Refining Profits: Why Orlen's Valuation Spells Opportunity
The cyclical and contrarian bet on Poland's largest company
Summary
Orlen, the largest Polish company, has recently consolidated the oil and gas sector in its country by merging with Lotos and PGNiG.
Despite the merger, Orlen maintains a stock valuation well below its historical levels (around 2x 2022 earnings vs. 6x average and 0.45x NAV), which represents a great opportunity if the cycle continues.
The company has the ambitious goal of doubling its EBITDA by 2030, driven mainly by investments in renewable energy and gas.
Despite the volatility/price cycles of oil and gas, Orlen offers a solid value proposition due to its low debt, vertical integration, and growth potential in the sustained demand for oil and gas.
Investment Thesis in a Nutshell
Currently, Orlen trades at a substantial discount to its book value, standing at 0.45x, and has notably low multiples, with an EV/EBITDA ratio of 1.3x and a P/E ratio of 2.1x with respect to 2022 results.
In other words, it has a current market value of 15-17 billion euros and is generating around 5-7 billion in profit.
This valuation certainly takes into account various factors, including potential fluctuations in oil price/cycle (anticipating price decreases), uncertainties about capital allocation (particularly towards renewable investments), the company's shareholding structure, with 49% state ownership, and the vulnerability of the Polish currency, the zloty.
However, Orlen's unique strengths, including its complete vertical integration, diversified portfolio, and strong cash position, position it exceptionally well to navigate the energy transition while delivering significant value to its shareholders. Given the sustained demand for oil until alternative fuels like hydrogen become more prevalent, Orlen would have great earnings potential, especially given the limited investment in new oil wells and refining facilities during this transitional period.
Orlen's Business
Orlen SA is a Polish oil company founded in 1999 through the merger of Centrala Produktów Naftowych (CPN) and Petrochemia Płock. The company is the largest company in Poland and one of the leading oil and gas companies in Central and Eastern Europe, with a market capitalization of around 15 billion dollars. After the merger, Orlen became an energy conglomerate.
It engages in oil and gas exploration and production, refining, petrochemicals, fuel marketing, and power generation. It is a vertically integrated company with a relevant cyclical component, as the main activity (around 50% of the business) is the refining segment. The company operates in over 20 countries worldwide.
Poland's Economy
Orlen is highly significant to the Polish economy. The company is a major contributor to the state's finances (49% state ownership)
Poland is one of the fastest-growing economies in Europe, surpassing even South Korea in GDP growth since 1980. This puts Poland ahead of the United Kingdom by 2030, with a per capita GDP higher than that of the UK. Average growth of 2% is expected for the next three years. A country with such economic growth will require more energy. A clear beneficiary of this trend, expected to continue for decades, should be ORLEN, especially through a combination of traditional and renewable energies.
Lotos and PGNiG Mergers
In 2020, 27% of the company was owned by the Polish state. However, the shareholding structure changed recently as a result of two major mergers with the LOTOS and PGNiG groups. LOTOS was Orlen's largest competitor.
PGNiG was the country's largest gas wholesaler and retailer, with around 90% of gas sales to end consumers in Poland. The Polish state's stake in ORLEN increased after the mergers. In other words, shareholders of the acquired companies received Orlen shares as compensation, with the State compensated with a substantial amount as the main shareholder of the companies (for example, around 70% of the PGNiG group was state-owned), leading to an increase in its relative ownership. Therefore, the current shareholding has increased to 49.9%, which is not a random number. This acquisition was allowed by the European Commission, as long as it did not exceed 50% control, which has been the case.
Before these mergers, in 2020, Orlen had already acquired Energa, a relevant player focused on renewable energy generation.
The newly formed company resulting from all these mergers is led by Daniel Obajtek, who has been the CEO of Orlen since 2018. Obajtek is a Polish politician who served as a member of the Sejm, the lower house of the Polish Parliament, from 2007 to 2015. These mergers solidify Orlen's position and represent a significant step in the consolidation of the Polish energy sector. Poland’s politics are complicated, with a recent election that will probably result in a change of government. Management may potentially change, but I personally see Orlen in a strong position for the future.
