Wednesday, February 21, 2017 03:41 PM / ARM Research
In contrast to sector peers, which had a stellar 2016 performance, Forte Oil (FO) grappled with impact of NGN depreciation on dollar loans linked to its power plant and an elevated bill from the taxman. Earnings halved from 2015 levels and FO did not declare dividend. In response, the stock was heavily sold off by investors (-29.9% YTD, -81.1% over 52-week). Irrespective, current adjustments to earnings guides our rating upgrade to a NEUTRAL (from SELL).
In contrast to sector peers which had stellar 2016 performances, Forte Oil (FO) grappled with fall-out of NGN depreciation on dollar loans linked to its power plant and an elevated bill from the taxman. Earnings halved from 2015 levels and FO did not declare a dividend. In response, the stock was heavily sold off (29.9% YTD, -81.1% over 52-week).
Current valuations, combined with our upwardly adjusted earnings forecast, underpin our rating upgrade to a NEUTRAL (from SELL). Specifically, our rating reflects the potential upside in the LPG and lubricants segments, hinged on higher prices and volumes, gross margin recovery in its Power business as well as tax rate normalization.
Pertinently, we expect to see weighty YoY upside in Q1 2017. We particularly like FO’s market positioning—closest rival to market leader, Total—in key petroleum products and the high margin lubricants market, which will be supportive for earnings. Elsewhere, we forecast a 100bps market share gain from inorganic growth.
Nonetheless, our view on input cost pressures and PMS volume contraction— which drove underlying weakness in FY 16 numbers— guides our tempered optimism on earnings for 2017.
Higher finance charges and tax rates dent FY 16 results
FO’s audited FY 16 numbers showed underlying earnings weakness which reflected pressures from financing and the taxman. On the former, finance charges jumped following NGN depreciation as FO booked losses on FX loans related to its Geregu power plant ($10million). Further down, FO reported higher effective tax rate in FY 16 (45.9%) which largely drove earnings lower by about half. According to management, the steep jump in tax rate was a fallout of differences between the tax provision in 2015, when FO paid record low effective tax rate of 17.4%, and actual tax paid per provision of CITA which was charged to the income statement in Q3 16 (Higher effective tax rate of 58.9% (+452pps YoY and +2.1pps QoQ))
Currency pressures squeeze operating margin
In line with sector-wide pattern of strong top-line growth, FO reported sturdy growth in revenue (+19.3% YoY to N148 billion) hinged on higher sales in Fuels (+16.6% YoY), Lubricants (+85.5% YoY), and Power (+26.1% YoY). Specifically, LPG and lubricant volumes grew 303% and 65% YoY respectively despite higher prices that copiously offset the cost pressures on these segments. To add, management attributed the rise in volumes to its recently revamped LPG facilities in Apapa as well as aggressive marketing and development of new channels (Forte Oil deployed sales Kiosk in 40 mechanic villages in 2016).
At another end, FO attributed top-line gains in the power segment to upsurge in Geregu’s output to 435MW (previously 415MW) and increase in prices.
However, input cost pressures were evident, particularly for non-fuel products, as FO sourced FX at higher than official rates to import lubes, whose cost more than doubled YoY in 2016. Similarly, naira weakness and upswing in domestic gas prices drove the cost of gas feedstock at Geregu Power Plant higher. Accordingly, gross margins shrank 88bps to 13.8%. Consequently, EBIT margin declined marginally despite top-line gains and lower operating cost (-3.0% YoY to N13.3 billion).
Late adjustment of petrol prices to drive focus on non-PMS volumes
Going into 2017, delayed adjustment to the PPPRA pricing template to reflect new crude price reality poses challenges to top-line expansion. In addition, petroleum marketers should grapple with persisting FX scarcity and increased prospects for NGN depreciation. In our discussions with FO, management noted that focus would be on raising non-fuel volumes as margins on PMS comes under pressure.
Specifically, FO identified non-regulated LPG and lubricants, where prices have been hiked, as focus for volume push in 2017.
