Sinopec: Benefit From Domestic Demand Rebound – China Petroleum & Chemical Corporation (NYSE:SNP)

Background

China’s oil & gas industry was hit badly by the recent outbreak of COVID-19 and turmoils in the global crude oil market. There are three main players in the industry, CNOOC Limited (NYSE:CEO), PetroChina Company Limited (NYSE:PTR), and Sinopec (NYSE:SNP). Although the recent turbulence has a very similar impact on all three of them, they may have suffered in different ways and are expected to recover to different levels as well. We have seen great opportunities in this sector right now and have finished analysis on each of the three companies to form a complete series. In this piece of the series, we will focus on SNP.

Investment Thesis

The epidemic situation in China has improved significantly, the resumption of production is in order, which indicates the demand for oil & gas will return to the normal level quickly. The recent oil price war between OPEC and Russia will not have a material impact on SNP. We believe the recent sell-off is irrational, and the current share price of SNP presents a good entry point for value investors.

The Company and the Business Segments

China Petroleum & Chemical Corporation (or Sinopec) is an energy and chemical company operating in China. The company’s main business segments include exploration and production, refinery, marketing and distribution, chemicals segment, and others:

Chart: Proportion of revenue of each segment (2014-2018)

Source: SNP annual report

As seen from the chart, SNP has a relatively diversified revenue structure compared to its peers:

  • For CEO, more than 95% of its revenue comes from crude oil sales.
  • For PTR, the production and marketing of refined oil products make up 75% of its total revenue. While this is also the largest segment for SNP, the percentage is much lower (around 55%).

The diversification of SNP’s revenue sources helps the company to achieve great profitability grade compared to its peers, due to its outstanding turnover ratio and cash generation capabilities:

Chart: SNP’s Profitability Grade

Source: Seeking Alpha

This also helps SNP to generate a higher Return-on-Equity, as well as more attractive dividend yield (as discussed below):

Chart: SNP’s ROE Compared to its Peers

Source: Seeking Alpha

The Impact of Coronavirus and Oil Price War

SNP’s share price was hit badly during the recent market turbulence, due to the outbreak of the coronavirus (COVID-19) and the recent oil price turmoil.

However, we believe that the peak of China’s epidemic has passed, as multiple sources have provided evidence that the new cases have been dropping to double or even single digits, and Chinese economic activities have been picking up. Our estimation is that the country will resume to normal by mid-April.

As for SNP, according to the NATURAL GAS NEWS, work has fully resumed at SNP’s fueling field as of March 23. We assume that the short-term negative impact on SNP will be limited to just Q1 2020, while the overall 2020 revenue growth will be moderately slowed down.

On the oil price side, when Saudi Arabia started the price war on March 8th, SNP’s stock price fell sharply by more than 7% within that day. However, since China is a net oil importer, the falling oil price should help refinery companies like SNP since it means lower costs for the company. This can also be proved by the fact that SNP’s share price was less affected by the oil price drop, as compared to companies whose revenue depends more on the oil price like CEO.

Exhibit: SNP and CEO Share Price vs Oil Price – 1 month

Source: Bloomberg

A DCF Valuation Model for SNP

As we mentioned above, the epidemic will undoubtedly impact the Q1 earnings of SNP. However, with the situation largely under control in China, we believe the consumption will rebound significantly from the second quarter. This will lead to stable recovery for the petroleum and chemical industry in the remaining part of 2020.

In our model, we made some key assumptions:

  • We assume that the Cost of Revenues (% Total Revenues) will be 70%, slightly lower than the lowest value of the previous five years.
  • We assume the growth rate of Marketing & Distribution and Exploration & Production segments to decrease slightly in 2020, while the other segments are assumed to continue the growth rate of 2018.
  • We assume that the tax rate will be at the lowest level (18%) over the past five years, due to the government’s stimulus plan.

Exhibit: Historical Revenue and Projection

SourceAuthor’s Projection

Exhibit: Assumptions Made for the DCF model

SourceAuthor’s Projection

According to the DCF model, the target price for SNP is around $65, which means there is up to 50% upside room based on the current share price.

Exhibit: DCF Model Conclusions

Source:Author’s Projection

Stable Earnings History is an Extra Plus

The recent drop in SNP’s share price has raised its dividend yield up to 13%, making it an extremely attractive target for value investors.

Exhibit: SNP’s Dividend Scorecard

Source: Seeking Alpha

Although people might be concerned about the dividend safety of SNP, its dividend history shows that the company was able to maintain strong earnings even during the tough times (such as 2016).

Exhibit: SNP’s Dividend History

Source: SeekingAlpha

In the past 3 months, the share price of SNP has dropped more than 29%, much more than the loss of major China ETF such as iShares MSCI China ETF (NASDAQ:MCHI). The share price plunge was due to the irrational concerns, which brings long-term value investors a good opportunity to buy SNP:

Exhibit: SNP Share Price and MCHI over 3-month

ChartData by YCharts

Conclusion

We think the company will recover from the epidemic quickly as China’s economic activities pick up. Our model shows that the current share price of the company is undervalued, even when conservative assumptions have been made. This presents a good entry opportunity for long-term value investors.

Risk Factors

With the coronavirus outbreak becoming a global pandemic, China now faces the risk of a second-round outbreak. If the country goes into lockdown mode one more time, the damage to the economy may hurt SNP as the demand for oil & gas will drop significantly.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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