I got the below comment and thought of posting on it.

Rohit,
I am not sure if abandoning HPCL is such a good idea right now. You can buy good stocks at bargain only during distressed times. First crude prices will definitely go down. its just a temporary blip and secondly government cannot afford to shut down these PSU oil companies. Definitely PSU oil companies are not a long term bet for me..but for the short term ..i guess there is an excellent opportunity as of now. I know i can be wrong.

Selling is always a difficult decision especially if the underlying assumptions change. I personally analyse my stocks every quarter and more frequently if the underlying situation changes. In case of HPCL, I was banking on two key points
– Margins will not deteriorate drastically and maybe improve a bit in the next 2-3 years as other initiatives from the company bear fruit.
– market would realize that the company sells at 20-30% of asset values and will reduce the gap

Clearly the spike in Oil prices has invalidated the first point and the second may not happen soon due to point 1. I rarely make sell decision by short term drops in price. If the intrinsic value of the company is steady or growing, I will hold on to the company for a long time.

In case of HPCL, my key concern is that the intrinsic value of the company is being destroyed on a daily basis and at a very rapid rate. Time is not on my side in this case. The current oil price may turn out to be temporary. However I am not willing to bet on that as, the longer the oil price remain high, the more the company will bleed.

Finally an investment idea needs to be compared with all the other options or ideas. As of now, I can see other ideas which are better from a risk reward perspective and hence I decided to move out from HPCL.

I had written the post below on 20-May. Since then the government has started thinking of raising the fuel prices. Note the word – thinking. The decision to raise prices is easier said than done. Even if the prices are raised, the haemorrhaging of the oil companies will reduce only partly.
———————————————————————————————————————————————————–

I had written about HPCL earlier see here and here

The key elements of the investment thesis was as follows

1. The company is currently engaged in diversifying its revenue streams via various initiatives and reduce the impact of the pig headed policies of the government. These initiatives are lube marketing, Gas distribution and retail initiatives and oil trading and risk management. The market is currently not valuing any of these real options.
2. The GRM and net refining margins are at their lowest. Going forward the worst case sceanrio is that they would remain at the same level. If that is the case, the bottom line should still improve as the various company intiatives take effect (see page 53 of Annual report)
3. The 9 MMT refinery and expansion of Vizag refinery to 15 MMT and export of the petro-products and E&P activities should help the company improve its margins going forward.

The key unsaid assumption was that oil would not spike sharply. Oil prices are now at 130 usd a barrel (double the levels at the time of the analysis) and show no signs of coming down. In addition , I also read the following report – oil firms weeks away from bankruptcy. Now I do not believe the oil firms will go bankrupt – technically speaking. It is in the interest of the government to keep these companies alive. However the future looks bleak for these companies for the following reasons

1. Oil prices are unlikely to come down anytime soon. So the only way the government can sustain these companies is by issuing oil bonds. To raise cash, these companies will have to sell the oil bonds at some discount , incurring losses.
2. The government is unlikely to compensate these companies fully, wanting to keep the deficeit under control. As a result expect these company to incur losses for the forseeable future. In such a scenario, I am not sure how much these companies can invest in profitable growth and other assets.
3. These companies will increasingly look like the State SEB and other power companies in the long run – forever subsidsing the consumer due government pressure and unable to grow the business or invest in it.

Key learnings

1. I was clearly wrong about point 2 in the thesis. I never expected the oil prices to spike to 120+ (if i knew, oil futures would have been a great investment) . I never expected this government to remove the subsidy (and the next government wont do that either – it is not in their self interest). However the price spike in crude will be devastating to the oil companies.
2. Ignoring key pyschological principle – self interest combined with a crude price shock. Individuals and goverments take actions which are in their personal interest. Which political party is ever going to increase fuel prices and risk losing elections. I expected the government to behave in the way it is now. However self interest combined with high crude price will hurt the companies big time. As long as the prices were 100 usd or lower, the situation was bad, but now it is dire for these companies.

The loan waiver was still a one time event (hopefully). However the above subsidy is ongoing and will hurt the oil companies in the long run (in the short run they will be compensated via oil bonds and other mechanism). The above thesis was reasonable for moderately high crude prices. However the current price shock could drive the networth to zero.

Disclosure – I am exiting my position at a small gain. HPCL has not been a big position for me. The risk reward situation was good initially. However with the oil prices shooting up, I think the risk is not commensurate with the return.

Added note : In life there is no free lunch. Till date the government has subsidized fuel by gouging the oil companies. That well is now dry. Eventually all this subsidy will have to be paid by someone. It will likely come through taxes and higher inflation (most likely a combination of both).

About
Maruti Suzuki is india’s largest car company with brands such as Maruti 800, Alto, Swift etc. The company sold around 760000 cars in FY08 and currently holds a 50%+ market share

Financials
The company has achieved a 10%+ growth for the last few years. In addition the ROE has been 20%+ for the last few years and net of cash the ratio is upwards of 50%. The net profit margins have gone up from 5.8% to 9.8% in the current year. The company is a zero debt company and has almost 3000 Crs + cash and investments as of 2007.

In addition the efficiency ratios have improved from 2003 onwards. The company is now working on 0 Wcap. The recievables ratio is up from 14 to around 19 (2007). The total asset ratio has improved to around 5.

The company has thus improved its profitability and asset turns in the last few years. The improvement in net margins is really commendable as this has happened in times of rising raw material prices and higher competition.

Positives
Maruti is one the most well know brands. I really doubt if there is an indian who is not aware of maruti suzuki (rather their cars).

The company has a strong balance sheet, great brands and has been able to add new successful models consistently in the past few years. In addition the company now has full support from the parent for new models.

In addition to the above the company has the largest dealer and service network.

Risks
I see competition as the biggest risk. There will be swings in the demand. However as India prospers, the unit volumes are bound to go up. However with China and India being the high growth markets globally, there is bound to be intense competition in this sector. This could have an impact on the margins going forward.

The risk to margins is not from the pricing alone. Higher competition means, shorter product cycles and hence the amorization of the development expenses is now over shorter period. Case in point – The Company has rightly hiked its depreciation rates.

In addition during the year 2000-2002, the company had quite a stumble. The company was suddenly faced with slowing demand and increased competition. As a result the company made its first loss in years. However the company has learnt from it and has become far more efficient.

Competitive analysis
The firm has competitive advantage from a high market share and well know brands. The high volumes drives economies of scale for the company in manufacturing, purchasing, distribution and such scale driven activities.

In addition the company has increased the lead by expanding its distribution networks (more dealers), opening new service centres and by expanding into allied services such as insurance and used car sales. All this results in higher customer lockin and more repeat business.

Valuation
It is quite apparent that the company has considerable competitive advantage. However what is not easy to figure is how competition will increase and impact margins in the future.

With an assumption that the margins will remain between 7-9% (which is slightly higher than the global averages) and a 8-10% growth, and CAP of 9 years , the intrinsic value comes to around 1200-1300. I think the growth and CAP assumptions are reasonable. However the net margins are a wild card.

Added note: A 6-7% margin assumption would give an intrinsic value of around 1100.

Conclusion
The company sells at around 40% discount to the above intrinsic value. However I still have my doubts on the net margins. As a result although the company appears undervalued at current prices, I do not have any investment in the company. I would be prefer to have a higher discount to intrinsic value to make a commitment in order to reduce the downside risk from net margins.

Disclaimer – I may change my mind based on new information and may invest in the company. I may however not post when I do so. So as usual please make your own decision and read the disclaimer.