Tuesday, August 3, 2010

Buy GAIL on dips

The company plans to almost double its pipeline network and capacity over the next four-to-five years.

Anand Kalyanaraman

Investors with a high-risk appetite can consider buying the stock of GAIL (India), the country's predominant natural gas transmission and trading player.

At its current price of Rs 472, the stock has gained almost 70 per cent over the past year and discounts its trailing 12 month earnings by around 18 times. Though it trades close to its all-time high, we believe the stock still offers scope for upside, primarily due to the company's strong positioning, good performance and massive expansion plans in the burgeoning Indian gas market, where demand growth outpaces rapid growth in supplies.

The sanguine outlook is reinforced by recent regulatory surprises — on the tariff front and on marketing margins on administered pricing mechanism (APM) gas. Also, good showing and expansion plans in other major segments such as petrochemicals lend confidence about the company's prospects. Contingent positives (success in exploration efforts and removal of subsidy overhang), if they materialise, may further improve returns.

Ramping up

GAIL has lined up massive expansion plans to capitalise on favourable demand-supply dynamics in India. Despite increased supply of gas from domestic sources (mainly Reliance's KG-D6) and augmentation expected from new domestic finds and imported liquefied natural gas, the demand is expected to outstrip supply in the country.

GAIL, being in a position of eminence in the gas trading and transmission market, is in a sweet spot, and is the process of ironing out the infrastructural creases to cater to the market expansion.

The company, which has a current gas transmission network of around 7,200 km and transmission capacity of about 160 million metric standard cubic meter per day (mmscmd), plans to almost double its pipeline network and capacity over the next four-to-five years.

Capex plans worth around Rs. 35,000 crore have been lined up and expansion plans include currently under-served markets of the country including South India. In the near term, GAIL which had laid around 800 km of pipeline in 2010, plans to spend around Rs. 8,000 crore to lay 1,200 kms of pipeline in 2011 and increase transmission capacity to 200 mmscmd by the end of the year.

Expansion plans have also been lined up in other key segments such as petrochemicals and the high-margin city gas distribution. The company is also investing more in its exploration and production efforts (the company has 27 oil and gas blocks, and three coal bed methane blocks).

GAIL's wide range of businesses, including transmission (natural gas and LPG), commodity (petrochemicals, LPG and other liquid hydrocarbons), gas trading and city gas distribution helps de-risk the business model and mitigates cyclical fluctuations in the petrochemicals and other business.

Key Regulatory upsides

Positive developments on the regulatory front in the recent past have given GAIL a shot-in-the-arm.

First among these was the notification of provisional tariffs by the downstream gas regulator, PNGRB. Though the tariff of Rs 25.46/mBtu (applicable retrospectively from November 2008) notified for the existing HVJ-GREP-DVPL pipeline was around 10.6 per cent lower than existing tariff, this was more than offset by the almost 88 per cent increase in the tariff to Rs 53.65/mBtu for the new DVPL/GREP upgradation pipeline. The new pipeline with almost similar capacity as the existing pipeline is likely to be commissioned in the second half of the current fiscal. GAIL stands to benefit significantly from an increase in the blended rate.

Also, GAIL will gain handsomely from the government move allowing it to charge a marketing margin of 11.2 cents/mBtu on APM gas, since around 60 per cent of the gas marketed by GAIL currently is from APM sources.

Healthy Financials

GAIL's financial performance over 2006-2010 has been healthy with the consolidated topline and bottomline growing at an annual rate of close to 16 per cent and 8 per cent respectively. In FY-10, sales grew around 9 per cent to Rs. 27,035 crore, while the bottomline increased 17.7 per cent to Rs. 3,328 crore.

Better growth in profits in the last fiscal was primarily driven by strong showing by the high-margin gas transmission business, and lower subsidy burden compared with the previous year. Overall, consolidated operating margins have been maintained above 20 per cent, while net margins continue to be in the early teens. Return on equity (close to 20 per cent) is healthy.

While natural gas trading continues to occupy the lion's share of revenues (in excess of 60 per cent), gas transmission (the main contributor to profit) increased its share in profits and accounted for more than half of the company's EBIT in 2010. This trend is expected to continue with the gas transmission business expected to grow strongly, going forward. This bodes well for the company's prospects, since the transmission business generates the highest margins.

EBIT margins in gas transmission further improved in FY-10 and touched 71 per cent. With the improvement in blended rate, this is expected to further improve. Also, margins in the gas trading business are also expected to improve significantly, with marketing margins allowed on APM gas.

However, the cyclical petrochemicals business, which accounts for around 30 per cent of EBIT, is expected to see margin pressure over the near term due to significant new capacity additions in many geographies.

In the latest quarter, GAIL registered good performance due to strong showing by most segments and reduced subsidy burden. This more than offset the one-time charge for the retrospective reduction in tariff (from November 2008) notified by PNGRB for the existing HVJ pipeline.

Comfortable cash position (in excess of Rs 4,500 crore), low leverage (around 0.3 debt to equity) and good operating cash flows provide the company enough headroom to fund its capital expansion plans.

Opportunities, risks

Big wins in its exploration and production efforts could integrate the company across the energy value-chain and provide a significant upside trigger for the stock.

This will also mitigate risks if expected gas volumes from other sources do not meet expectations. Lack of success, however, will result in an increase in write-off of exploration expenses and could prove to be a drag.

On the other hand, subsidy overhang continues to be a drag and a major risk factor for the company. GAIL's share (around Rs. 1,320 crore) of the subsidy burden in FY-10 on transport fuels accounted for more than 20 per cent of its operating profits for the year.

The Kirit Parikh committee recommendations on fuel price deregulation include exempting GAIL altogether from the subsidy sharing mechanism. The government move of more than doubling APM gas prices in May sent positive signals on its intent on fuel price deregulation.

However, it remains to be seen whether the powers-that-be will implement the recommendations, especially in the current high inflation environment. Any positive move on this front could provide another positive trigger for the stock. A business-as-usual scenario could depress the stock's prospects, especially in a regime of high crude prices and inflating subsidy bills.

Q1 Resules of 2010

GAIL (India) Ltd has reported a 35 per cent increase in its net profit for the first quarter of the current fiscal, as it transported more natural gas and LPG as well as made more revenues from marketing margins.

The company's net profit for the quarter stood at Rs 887 crore against Rs 656 crore in the corresponding previous quarter. GAIL has registered an increase of 18 per cent in turnover at Rs 7,096 crore (Rs 6,039 crore).

This is despite the heavy subsidy burden which GAIL had to share along with ONGC and Oil India to partially compensate the public sector oil retailers. GAIL has shared Rs 445 crore towards domestic LPG and PDS Kerosene subsidy in the first quarter (Rs 75 crore).

Net Sales

Addressing newspersons after the board meeting, GAIL Chairman and Managing Director, Mr B.C. Tripathi, said: “The net sales from natural gas trading during the first quarter increased by 17 per cent to Rs 5,452 crore and revenue from natural gas transmission business rose by 22 per cent to Rs 897 crore.”

“During the quarter GAIL's revenue from LPG transmission increased by 8 per cent to Rs 114 crore and the net sales from LPG and liquid hydrocarbons business increased by 14 per cent to Rs 781 crore,” he said.


Buy on dips around 430 levels and hold for a target of 525.

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