On power, management noted that increased capacity at Geregu, following refurbishment works in 2016, should translate to higher sales in the event of relative gas availability. To this point, we highlight that recovery in gas supply in late 2016 and increased FGN conciliatory moves in the Niger Delta speak to tamer risk of gas disruptions for the company. Consequently, we see scope for 10% YoY rise in power revenue over 2017 to N14.2 billion. Finally, while we see scope for tamer volume contraction in 2017 on the back of higher prices as well as supply constraints, we expect the noteworthy increase in LPG volumes combined with higher prices to support fuel revenue growth (+7% YoY to N130.1 billion). Overall, we estimate 8.4% YoY rise in FO’s revenues in 2017.
Stagnant PMS pricing range underpins soft margin outlook
Despite our benign expectation for gross profit, the weighty contribution of PMS to fuel revenues (circa. 70%), given sector-wide reliance on NNPC for PMS supply, should contain margin expansion. Specifically, FO noted that NNPC sourcing caps PMS margins at around N6/litre. For non-NNPC product sourcing, difficulty sourcing FX at the interbank rate implies that the company is losing market in the face of the current price cap of N145/litre. Accordingly, FO guides to wholesale PMS sourcing from NNPC which underpins our flattish gross margin expectation of 10% for fuels.
Elsewhere, recent upward product pricing across its deregulated lubricants’ business is expected to taper impact of cost pressures on earnings, underpinning our expectation for a 65bps expansion in lubes’ gross margin to 28%. On power, notwithstanding revenue growth from increased power generation, legal issues regarding the prior price increase, which suggest to a halt in further price increase, as well as FX pass-through on gas prices guides our gross margin expectation of 33% (-7bps YoY). Overall, we forecast a marginal increase (+9bps YoY) in gross margin to 14% largely from the lubes segment.
Financing pressures temper gains from tax normalization
Equally on finance expenses, while we see little scope for improvement in FO debt profile, management guided to plans to raise circa N20 billion via debt and equity over 2017 as well as outstanding payment of N15 billion from PPPRA, to cut the rate of borrowing by 100bps YoY to 17% in FY 17.
However, the combined effect of our views of further NGN depreciation as well as its recent bond issuance guides our finance cost at elevated levels (FO issued a 5-year N9billion bond in November 2016 at 17.5%. Our house call is for a USDNGN depreciation to N400/$ in H2 2017). Thus, we forecast a 21.4% YoY rise in finance cost to N5.2 billion.
On a slightly positive note, following the resolution of the issues with the tax authorities in 2016, FO guided to a normalisation in effective tax rates to statutory levels which removes a key pressure point to earnings outlook. However, the raised finance costs drive our view for softer earnings for FY 17F at N2.1 billion (-27.2% YoY).
Where is the worth?
Over 2017, we isolate price increases across its higher margin business (LPG and lubricants), sturdy growth in volumes and improved performance at the power business as key drivers of earnings. First, FO’s investments in new channels is supportive of volume growth. To add, the depreciation of the naira has led to significant decline in the influx of cheap unbranded lubricants which drove intense competition in the lubricants’ market in the past. Thus, we think the increased lube volumes from this as well as its solid and expanding retail market share is a low hanging fruit for FO. On power, coming from the vilest period of 2016, we think terrain over 2017 will show some recovery over the period to drive improvement in margins. Also, we expect better payments in 2017 and reduced receivables as FG pays more attention to the power sector.
That said, owing to sizable contribution of PMS to fuel revenues and total revenues (70% and 57% respectively), our thesis about delayed FGN response in tweaking fuel prices following the rise in crude oil price implies an almost flattish gross margin over 2017. To add, our forecast of a 21.4% YoY rise in finance cost to N5.2 billion bring EPS 27% lower to N1.93. We cut our FVE by 45% to N61.44. Beyond 2017, we anticipate a recovery in margins as we incorporate prospects for PMS prices even as on streaming of Dangote refinery in 2019 boosts prospects for sector deregulation.
In response to the soft earnings, the share price of FO has declined 29.9% YTD to N53.87 as investors reacted negatively to soft 2016 earnings, no show on dividends, structural issues around pricing and management guidance of possible dilution, in our view. Though management guides to strong outlook for revenues as it seeks to push more volumes for LPG and lubricants, we note that the potential for further devaluation and elevated finance costs pose downside risk to earnings in 2017.
The stock is currently trading on an FY 17 forecasted P/E of 30.7x which is at sizable discount to historical mean levels of 43x. We rate the stock a NEUTRAL on current pricing.