A tale of 2 SOEs

2017.04.14 09:38:36

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It’s always fascinating to observe how the stocks of companies in the same sector, either in the same country or across different countries can trade so differently from one another. What influences this intangible thing called valuation multiples, such as “Price book (P/B)” or “Price Earning (P/E)”? Does it remain static or does it change over time?

A simple story to illustrate the above would be to look at the history of two state owned enterprises (SOEs) - Korea Electric Power Corporation (Kepco), Korea’s leading power utility provider with group capacity in excess of 75000 MW and Indian Oil Corporation, India’s leading refiner and fuel retailer with 24000 retail fuel pumps, 65 mtpa refining capacity and 45% share of fuel retailing in India. Kepco and India Oil shared a similar story until 3 years ago as both companies were loss making SOEs trading at significant discount to the local market and their regional peers.

However, things began to look very different for both companies around 2014/2015. Kepco increased its share of nuclear power generation, raised tariffs and became profitable while Indian Oil benefited from a pragmatic Modi government which allowed them to completely pass on the fuel cost increases of diesel and gasoline, 2 of their major products.

Both companies produced handsome returns and outperformed the local markets, however Indian Oil’s story is a bit more interesting in terms of demonstrating how a good and efficient government can create a win-win situation for all stakeholders. Building on the previous government’s 2013 policy of permitting oil marketing companies to implement a marginal monthly price increase, an action which was adopted during the US Federal Reserve‘s tapering crises in late 2013, the Modi government went a step further towards reducing subsidies on other products like LPG (liquefied petroleum gas) and kerosene. Despite this policy receiving a lot of criticism on how the poor in India would be negatively impacted by fuel price hikes, the Modi Government persevered with what was right.

This was achieved by ensuring marginal price monthly increase and more importantly, specifically targeting commercial establishments who were not entitled to subsidized fuel through direct benefit transfer to the middle and low income households. The Indian government’s interference in price setting for the sector has reduced considerably since 2014. Thus, the ROE for Indian Oil has improved from 8% in 2013 to 15% and is expected to increase to 20% in next 2 years, the P/B ratio has re-rated from 0.6 to 2.4 resulting in a 400% return for shareholders since 2013. Having being restored to profitability, Indian Oil is spending nearly USD 4-5 billion annually to upgrade and build new refineries, boosting employment and local governments. Moreover, the value of the Indian government’s 58% stake in Indian Oil has gone up fourfold to nearly USD 17 billion.

In contrast, although Kepco’s stock is up 50% from its lows in 2013 as company has turned profitable, the absence of a fair tariff setting mechanism and fears of government intervention have constrained its re-rating. At 0.4x P/B and 5x PE, Kepco trades at nearly 60% discount to regional peers, and so it is not hard to imagine the potential gains for the Korean government and people at large should this discount narrow with a more predictable and fair tariff setting mechanism. Similar to India, where healthy state owned oil marketing companies are at the forefront of capital expenditure, Kepco can set a global precedent for safe, low cost nuclear energy from Korea. A win of USD 20 billion of nuclear orders from UAE was clearly positive for Kepco, however the journey to achieve credibility as global nuclear utility is long and arduous.

Our tale of two SOEs highlights that putting short term noise aside, markets are smart in the medium term at valuing businesses and owners on their ability to generate healthy returns and providing a fair outcome to all stakeholders. For SOEs and their majority shareholders – the government, the road to populism is always tempting in the short term but good, strong leadership is all about combining doing the right thing with pragmatism. If the sleeping state owned giants can get their act together, the potential rewards are immense!

By Rahul Chadha , CIO, Mirae Asset Global Investments Hong Kong

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