15.61 11.34 12.12 13.15 13.88 14.35 14.08

Day s in inv entory (without stock in transit) 22 19 27 24 20 18 16 16

Cash Conversion Cycle 10.65 7.88 2.20 3.16 4.58 5.59 6.50 6.38

FINANCIAL LEVERAGE:

Total Debt to Equity 3.73x 3.15x 2.77x 2.55x 2.08x 2.08x 1.94x 1.85x

Interest Cov erage 4.40x 2.06x 2.38x 2.62x 4.84x 5.45x 5.98x 5.82x

SHAREHOLDER RATIO:

Earning per share 80.3 25.5 38.8 46.4 58.6 66.4 74.7 75.5

Div idend per share 5.9 10.0 5.8 11.6 20.5 26.6 37.3 37.8

Div idend pay out ratio 7% 39% 15% 25% 35% 40% 50% 50%


19

As at June 30th FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E

Property Plant and Equipment 2.32% 1.67% 1.96% 1.57% 1.86% 2.02% 2.14% 2.66% 2.85% 3.21% 3.55%

Intangibles 0.01% 0.01% 0.02% 0.01% 0.02% 0.02% 0.02% 0.03% 0.03% 0.04% 0.00%

Long Term Inv estment 0.88% 0.57% 17.11% 12.30% 14.85% 15.24% 16.02% 3.13% 2.85% 2.76% 2.65%

Long Term Loans Adv ance and Other Receiv ables 0.12% 0.11% 0.13% 0.09% 0.09% 0.09% 0.08% 0.08% 0.07% 0.06% 0.06%

Long Term Deposits and Prepay ments 0.05% 0.03% 0.05% 0.04% 0.05% 0.05% 0.06% 0.07% 0.07% 0.07% 0.00%

Deffered tax 0.36% 0.61% 1.17% 1.74% 2.35% 2.71% 2.95% 3.41% 3.35% 3.39% 3.28%

NON CURRENT ASSETS 3.75% 3.01% 20.43% 15.76% 19.21% 20.13% 21.27% 9.36% 9.20% 9.52% 9.63%

Stores Spare Parts and Loose Tools 0.04% 0.04% 0.05% 0.05% 0.06% 0.05% 0.05% 0.07% 0.08% 0.08% 0.08%

Stock in Trade (Inv entory ) 36.31% 25.42% 37.63% 23.19% 17.14% 18.11% 18.60% 23.24% 24.05% 24.51% 24.78%

Trade Debts 47.48% 62.60% 27.17% 47.13% 52.97% 51.93% 50.50% 57.32% 56.86% 48.12% 47.53%

Loans and Adv ances 0.16% 0.15% 0.17% 0.13% 0.63% 0.15% 0.14% 0.15% 0.14% 0.14% 0.14%

Deposits and Short term Prepay ments 0.39% 0.73% 0.85% 0.67% 0.56% 0.60% 0.64% 0.65% 0.59% 0.55% 0.54%

Mark-up/ Interest Receiv ables on Inv estments 0.00% 0.00% 0.80% 0.60% 0.66% 0.65% 0.63% 0.00% 0.00% 0.00% 0.00%

Other Receiv ables 8.57% 6.06% 9.42% 5.67% 5.73% 5.60% 5.45% 5.75% 5.30% 5.18% 5.01%

Tax ation - Net 2.40% 1.53% 1.63% 1.26% 2.38% 2.20% 2.16% 2.87% 3.25% 3.69% 3.54%

Cash and Bank balances 0.88% 0.47% 1.85% 5.54% 0.68% 0.58% 0.56% 0.58% 0.53% 8.22% 8.76%

