Congratulation to all Hengyuan (HY) shareholders!

HY has reported strongest profitable quarter result in their history (RM361mil, EPS 120.6 sen). The question now is whether the profit of HY in Q3 is sustainable or not in Q4? To answer this question, let us go through a very important data in Q4 (Oct-Nov) that is closely related to HY’s profit margin – Crack Spread of Gasoline (Mogas 95, no more Mogas 92 product in Malaysia) and Diesel (Gasoil) as table and chart below:

Source: CME data (old spread data have been suppressed if you refer to latest Chart, Eg, if you use Mogas 95 chart of Dec to check Oct data, the value will be lower. Need to capture data daily or weekly)

I have calculated Malaysia weekly petrol price based on average 5-day Mogas 95 price and I found that they are quite well correlated (as shown in the above table). HY profit margin is closely related to the average spread (difference between brent oil and Mogas 95) 

Source: CME data

From the table above, the average spread of Mogas 95 and diesel with reference to Brent oil is about USD11.3 for the period of 2 Oct to 30 Nov (CME data). In my previous articles, I use Mogas 92 chart (RON 92) to estimate HY’s profit margin which is actually has spread lower than Mogas 95. For Malaysia market, RON92 is no longer available and the main products of HY are actually RON95 (gasoline) and diesel. In fact, Mogas 95 spread is higher than Mogas 92 by about USD2+ over the past 6 months. USD11.3 is relatively higher than the spread in Q3 and average spread of 2017 (USD8) as per reported in HY’s Q3’17 report. However, due to other products (~2-3% products consist of heavy fuel oil, naphtha and propylene) and jet fuel (just slightly lower) may have lower spread or margin, my estimated effective average spread for products of HY may be in the range of USD9.5 – USD10.3.   

What I like HY is its complex refinery system which is flexible to adjust their product ratios which they tend to produce higher profit margin products like gasoline and diesel. Let see the products composition from Shell annual reports 2014 and 2015 as below.

Source: Shell Annual report of 2014 and 2015

From the pie charts, we can observe that HY main products are Gasoil (diesel) and gasoline which their profit margin is much higher than fuel oil (negative margin). Annual report 2015 shows that 82% of their products are gasoil (diesel) and gasoline, as well as 6% are from jet fuel (margin around USD10).

Let us go through the current year prospect of HY’s Q3’17 report as below:

Source: Q3’17 report

From the CME average crack spread data, the refining margin should be slightly higher in the near term based which is contradicted with the prospects reported by the HY quarter report. There is one possibility that I can think of for this pessimistic short term prospect in HY report.

• The Q4 report maybe compare Oct and Nov data with the peak spread data in early Sept as shown in the Mogas 92 spread (spike to USD17 and settle at 12) as shown in the chart below:

Source: CME data

My estimation of Q3 average spread is about USD10 which is slightly lower than the gasoline’s spread in Q4 (USD11-12 from my Mogas 95 table).

Another proof or supporting data that Q4 spread is higher than Q3 is by referring to Malaysia Petrol and diesel price which are calculated based on the Singapore Platts (average crack spread). Let us see the following chart for the Malaysia petrol weekly price:

     Source: https://hargapetrol.my/malaysia-petrol-prices-list.html

In short, Malaysia petrol weekly price actually propotional to average (5 days) Mogas 95 price. HY profit margin is depending on average spread (difference between brent crude oil and Mogas 95)

Even we monitor the future 6 month Mogas 95 data from CME (as chart below), the future contract price is in the range of USD74.2-75.4. As long as Brent oil price stabilize in the range of USD58-USD63, crack spread will be maintained at around USD10 (which is a lucrative margin for refiner like HY). 

Source: CME future Mogas 95 data

When Hengyuan needs to pay income tax?

Some investors may ask around when Hengyuan needs to pay income tax. HY can be exempted of paying income tax is due to utilization of tax losses (deferred tax assets). Let us see the amount tax losses carried forward which have not been utilized up to Dec 2016 as below:

Source: Annual report 2016

There is RM267.7 mil carried forward tax losses which can be utilized for income tax exemption. Let see how much has been utilized so far for Hengyuan in 2017 as below

If Hengyuan is able to generate profit of RM345mil in Q4, it will utilize its entire remaining carried forward tax losses asset (RM86.3 mil). I may explain more on unabsorbed reinvestment allowance (RM495 mil) in my next article in future.

Key Financial data of Hengyuan

After released strong Q3 result, HY has shown big improvement in their financial ratio. The ratios improving range from ROE, ROIC, FCFO (free cash flow from operations), PE and EV. Let us see some of the key financial data of HY as table below:

We can see significant improvement of all financial data after Q3 result was released. What is more important for me is future data or profit. I would expect future profit and financial ratio to be further improved in view of high refined product crack spread (margin) in Oct and Nov 2017.

To justify whether HY is still cheap or not at current price (RM11.00), let see the FCF vs market capital and cash in hand vs market capital ratios as below:

FCF / Market cap = 668 mil / 3300 mil = 20.2% (over 9 months only)

Cash in hand / Market cap = 897.7 mil / 3300 mil = 27.2% (over 9 months only)

Let compare FCF / market capital ratio among Hengyuan, Petronm and Petdag to see which company has strongest cash yield from their operations.

