Potential in pipeline - GAIL (India) : Buy

The company is well-poised to ride the supply wave, whether the thrust is provided through domestic sources of gas or imported liquefied natural gas.



Investors with a long-term perspective can consider investing in GAIL (India), the country's dominant gas transporter. At its current price of Rs 461, the GAIL stock discounts its trailing 12-month earnings by around 16 times, lower than its historic valuation levels.

Even as gas importers such as Petronet LNG and city gas distributors such as Indraprastha Gas were the toast of the bourses over the past year, GAIL India had a lacklustre run, with its scrip registering only a marginal rise. A combination of factors has contributed to the poor showing.

An unexpected decline in the supply of domestic gas supply from Reliance's KG-D6 fields raised concerns about GAIL's significantly expanded gas pipeline infrastructure being underutilised and affecting profitability.

Also, the government's flip-flop last fiscal on the extent of subsidy-sharing by the upstream companies, including GAIL, added to the jitters. The increasing competition in the gas transmission business with expansion plans of players such as GSPL also played its part. These concerns however seem overdone.

Gas imports increase

The fallout from the dip in domestic production from the KG-D6 fields over the last year has been also felt on GAIL's gas transmission business, which accounts for around half the company's profits. However, we expect the company, which has been bolstering its pipeline infrastructure, to beat the odds in the long term. The dynamics of the natural gas industry in India should help GAIL make optimal use of its expanded pipeline network. Given its clear cost benefits over most other substitutes, the demand for natural gas in the country outstrips supply, and this scenario is likely to continue.

To meet this demand, imported gas (regassified LNG) is rapidly stepping in to fill the vacuum left by the domestic gas shortfall. This is apparent in the strong volume and profit growth registered by Petronet LNG over the last year. There are ambitious plans underway in the industry to significantly expand the capacity of existing LNG terminals and also set up new ones on both the West and the East Coast.

GAIL, which is in the process of expanding transmission capacity (from around 170 mmscmd to 300 mmscmd), and its pipeline network (from 8,000 kms to 14,000 kms) in the next three years at an outlay of around Rs 30,000 crore, will be well-poised to handle the increased gas flow.

Meanwhile, if Reliance Industries manages to get gas output back on track, or production commences from new domestic sources such as ONGC's or GSPC's fields in the KG basin, that too should benefit GAIL's prospects. In essence, the company is well-poised to ride the supply wave, whether the thrust is provided through domestic sources of gas or imported liquefied natural gas.

In the interim, GAIL itself has been increasing the import of spot cargoes to meet demand, which has helped improve margins of its gas trading business. This is likely to continue. The company also plans to double the capacity of its petrochemicals business, which accounts for more than 20 per cent of its operating profits.

Subsidy concerns

While subsidy-sharing continues to be an irritant for GAIL, despite the recommendations of many expert committees to exempt it, the company, thanks to its relatively minor share in the burden, is less affected.

For the most part, the company has been putting up a good show in spite of the subsidy overhang. The exception was in the March quarter of FY-11 when a sharp increase in the upstream subsidy burden for the fiscal (from 33.3 per cent to 38.7 per cent) resulted in GAIL report a profit decline.

The latest June quarter saw a return to upstream companies bearing around a third of the burden. Further, GAIL's share of the upstream burden also reduced to 4.7 per cent from around 7 per cent in FY-11.

This is an encouraging sign, though it remains to be seen whether it will be sustained. Also, the government's move in late June to increase the prices of petroleum products and reduce taxes should help moderate under-recoveries.

Competitively positioned

On the competition front, given the seemingly insatiable demand for gas in large parts of the country, the ocean seems large enough to easily accommodate more than one big fish.

GAIL has a first-mover advantage and controls 75 per cent of the gas transmission business in India. New high-potential markets such as South India, where GAIL is leading the expansion charge, could open up substantial vistas for growth. Also, similar to many infrastructure projects, increased gas supply and new pipelines is expected to spur latent demand.

Strong financials

GAIL's good financial performance and its robust balance-sheet strengthen its case. In FY-11, the company's consolidated revenues grew around 30 per cent year-on-year to Rs 35,107 crore while profits increased around 21 per cent to Rs 4,021 crore. This was aided driven by an increase in transmission volumes and marketing margins on administered price mechanism (APM) gas.

The latest June quarter has seen turnover increase by 25 per cent to Rs 8,867 crore and profits grow 11 per cent to Rs 985 crore. Margins, though, have declined due to increased cost pressures and the expansion in progress. The company's low debt-to-equity (0.12 as of March 2011) provides adequate room for leverage to fund further expansion.

Major success in its exploration and production forays, while so far elusive, will also boost the company's prospects. Besides, investments in Petronet LNG and Indraprastha Gas, which have been on a strong wicket, should help GAIL.

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