CURRENT ASSETS 96.25% 96.99% 79.57% 84.24% 80.79% 80% 78.73% 90.64% 90.80% 90.48% 90.37%

Net Assets in Bangladesh 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

TOTAL ASSETS 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

Issued Subscribed and paid-up 1% 0% 1% 1% 1% 1% 1% 1% 1% 1% 1%

Reserv es 15% 13% 21% 20% 23% 26% 27% 32% 32% 33% 34%

TOTAL EQUITY 16% 14% 22% 21% 24% 26% 28% 32% 32% 34% 35%

Retirement and Other Serv ice Benefits 1% 1% 2% 1% 2% 3% 3% 3% 3% 3% 3%

Long term deposits 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0%

Deferred Liabilities 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0%

NON-CURRENT LIABILITIES 1% 2% 2% 1% 2% 3% 3% 3% 3% 3% 3%

Trade and other Pay ables 73% 71% 70% 52% 43% 42% 46% 59% 63% 62% 61%

Prov isions 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0%

Accrued Interest / Markup 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0%

Short Term Borrow ings 9% 13% 6% 25% 30% 29% 22% 4% 1% 0% 0%

Tax es Pay able 0% 0% 0% 0% 0% 0% 0% 0% 0% 0% 0%

CURRENT LIABILITIES 83% 84% 77% 77% 73% 71% 69% 65% 65% 63% 62%

TOTAL LIABILITIES 84% 86% 78% 79% 76% 74% 72% 68% 68% 66% 65%

TOTAL EQUITY AND LIABILITIES 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

Common Size Analysis Balance Sheet

ASSETS

LIABILITIES & EQUITY


20

FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E

Sales 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%

Less: Sales Tax -14% -14% -14% -14% -17% -23% -23% -22% -22% -23% -23%

Less: IFEM -1.7% -1.0% -1.2% -1.2% -1.6% -2.6% -2.4% -2.2% -2.1% -2.1% -2.2%

Net Sales 84% 85% 85% 84% 82% 74% 75% 75% 76% 75% 75%

Cost of Product Sold -81% -83% -82% -82% -80% -71% -72% -73% -73% -73% -72%

Gross Profit 3.5% 2.9% 2.6% 2.6% 2.1% 3.0% 3.0% 2.7% 2.6% 2.5% 2.5%

Other Income 0.6% 0.8% 0.5% 1.4% 1.3% 1.3% 1.2% 0.6% 0.5% 0.6% 0.6%

Operating Costs: 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Distribution & Marketing Ex penses -0.6% -0.6% -0.6% 0.0% -0.7% -0.9% -0.9% -0.8% -0.7% -0.7% -0.7%

Administrativ e Ex penses -0.2% -0.1% -0.1% -0.1% -0.2% -0.2% -0.2% -0.2% -0.2% -0.2% -0.2%

Other Operating Ex penses -0.2% -0.8% -0.3% -0.3% -0.3% -0.3% -0.3% -0.3% -0.3% -0.2% -0.3%

Total Operating Cost -1.0% -1.5% -1.0% -0.9% -1.3% -1.4% -1.4% -1.2% -1.2% -1.1% -1.1%

EBITDA 3.1% 2.2% 2.1% 3.1% 2.1% 2.9% 2.8% 2.1% 1.9% 1.9% 1.9%

Depreciation & Amortization 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1% 0.1%

EBIT 3.0% 2.1% 2.0% 3.0% 2.0% 2.7% 2.7% 2.0% 1.9% 1.9% 1.8%

Finance Cost -1.2% -1.0% -0.6% -0.7% -1.0% -1.2% -1.0% -0.4% -0.3% -0.3% -0.3%

Share of Profit from Associates 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%

Profit Before tax 1.84% 1.14% 1.48% 2.34% 1.08% 1.63% 1.70% 1.64% 1.55% 1.60% 1.55%

Tax ation -0.3% -0.4% -0.5% -0.8% -0.5% -0.5% -0.5% -0.5% -0.5% -0.5% -0.5%

Profit After tax 1.5% 0.8% 1.0% 1.5% 0.6% 1.1% 1.2% 1.1% 1.1% 1.1% 1.1%

Common Size Analysis P&L


21

Ratio Analysis


PROFITABILTY:

ROE 32% 8% 12% 13% 14% 15% 16% 15%

Profit margin 2% 1% 1.49% 1.56% 1.52% 1.44% 1.48% 1.45%

Asset Turnover 3.63 2.56 2.06 2.30 2.99 3.49 3.58 3.57

Leverage 4.73 4.15 3.77 3.55 3.08 3.08 2.94 2.85

ROA 7% 2% 3% 4% 5% 5% 5% 5%

LIQUIDITY:

