The Hindu Business Line : Gujarat State Petronet: Invest

THE IPO of Gujarat State Petronet Ltd (GSPL) can be considered for investment with a two/three-year perspective. The returns on the investment being made by the company now in expanding its pipeline network will begin to be felt only from the later part of 2007-08. In the interim period, earnings could come under pressure from rising depreciation and interest costs.

The long-term prospects for the company will be promising once the expansion plan is completed, as natural gas is a prime energy source in Gujarat, which is a fast-growing gas market. The company has the advantage of operating in a region where there is likely to be increasing availability of natural gas from imports and domestic sources.

With its network of pipelines linking supply sources to consumption centres fully in place, GSPL will be well-positioned to exploit the growing gas market in the region.

Unique business model

When it lists on the market, the GSPL stock will be the first pure transmission play in the gas sector. GAIL and Gujarat Gas, the two other listed gas companies, are into both transmission and marketing with the bulk of the revenues coming from the latter.

GSPL is an "open access" gas transmission pipeline operator, which means that it offers the service of transporting gas to customers who have the demand and have tied up the supply source.

Consequently, GSPL will not be subject to any commodity price risk, as its responsibility is restricted to transporting the gas only.

The flip side to this, however, is that revenue growth can come only from increasing transportation volume, as marketing margins will be absent.

The IPO is meant to part-fund the expansion plan of the company, which operates a 433-km pipeline from Hazira in south Gujarat to Kalol, near Ahmedabad. GSPL will add a further 742 km of pipelines and branch into untapped areas of the State such as Morbi, known for its ceramic tile industry, and to Rajkot.

GSPL will have an extensive pipeline presence in the State but the critical factor will be building a market for gas in these untapped areas, especially given that such gas will be priced at free-market levels.

What lends confidence though is that the competing fuels such as naphtha are priced higher than natural gas, a factor that could help develop a market for the latter.

Parent's backing

The support of Gujarat State Petroleum Corporation(GSPC), an oil and gas exploration and production company, which is also the parent of GSPL, lends a great measure of confidence.

GSPC presently uses GSPL's pipeline to market the gas it sources from Petronet LNG and has indicated that it will use the GSPL network, wherever available, to transport its gas.

Competition is limited in the form of GAIL's cross-country network that passes through Gujarat and Gujarat Gas' pipelines, but there will be no competition in the new pipeline sections that GSPL is now planning.

Unlike GAIL, GSPL charges users based on the distance it transports the gas, which means that it is price-competitive compared to the former. GSPL has short, medium and long-term contracts for transport of gas with the bulk of business coming from medium term contracts that are of five years duration.

Customer profile

Power producers account for a little over half of GSPL's customers while fertiliser and steel producers account for 13 per cent each.

About half Gujarat's installed power capacity is gas-based and this proportion is only likely to increase in future, given the relatively easy availability of gas in the State compared to coal.

Given this dependence of the State on gas-based power, such plants cannot afford to shut down which, in turn, means that GSPL is assured of a committed transmission volume from these customers.

Rising charges

Given the capital investment in new pipelines, depreciation is likely to rise sharply over the next few years. Until the company begins to operate its new network at full capacity levels, which could possibly be only by 2008-09, earnings at the post-tax level could come under some pressure.

Of course, cash profits generation should be comfortable assuming that GSPL is able to utilise the new pipelines to capacity.

Similarly, interest costs could rise following the increase in loans from about Rs 500 crore now to almost Rs 1,400 crore.

While the debt-equity will still be at normal levels, the rising interests costs could stifle earnings growth.

The regulatory risk

The Petroleum Regulatory Board Bill is pending in Parliament. An earlier draft pipeline policy of the government had indicated that GAIL would be the nodal agency for implementing pipelines in the country but this was opposed by the industry.

The Bill, however, proposes to empower the regulator who will be set up soon, to grant permission for pipeline construction and finalise open access norms.

This is an uncertain variable, as it is not known now how the policy will evolve on this front.

Assuming that fetters are not placed on who can lay pipelines, GSPL has the option of branching out of Gujarat at a later stage in pursuit of new business.

Pricing and valuation

The offer price of Rs 23-27 and price-earnings multiple of 29 (on fully diluted equity and earnings of first half of this fiscal) at the upper end appears steep in the light of the past performance of the company.

GAIL and Gujarat Gas, which enjoy superior margins and have a presence in marketing gas, are discounted at just nine and 18 respectively based on latest available earnings.

Though GSPL's valuation appears stiff, it should be pointed out here that the company is on the investment mode now and building up its business; at this stage, cash profits are likely to be the focus and here the company is on a strong wicket.

PEM comparisons at this stage could, therefore, be misleading. The fact is that the business prospects appear good and the bottomline is that investors should not expect large gains in the near term while investing in this IPO.

Offer details: The offer of 13.80 crore shares, which will take the equity base to Rs 542 crore, opens on January 24 and closes on January 28.

The lead managers are Kotak Mahindra Capital Company and HSBC Securities.

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