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Subdued refining margin drags 2Q performance

* HPCL’s reported 2QFY25 financial performance was significantly below our expectations, mainly due to a weaker refining margin. LPG under-recoveries have largely remained in line with the 1QFY25 trend. Overall, refining GRM remains soft in Oct’24, and the oil demand outlook too remains muted. As a result, we trim our GRM assumptions for 2HFY25/FY26/FY27. Meanwhile, OMCs continue to generate strong marketing margins on MS/HSD currently, and as such, despite a dismal 2QFY25 earnings performance, we believe 3QFY25 profitability could improve further on a sequential basis.

* HPCL missed our EBITDA/PAT estimates in 2QFY25 by 41%/73%, due to lower than estimated refining margin of USD3.1/bbl (est. of USD5/bbl). While LPG-related under-recoveries amounted to INR20.6b in 2Q, inventory loss stood at INR14b during the quarter.

* Refinery throughput was 8% above estimate at 6.3mmt (up 10% YoY). The company expects zrefining throughput to improve post-commissioning of the expanded capacity at Visakhapatnam refinery. Singapore GRM (SG GRM) has been averaging USD3/bbl in Oct’24 vs. USD3.6/bbl in 2QFY25, implying that refining might remain under pressure in 3QFY25.

* In the marketing segment, sales volumes came in line with our est. at 11.6mmt (up 8% YoY). OMCs are currently earning a gross marketing margin higher than our assumption of INR3.3/lit for both petrol and diesel. Among OMCs, HPCL has the highest leverage to marketing and would benefit the most due to an uptick in marketing margins.

* Commissioning of the bottom upgradation unit at Visakhapatnam refinery would result in the distillate yield improving 10% from 1QFY26. The company expects the mid-cycle GRM to be ~USD6-8/bbl. Additional GRM of USD2-3/bbl shall be generated post-commissioning of the bottom upgradation unit at Visakhapatnam refinery. De-merger of lubricant business also provides a value-unlocking opportunity.

* HPCL took a hit of INR20.6b due to LPG under-recoveries in 2QFY25. However, LPG being a controlled product, HPCL remains hopeful of financial support from the government. Owing to weak refining performance, we cut our FY25 EBITDA/PAT estimates by 27%/49%; we also reduce our FY25/FY26 GRM estimate to USD4.6/6.1 per bbl (vs. previous est. of USD6.6/8.1 per bbl.

* We reiterate our BUY rating on the stock, valuing it by the SoTP method to arrive at our TP of INR455. The start-up of the Rajasthan refinery (HRRL; HPCL has a 74% stake) can be a key catalyst in FY26E, in our opinion.

Miss on EBITDA/PAT due to low refining margin

*  HPCL’s EBITDA stood at INR28b in 2QFY25 (41% below our est. of INR47b, down 68% YoY, up 33% QoQ).

* The miss was due to lower-than-estimated GRM, which was 38% below our estimate at USD3.1/bbl (-62% YoY).

* The LPG under-recovery amounted to INR20.6b, which we believe could be reversed in due course as the LPG remains a controlled product.

* Refining throughput was 8% above our estimate at 6.3mmt (+10% YoY).

* Marketing volumes stood at 11.6mmt (est. 12.2mmt), up 8% YoY.

* Marketing margin (including inv.) stood at ~INR4.2/lit (est. INR5.2/lit), down 42% YoY. The miss is likely attributable to LPG under-recovery.

* PAT came in 73% below our est. at INR6.3b (down 88% YoY, up 77% QoQ), due to lower-than-estimated other income and higher-than-estimated finance cost.

* In 1HFY25, net sales grew 3% to INR2.1t, while EBITDA/PAT declined 73%/91% to INR48.5b/9.9b, respectively. In 2HFY25, we expect net sales/EBITDA/PAT to declined 20%/24%/45%.

* As of Sep’24, HPCL had a cumulative negative net buffer of INR45b, due to the under-recovery on LPG cylinders (INR1b as of Mar’24).

Highlights of the 2QFY25 performance:

Operational performance:

* The highest-ever crude throughput of 12.1mmt was recorded in 1HFY25.

* The company achieved the highest-ever ethanol blending of 15.6% in 2Q.

* HPCL has commissioned 353 new retail outlets nationwide, bringing the total number of outlets to 22,501.

* HPCL experienced a sales volume increase of 5.6% this quarter, compared to a 1.8% growth in the PSU industry. Additionally, HPCL gained a market share of 0.78% among PSU oil companies during this period.

Update on the ongoing projects:

* Capex of INR37.7b was incurred in 2QFY25 (INR65.9b capex incurred in 1HFY25).

HRRL:

* Key process units, diesel hydro-treating (DHDT), and hydrogen generation unit (HGU) are currently in the pre-commissioning phase. The overall physical progress of the project has surpassed 82%.

* As of Sep’24, total commitments stood at INR708.7b and capex was INR505.7b.

Other highlights

* The 3.55mmtpa residue upgradation facility at its Visakhapatnam refinery, one of the largest and most energy-efficient residue hydrocracker units globally, is anticipated to be mechanically completed shortly, with the commissioning expected in 4QFY25 (one quarter delay).

Valuation and view

* HPCL remains our preferred pick among the three OMCs. We model a marketing margin of INR3.3/lit for both MS and HSD in FY26/27, while the current MS and HSD marketing margins are INR12.6/lit and INR10.4/lit, respectively. We view the following as key catalysts for the stock: 1) de-merger and potential listing of the lubricant business, 2) the commissioning of its bottom upgrade unit, and 3) the start of its Rajasthan refinery by end-4QFY25.

* HPCL currently trades at 1.4x FY26E P/B, which we believe offers a reasonable margin of safety as we estimate FY26E RoE of 15.3%.

* Our SoTP-based TP includes:

* The standalone refining and marketing business at 7x Dec'26E EBITDA.

* INR37/sh as potential value unlocking from de-merger of the lubricant business.

* HMEL at 12x P/E based on its FY24 PAT (HPCL’s share), deriving a value of INR35/share.

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