Current ratio 1.08x 1.10x 1.13x 1.14x 1.40x 1.41x 1.44x 1.46x

Quick ratio 0.79x 0.87x 0.87x 0.87x 1.04x 1.03x 1.05x 1.06x

CFO/CAPEX -38.50 -13.53 5.11 16.00 10.29 7.02 14.98 4.77


ACTIVITY:

LNG Receivables Turnover - 1.80 3.49 4.87 8.11 9.13 10.43 10.43

Power sector receivables turnover 5.53 2.35 1.74 1.92 2.21 2.43 2.81 2.92

Days Power sector receivables 66 166 210 190 165 150 130 125

Days LNG receivables - 203 105 75 45 40 35 35

Inventory Turnover 13.76 15.61 11.34 12.12 13.15 13.88 14.35 14.08

Days in inventory (without stock in transit) 22 19 27 24 20 18 16 16

Cash Conversion Cycle 10.65 7.88 2.20 3.16 4.58 5.59 6.50 6.38

FINANCIAL LEVERAGE:

Total Debt to Equity 3.73x 3.15x 2.77x 2.55x 2.08x 2.08x 1.94x 1.85x

Interest Coverage 4.40x 2.06x 2.38x 2.62x 4.84x 5.45x 5.98x 5.82x

SHAREHOLDER RATIO:

Earning per share 80.3 25.5 38.8 46.4 58.6 66.4 74.7 75.5

Dividend per share 5.9 10.0 5.8 11.6 20.5 26.6 37.3 37.8

Dividend payout ratio 7% 39% 15% 25% 35% 40% 50% 50%


22

Valuation using Core business and non-core business FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E

EBITDA w ithout penal income & markup on PIBs 26,094

12,271

16,943

19,554

23,206

26,200

29,540

30,243

Less: Taxation (11,151)

(5,097)

(4,962)

(5,662)

(6,826)

(7,731)

(8,695)

(8,796)

Add: WC Change

(76,177)

(27,954)

(3,028)

15,075

10,170

1,170

26,523

(5,217)

Less: Capex

(1,384)

(1,479)

(1,675)

(1,799)

(2,654)

(2,924)

(3,223)

(3,549)

FCFF (62,619)

(22,260)

7,278

27,168

23,896

16,715

44,146

12,681

0 1 2 3 4 5

NPV of FCFF 100,996

7,278

24,574

19,550

12,369

29,548

7,677

Terminal Value 104,621

PV of Terminal Value 63,338

Enterprise v alue

164,334

Less: Net Debt 96,935

Equity Value 67,399

Core share Price 248.08

Non-core share Price

298.14

Target Price 546.21


23


24

-

50.00

100.00

150.00

200.00

250.00

300.00

350.00

400.00

450.00

500.00

4-Jan-10 4-Jan-11 4-Jan-12 4-Jan-13 4-Jan-14 4-Jan-15

PK

R/

sha

re

5X 4X 3X 2X


25

Sensitivity factor

Current price 321.27

PKR/USD depreciation Target price Upside Decision

4.0% 428 33% Buy

6.0% 416 29% Buy

7.7% 383 19% Hold

8.0% 379 18% Hold

Circular debt

LNG receivables days

Constant at 70 (from 2017-21) 330 3% Sell


Constant at 50 (from 2017-21) 400 24% Buy

Rise in interest rates (increase from our assumptions)

Kibor = 10.1% 428 33% Buy

Kibor = 12.1% 374 16% Hold

Kibor = 14.1% 345 8% Sell

Kibor = 14.6% 338 5% Sell

Brent (w/o incorporating inv. Losses & gains)

10% increase ev ery year (from 40 USD in 2016) 339 5% Sell

10% decrease ev ery year 474 47% Buy

Constant at 50 410 28% Buy

5 USD increase ev ery year from 2017 348 8% Sell

7 USD increase ev ery year from 2017 319 -1% Sell

Inventory losses/gains

Assumption for volatility of USD/barrel:

