Philippine Markets Newsletter

The economic shutdown continues to disrupt this oil refinery’s recovery. A 17.8x Uniform P/E suggests the market is pricing in this bearish sentiment

June 2, 2020

With the substantial weakening of oil demand during the COVID-19 pandemic, there is a glut of crude oil that has forced oil companies to shut down most of their operations.

As a subsidiary of one of the Big Oil companies, this company has not yet recovered from the extreme market sell off since March.

Additionally, its Uniform (UAFRS-based) profitability is reflecting the same negative sentiment for the firm.

Also below, Uniform Accounting Embedded Expectations Analysis and the Uniform Accounting Performance and Valuation Tearsheet for the company.

Philippine Markets Daily:
Tuesday Uniform Earnings Tearsheets – Philippine-listed Focus
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Just this April, Brent crude prices drastically fell to its lowest level in nearly two decades at less than $20 per barrel. Its collapse was worse than during the 2008 financial crisis and the 2014 oil glut.

The oil market seems to be in the midst of another downturn, even though prices have only partially recovered since 2014. The reason for such a slow recovery is because many of the factors that led to the 2014 oil glut still persist.

The growth of China and other developing countries continues to weaken, the United States is still expanding its fracking operations, and Saudi Arabia remains steady in its oil production. The culmination of these factors have made the world’s excess oil supply reach near historical highs through 2019.

Now, with the COVID-19 pandemic, excess oil supply is forecasted to jump to levels never seen before. Lay-offs and business closures have diminished demand by so much that many oil companies are facing difficulties storing unsold inventory.

One of the most affected oil companies has been Royal Dutch Shell plc (RDSA:NLD), the second largest oil company in the world in terms of revenue. In 2020, the company is forecasted to earn immaterial profitability.

By association, the market also has bearish expectations for its Philippine subsidiary, Pilipinas Shell Petroleum Corporation (SHLPH:PHL). Despite being the second largest oil refining company in the country, its ROA is expected to fall from 5% in 2019 to 4% in 2020.

Moreover, ROA expectations may further plummet. Pilipinas Shell has just recently released their Q1 2020 results, reporting a revenue decline of 14% from Q4 2019.

In an effort to conserve cash, Pilipinas Shell announced that it will defer the distribution of dividends to support the health of its balance sheet.

Additionally, the company announced that it is halting its 110,000-barrel-per-day Tabangao refinery for a month to conserve cash and reduce operating expenses.

However, the company’s balance sheet initiatives have not convinced investors. Unlike other Philippine companies, Pilipinas Shell’s stock price continues to deteriorate. The company’s stock price is down by 60% year-to-date.

There are two factors that are influencing investors concerns. First, the International Energy Agency (IEA) estimates that global oil demand could fall by as much as 6% in 2020. In Q1 2020, IEA reported a 5% decrease in global demand driven by the reduction in road and aviation transports.

In addition, President Duterte recently hiked oil tariffs by 10%, hampering the company’s ability to recover.

More importantly, Pilipinas Shell may be accurately priced despite the bearish sentiment. Even if the government relaxes quarantine restrictions, it would take some time for fuel demand to ramp back up because people and businesses would need to recover first.

Relative to Uniform earnings, the company is currently trading below corporate averages at a 17.8x Uniform P/E (V/E’). At these levels, both market and UAFRS-converted analyst expectations are forecasting the company to sustain 4% ROAs through 2024.

Historically, Uniform metrics have also shown that Pilipinas Shell has had underperforming profitability. As-reported metrics claim that the company had a 7% ROA in 2019, but when removing the accounting distortions, Shell’s Uniform earning power is truthfully only at 5%.

One of the main contributing factors is how Philippine Financial Reporting Standards (PFRS) accounts for property, plant, and equipment (PPE).

According to PFRS, PPE is recorded at historical costs – that is, in the purchasing power the year the fixed asset was recorded. But to better reflect reality, PPE should be adjusted for inflation for each year of use.

In Uniform Accounting, adjustments have to be made so that the asset and cash flow values accurately reflect the current purchasing power each year.

In 2019 alone, the company should have recognized PHP 21 billion more in fixed assets when adjusting for inflation.

