Investors with a high-risk appetite can consider taking exposure to the stock of Indraprastha Gas, the monopoly city gas distributor in Delhi. The stock took a deep cut (around 40 per cent) on April 9-10 and has slipped further since then. This followed the downstream regulator PNGRB's directive to the company to slash network tariff and compression charge by around 60 per cent — with retrospective effect from April 2008.

The market reaction was on expected lines. The proposed cuts would result in the company potentially facing losses on its operations. The retrospective effect would entail payout of around Rs 1,500 crore and erode its net worth. Indraprastha Gas has sought relief from the Delhi High Court. Till the case reaches conclusion, it will be business-as-usual for the company, and tariff and rates will not be cut.

Much hinges on the outcome of the legal process. If PNGRB's directive is upheld by the Courts, there could be more pain in store for the Indraprastha Gas stock. A positive verdict for the company, on the other hand, could see the stock bounce back and recoup losses.

Our buy recommendation on Indraprastha Gas is based on the prevailing attractive valuation of the stock, and optimism about at least partial relief to the company.

Indraprastha Gas currently seems to have leeway to adjust marketing margin to mitigate potential dip in network tariff and compression charge. But for recent regulatory troubles, the company is a solid franchise with good business prospects, strong competitive position and robust financials. At its current price of Rs 225, the stock discounts its present trailing twelve month earnings by around 11 times.

Case strengths

Indraprastha Gas was set up in the late 1990s on the directions of the Supreme Court of India to combat air pollution in the national capital region. Today, its pipeline network caters to a wide range of compressed natural gas (CNG) and piped natural gas (PNG) customers in Delhi and surrounding regions. The company is integral to the fuel security of the national capital and this may work in its favour on the pricing issue.

Indraprastha Gas after the order has questioned the power of PNGRB to determine its tariffs, but it did submit its proposed tariffs to the regulator. The company has also questioned PNGRB's assumptions used to arrive at the tariffs and charges.

Marketing margin shield

For instance, the regulator has calculated the ratio of the company's actual capex spend to that proposed in 2009 and 2010, and applied this metric to extrapolate capex spend until 2025. Indraprastha Gas could argue that its higher actual capex spend in 2011 and 2012 should be considered to make projections. Likewise, in other areas of contention such as variable costs and volumes, there could be room to tweak the assumptions.

The possibility of an increase in marketing margin could also provide respite to Indraprastha Gas. The company earns its revenue from three sources — network tariff, compression charge, and marketing margin. Marketing margin is not yet within PNGRB's purview.

In the event of an unfavourable outcome in the case, Indraprastha Gas could adjust marketing margin to set off the negative impact.

The risk arises if marketing margin also comes under the ambit of the regulator. News in January 2012 about proposed caps on marketing margins of gas entities had taken a toll on many gas company stocks. Indraprastha Gas believes that the cap, if and when implemented, would not apply to it since it incurs expenses on the sourcing and marketing of gas. In any case, the process is likely to be long-drawn.

Also, given that so far, marketing margin was not regulated, Indraprastha Gas could possibly take this shelter to ward off the retrospective effect on network tariff and compression charge.

Robust business

Except the regulatory overhang, the company's business inspires confidence. Demand for natural gas is growing, given its cost advantages. The company has been raising prices to offset rising cost pressure due to costlier imported gas in its supply mix. This should help avoid a repeat of the December 2011 quarter when profits dipped 10.5 per cent. The company plans to spend Rs 2,200 crore in the FY-12 to FY-15 period to expand its network.

If Indraprastha Gas wins its bids for setting up city gas networks in Ludhiana and Jalandhar, it will be an added boost. The company's financial position before this development was robust with debt-to-equity of 0.45 (as on September 2011), providing room for leverage to fund expansion plans.

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