Gujarat Gas: Buy

Investors with a high-risk perspective can buy the stock of Gujarat Gas, the country's largest private city gas distributor (CGD) by sales volume. Prospects of aggressive bidding for promoter BG Group's stake in the company, good growth potential, strong pricing power, and reasonable valuation support our recommendation. At its current price of Rs 397, the stock trades at around 15.5 times its trailing 12-month earnings, lower than the levels it had traded in the past. If BG Group's stake sale happens at a premium to the prevailing market rate, minority shareholders would also benefit from the mandatory open offer for 26 per cent stake from public shareholders.

Bidders line up

The Gujarat Gas stock, after declining sharply over the last couple of months, has recouped some lost ground. The stock fell steeply since early November when BG Group announced its intent to sell its stake (about 65 per cent) in the company.

The announcement triggered concerns of Gujarat Gas losing the backing of the global hydrocarbon major in its gas sourcing efforts, especially when it is becoming increasingly dependent on imported liquefied natural gas (LNG).

Also, margin pressure due to rising LNG cost and a dip in profits in the September quarter on a sequential quarter basis took a toll. However, over the last fortnight, the stock has made a comeback, aided by the steep price hike taken by the company in end-December. Besides, there are reports of interest being evinced by several players for the stake buy from BG Group. The bidders are said to include the Adani Group, and also hydrocarbon majors such as GAIL, GSPC, BPCL, HPCL, Indian Oil, and Oil India. Many of these companies already have a presence or have plans to enter the high-potential CGD business in the country.

The winning bidder may have to pay a premium for BG Group's stake in Gujarat Gas. The company operates in the Surat, Bharuch and Ankleshwar regions of Gujarat, a State with a well-developed gas sourcing and distribution infrastructure. It currently distributes around 3.5 mmscmd of gas to more than 3.3 lakh industrial, commercial, domestic and CNG customers through a network of around 3,900 kilometres. Gujarat Gas has also bid for the gas distribution business in Bhavnagar district. Strong economic growth and high industrialisation have translated into growing demand for gas in Gujarat.

The ready, extensive distribution network of Gujarat Gas in key markets of the state make BG's stake sale an attractive buying opportunity for many interested investors.

Setting up a gas distribution network from scratch is an expensive and time-consuming affair. With the CGD business in Gujarat set to grow at a healthy pace, BG Group can expect to realise a good price. While the details of the bids are not yet known, reports suggest that they could be in the range of $600 million to $800 million, which would translate into a per share value of around Rs 370 to Rs 490. At the current market price, BG's stake in the company is worth around $650 million.

For minority shareholders, the acceptance ratio in the open offer (ratio of shares accepted to those tendered) will be quite high (around 75 per cent), even if all non-promoter shareholders who hold around 35 per cent in the company tender their holdings.

Pricing power

Gujarat Gas has regularly exhibited its ability to pass on cost hikes. The latest such hike was in December 2011, when it raised price for the industrial segment (more than four-fifth of the company's sales) by more than 20 per cent.

This has alleviated, to a good extent, concerns of margin pressure due to the growing component of costlier, imported gas in the company's portfolio. While the December quarter would continue to see margin pressure, the latest price hikes should reflect positively in the coming quarters.

Gujarat Gas, after a decline in sequential quarter volumes in the first half of 2011 (the company follows a calendar year), managed a good 8 per cent growth in the September quarter (326 mmscm). The impact of the recent price hike on volumes though needs to be seen. In the medium term, LNG prices are expected to moderate which should help the company improve off-take.

Also, if the company wins the Bhavnagar bid, there could be good upside in volumes. Besides, more than a third of the proposed Delhi Mumbai Industrial Corridor project passes through Gujarat and covers the company's areas of operation. This should also aid volumes.

Sourcing concerns

With domestic supplies falling, the company has been increasingly resorting to imported gas to meet its requirement. There have been concerns that with BG exiting, Gujarat Gas may have trouble sourcing LNG at competitive rates.

However, most bidders being established names in the oil and gas business are likely to have the bandwidth to support the gas sourcing initiatives of the company. Besides, a chunk (in excess of 60 per cent) of the company's gas supply at current levels is tied up until 2018.

Healthy Financials

Notwithstanding the dip in sequential margins and profits (down 16 per cent) in the September quarter, Gujarat Gas still posted healthy operating margins of around 20 per cent, and net margins of around 13 per cent. On a year-on-year basis, growth in the first nine months of 2011 was robust with sales rising around 33 per cent and profits growing by 42 per cent. The December quarter may disappoint on a sequential basis, but recent price hikes should aid performance in 2012. The company has negligible debt, and also yields high dividend (dividend yield was more than 3 per cent in 2009 and 2010).

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