Research Notes

Lukoil Posts Strong 9M04 Financials

Current price - $ 29.80
Current fair price - $ 38.74
Last fair price - $ 35.92
Upside potential - 30%
Recommendation - Buy

Maria Radina
(095) 204-8275
radina@finam.ru

Kseniya Samartsieva
(095) 204-8274
samartsieva@finam.ru

The company’s results look much better than those in the year-earlier period:

• 9m 2004 and 3Q 2004 net revenue from sales surged 48% and 58.7% compared to the same period last year;

• growth in net revenue outstripped costs by 2.2% and 3.3% in 9M04 and 3Q04, respectively;

• operating profit rocketed by 91.7% in 3Q 2004 and by 78% in 9m 2004 year-on-year;

• all in all, the oil firm’s 9M04 net profit calculated under US GAAP totaled $3.1 bln, i.e. 60% more than in the same period last year, while in the third quarter the rise in net profit was truly impressive, nearly up 100% (see Table 1).

Table 1. Lukoil’s financial highlights in the reporting period

Revenue

The rise in net revenue was largely driven by record-high crude oil prices both on domestic and global petroleum markets, as well as changes in the structure and routes for sale of hydrocarbons and petroleum products.

According to the oil company’s financials, 9M04 growth in sales prices for crude oil and petroleum products on international markets averaged 24% (from $26.7/bbl to $33/bbl), 31% for high octane gasoline (from $299/ton to $393/ton), while 3Q04 figures are 38% and 44%, respectively.

As for changes in the sales structure and routes that pushed up net revenue: exports rose due to a reduction in domestic sales and increased trading volumes on markets in Western Europe, South East Asia, North and Central America.

In the second quarter of 2004 Lukoil commissioned the first stage of its new oil terminal in Vysotsk, which enabled the company to export an additional 5 mln tons of oil above Transneft’s oil export schedule.

Costs

We are especially pleased to note that Lukoil has finally started to manage its costs efficiently. In dollar terms the company’s operating expenses remained flat, and given the ruble’s appreciation in the first nine months of the year they even dropped by 11%.

However, the question arises as to what pushed costs down, since the inflation rate in the industrial sectors reached 23.3% in 9m 2004, according to Economic Development and Trade Ministry. Thus, it is possible that apart from savings due to downsizing, Lukoil managed to reduce operating expenses by substantially cutting the scope of works and services related to oil and gas extraction and refining. Meanwhile, during the period of sky-high crude prices the oil company could start forming stockpiles and also engage, for example, in conducting major and current well workovers.

The oil major’s financials were adversely affected by rising transport costs and the heavier tax burden on Russian oil companies. Lukoil’s transport costs soared 40% in the first none months of 2004, whereas tax payments (except for profit tax) surged 42% against the same period last year. Unfortunately, the oil firm is unable to keep these cost items under control, as it is simply impossible to optimize payments for these items. At the same time Lukoil is able to control costs related to the purchase of crude oil and petroleum products. Costs under these items jumped 71% in 3Q 2004, although these transactions are quite opaque.

Overall, as we have already noted, growth in costs in the reporting period was lower than that in revenue.

Profit margins

As a consequence, the oil major’s profit margins were positive. Based on 3Q 2004 and 9m 2004 results, Lukoil posted gains in all ratios (see Table 2 and Figure 1).

Table 2. Lukoil’s profit margins

Figure 1. Lukoil’s 9M04 and 3Q04 profit margins

Until recently, Lukoil was trailing Yukos and Sibneft by these ratios, but at present the oil company is catching up with the former oil industry leaders.

Cash flows

Lukoil’s net cash flow remained flat in 9m 2004 compared to 9m 2003 (fig. 2)

Figure 2. Lukoil’s cash flows in 9m 2003 and 9m 2004, $ mln

This was possible due to increased capex and new acquisitions. However, we do not view this fact as downbeat, since the company is making active use of the current favorable market trends to lay the groundwork for its activities in the future.

Valuation

Lukoil’s financial data as of 9m 2004 enabled us to revise our fair value of the company’s market cap. As a result, we have upgraded the fair price by 8% from $35.92 to $38.74 per share.

Our forecasts are underpinned by the following data:

We are of the opinion that in the future Lukoil will maintain tough cost containment measures and opex will not top $2.6 per barrel over the next two years. According to our estimates, the growth rate of SG&A costs will not exceed 10% a year.

The only threat to Lukoil’s share value is a further rise in transport tariffs, which will have a negative impact on the corresponding line item in the P&L statement.

While preparing our valuation model for Lukoil, we proceeded on the assumption that the tax burden will remain unchanged.

Capex was estimated based on Lukoil’s strategic development plan, which provides for total investments amounting to $30 bln up to 2014.

Summing up, we would like to reaffirm our opinion that Lukoil’s shares are one of the most attractive investment vehicles on the Russian stock market. The oil major’s operating and financial results underscore that its restructuring program has been a success and efficiency of the company’s management has increased.

Investors would be well advised to focus on Lukoil stocks once again, since this oil play should be valued mostly by market, rather than political, criteria.

Forecast of Lukoil’s Balance Sheet

Forecast of Lukoil’s P&L Statement

Calculation of Lukoil’s cash flow

Maria Radina

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