Investing is not about hearsay of buy call from your coffee shop’s friends. We need to know what we are buying and what the future possible fair value are for our selected companies. If we are buying companies with reasonable (cheap) valuations, then we have a good chance of making profitable investments.

Most analysts and value investors look at PE, dividend yields, ROE and EV/EBIT, ROIC ratios to value a company worth to invest or not. I will use PE (most common in the market) and free cash flow, FCF (my personal favorite valuation metric) to evaluate Petronm.

From the latest Petronm released result, it reported a net profit of RM91 mil (EPS of 33.7 sen) for second quarter (Q2) of 2017. This Q2 result has shown relatively good improvement (48%) by year of year (YoY) comparison in profit (Q2’2017 vs Q2’2016). Some may notice that there is an one-off gain in this report from disposal of service station due to compulsory acquisition by government.

If you compare the revenue of the Q1 and Q2’17, actually there are no much difference. I infer that the drop in Q2 profit mainly due to inventory/stock loss which Petronm did not specify the amount in the report. Please refer to my Free Cash Flow from operation table (3^rd table of my article) for an overview of the Petronm’s cash flow comparison for 2016 and 2017. Even you removed the petrol station disposal gain of RM39 mil, Petronm still generated positive FCF from operation of RM234 mil for the past 6 months of 2017 (compared to accounting profit of RM199 mil (Q1+Q2). The drop in profit margin or net profit in Q2 is mainly due to “accounting theoretical inventory loss” which has not been realized which I can show you how strong the “real operation profit or positive cash flow” in the next section.

Let me give you one example, if one company reported a  HIGH accounting profit but high negative cash flow until they need to issue right issue or loan stock to raise fund, do you think this HIGH accounting profit make sense or valuable for shareholders? 

As I mentioned before in my part 6 article, the quality of earning is depending on the free cash flow from operation (FCFO) and not merely looking at the “accounting profit (RM91 mil)”. Let us go through the FCFO of Petronm in the past 6 months of 2017 vs 2016 as below:

Source: Q2’17 report

What I can observe from that there is a big or significant improvement of FCFO (RM273 mil) from operation in first 6 months of 2017 vs 2016. It is worth noting that RM273 mil can be translated to EPS of 101 sen. If you taken out the one-off disposal gain of RM39 mil, the total positive cash flow for Petronm is still stand at RM234 mil which can explain it is still earning relatively high profit margin from refinery and retails in Q2. If Petronm really earned relatively low profit margin, then logically its cash flow should drop YoY and QoQ.

In short, the reported accounting net profit of EPS33 sen actually include “theoretical unrealized stock loss”. This unrealized loss actually proven and supported by strong positive FCFO which is the actual MONEY that can be used to pare down debt and future dividend payout.

Let us see how Petronm used the FCFO of RM273 mil in Q2’17 as below.

Source: Q2’17 report

We can notice that Petronm has paid off RM241 mil of debt (borrowings) in first 6 months of 2017 vs RM133 mil in 2016. Even the total borrowings reduced significantly by RM241 mil, its cash flow just reduced from RM171 mil to RM156 mil.  

For new valuation of Petronm in coming 6 month, let us revisit my Petronm’s estimation (Part 1 and part 3 articles https://klse.i3investor.com/blogs/david_petronm/127594.jsp) as below:

2016 (actual) vs 2017 (estimated) Profit

The reasons for my readjustment (115%) for Q3’17 forecast result is due to strong average crack spread (refining margin improve from USD8.25 to USD12.5) in July and August. Besides, moderate growth in the sales of refined products retails business provides stable profit. Besides, Petronm is likely to record inventory/stock gain in Q3’17 if the crude oil price stay above USD48. The readjustment in Q4 (110%) is due to Q4 is their peak season and strong retail and refinery margin may drive the profit growth. From my new estimation (refer table above), we can notice that Petronm is likely to produce forward EPS of 164.35 sen for year 2017 which translate to forward PE ratio of 5.65 based on current price of RM9.29. Let see the latest crack spread data which is the main profit driver for Petronm’s Q3 profit visibility.  

From CME website

Comparison with Regional Peers

To evaluate whether Petronm valuation is cheap or expensive, let us have a direct PE ratio comparison with regional refiner and retail peers. Table below shows comparisons of PE ratio of the 3 refining and/or retails companies in Asia.

We can notice that Petronm is still trading at relatively low PE ratio as compared to regional peers. Anyway, this is not apple to apple comparison for SK innovation and Petdag as SK innovation mainly focus on refinery without retail business while Petdag only deal with gasoline and other related products retails. The closest comparison is with Petron Corp Philippines as Petron Corp deals with both refinery and retail businesses. Currently Petronm is trading at nearly half the PE valuation (5.65) as compared to its mother company Petron Corp.   

Before I can give a future projected fair valuation to Petronm, let us go through the table below for FCFO, total borrowing and cash in hand comparisons for Q1’17 vs Q2’17.

Source: Q1’17 and Q2’17 reports of Petronm

It can be observed that Petronm has consistently improved its FCFO and reduced its borrowing level to nearly zero (from 251 mil to 66 mil in 3 months). Currently it is actually a net cash company if we consider its cash in hand (cash in hand minus total borrowing). Even you removed the disposal gain of RM39 mil, Petronm still generated FCFO of RM234 mil for the past 6 months of 2017.  

With a projected EPS of 164.35 sen (RM443 mil profit) for FY2017, fair forward PE for Petronm should be in the range of 7.5 to 9. With PE of 7.5, the fair value of Petronm should be RM12.33 while at high side of PE, Petronm possible to be valued at RM14.79. I will provide reasons on why Petronm should deserve higher PE than 5.65 in my summary section.

Key Catalyst: Higher profit contribution from Refinery segment in Q3.

Risk

1.       Inventory/stock loss from crude oil price dropping. This is not likely to happen as current Brent crude oil price stays above USD48. In fact, it maybe able to record a stock gain if Brent oil price stayed above USD48 in the end of Sept.

2.       Big drop in refinery margin which I think is not likely to happen in short term based on my monitoring on Singapore Future crack spread of refined finished products (Mogas 92).

Summary:

1.       The first reason why Petronm deserves higher PE is it has shown consistent and increasing EPS for past 3 quarters (41.7sen, 40.2 sen, 33.7 sen) in 2017 as compared to 2016.

2.       The second reason why Petronm deserves higher PE is it has generated strong free cash flow from operation over past two years and has reduced its debt close to zero in 3 years time.

3.       The third reason why Petronm deserves higher PE is it keeps expanding its retails petrol station networks and retails market shares (more than 19%), strong commercial sector growth (Jet fuel and lubricant). Retails segment provides a stable profit avenue can serve as a cushion even refining margin drops in the future.

4.       The forth reason why Petronm deserves higher PE is I expect Q3 result to be a record high due to stronger refinery margin (crack spread) can be observed from July to August and possibility of stock gain recorded.

5.       I hope my article can help investors to see the real value of Petronm from its strong free cash flow from operation and future potential of its refinery and retails businesses.

6.       In my opinion, a good company after paid for its operations cost and invests new capital (if any), and still has money left over. The left over money is free cash flow which is can be used for dividend, future reserve and expansion.

Petronm Technical Chat:

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Disclaimer:

This writing is based on my own assumptions and estimations. It is strictly for sharing purpose, not a buy or sell call of the company.