Following the release of H1’17 results, we spoke with management to understand the key drivers of its performance, and its outlook for the rest of the year. We maintain our target price (TP) of N110.17 and maintain our BUY rating on the counter. Kindly find key highlights from our discussion.
Re-positioning downstream business to connect with wider customer base.
According to management, FO has recently been focusing on a number of customer-centric initiatives that will increase customer traffic and asset utilisation at its retail outlets. It has partnered with GTBank and MTN to open mobile banking and telecoms kiosks with additional offerings from other service providers such as convenience stores to be rolled out soon.
In addition to harnessing partnerships with convenience stores, financial institutions and telecommunications firms, the company is expanding its branch network and intends to open 40 retail outlets annually over the next five years thus bringing the number of its retail outlets to 650 by 2022 from 450 currently.
Total, the current market leader, has 550 retail stations in comparison.
The expansion should boost volume as retail outlets accounted for 70% of petroleum sales in Nigeria in 2016 according to the Independent Petroleum Marketers Association. Given the correlation between number of retail outlets and market share, FO could well be the market leader by 2022, ceteris paribus.
Further, partnership with fast food and retail chains at the new outlets should boost rental income (non-fuel income).
Making inroads into unconventional resources
There is a growing movement to force the extinction of vehicles that run on fossil fuels, with the United Kingdom and France being the latest countries to ban the sale of gasoline and diesel cars by 2040.
To this end, FO’s management disclosed that it is diversifying into renewables energy and has partnered with a major solar solutions company in China.
According to management, the first batch of solar panels should arrive towards the tail-end of Q3’17 with revenue contribution expected to kick from Q4’17.
About 120 million people (of Nigeria’s 170 million populations) do not have access to electricity.
Those who are connected to the grid – mostly in urban areas – receive limited supplies, because grid connection is generally bad due to poor infrastructure and the required infrastructural upgrade is estimated to cost huge sums of money.
Stakeholders in the Nigeria energy market now believe that solar power, (off grid and on grid) provides the fastest route to increasing energy access.
Using Kenya as a case study, M-KOPA Solar has provided off-grid solar power to about 400 million households within four years and has seen its revenue rise from zero to about $40 million within this same period.
M-KOPA is now present in three Africa countries is exemplary of the massive opportunity for off grid solar throughout the African continent.
FO’s improved earnings outlook could re-trigger interest from Multinational Oil Companies.
The firm’s earnings outlook has considerably improved following a deliberate positive shift towards higher margin business segments. Contribution to aggregate revenue from production chemicals, lubricants and power have risen to 2% (H1’16: 1%), 10% (H1’16: 6%) and 26% (H1’16: 5%) respectively whilst the fuel division has seen its contribution fall to 63% (H1’16: 88%).
The change in strategy has been positive with the firm’s return on equity improving to 10.6% in H1’17 from 6.5% in FY’16. In our view, the improved earnings outlook could renew interest from Multinational Oil firms.
We recall that the proposed acquisition of a 17% stake in the company by Mercuria Energy Group fell through.
Proposes capital raising of ₦20 billion Forte Oil has disclosed plans to raise N20 billion capital by way of equity out of the N100 billion approved by the shareholders at its Annual General Meeting, AGM, to boost its operations.
The offer is targeted at High Network Individuals and Institutional investors.
Whilst we expect earnings per share to be diluted following the offer, we highlight some positives from the capital expansion.
According to management, proceeds from the offer will amount to N19.6 billion. 43% of the proceeds will be deployed towards working capital, 41% will be devoted to expansion works (management intends to add 40 new retail outlets for the next 5 years) whilst the balance will finance the automation of the lubricant facility.
In our view, this provides scope for the company to expand its earnings particularly from 2018.
Valuation maintained pending further details on the issue
The details on timing and price of the Offer are yet to be communicated.
