Description

Investment thesis

• The H shares (386 HK) and the American Depositary Shares (SNP US) of China Petroleum & Chemical Corporation (or Sinopec) are very cheap.

• The company is trading at 47% of tangible book value despite having delivered an average ROE of 7.2% from 2016 to 2020 in a very difficult oil & gas environment. Going forward I estimate the company will generate an ROE of around 10%, which translates to a P/E below 5x and a dividend yield of 12%.

• I believe returns going forward will be significantly above the high dividend yield as the company grows its earnings base and the discount to book value narrows.

• The very low valuation, the reasonable ROE, the high dividend payout ratio, the net cash position and the lower sensitivity to oil prices vs international peers indicate that a permanent loss capital over a three to five year timeframe is unlikely as long as Brent is at $45/bbl or higher.

Company overview

1. Exploration and production: Third largest oil and gas producer in China. Oil is about 60% of production on a boe basis, gas is 40%. The Shengli field is around 35% of production. Located in the Shandong province, it is second largest oil field in China and was discovered in the 1960s. The division is also a larger importer of LNG.

2. Refining: Largest refiner in China and the world with a capacity of 6.0MMbbl/d.

3. Marketing and distribution: Largest distributor and gas station company in China with approx. 30,600 self-operated service stations. Sinopec only owns 70.4% of this division. A 30% minority stake was sold in 2014 for RMR 107bn ($17.5bn) to a consortium of Chinese investment companies.

4. Chemicals: Largest petrochemical company in China and one of the five largest chemical companies in the world by sales. The chemical operations are integrated with the refineries and a significant amount of feedstock is supplied from its own operations. The division has multiple subsidiaries, many of which are not wholly owned.

5. Equity investments: The company has a RMB 71bn investment in Pipechina. Pipechina was formed in 2020 after acquiring multiple midstream assets from China’s national oil companies. Sinopec sold RMB 125bn of assets to the company in exchange for approx. RMB 50bn in cash and a 14% equity stake. Other significant equity investments are a stake in Sinopec Finance and a stake in a SIBUR, a Russian petrochemical company.

Valuation is overstated in databases and research reports

• At HKD 3.63 the H shares (386 HK) effectively trade at RMB 2.96/share while the ADS (which represent 10 shares) at $46.51 trade at RMB 2.95/share. This represents an approx. 30% discount to the Chinese-listed A shares (600028 CH) at RMB 4.23/share.

• Many databases and research reports show valuations based on the trading price of the A shares, thereby significantly understating how cheap the H shares and the ADS are.

• Furthermore, most enterprise value calculations are overstated due the company’s significant non-controlling interests. With the company trading below 0.5x tangible book and with all of its publicly-traded subsidiaries trading below book, an enterprise value calculation that includes the balance sheet value of NCI significantly overstates the total implied market value of the company.

• Below I am including NCI at 50% of book value to calculate my enterprise value.

Normalized return on equity

• From 2016 to 2020, Sinopec generated an average ROE of 7.2%. This year the company is on track to generate an ROE of 10%. I would argue that this is actually a reasonable ROE given the difficult environment for oil & gas over this period and the net cash position of the company. ROIC is roughly equal to ROE given the limited leverage. Going forward, I see the company generating a 10% ROE or higher.

Segment results

• Digging into the segments, we can see that refining, marketing and chemicals generated an attractive ROE from 2016 to 2020. Given the attractive ROE, these divisions should be worth at the very least 1.0x tangible book.

• Valuing all other operations at 1.0x tangible and the wholly owned E&P segment at 0 would result in an equity valuation of RMB 569bn, 59% above the current share price.

• Due to the large percentage of value coming from the non-E&P divisions, there is a lower sensitivity towards oil & gas prices than for other integrated peers.

• While the results of the E&P division were very unsatisfactory over the last five years, I see better results over the next five years due to a more favorable oil price environment.

Earnings drivers over the next five years

• Revenue from oil production is roughly equal to double the revenue from natural gas production. Realized oil prices are in line with international benchmarks. Natural gas prices are semi-regulated in China. The way I understand this is that natural gas prices still follow international prices but there can be a lag as regulated prices smooth out fluctuations in the short term.

• Assuming $70/bbl for Brent oil prices and $7.80/kcf for the average Chinese city gate natural gas price going forward vs an average of $55/bbl and $6.30/kcf in the 2016 to 2020 period results in an incremental RMB 38bn of EBIT for the E&P division and a 10% segment ROE. This uplift in EBIT would also take the whole company ROE from 7.2% to 10.8%.

• Sinopec’s chemical, refining and marketing operations have more scale and higher profitability than its closest peer, Petrochina. I assume similar results going forward for these segments than over the last five years.

Dividend policy

• The company doesn’t have a specific dividend payout target but has paid consistent dividends since coming public. Over the last five years, dividends were 77% of my estimate of normalized net income. Analyst estimates for 2021 imply a dividend payout ratio of 60%, which seems like a conservative estimate for the next five years as well given the historical range. 

Government ownership

The Chinese government owns 68.8% of the company. I think the government’s control of the company is less of a risk than current headlines suggest.

• First, the risk of oil companies in developing markets is usually nationalization. This is not a risk here as the government is already in charge of the company, regardless of whether they own 69% or 100%. The only reason for acquiring the remaining 31% would be as an attractive long-term investment, it wouldn’t win you any political points over the next five years.

• Second, the national oil companies generate a lot of government revenue through dividends that I assume the governments wants to continue. Government action seems like a bigger risk at companies where China doesn’t have a stake and whose current operations are not aligned with the national agenda.

• Lastly, the much-discussed Chinese technology companies operate through VIEs and don’t pay any dividends. I think that is a very different situation from SOEs that pay significant dividends.

Having said all that, the government and Sinopec will take certain actions that cost the company for the benefit of the country such as importing LNG at a loss. But these actions are already in the numbers and I would argue that we are being well compensated for this risk.

Catalyst

• Improving ROE

• Lots of dividends