The author is an analyst of Shinhan Investment Corp. He can be reached at email@example.com. -- Ed.
Initiate coverage with BUY for a target price of KRW83,000
We initiate coverage of S-Oil at BUY for a target price of KRW83,000, based on 2020F BPS of KRW57,289 and a target PBR of 1.5x (PBR low recorded during the previous market boom). The company’s earnings are forecast to grow sharply in 2H20 vs. 1H20, with Saudi Arabia slashing its official selling price (OSP) and oil prices set to rise on demand recovery in 2H. Nevertheless, S-Oil shares have plummeted to trade at the low end of the valuation band (12MF PBR of 1x) due to concerns over steep oil price declines and slowing oil demand. Believing negatives are already priced in at current share price levels, we see strong upside potential rather than additional downside risk.
Key investment points: 1) 2H20 earnings upturn; 2) HSFO price falls; and 3) higher share of olefin
First, refining operating profit is expected to rise KRW902.7bn HoH in 2H20, backed by Saudi Arabia’s OSP cuts and oil price hike on demand recovery. Refining margin should improve by USD2.3/bbl YoY in 2020, with a USD1/bbl rise in margin estimated to boost profits by KRW280bn per annum. Second, the implementation of IMO 2020 rules will likely drive down high sulfur fuel oil (HSFO) prices, leading to a rise in lube oil spread and margin improvement at the residue upgrading complex (RUC) and olefin downstream complex (ODC). Third, the RUC and ODC convert low-margin residue oil into high-margin gasoline, PP, and PO. Through RUC/ODC operations, the share of olefin derivatives in the petrochemical portfolio has climbed to 37% (vs. previous 8%), helping to lower earnings sensitivity to changes in market conditions.
2020 OP forecast at KRW687.3bn (+53% YoY)
S-Oil is projected to report operating loss of KRW307bn (negative swing QoQ) for 1Q20, due to inventory valuation losses on sharp oil price falls and negative lagging effect. By division, the company should post operating loss of KRW406.8bn (continued loss QoQ) from refining, profit of KRW14.5bn (-28% QoQ) from petrochemicals, and profit of KRW85.3bn (-13% QoQ) from lube base oil. Weak refining earnings are attributable to about KRW350bn in inventory valuation losses and low refining margins. Despite sluggish demand, the profit drop should be smaller from lube base oil thanks to limited decline in spread.
For 2020, operating profit will likely grow 53% YoY to KRW687.3bn. By division, operating profit is forecast at KRW219.9bn (positive swing YoY, +KRW245.2bn) from refining, KRW355.7bn (+62% YoY) from lube base oil, and KRW111.7bn (-56% YoY) from petrochemicals. The refining division should see sharp earnings growth from loss of KRW341.4bn in 1H to profit of KRW561.3bn in 2H. Complex refining margin is expected to improve by USD2.3/bbl YoY and lube base oil margin by USD75/ton YoY in 2020.