Case 071Company analysis and valuationHard
The market values a refiner at 5 times current EBITDA, earned at a refining margin of 12 dollars a barrel. Your variant view uses a mid-cycle margin of 7 dollars. Work out EBITDA at both margins and defend the multiple you would apply.
1The situation
Kutch Coastal Refining processes 110 million barrels of crude a year. Its refining margin, the value of the products less the cost of the crude, is 12 dollars a barrel today after a run of tight product markets; operating costs are about 4 dollars a barrel. Use Rs 85 to the dollar as a case assumption. The market values the company at 5 times current EBITDA, and it has Rs 9,000 crore of net debt.
Your work on the industry cycle suggests a mid-cycle margin of about 7 dollars. For a cash flow check: maintenance capex is Rs 800 crore a year, depreciation Rs 900 crore, tax 25%, cost of capital 10% and long-run growth 2%. Assume today's margin lasts two more years before reverting.
2Your task
What is EBITDA at 12 and at 7 dollars, what multiple would you apply and to which earnings, and what does that make the equity worth against the market?
Quick check
The margin falls from 12 dollars to 7, about 42%. What happens to EBITDA?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
EBITDA is Rs 7,480 crore at 12 dollars and Rs 2,805 crore at 7, and the multiple belongs on the mid-cycle figure. A cash flow check supports about 6.9 times mid-cycle EBITDA, Rs 19,492 crore, plus Rs 6,085 crore for two more peak years. Less Rs 9,000 crore of debt, equity is worth about Rs 16,577 crore against Rs 28,400 crore, 42% lower. The market's 5 times peak is 13.3 times mid-cycle.
Step 1Why does EBITDA fall so much more than the margin?
Because the refinery's costs do not care what the margin is. A taxi driver who clears Rs 1,200 a day after Rs 400 of fuel and upkeep takes home 800; if fares drop to Rs 700, he takes home 300, not 467. At 12 dollars, EBITDA is 8 dollars a barrel times 110 million barrels, Rs 7,480 crore; at 7 dollars it is 3 dollars a barrel, Rs 2,805 crore, 62.5% lower for a 41.7% lower margin. That operating leverageThe way fixed costs make profit swing proportionally more than revenue or margin. is why refiners' earnings swing so hard, and why a multiple on peak earnings is dangerous.
Step 2What multiple belongs on which earnings?
A multiple is a shortcut for a stream of cash that lasts for years, so it should sit on earnings that can last. Cyclical earnings at the top of the cycle will not last, so the multiple belongs on mid-cycle earnings, and a low multiple on peak earnings is not the same thing as cheap. Check the multiple with cash flow. At mid-cycle, EBITDA of Rs 2,805 crore less Rs 800 crore of maintenance capex and Rs 476 crore of tax leaves about Rs 1,529 crore of free cash flow. Growing 2% and discounted at 10%, that is worth Rs 19,492 crore, about 6.9 times mid-cycle EBITDA. That is the multiple you can defend.
Step 3What is the equity worth once the windfall is added?
The peak is real while it lasts, so count it separately. Two more years at 12 dollars add Rs 4,675 crore of EBITDA a year above mid-cycle, Rs 3,506 crore after tax, worth about Rs 6,085 crore today. Mid-cycle value plus the windfall is Rs 25,577 crore; less Rs 9,000 crore of net debt, equity is about Rs 16,577 crore against a market value of Rs 28,400 crore. Expressed the market's way, fair value is only 3.4 times today's EBITDA, not 5.
Step 4How do you defend the variant view to a sceptical PM?
Turn it into a single testable number. At the market's value, and with the cash flow multiple of 6.9, the price implies a refining margin of about 9.8 dollars a barrel for ever, against a mid-cycle of 7. So the debate is whether the industry has changed enough to hold margins near 10 dollars: closures of old refineries, new capacity delayed, demand for particular products. Bring evidence on each. The equity is also leveraged to the call: with Rs 9,000 crore of debt, small changes in the margin move the equity value by a large percentage. Say the limitation: mid-cycle is itself an estimate, and a 1 dollar error in it moves EBITDA by about Rs 935 crore.
Where candidates lose it
The common loss is calling the stock cheap at 5 times EBITDA without asking which EBITDA. At peak margins a low multiple is the market being careful, and the same price is 13.3 times mid-cycle earnings.
The second is scaling EBITDA with the margin, cutting it 42% instead of 62.5%. Operating costs stay when margins fall, and missing that makes the variant view far weaker than it should be.
What the interviewer asks next
- How would you estimate a mid-cycle margin, and over what period?
- The company announces a large buyback funded with peak cash flow. Does that change your view?
- Which would you rather own at the peak of the cycle: the refiner or a pipeline company, and why?
- What would make you change your mind within a quarter?
Asked at Franklin Templeton, Oil & Gas, San Mateo, 2024 (Wall Street Oasis): Why did I have a variant view of the multiple I applied to a refiner company relative to street expectations.
Asked at Franklin Templeton, Oil & Gas, San Mateo, 2024 (Wall Street Oasis): light technicals revolved around companies I had researched within my coverage space and a stock pitch I had prepared for the interview
Company names and figures are illustrative.