Transition to Renewable Energies and Dividend Policy
Knowing where a company is heading is a crucial aspect of any valuation or thesis, particularly when it comes to capital allocation during the transition to green energy. Orlen has shared its plan for 2030, which is publicly available on its website.
Orlen's 2030 plan focuses on three key pillars: decarbonization, sustainable growth, and integrity and responsibility. To achieve these goals, Orlen will invest a total of 320 billion zlotys (65 billion euros) over the next seven years. These investments will focus on the following projects:
Renewable Energies: Orlen will build new solar and wind power plants, as well as biofuel facilities.
Energy Efficiency: Orlen will improve the efficiency of its operations in all business segments.
Carbon Capture and Storage: Orlen will develop technologies to capture and store the carbon dioxide produced by its operations.
Electric Mobility: Orlen will build a network of electric vehicle charging stations and develop new products and services for the electric mobility market.
The division is shown in the image below:
To finance these investments, Orlen will use a significant portion of its current earnings and debt capacity, reducing the available cash for buybacks and dividends. However, this strategy is aimed at generating more long-term earnings. This implies that the cash available for dividend payments will be limited.
However, I maintain an optimistic view on this matter, given the importance of ORLEN's dividends for Poland as a nation. Additionally, Orlen has recently provided clarity on its dividend policy, indicating that approximately 40% of free cash flow will be allocated to dividend payments. See more details below.
Even in a scenario of oil price reductions, Orlen is committed to maintaining a base dividend, unless substantial unforeseen challenges occur. Currently, this base dividend amounts to 4.00 zlotys per share, equivalent to approximately one billion euros annually, and is expected to increase incrementally by 0.15 zlotys each year until 2030.
Given the current share price, this translates to a minimum dividend yield ranging from approximately 7% to 10%, depending on the company's commitment to at least deliver the "base dividend". In this context, Orlen takes on the character of an investment with pure yield, particularly if it encounters obstacles to improve its financial performance. However, it is essential to highlight the company's ambitious strategic initiatives, which could substantially shape its trajectory in the coming years.
The new investments are expected to generate an accumulated EBITDA of over 400 billion zlotys by 2030 (approximately 85 billion euros), implying a total annual EBITDA of around 15 billion for the year 2030. Therefore, the company is currently valued at approximately 15 billion euros in the stock market, and its plan is to achieve an annual EBITDA of 15 billion euros by 2030. This means that if they manage to follow their plan, Orlen would trade at an implied EV/EBITDA ratio of 1x in 2030.
Valuation
In this case, I perform a multiples-based valuation, with historical data serving as a benchmark. A discounted dividend model could be valid, although a discounted cash flow model is understood to lose much sense when almost everything will go to CAPEX.
In any case, we are talking about Poland and a cyclical sector, so the discount is high, no less than 11-12% and no more than 14% according to my calculations. It is important to note that a direct comparison of earnings between 2022 and 2023 is not feasible due to several factors. These include the partial inclusion of the year of the Lotos and PGNiG mergers (the full year was not considered) and the exceptionally high oil and gas prices in 2022.
However, we can gather information from H1 2023 results and the 2021 results (considering the PGNiG and Lotos groups plus Orlen's figures), which offer a more representative benchmark, reflecting a return to more typical oil prices (around $60-80 per barrel). During H1 2023, Orlen reported net earnings exceeding 14 billion zlotys and an EBITDA of over 24 billion zlotys, equivalent to approximately 3 billion and 5 billion euros, respectively. In a hypothetical scenario where Orlen's profitability remains unchanged for the rest of the year, the resulting P/E ratio would be 5x, and the EV/EBITDA ratio would be 3x, both notably low for companies in the oil and gas sector. If this level of earnings persists until the end of the year, these ratios would decrease even further to approximately 2.5x and 1.5x, respectively. Remember that the company is valued at 15-17 billion euros in the stock market. Even considering the mediocre results of Q3 2023, EV/EBITDA would still stand at 2.5x and PER around 4x.
