vk.com/id446425943

Russia

Energy: Integrated Oil & Gas

15 March 2019

Lukoil, ord. (LKOH RX, USD)

Hold (13 Nov 2018, 06:11 UTC)

Previous: Buy (12 Jan 2018, 13:01 UTC)

Target price, 12mo: 86.00

Last price: 85.64 (07 Mar 2019, close)

Expected total return: 5%

Upside, 12mo: 0%

DY, next 12mo: 4.4%

Lukoil, ADR (LKOD LI, USD)

Hold (13 Nov 2018, 06:11 UTC)

Previous: Buy (12 Jan 2018, 13:01 UTC)

Target price, 12mo: 86.00

Last price: 85.64 (07 Mar 2019, close)

Expected total return: 5%

Upside, 12mo: 0%

DY, next 12mo: 4.4%

Share price performance, 12-mo

Key financial highlights

Multiples and yields are calculated based on period-average prices where available.

Source: Bloomberg, Company data, VTB Capital Research

Focus

Lukoil

I can see clearly now the rain is gone

Lukoil is one of the best examples of a gradual but steady improvement in corporate governance, and we think this has been appreciated by the investment community. With USD 1.7bn spent on the buyback since September, the stock is one of the best performing in the sector. We note that in some weeks, the company has accounted for more than 20% of the ADTV this year. We continue to have a relative preference for Lukoil in the oil sector in Russia. However, the upside on the stock is capped by our reserved stance on oil prices. We reiterate our 12-month Target Price of USD 86 (5% ETR) and Hold recommendation.

Steady improvement in corporate governance. Lukoil is one of the brightest examples of a multi-year corporate governance improvement, and we think the investment community has started to appreciate this of late. In 2013, the company explicitly stated its targets on this front, but real delivery came with the treasury shares issue resolution in January 2018. Since 2013, Lukoil has addressed every issue, including international M&A (limited activity), decent dividends, buybacks and the cancellation of treasuries.

Lukoil to benefit modestly from regulatory changes. Lukoil will not particularly benefit from the introduction of EPT, we think, as Filanovskogo enjoys a special tax regime, while Korchagina would be better off staying under the current regulations (thanks to the existing tax breaks). However, the company is to increase the share of high-margin barrels further thanks to HTR expansion. The risks for Lukoil stem from a potential payment under the damper mechanism that could lead to USD 0.2bn of additional taxes (1.4% of EBITDA) in 2019 in our base scenario (under the current oil price, Lukoil might get some USD 0.6bn from the state, though, we estimate).

Buyback is one of the most important stock price drivers. Lukoil has spent some USD 1.7bn since last September, or 55% of the announced USD 3bn buyback. It formed more than 20% of the ADTV in February, which we believe is probably the most important factor behind the rally in the name (Lukoil has outperformed the RTS and RTS O&G by 9% and 14% YTD).

‘Inside out’ indicates undervaluation if oil price holds. Lukoil’s tax breaks have historically formed c.65% of earnings, making the company’s profitability dependent on the oil price. Given our muted stance on the crude price (USD 57/bbl in 2019F) we estimate that Lukoil’s shares are now trading at a 73% premium to the NPV of its tax reliefs. However, the stock is trading at just a 9% premium to the NPV of the tax breaks under the current oil price, which might be a good indication of the likely shares appreciation for those investors with a more bullish view on oil prices, we think.

Dmitry Loukashov, CFA, Equities Analyst

+7 495 663 46 34 // dmitry.loukashov@vtbcapital.com

Ekaterina Rodina, Equities Analyst

+7 495 663 47 33 // ekaterina.rodina@vtbcapital.com

Alexander Donskoy, Equities Analyst

+7 495 660 67 88 // alexander.donskoy@vtbcapital.com

Artur Muradyants, Equities Analyst

+7 495 663 46 38 // artur.muradyants@vtbcapital.com

Aydar Safin, Equities Analyst

+7 495 663 46 32 // aydar.safin@vtbcapital.com

vk.com/id446425943

Russia

Energy: Integrated Oil & Gas

VTB Capital Facts & Forecasts

Russia

Energy / Integrated Oil & Gas

Lukoil

Prices as of: 7 March 2019

Share price performance, 12-mo

Mar May Jul Sep Nov Jan Mar

LKOH RX, USD, lhs

Relative to MOEX Index, %, rhs

Company description

Lukoil is Russia's largest non-state-owned integrated oil and gas company. In 2018, it produced 84.8mmt (flat YoY) of crude oil (including oil produced within international projects) which makes it the second largest oil producer in Russia. Refining occurs in Russia (in the Central region and Timano-Pechora) and abroad (Romania, Bulgaria, Italy and the Netherlands). The company's total proved reserves of crude amounted to 12bn bbl, according to SEC standards, as of the end of 2018, thus representing a robust 19 years of liquids reserves life. Total refining in 2018 was 73.9mmt (also flat YoY).