-5 ev ery year 332 3% Sell

+5 ev ery year 497 55% Buy

-10 ev ery year 250 -22% Sell

-5 in 2016 392 22% Buy

-10 in 2016 369 15% Sell

Increase in LNG margins from 1.82 to 4% 615 91% Buy


26

Bargaining Power of Customers - LOW: Since prices are regulated by OGRA customers doesn’t have any bargaining power for regulated

products such as HSD, MOGAS, LNG or FO. There is low switching cost. No particular group carries a significant weight. Since prices are fixed,

end users of HSD & MOGAS make their purchase according to their convenience and proximity of dealer. FO end users are bound to buy from

PSO according to long term Fuel Supply Agreements (FSA) signed by them therefore no bargaining power lies with them either. However, only

1 out of 6 Power plants according to power policy of 2002 purchase FO from PSO. Moving forward, LNG is also solely imported a nd sold by

PSO thus this situation is not looking to change very soon. Many B2B consumers are given PSO cards which makes it necessary for them to buy

from PSO further limiting their bargaining power.

Intensity of Competitive Rivalry - MODERATE: PSO is the market leader in white & black oil but Pakistan Shell Limited (PSL) is leader in

lubricants. Competition is limited to few companies but has been increasing gradually in recent years. The biggest competition it faces comes

from PSL. Regulated prices for most of the products make it even more difficult for firms to compete. Deregulation in prices and product

differentiation exists only in lubricant category where Shell Helix is currently the market leader with a 35% market share, PSO has a market

share of 25% while Chevron stands at 29%. PSO being a government organization enjoys a lot of securities that others players do not, for

example it provides FO to most of the Power plants in the country due to long term fuel supply agreements. PSO’s plans of acquir ing controlling

share in PRL and vertical integration will further improve its competitive position. PSO has storage facilities all over Pakistan i.e. at 36 locations

with a capacity of 552,000 tons. SPL only has 65,000 tons storage capacity.

Bargaining Power of Suppliers - LOW: PSO imports Black Oil from Kuwait Petroleum and Qatar Petroleum via supplier contract which is

usually valid for 1-2 years. Suppliers deliver in high volumes based on pre-contract agreement hence, there is low bargaining power of

suppliers internationally. Locally, PARCO, NRL and PRL are the fuel suppliers to PSO. The local refineries supply fuel throug h long-term

contracts according to which, fuel supply is matched to the market share of the OMC. The one with the highest market share ge ts to meet its

fuel requirements first and the rest is distributed to the OMCs in accordance with their respective market share s. As of now, PSO has the largest

market share in both Black Oil & White Oil Markets hence, the bargaining of local supplier is also low.

Threat of Substitutes - MODERATE: Due to the energy crisis prevalent in the country, there exist moderate threat of new substitutes in both

white and black oil markets. Product substitutes are natural gas, coal, solar power and renewable energy. Substitutes in Black Oil Market such

as, coal & LNG can be a threat to PSO but since PSO is the sole importer of LNG as well, it faces threat of cannibalization and not losing its share

to some other competitor.

Barriers to Entry - HIGH: There are high barriers to entry for OMCs in the industry. To start as an OMC you need capital in billions (Total

investment capacity of PKR 500 million or more over an initial period of three years, with minimum upfront equity of PKR100 million based

on the criteria of 60:40 debt/ equity ratio, supported by a due diligence certificate from a scheduled bank or financial inst itution), storage

facilities, license from the government and have an initial retail network. Very less product differentiation & regularized prices also make it

difficult to enter the industry. Recently, some small OMCs have emerged in the industry such as, Hascol Petroleum and Admore Gas and some

other small companies are operating in Punjab.

