Lotos held a conference call today to discuss its 3Q12 results. Qualitatively, we see the 3Q12 results as stellar, even better than implied by the operating environment. We now see our clean LIFO EBIT forecast of PLN 1.0bn for full-year 2012 as overly pessimistic in light of Lotos’ 9M12 results and the outlook for 4Q12. Our rough estimate suggests clean LIFO EBIT could be around PLN 1.4bn in 2012 (up from PLN 579m in 2011), which would leave Lotos trading at a 2012F EV/EBITDA of 5.6x, only marginally above the median of CEE oils. This, however, is where our optimism ends: the current strength of refining margins is unsustainable, uncertainties surrounding future cash-flows from the Yme field are overwhelming; information regarding the launch of B8 production is scant; the firm’s financial footing is still very weak and in our view leaves the company only able to complete in one out of three key targets (i.e. upstream acquisition, retail acquisition, dividend); and the valuation continues to look excessive on an EV/EBITDA of 7.0x for 2013F, or a 45% premium to peers. We retain our Sell rating.
The main points of the call were as follows:
(-) Lotos’ 4Q12 earnings momentum to lag behind PKN and CEE integrateds: With benchmark refining margins down US$ 6-7/bbl in the last fortnight, we expect a material deterioration in Lotos’ underlying earnings in 4Q12. Indeed, with the refining segment having generated 86% of clean LIFO EBIT in 3Q12, Lotos has the highest exposure to falling refining margins in our coverage universe. This suggests Lotos will record the weakest q/q earnings dynamics among CEE oils. Admittedly, however, clean LIFO EBITDA is forecast to show a nice y/y improvement. Our backof- the-envelope calculation suggests clean LIFO EBITDA at PLN 240m in 4Q12 versus PLN 88m in 4Q11.
(=) Superb margin capture explained: Refining margin (based on clean LIFO EBIT) averaged US$ 8.1/bbl in 3Q12, better than we had anticipated and better than implied by the operating environment. Apart from the improving blended crack spread on Urals (US$ 10.1/bbl in 3Q12 versus US$ 8.5/bbl in 3Q11), Lotos said the stronger-than-forecast margin capture was explained by i) better trade margins, partly due to seasonally stronger demand and ii) cheaper feedstock processed. As we expect both of these positives to fade going into 4Q12, Lotos’ earnings should move in line with the external macro in the period.
(+) Impressive sales volumes may be maintained in 4Q12: Lotos said the robust refined product sales volumes could be explained by intensified export activities. As the majority of exports went to Scandinavian markets, the restart of the Inglostadt refinery in Germany should not materially comprise this positive trend in 4Q12.
(=) Lotos continues to seek upstream assets in Norway but completion is unlikely this year: Lotos confirmed that it still targets spending around US$ 200m on some Norwegian production licenses in 2012/2013. However, it now seems unlikely that Lotos will be able to live up to its earlier promise to complete the transaction by the end of this year. The US$ 200m amount suggests the targets are likely to be minority
stakes in mature assets, which are not necessarily the most desirable investments. However, Lotos can apply its tax assets “against” the acquisition, hence it would only need to finance roughly 50% of the investment from its own cash flow or from a loan. A US$ 100m investment represents around 50% of Lotos’ annual capital expenditures, which may not be that easy to raise given the company’s stretched balance sheet. Assuming a 10-year reserve life and a US$ 15/boe valuation, annual production could be around 180kt (i.e. 75% of Lotos’ 2011 production). However, per barrel profitability would be significantly below that of Polish operations as the headline tax rate in Norway is 78%.
(=) Lotos confirms interest in Neste Oil’s petrol stations: Lotos confirmed it is interested in buying Neste’s Polish retail network (106 petrol stations) although it did not disclose any details due to a confidentiality agreement signed with Neste Oil. As we noted earlier, it is a no-brainer that Lotos is interested in these assets, as its retail arm is barely profitable due to the lack of economies of scale. However, as always, the price would need to be right for this to be a deal for shareholders to get excited about. Indeed, applying the average price paid per filling station (around US$ 1.3m per station) in Europe over 2005-2011 puts the value of the network at around US$ 141m (PLN 450m), an amount which equals roughly two-thirds of Lotos’ annual capital expenditures. This may not be that easily financed, especially if one considers Lotos’ desire to buy an upstream asset for a total consideration of around US$ 200m in the not too distant future.