Company website

http://www.lukoil.com/

Shareholder structure

Management of the company 39%

Source: Company data, VTB Capital Research

Research team

Dmitry Loukashov, CFA / +7 495 663 46 34

Ekaterina Rodina / +7 495 663 47 33

Alexander Donskoy / +7 495 660 67 88

Aydar Safin / +7 495 663 46 32

Artur Muradyants / +7 495 663 46 38

Lukoil

Last model update on: 5 March 2019

Figure 1: More than half of USD 3bn buyback has been spent by now

Source: Company data, VTB Capital Research

Figure 2: Lukoil’s shares have outperformed RTS O&G by 23% since the buyback was launched

30%

Source: Company data, VTB Capital Research

vk.com/id446425943

Russia

Energy: Integrated Oil & Gas

Lukoil

We note the consistent trend of corporate governance improvements across the board at Lukoil in recent years. While, from the operational profitability standpoint, the company has remained more or less the same, in our view it is corporate governance that has provided the impetus for the appreciation in Lukoil’s shares. And it must be noted that over the last 12-15 months, Lukoil has addressed almost all the issues which had been raised:

Poor communication practices

Low dividends and reluctance to revise dividend policy

Treasury shares on the balance

International expansion

•Refineries in Europe

•Offshore exploration in Africa

General lack of care about minorities

Improving corporate governance practices was one of the key targets of the company’s 2013 Strategy, with the first strategic aim being ‘Value creation and accelerating the growth of dividends’. Since then, Lukoil has behaved consistently. Based on the stock’s performance, we think that, although this was visible, investors were not in rush to price it in. The stock only started to outperform peers visibly after the company announced its intention to cancel 12% of treasury shares in January 2018. Since then, Lukoil has been the second best performing stock in the oil space (after Tatneft, which has also massively improved its corporate governance), delivering +49% in capital gains since 1 January 2018 and outperforming the RTS O&G Index by 31% in dollar terms.

Figure 3: Lukoil is among the top performers over the last five years

40%

30%

20%

10%

0% -10% -20% -30% -40% -50% -60% -70%

Source: Bloomberg, VTB Capital Research

Figure 4: Crude production in Russia remained broadly flat…

1.80

1.75

1.70 mnb/d 1.65 1.60

1.55

1.50

Source: Company data, VTB Capital Research

Figure 5: …as did the financial performance, at first glance

20

18

16

14

12

USDbn 10

8

6

4

2

-

Source: Company data, VTB Capital Research

vk.com/id446425943

Russia

Energy: Integrated Oil & Gas

Lukoil

Although the company had started to limit risky international activities, this had no immediate effect on the stock price (even when Lukoil really started to focus on the dividends part of the story). The first signs of a renaissance in investment community interest towards Lukoil’s shares merged after the approval of the new dividend policy, which made the distribution of dividends more predictable. Before that, the company’s official dividend policy implied a payout of not less than 15%. In April 2016, the payout ratio was increased to 25%, while the potential downside was limited to rouble inflation of the previous year’s DPS (the company pays out the higher of these two). Although this was an important step in the overall corporate governance improvement of Lukoil, this did not see any tangible reflection in the stock performance, which makes us think that investors were not really impressed back then.

The strengthening of the IR team in August 2016 led to an immediate improvement in disclosure practices (operating statistics became available before the financial results were published, databook updates were given in a timely fashion, etc). Moreover, this led to management being more accessible (during conference calls and investor/analyst meetings), which we think was also appreciated by investors.

After that, there was only one disturbing factor left in Lukoil’s story: the 17% quasitreasury shares stake. And, finally, continuing the trend of the improvement in corporate governance, in January 2018 Lukoil announced its intention to cancel almost 12% of share capital (100.6mn shares) with some 5% to be spent for the management compensation programme. We think this was the real turning point, when investors’ appreciation of the steady, multi-year improvement in the corporate governance at Lukoil finally started to be reflected in the stock’s performance. The treasury shares were officially cancelled in November last year.

Furthermore, during its Strategy Update in March 2018, Lukoil announced its intention to spend half of the FCF generated at oil prices above USD 50/bbl for the shares buyback. In September 2018, the company announced a USD 3bn buyback programme for 2018-20 with all treasuries to be cancelled after the completion of the buyback. Given the accelerated pace of the buyback (USD 1.66bn has been spent as of now) the company stated that it might complete it as early as this year. This buyback is to be followed by another one, the details of which are to be discussed in 3Q19.

In addition, on 6 March the company’s BoD approved the amendment of the dividend policy, which is now going to account for the shares owned by Lukoil’s Group. This means that the greater buyback pace could provide for faster dividends growth. As a result of this amendment, we estimate that for 2018 Lukoil’s shareholders might receive RUB 5 more in DPS, which implies 0.1% additional DY. For 2018 in total, the company might pay RUB 240 (including RUB 85/share distributed for 9mo18) or 4.3% DY, on our numbers.

Over the last 20 years, Lukoil’s FCF has turned negative only once, in 1998. The company has sustainably generated positive FCF, although we do not think this was really appreciated by the investment community, given that sharing this cash with investors was not considered to be a priority. Now, that is no longer valid. With USD 1.7bn of cash spent on the buyback of own shares over the last six months and the intention to amend the dividend policy to account for the cancellation of the treasuries, Lukoil is essentially sharing its FCF with minority investors. We therefore believe that it is worth reminding ourselves what Lukoil as a company is now.