Hurdles in the Pipeline

GAIL, a natural gas transmission company which was started in the late eighties, has grown organically by building large networks of natural gas pipelines covering over 8,500 kms and having a capacity of around 170 mmscmd (million metric standard cubic metres per day). It is India’s largest natural gas transmission and trading company. About 75 per cent of its transmission business and 50 per cent of its trading business is carried within India.

Positives
Superior margins. The company uses natural gas from the Panna-Mukta-Tapti fields as feedstock for its petrochemical plant. The price of this gas is fixed, which gives the company a high operating leverage. The bottom line of its petrochemical business is affected mainly by an increase or decrease in the international price of polyethylene (a key output).
The company’s petrochemical business also enjoys a cost advantage vis-à-vis rivals: the cost of the gas that it uses is less than one-third the cost of the naphtha that other petrochemical producers use. Hence, GAIL enjoys superior EBITDA margins of around 45-50 per cent while its peers have an EBITDA margin of barely 15-20 per cent. According to a report from Ambit Capital, the availability of low-cost gas supply for the ongoing expansion at Pata (where the company plans to double its capacity) and expectation of strong polyethylene prices will sustain its positive margins.
Assured returns. GAIL has five approved but unbuilt pipelines. According to a report by Edelweiss Securities, these pipelines have been assured a post-tax return on capital of 12 per cent with uncapped leverage. The assured return on capital on pipeline investments reduces risks and provides visibility to the company’s earnings.
No tariff uncertainty. There is no tariff uncertainty for GAIL as the Petroleum and Natural Gas Regulatory Board (PNGRB) has approved tariffs for its key new DVPL-GREP upgradation pipeline. PNGRB has also approved the tariffs for its key existing pipelines. The old HVJ-GREP-DVPL pipeline tariffs got reduced around 11 per cent and the new DVPL-GREP upgradation pipeline saw a tariff approval that was 110 per cent higher than that of the older pipeline owing to significantly higher capital expenditure (capex) on the new network. Moreover, as its old HVJ-GREP-DVPL pipeline, which accounts for around 50 per cent of GAIL’s transmission volumes, is operating at full capacity, the incremental volume is flowing through the new DVPL-GREP upgradation pipeline which is parallel to the old HVJ-GREP. Analysts at Ambit believe that as the tariff for the new DVPL-GREP upgradation pipeline is more than twice the tariff for the old HVJ-GREP-DVPL pipeline, GAIL’s weighted average tariff is expected to increase at a compounded annual growth rate (CAGR) of 4.8 per cent over FY11-FY15. This growth in tariff will offset some of the weakness due to slower growth in transmission volumes.
Subsidy overhang exists but least impacted PSU. GAIL shares the subsidy burden of oil marketing companies on account of under-recoveries. LPG and other liquid hydrocarbon businesses have historically been affected by the subsidy burden. GAIL, however, bears the subsidy burden only on cooking fuel. When the price of crude oil rises, the bulk of incremental under-recoveries arise from diesel. GAIL does not share the subsidy on diesel. Therefore, among oil PSUs, GAIL is the least affected by a spike in the price of crude oil internationally.
Moreover, while the deregulation of diesel appears unlikely for the present, the subsidy burden on cooking fuel could decline significantly over the next few years due to better targeting of the subsidy. According to a report by broking house Ambit Capital, the government plans to restrict the supply of subsidised LPG cylinders from four to six per family per annum. Such a measure could potentially lower the subsidy burden on LPG by 30-40 per cent. This could in turn boost GAIL’s earnings per share (EPS) for FY13 by 11 per cent.

Opportunities
Aggressive expansion plans. Over the last three years (FY09-11), GAIL’s capex has increased by a remarkable 172 per cent. The company has aggressive capex plans even in the future.
Between FY12-14, GAIL plans capex of Rs 28,641 crore: Rs 7,692 crore will be spent in FY12, Rs 11,327 crore in FY13, and Rs 9,622 crore in FY14. Of this 39 per cent will be spent on pipelines, 29 per cent on petrochemicals, 7 per cent on E&P, and 25 per cent on other verticals.
These aggressive capex plans will call for bborrowings both from the domestic and the international markets. Altogether the company plans to borrow around Rs 13,675 crore to fund its capex plans. A majority of the borrowings (around 46 per cent) will come from term loans, 34 per cent will be raised by issuing bonds, and 18 per cent will be provided by the Oil Industry Development Board (OIDB).
The company’s high capex plans of the last few years have had a significant impact on its financials. Its dividend payout ratio, for instance, has declined significantly. In FY09 its dividend payout ratio stood at 31.4 per cent; this had declined to 23.7 per cent by FY11. In addition, the company’s borrowings have also increased significantly during this period. Over the last three years its total debt has grown at a compounded annual rate of 22.2 per cent. Its return on capital employed (RoCE) has declined by around 2.14 percentage points between FY08 and FY11, though it has always stayed above the 20 per cent mark during this period.
Owing to its significant capex plans, the company’s free cash flow has turned negative in the past two years.
Doubling capacity by FY14. The company plans to double its pipeline capacity from 170 mmscmd to 340 mmscmd. Its capacity expansion plans will get implemented two years ahead of that of its chief rival, Gujarat State Petronet Ltd. (GSPL). This is expected to create high entry barriers and significantly reduce the threat of competition for GAIL.
But with production from the KG D6 Basin being half of what was originally envisaged, and given the delays in the development of other key gas blocks, the supply outlook for domestic gas has deteriorated significantly. According to a report by Ambit Capital, the slow growth in transmission volumes will result in pipeline capacity utilisation languishing at 30-40 per cent over the next two to three years. This will drag GAIL’s RoCE from the gas transmission business to 17-18 per cent between FY12 and FY14.
But the flow of gas is expected to pick up from FY15-FY16 due to import of LNG and also due to improvements in supply from domestic sources. Analysts at Ambit expect the company’s utilisation level to improve to 50-60 per cent and RoCE to rise to 19-22 per cent by FY15-FY16.

Concerns
A possible decline in the international price of polyethylene could hit GAIL’s petrochemical margins as it has high operating leverage due to the fixed-cost nature of its feedstock. Moreover, a high subsidy burden of over Rs 1 trillion for the sector in FY12 will continue to be a drag on the stock.

Valuation
The stock is currently trading at a price-to-earnings (P/E) ratio of 12.96 (as on December 23) which is below its five-year median P/E of 13.7. But based on a TTM EPS CAGR of 12.8 per cent over the last five years, its price-to-earnings to growth (PEG) ratio comes to an unattractive level of one.
The company has substantial capex slated ahead for transmission pipelines. It also has significant plans in the city gas distribution space which could be value accretive. The absence of tariff risk is another key positive for the stock. However, the stock currently looks expensive based on its PEG ratio.
The stock’s fortune will be contingent on the visibility of gas supply, which appears bleak currently. Therefore, wait for some time till both valuations and visibility of gas supply improve.