Mahanagar Gas: Growth in the pipeline

Underpenetrated markets coupled with favourable regulatory conditions should keep the company on the growth path

The market is seeing a raging bull run, but not all stocks have been running up breathlessly. Since early November, the stock of Mumbai-based city gas distributor Mahanagar Gas has fallen about 20 per cent. This seems primarily due to concerns about tepid volume growth in the September 2017 quarter. Profit booking in the stock that has more than doubled since its initial public offer (IPO) in June 2016 could also have contributed to the weakness. The fall though presents a good buying opportunity for investors with a long-term perspective.

At ₹1,045, the Mahanagar Gas stock quotes at 23 times its trailing 12 month earnings, lower than the average 25 times it has traded at since listing. The stock is also cheaper than peer Delhi-based Indraprastha Gas that now trades at about 35 times earnings. While Mahanagar Gas is smaller than Indraprastha Gas, there is scope to narrow the valuation gap that has increased in recent months.



Big demand potential



On the business front, volume growth is expected to improve by 1-2 percentage points in the second half of the year from the 4 per cent level seen in the September 2017 quarter. GST implementation and lower compressed natural gas (CNG) demand by state transport undertakings affected volumes in the September quarter.

The management expects volume growth in the second half of the FY-18 to be better than the first half, driven by factors such as registration of about one lakh new three-wheelers and expansion in new areas of operation such as Raigad. Mahanagar Gas should also benefit from the increasing competitiveness of CNG vis-à-vis diesel and petrol that have seen sharp price hikes recently.

CNG supply to vehicles is the company’s major business, accounting for about 75 per cent of volumes. Domestic PNG supply to households is the next biggest segment accounting for about 12 per cent of volumes. PNG supply to commercial and industrial establishments make up the rest of the volumes. Compared with alternative fuels such as petrol, diesel and liquefied petroleum gas, CNG and PNG are cleaner fuels and offer significant cost benefits to consumers. Increasing price differentials bode well for city gas distributors such as Mahanagar Gas which also enjoy strong pricing power to pass on cost increases.

The company’s volume growth has been driven by steady conversion of vehicles to CNG and more households opting for PNG. In its mainstay market of Mumbai and surrounding regions, the company supplies CNG to about 5.8 lakh vehicles and PNG to about 10.5 lakh households, 3,250 restaurants and about 230 industrial and commercial establishments. There is still significant potential in the market with penetration estimated in the range of 32-35 per cent for vehicles, households and restaurants, and about 50 per cent for industrial and commercial establishments.

On an average, about 6,000 vehicles including private cars and three-wheelers convert to CNG each month in and around Mumbai.

Mahanagar Gas ran a pilot programme in Mumbai with CNG-run two-wheelers and found significant operating cost savings (about 50 per cent) vis-à-vis petrol-run two-wheelers. The company hopes to have about 1,000 CNG-run two wheelers on the road in the near term, to start with. The initiative, if successful, could mean another big opportunity for the company with the market potential of about 18 lakh two-wheelers.

Strong barriers to entry give incumbents in the city gas distribution (CGD) business such as Mahanagar Gas an advantage, make it difficult to dislodge them from their existing areas of operation. Besides, the government has ambitious plans to expand the CGD network across many cities. This can present good opportunities for seasoned players such as Mahanagar Gas.



Cost advantage



The government’s thrust to promote clean fuel has resulted in favourable regulatory changes for CGDs such as Mahanagar Gas. Companies supplying CNG to vehicles and PNG to households have been given top priority in domestic gas allocation. Mahanagar Gas gets nearly 85 per cent of its revenue from these businesses. The price of domestic gas has come down sharply over the past few years, thanks to the formula-based pricing mandated by the government. Domestic gas prices have risen somewhat in the latest revision, but are expected to stay benign. The cost of imported gas used to supply PNG to commercial and industrial customers had also come down sharply due to weakness in international prices, but has risen of late. But with prices of alternative crude-oil based fuels also shooting up, CGDs such as Mahanagar Gas with good pricing power are in a position to pass on cost hikes.



Strong financials



Despite tepid volume growth, the company’s profit in the half-year ended September 2017 increased nearly 28 per cent y-o-y. Cost benefits, thanks to cheap gas, helped. Passing on a portion of the cost benefit to customers meant revenue growth of just about 6 per cent during the half-year ended September 2017, but operating margin grew to about 40 per cent from 34 per cent in the year-ago period. The company is incurring capital expenditure of about ₹250 crore a year to expand its infrastructure and widen market reach. A strong balance-sheet will help fund the expansion.

Risk

The possibility of a shift to electric vehicles could disrupt the transportation and fuel markets. But given the many challenges — economic, technological and infrastructural — the shift, if it happens, may take quite some time to materialise. In that scenario too, suppliers of clean fuels such as CNG should be better placed and may be able to hold their own better than suppliers of more polluting fuels such as petrol and diesel. That said, investors should keep a watch on developments and make course corrections if the need arises.

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