When we add PHP 21 billion more to Pilipinas Shell’s PHP 103 billion asset base and with the many other adjustments Valens makes, we arrive at a TRUE earning power of 5%.

Market expectations are for Pilipinas Shell’s earning power to decline

Pilipinas Shell currently trades below recent averages relative to Uniform earnings, with a 17.8x Uniform P/E (Fwd V/E’). The market has bearish expectations for the firm at these levels, projecting Uniform ROA to decline from 5% to 4% levels through 2024, accompanied by 1% asset shrinkage.

Analysts have similar expectations, projecting Uniform ROA to decline to 4% levels by 2021, accompanied by 8% asset shrinkage.

Historically, Pilipinas Shell has seen cyclical profitability. After posting negative profitability in 2014 due to the oil price collapse, Pilipinas Shell’s profitability rebounded to a high of 9% in 2017.

Thereafter, the company’s earning power receded to just 5% in 2019.

Pilipinas Shell’s earnings margin is expected to decline

Trends in Uniform ROA have largely been driven by similar trends in Uniform earnings margin.

From -3% in 2014, Uniform margins slowly improved until it achieved 6% peaks in 2016-2017, before declining again to 3% levels in 2018-2019.

Every year, as-reported earnings margins have been overstated, making the company appear to be a much stronger business than real economic metrics highlight.

At current valuations, markets are pricing in expectations for declines in both Uniform earnings margin and Uniform asset turns.

SUMMARY and Pilipinas Shell Petroleum Corporation Tearsheet

As the Uniform Accounting tearsheet for Pilipinas Shell highlights, the Uniform P/E trades at 17.8x, which is below corporate average valuation levels and its own recent history.

Low P/Es require low EPS growth to sustain them. In the case of Pilipinas Shell, the company has recently shown a 20% Uniform EPS shrinkage.

Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Pilipinas Shell’s Wall Street analyst-driven forecast is a 45% decline in 2020 before seeing a 4% growth in 2021.

Based on current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Pilipinas Shell’s PHP 17.12 stock price. These are often referred to as market embedded expectations.

The company can have Uniform earnings shrink by 11% each year over the next three years and still justify current prices. What Wall Street analysts expect for Pilipinas Shell’s earnings growth is below what the current stock market valuation requires.

The company’s earning power is below the long-run corporate average. However, cash flows are significantly higher than its total obligations—including debt maturities, capex maintenance, and dividends. Together, this signals low credit and dividend risk.

To conclude, Pilipinas Shell’s Uniform earnings growth is below peer averages in 2020, and the company is trading above peer valuations.

About the Philippine Market Daily
“Tuesday Uniform Earnings Tearsheets – Philippine-listed Focus”

Some of the world’s greatest investors learned from the Father of Value Investing or have learned to follow his investment philosophy very closely. That pioneer of value investing is Professor Benjamin Graham. His followers:

Warren Buffett and Charles Munger of Berkshire Hathaway; Shelby C. Davis of Davis Funds; Marty Whitman of Third Avenue Value Fund; Jean-Marie Eveillard of First Eagle; Mitch Julis of Canyon Capital; just to name a few.

Each of these great investors studied security analysis and valuation, applying this methodology to manage their multi-billion dollar portfolios. They did this without relying on as-reported numbers.

Uniform Adjusted Financial Reporting Standards (UAFRS or Uniform Accounting) is an answer to the many inconsistencies present in GAAP and IFRS, as well as in PFRS.

Under IFRS, each company’s financial statements are rebuilt under a consistent set of rules, resulting in an apples-to-apples comparison. Resulting UAFRS-based earnings, assets, debts, cash flows from operations, investing, and financing, and other key elements become the basis for more reliable financial statement analysis.

Every Tuesday, we focus on one Philippine-listed company that’s particularly interesting from a UAFRS vs as-reported standpoint. We highlight one adjustment that illustrates why the as-reported numbers are unreliable.

This way, we gain a better understanding of the factors driving a particular stock’s returns, and whether or not the firm’s true profitability is reflected in its current valuations.

Hope you’ve found this week’s Uniform Earnings Tearsheet on a Philippine company interesting and insightful.

Stay tuned for next week’s Philippine company highlight!


Angelica Lim & Joel Litman
Research Director & Chief Investment Strategist
Philippine Markets Daily
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