012345

Threat of new entrant

Threat of Substitutes

Bargaining Power of SuppliersCompetition in industry

Bargaining Power ofCustomers

Porter's Five Forces


27

0 100 200 300 400 500 600

Stock of Debt - Beginning of the Year

Total (DISCOs Receivables)

CPPA Receivables from KESC

Total Tariff & Subsidy Issues

PKR billion

Circular debt stock (FY2012)

Macroeconomic variables

FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E

GDP grow th rate 4.03% 4.24% 4.50% 4.50% 5.20% 5.20% 5.20% 5.20%

Inflation 8.6% 4.4% 4.7% 5.5% 5.0% 5.0% 5.0% 5.0%

Ex change rate (PKR/USD) 102.85 101.29 105.34 109.56 113.94 118.49 123.23 128.16

Discount rate/ Kibor 10% 7% 7.00% 8.10% 8.10% 8.10% 8.10% 8.10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16E FY17E FY18E FY19E FY20E FY21E

Mogas vs CNG consumption in transport

Mogas % CNG %


28

0%

2%

4%

6%

8%

10%

12%

0.00

0.50

1.00

1.50

2.00

2.50

3.00

mil

lio

n T

OE

CNG consumption in transport

CNG used in transport sector Share of natural gas allocated to transport

0.00

2.00

4.00

6.00

8.00

10.00

12.00

Co

st, P

KR

/km

Petrol-CNG price parity

Petrol CNG


29

FY15 FY16E FY17E FY18E FY19E FY20E FY21E

Brent (USD/barrel) 73.46 39.85 46.06 52.00 54.90 54.90 54.90

LNG margin (PKR/ton) 736 738 769 887 967 1005 1046

FO margin (PKR/ton) 1,549 867 879 1,072 1,195 1,243 1,293

LNG sales (mn tonnes) 0.30 1.80 3.61 6.86 10.10 13.53 13.53

FO sales (mn tonnes) 9.11 8.13 7.62 7.22 6.76 3.51 3.51

LNG contribution to core profits 0.7% 4.7% 8.6% 16.1% 22.9% 30.5% 30.5%

FO contribution to core profits 32.2% 16.7% 13.9% 13.7% 12.7% 6.6% 6.6%

Source: Team estimates


30

Sensitivity factor

Current price 321.27

PKR/USD depreciation Target price Upside Decision

4.0% 428 33% Buy

6.0% 416 29% Buy

7.7% 383 19% Hold

8.0% 379 18% Hold

Circular debt




Constant at 50 (from 2017-21) 400 24% Buy


Kibor = 10.1% 428 33% Buy

Kibor = 12.1% 374 16% Hold

Kibor = 14.1% 345 8% Sell

Kibor = 14.6% 338 5% Sell


10% increase ev ery year (from 40 USD in 2016) 339 5% Sell

10% decrease ev ery year 474 47% Buy

Constant at 50 410 28% Buy

5 USD increase ev ery year from 2017 348 8% Sell

7 USD increase ev ery year from 2017 319 -1% Sell



-5 ev ery year 332 3% Sell

+5 ev ery year 497 55% Buy

-10 ev ery year 250 -22% Sell

-5 in 2016 392 22% Buy

-10 in 2016 369 15% Sell

Increase in LNG margins from 1.82 to 4% 615 91% Buy


31

EPS

PKR/USD depreciation FY16E FY17E FY18E FY19E FY20E FY21E

4.0% 0.49 0.49 0.49 0.49 0.49 0.49

6.0% 38.01 45.42 57.29 64.73 72.92 73.67

7.7% 35.83 42.82 53.69 60.24 68.18 68.63

8.0% 35.59 42.53 53.29 59.74 67.66 68.06

Circular debt


Constant at 70 (from 2017-21) 38.81 47.14 51.17 54.75 60.12 62.72

Constant at 65 (from 2017-21) 38.81 47.90 52.50 56.68 62.70 65.20

Constant at 50 (from 2017-21) 38.81 50.18 56.48 62.46 70.25 72.36


Kibor = 10.1% 0.49 0.49 0.49 0.49 0.49 0.49

Kibor = 12.1% 22.75 34.16 51.30 58.93 68.87 69.43

Kibor = 14.1% 16.19 27.71 47.20 54.65 65.97 66.38

Kibor = 14.6% 14.53 26.06 46.12 53.50 65.25 65.61


10% increase ev ery year (from 40 USD in 2016) 39.38 45.19 56.56 64.66 75.80 79.48