Comparable companies of similar size, such as Shell, BP, Repsol, and Exxon, usually have P/E multiples ranging from 5x to 10x. This underscores the fact that we defend in the thesis, a significant margin of safety even if Orlen's earnings experience a decline.
Assuming a conservative P/E ratio of 4x, the potential upside compared to the current stock price could be approximately 60%.
It is worth noting that historical P/E ratios for the past eight years have been around 6-8x. In terms of EV/EBITDA, the average ratio during the 2014-2022 period has been around 6x, indicating significant potential upside. If Orlen achieves its growth prospects from 2023 to 2030, the current valuation levels are clearly very low.
Even considering Orlen's EBITDA levels in 2021, which include contributions from the PGNiG and Lotos groups and amount to approximately 6.5 billion euros, the company would still operate at a conservative EV/EBITDA multiple of 2.5x.
The historical multiple is significantly better (4.5x EBITDA and 6x earnings in the last 5 years).
It must be said that the valuation is highly dependent on the cycle in any case.
Although the earnings multiples of comparable companies range from 5x to 10x, I have chosen to opt for a conservative multiple of 4x. Over the past 5 years the average has been around 6x:
• Base Case: Using H1 2023 results as a proxy with a 4x earnings multiple. Normalized earnings in 2023 ≈ 27 billion zlotys. 4x = 104 billion zlotys, representing a 48% potential revaluation compared to the current value.
Using EV/EBITDA multiples of 3x (average 4.5x over the last years):
• Base Case: Using H1 2023 with a 3x multiple. Normalized EBITDA in 2023 ≈ 48 billion zlotys. 3x = ≈144 billion zlotys, indicating a 105% potential revaluation compared to the current value.
However, the most likely scenario involves a reduction in profits, based on a European recession and decreased demand for Orlen products. Therefore, we will assume the same (already depressed) multiples in a stress case, where annual earnings are 18 billion zlotys and EBITDA is 30 billion. These multiples are conservative. The following results are obtained:
• EV/EBITDA 3x. Base case using full results for 2021 (more depressed), integrating absorbed groups, with 3x multiples ≈ 30 billion zlotys. 3x = ≈90 billion zlotys, resulting in a 29% potential revaluation compared to the current value.
PER 4x. 18 billion * 4x = 64 billion, which is <-10% compared to the current price.
All of these results don't consider dividends, expected to amount up to 10% per year.
In the long term, if the plans of achieving 60 billion zlotys in EBITDA by 2030 materialize, at current (depressed) multiples, we could see a 150% potential revaluation over 7 years, in addition to dividends (around 7 to 10% for a compounded annual growth rate of 21%, or historically 28% compounded annual growth).
In any case, it's crucial to recognize that Orlen intends to allocate a significant portion of its EBITDA (and free cash flow) to capital expenditures.
This aligns with current market expectations, which are influenced by relatively high estimates of the weighted average cost of capital (WACC), estimated at around 14%.
Consequently, cash flows beyond the fourth or fifth year are almost negligible, and Orlen's current investment and dividend policies heavily impact market prices. If the economic cycle takes a downturn, the valuation would be affected if current multiples are maintained. Currency as well as political risk and not only projected results are also a significant factor to consider.
Conclusion
Orlen presents a compelling opportunity for investors seeking a blend of stability, potential for substantial gains, and a dependable dividend stream. The company's current valuation is notably attractive, offering a reasonable safety margin.
However, it's imperative to acknowledge the inherent risks associated with the economic cycle, especially in light of potential fluctuations in oil prices. Despite these challenges, Orlen stands out as a prominent global player in the sector, solidifying its competitive advantage and fortifying its moat.
While the expansion into renewable energy does introduce certain risks, such as increased competition, Orlen's robust positioning and strategic initiatives equip it to thrive in this evolving landscape.
In essence, Orlen not only offers the potential for capital appreciation but also ensures a reliable dividend stream for the foreseeable decade. This dual benefit, coupled with the company's competitive edge, underscores the compelling investment proposition it presents to astute investors.