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Gulf Oil Lubricants

Melting crude puts it in a sweet spot

November 28, 2014

View: Positive
CMP: Rs460

Key points
 Falling input cost to boost earnings as well as our confidence in GOL: During the first week of September
2014, we had initiated soft coverage on Gulf Oil Lubricants (GOL) with a positive view in the Viewpoint report
titled Re-structuring to lead re-rating in line with peers in which we had talked of a healthy earnings growth
of about 17% (supported by incremental capacity and falling crude prices) and a re-rating post-demerger from
the parent company. Since then the stock has appreciated sharply fuelled by a sharp fall in global crude oil
prices as base oil (a derivative of crude oil) is the key raw material for the company. The fall in the crude oil
prices has been much sharper than our and the Streets expectations. Hence, we have tried to work out the
potential impact of the falling crude oil prices on GOLs earnings and re-examine our stance on the stock. We
believe that the softening of crude oil prices over a period of six to nine months will boost the earnings and
margin of GOL in H2FY2015 as well as our conviction in the stock.
 Crude oil is down by about 30%; likely to remain weak in near term: The Brent crude oil prices have melted
down by around 30% in the last one quarter to $75 per barrel. The global oil prices had already been softening
because of higher supply (US shale and fracking induced crude oil production is at a 27-year high); now the
Organisation of Petroleum Exporting Countries (OPEC)s decision to maintain the current production of 30 million
barrels a day brings fresh weakness in the commodity. Historically, production cuts by OPEC halted the fall in crude
oil prices but in view of the recent decision of the OPEC the global crude oil prices are expected to remain weak for
a couple of months at least. Besides, the supply improvement in the USA because of the Shale technology is a
fundamental change that will not be reversed anytime soon.
 GOL could retain some benefit; fair chance of earnings revision: Historically, prices of base oil moved with a
0.9x correlation with crude oil prices; hence we expect the price of base oil (input for GOL) to fall sharply, though
with some lag. Consequently, we expect the margin and earnings of GOL to improve in H2FY2015. However, we
dont rule out that the event could trigger a price cut among its peers (the other lubricant players) due to their
attempt to pass on some of the benefits to customers. Nevertheless, we believe that by virtue of selling branded
products and not commodity oil, lubricant companies are well placed to retain part of the benefit at their end.
Moreover, given the overall improving macro environment in India which indicates a demand recovery in the
consumer industry (automobiles), there are chances that these companies would not go for a sharp cut in prices
and would prefer to retain some benefit.
 Positive stance retained: We have run a scenario analysis to understand the impact of the event on the earnings
of GOL in case it cut prices and passes on the benefit partially to the customer. As per our likely scenarios, the
earnings per share (EPS) of GOL could vary between Rs24 and Rs29 in FY2016. Given the potential earnings growth
of above 20% in the next two to three years and a sustainable hefty return on equity of 40%, the price/earnings (PE)
multiple of 20x looks justified for GOL. Moreover, post-demerger there is a re-rating lever for the stock as now it is
a pure play on the lubricant space where the benchmark leader (Castrol India) trades at a PE of ~35x. Hence, we
expect the stock to deliver returns of another 15% or so from the current level and remain positive on the stock
despite the recent run-up in its price.

sharekhan

Viewpoint

Scenario analysis

Given the most likely EPS band of Rs24-29, we have tried

to forecast a potential price target for the stock based
on a range of PE multiples. We believe the company is
expected to deliver an earnings growth of above 20% in
the next two to three years and enjoys a sustainable return
on equity of 40% which will justify more than 20x PE
multiple for the company. Moreover, GOL is now a pure
play on the lubricant industry as it has been demerged
from the parent company, Gulf Oil Corporation, in July
2014. The demerger will continue to be the key re-rating
trigger for the stock, in line with its peers in the lubricant
industry. Though the valuation of Castrol India will remain
at a premium to that of GOL, being the market leader
and because of a higher RoE of 80%, the gap between the
valuations of GOL and Castrol India will narrow down
further. Therefore, a PE multiple of 20+ looks justified
for GOL and the potential price target could range
between Rs500 and Rs550, assuming that crude oil prices
shall remain soft over the medium term.

We have analysed four scenarios, given the crude oil prices

are going to remain low for another six to nine months.
The first scenario is where the company will retain all
the benefit and not take any price cut, while in the second
scenario around 50% of the benefit would be passed on to
the customer through a price cut. The third and fourth
scenarios have been built with an assumption of passing
of the benefit by 75% and 100% respectively through a cut
in lubricant prices. In keeping with these scenarios, we
have also come up with matching forecasts for GOLs EPS
in FY2015 and FY2016. We believe scenarios II and III are
likely, hence the EPS of GOL could vary between Rs24 and
Rs29 in FY2016.
Scenario/ EPS
Particulars

FY15E

FY16E

Scenario-I: No benefit passed

35

40

Scenario-II: 50% benefit passed

25

29

Scenario-III: 75% benefit passed

21

24

Scenario-IV: 100% benefit passed

16

19

Viewpositive stance retained; Hold and ride the gain

The stock price of GOL has appreciated by around 45% since
our Viewpoint report; still we believe there is enough steam
left in the stock, as fundamentally crude is standing on
weak grounds which could be the biggest earnings booster
even if the company passes on part of the benefit to the
customer in response to a price cut by its competitors.
Apparently, the concern over the supply of crude oil is not
going to ease soon as the shift to shale-based production is
a fundamental change. Therefore, we believe the company
is in a sweet spot which will reflect on its margin and
earnings in the next couple of quarters. We remain positive
on the stock despite the recent run-up in its price.

Price target potential band

PE (x)
Scenario I

Price target
Scenario II Scenario III Scenario IV

15

600.12

439.25

358.81

278.38

17

680.13

497.82

406.66

315.50

20

800.16

585.67

478.42

371.17

22

880.17

644.23

526.26

408.29

25

1,000.20

732.08

598.02

463.97

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Viewpoint

November 28, 2014