10% decrease ev ery year 39.38 48.96 55.77 58.80 63.06 64.80

Constant at 50 39.38 42.31 57.14 64.32 71.87 73.07

5 USD increase ev ery year from 2017 39.38 44.72 56.41 64.79 76.46 79.72

7 USD increase ev ery year from 2017 39.38 43.78 55.97 65.12 79.89 83.84



-5 ev ery year 32.25 36.29 48.17 54.34 65.37 66.05

+5 ev ery year 46.51 52.48 66.00 73.54 83.34 85.48

-10 ev ery year 25.13 28.20 39.11 44.46 56.38 56.32

-5 in 2016 32.25 44.05 56.87 63.86 74.19 75.59

-10 in 2016 25.13 43.72 56.51 63.49 74.02 75.42

Increase in LNG margins from 1.82 to 4% 43.32 52.64 74.21 92.30 115.16 118.76


32

Assumptions

Macroeconomic Variables

GDP: IMF forecast of 4.5% till 2017, 5.20% till 2021

Exchange rate: 4% increase YOY after FY15 KIBOR: 7% in 2016, 8.10% till 2021

Inflation: IMF forecast 5% during FY16 till FY21

En ergy Supply & Demand

Final energy consumption has been forecasted using GDP + some portion of unmet demand each year. Energy supply has been forec asted using energy consumption.

Pakistan's energy mix in the future will be titled more towards cheaper fuels, like gas and coal. This can be reflected through the upcoming projects (Iran-Gas

pipeline, LNG imports, Coal based power plants, nuclear projects). All upcoming energy projects have been taken with a lag of 1 year, based on historical performance of such similar projects.

Local gas production will decline by 5% per annum. We expect low gas reserves in low gas production LNG imports: 200 mmcfd in 2016, 400 mmcfd in 2017, 760 mmcfd in 2018, 1120 mmcfd in 2019 and 1500 mmcfd in 20 20.

We expect LNG powerplants to come online in Punjab in 2020E due to new LNG terminals at PortQasim and gas pipeline projects w hich will bring LNG production to 1500 mmcfd

Iran Pakistan Gas Pipeline: We expect 35% of 750 mmcfd from IP gas pipeline in 2019, 75% of 750 mmcfd in 2020 and 100% of 750 mmcfd in 2021

Coal import for cement will decline by 1.3% as per Energy year book Coal supply to Power sector will increase by 7.4% as per Energy Year Book

I ton of LNG = 2.08 TOE

Gas production & consumption:

The decline in local natural gas production/consumption is divided between gas consumed by CNG & Industries [CNG in Transport sector will decline by 20%

in 2016 and by 5% in each year from 2017 till 2021 Imported LNG will hardly be allocated to transport sector [We have assumed that LNG will first be used to run inoperative power plants]

Imported LNG would be allocated to a) Power sector b) Fertilizer c) Domestic (determine 70%,25%,5% share) Assumptions for LNG future supplies: We Assume LNG supply will increase by 500% in FY16, 100% in FY17, 90% in FY18, 47% in FY19 and 34% in FY20. [The

growth difference is due to Plants coming online] Assumptions for future projects of gas, hydel (52% utilization rate), coal (80% utilization rate in future) and nuclear (70% utilization rate in future) We have assumed that from 2016, the energy consumed will be more than the actual historical relation/figures. This is b/c of upcoming energy projects due

to which a certain % of uncatered demand will be met. PSO's market share will remain same in future

Mo gas

Petrol sales growth has been derived from 4 key factors: Number of passenger vehicles on the road, CNG availability, Petrol-CNG price parity and GDP per

capita In 2015, 6% of local gas was allocated to transport sector, in form of CNG. It has been assumed that from 2016-21, only 5% of the local gas would be

allocated to the transport sector. This is in line with GoP's latest gas allocation policy, in which transport sector has the least priority for gas supply. The government would primarily focus on ensuring gas supplies to domestic, power, fertilizer sectors and industries.