However, assuming that the Offer is issued at FO’s 30-day VWAP (₦56.90), we estimate that a full subscription to the offer would increase FO’s outstanding shares by 33% which will translate to a post-offer target price of ₦73.11 (if we retain our current valuation assumptions). This still implies a 28% upside to the 30 day VWAP of ₦56.90.
Therefore, pending further details from the Offer, we retain our BUY rating on the company.
Delay in adjusting PPPRA template to drive focus on higher margin businesses – lubricants and power
Going into H2’17, delayed adjustment to the PPPRA pricing template to reflect new crude price and FX reality poses challenges to top-line expansion.
Management disclosed that the bulk of their imports was financed with FX from the prior year and that at current rates, their landing cost will overshoot the expected open market price for PMS.
As such, the bulk of their purchases going forward will likely be from the NNPC, thereby informing our outlook of volume contraction in 2017.
We estimate a 32% drop in fuel division revenues to N82.7 billion. In addition, focus would be on raising non-fuel volumes such as non-regulated LPG and lubricants, where prices have been hiked in H2’17.
About forty (40) lubes sales points/mini kiosks will be rolled out this year in mechanic villages and would be internally funded. As such, revenues from the lubricant division should rise by 23% YoY.
On power, management noted that increased capacity at Geregu coupled with improved pricing should translate to higher sales subject to gas availability.
Capacity utilisation averaged 65% in H1’17 and management has taken the added measure of taking an insurance cover that will guarantee their gross profit in the event of gas supply hiccups.
We expect better payments in 2017 and lower receivables as FG pays more attention to the power sector.
Consequently, we see power revenue doubling to N22.6 billion based on our capacity utilisation estimate of 70%.
Overall, we estimate a 10% decline in FO’s aggregate revenue to N134 billion in FY’17.
Increased contribution from higher margin businesses underpins improved margin outlook
Rising contributions from the higher margin businesses underpins our expectations of margin expansion in FY’17.
Specifically, contributions from the lubes and power division spiked to 10% and 26% from 6% and 5% in H1’16 respectively.
However, recent upward product pricing across its deregulated lubricants’ business as well as FX pass-through on gas prices will negatively impact the extent of increase in gross margin.
Hence, we expect a 496bps expansion in aggregate gross margin to 19% in FY’17 (FY’16: 14%).
Since FO didn’t declare any dividend in the prior year leading to the elimination of dividend tax, we envisage a lower effective tax rate (FY’17E: 10%) in 2017 which vastly improves the firm’s earnings outlook.
As such, we expect forecast a 176% rise in net profit to N7.9 billion.
H1’17 Performance Review
Revenue contracts on lower contribution from fuels business
FO reported a 22% YoY decline in H1’17 turnover to N65.6 billion as the Fuels division reported weaker sales – down by 24% YoY.
A further breakdown shows that the revenue growths from the Power (+119% YoY) and Lubricant (+50% YoY) segments outpaced H1’16 records of 21% and 30% respectively on the back of stronger pricing as well as increased output.
We recall that electricity tariffs were raised last year (Feb’16) and that gas supply has been relatively stable.
According to management, capacity utilisation at the power plant averaged 65%.
Retail prices of lubricants and other oils have been raised to accommodate higher input costs stemming from the impact of the Naira devaluation on the prices of base inputs. The Naira devaluation has also capped imports providing an avenue for domestic producers to increase their market share.
Due to increased contributions from the higher margin businesses, gross margin for the period strengthened to 19% from 15% in H1’16.
Lower OPEX supports Q1’17 earnings
With an increase in the company’s reliance on debt following the N9 billion bond programme, FO recorded a 12% YoY spike in net finance charges to N2.9 billion from N2.6 billion in H1’16.
Consequently, PBT rose by a mere 11% YoY to N4.7 billion. Further down, FO reported lower effective tax rate in H1’17 (13% vs. 48% in H1’16) which largely drove earnings higher by 84% YoY to N4.1 billion.
According to management, the steep decline in tax rate was due to the fact that FO did not declare a dividend in FY’16 and accordingly will not be required to pay dividend tax in 2017.