We can see HY cash yield rate from operation is 2.5 times stronger than Petronm and 5 times stronger than Petdag. The ratio of 20.2% (9 months only) is much higher than bank’s fixed deposit rate (1 year 3.2%) and it is an excellent ratio. If current spread can be maintained till Q2 of 2018, this ratio will be further improved but will be affected by the shut down (one time maintenance shut down and upgrade) of Euro 4 upgrade in Q3’2018. In fact, if we consider its huge inventory value of RM1263.3 mil (can offset 95% of its borrowings), Hengyuan actually in a good net cash position of over RM850 mil cash. This cash level is equivalent to RM2.83 cash per share. Again, what I want to see is the future 6 months profit visibility which is closely related to crack spread.  

Some may claim that refinery is a cyclic business from past data. I am not too interested on past crack spread data that are too long ago (due to the crude oil price big fluctuation in 2014) but more interested on past 11 months data of 2017 and future 6 months data.

Source: CME data

Do you think the above crack spread chart over past 11 months of 2017 indicates refinery is a cyclic business? I don’t think so and even future 6 months I think the spread may sustain at USD9 or above (Mogas 95). As long as Brent oil price is stable in the range of USD50-65, I believe the crack spread will be quite stable in 2018 (mainly supported by increasing demands and limited supply).

If you own a car(s), don’t you think petrol (gasoline) or diesel is essential for you? Is it we need to go to petrol station every week (or two weeks) if we own a car? Maybe some of you may argue that electric car may replace petrol car in 10-20 years’ time, but how about aircraft’s jet fuel consumption? How about big ship transportation and power generation which rely on fuel oil?

If petrol, diesel (mainly lorry, some machines), and jet fuel are essential for our current transportation system, it is NOT likely petroleum refined products is a cyclic business in future (unless there is a sudden increase in supply). This is something like consumer essential products (like milo, bread) is unlikely a cyclic business. Conventionally, Q4 (Oct-Dec) is peak season for Henyuan due year-end holidays which normally lead to higher land and air travelling. Let us have a look on refinery outlook in the next section.

In short, I believe crack spreads are suddenly so high in 2017 are due to refinery closures (tighter regulation require big investment) or insufficient increase in refining capacity, as demand continued to grow. Anyway, petrol was essential product in 2014 too, yet crack spreads were almost zero at that time may due excessive supply at that time.

Refinery Outlook

Let us go through two news related Asia refiners activities and Shell (international oil giant) for world refinery outlook as below:

https://www.reuters.com/article/us-china-oil-refining/chinas-oil-refiners-rush-to-cash-in-on-bumper-profits-idUSKBN1DG19N

Excerpt from the news as below:

Another news is from Shell which has started to focus on downstream businesses which they now view it can be a good profit contribution to their group’s profit.

https://www.thestar.com.my/business/business-news/2017/11/07/shell-to-secure-future-of-refining/

Excerpt from the news as below:

Based on current Asia’s vehicles population growth, I would expect the current refining margin (USD9) to be sustainable for a least 6 months in view of many refiners are scheduled to have maintenance shut down.

I maybe cover Hengyuan’s 2018 profit forecast, Euro 4m upgrade, diesel demands in 2020, SWOT, comparison with other companies etc in my future article.

Risk

1.      Unplanned shut down due to unexpected machines or refinery system break down.

2.      Fire or explosion due to accident.

3.      Delay in Euro 4M project upgrade.

Summary

1. HY’s profit visibility in Q4 still good based on current spread data on gasoline and diesel.

2. Forward 3-month PE of Hengyuan could be very attractive (below PEX3.5) even based on current price of RM11.00.

3. The high quality of Hengyuan’s earning is supported by strong ROIC (48.1%), ROE (56.3%), and strong cash flow generation from operation.

4. There is possible inventory gain for HY in Q4 as current Brent oil price stay above USD57 (current pirce is USD61).

5. Recent RMUSD rate appreciation will further benefit HY as its material cost will be lower. Besides, it also may have forex gain as it has over RM1.3 billion of USD denominated loan.

6. The outlook for refined products is still bright in 2018 as in view of many refiners are scheduled to maintenance shut down, increasing demands from growing vehicle populations and limited refined product supply.

7. HY’s management has started to follow up closely for the Euro 4M equipment fabrication even from Q3’17 (1 year from 2018). They have anticipated possible delay in the fabrication of the equipment and now already started to look for alternative to minimize the delay. This indicates that they are well-prepared for possible challenge in this upgrade project (still has about 11 months of time and they may seek technical help from parent company as Hengyuan China is currently producing Euro 5 products).

8. Maintenance shut down/upgrade is one time event in every 3 years and this is normal for all refiners around the world. In fact, previous planned minor maintentence in Q2 increases the production volume by 0.6 mil barrels in Q3. I would focus more on the overall future 12 months profit and cash flow generation visibility in FY2018 for HY (短暂的休息是为了走更长远的路). 

If you interested on my analysis report, please contact me at davidlimtsi3@gmail.com

You can get my latest update on share analysis at Telegram Channel ==> https://t.me/davidshare

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.