HSD HSD sales growth has been derived from 3 key factors: LSM growth, Industrial sector and increased in Total motor vehicle growth (HCV)

We assume 2.5% growth in LSM, 3.85% growth in Industrial sector and average 4% growth in Motor Vehicle growth (HCV) in years FY2016-FY2021


33

References:

http://www.ocac.org.pk/ (Oil Companies Advisory Committee)

http://www.brecorder.com/fuel-a-energy/

http://www.ppib.gov.pk/

http://www.ogra.org.pk/ (Oil & Gas Regulatory Authority)

http://data.worldbank.org/ (World Bank Database)

https://www.imf.org (World Economic & Financial Survey)

http://www.pide.org.pk/ (Pakistan Institute of Development Economics)

http://www.reuters.com/

http://www.bloomberg.com/

http://www.investing.com/ http://www.sbp.org.pk/ (State Bank of Pakistan)

http://www.finance.gov.pk/survey_1415.html (Pakistan Economic Survey)

http://pdf.usaid.gov/pdf_docs/pbaad538.pdf (USAID Circular Debt Report)

http://www.mowp.gov.pk/gop (Ministry of Water & Power) (Capping Circular Debt Report Sep 2015)

http://www.nepra.org.pk/ (State of the Industry Report) http://www.wapda.gov.pk/

http://www.psopk.com/en/investors/results-reporting/financial-highlights (Annual Reports)

http://dps.psx.com.pk/ (Data Portal Pakistan Stock Exchange)

http://www.pakistanlawsite.com/

http://www.pbs.gov.pk/ (Pakistan Bureau of Statistics)

http://hdip.com.pk/ (Hydrocarbon Development Institute of Pakistan)

http://www.mpnr.gov.pk/ (Ministry of Petroleum & Resources) (Pakistan Energy Year Book 2014)

http://www.eia.gov/ (US Energy Information Administration)

http://www.opec.org/ (World Oil Outlook)

http://investorguide360.com/

http://www.scstrade.com/

http://www.ocac.org.pk/

http://www.brecorder.com/fuel-a-energy/

http://www.ppib.gov.pk/

http://www.ogra.org.pk/

http://data.worldbank.org/

https://www.imf.org/

http://www.pide.org.pk/

http://www.bloomberg.com/

http://www.investing.com/

http://www.sbp.org.pk/

http://www.finance.gov.pk/survey_1415.html

http://pdf.usaid.gov/pdf_docs/pbaad538.pdf

http://www.mowp.gov.pk/gop

http://www.nepra.org.pk/

http://www.wapda.gov.pk/

http://www.psopk.com/en/investors/results-reporting/financial-highlights

http://dps.psx.com.pk/

http://www.pakistanlawsite.com/

http://www.pbs.gov.pk/

http://hdip.com.pk/

http://www.mpnr.gov.pk/

http://www.eia.gov/

http://www.opec.org/

http://investorguide360.com/

http://www.scstrade.com/

Disclosures: Ownership and material conflicts of interest:

The author(s), or a member of their household, of this report does not hold a financial interest in the securities of this company. The author(s), or a member of their household, of this report does not know of the existence of any conflicts of interest that might bias the content or publication of this report.

Receipt of compensation: Compensation of the author(s) of this report is not based on investment banking revenue. Position as a officer or director: The author(s), or a member of their household, does not serve as an officer, director or advisory board member of the subject company.

Market making: The author(s) does not act as a market maker in the subject company’s securities. Disclaimer: The information set forth herein has been obtained or derived from sources generally available to the public and believed by the author(s) to be reliable, but the author(s) does not make any representation or warranty, express or implied, as to its accur acy or completeness. The information is not intended to be used as the basis of any investment decisions by any person or entity. This information does not constitute investment advice, nor is it an offer or a solicitation of an offer to buy or sell any securi ty. This report should not be considered to be a recommendation by any individual affiliated with CFA Pakistan, CFA Institute or the CFA Institute Research Challenge with regard to this company’s stock.

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