The GAIL stock appears overvalued at current price given the serious worries over the company's earnings growth prospects in the medium term.

Raghuvir Srinivasan

Transmission business growth slows
Margin erosion from higher feedstock prices
Access to reserves a challenge

Shareholders of GAIL (India) may consider exiting the stock at current valuation. The company's performance in 2006-07 points to some serious worries over its earnings growth prospects in the medium term. GAIL appears to be hemmed in by growing competition in its core business of gas transmission even as higher gas prices are set to erode margins in its petrochemicals and LPG (liquefied petroleum gas) businesses, something that was already felt in 2006-07.

Primary dependence on the Bombay High field, which is struggling to increase gas production volumes, and the absence of adequate replacement for this is likely to affect the gas marketing business, unless the company hits pay dirt in its upstream exploration activity. There is also the added regulatory uncertainty of a demerger of the gas transmission business and its impact on the company. All these factors point to a significant downside in the stock from current levels.

Pointers from performance

The gas transmission business is the prime earnings driver for GAIL bringing in 57 per cent of the EBITDA (earnings before interest, depreciation, tax and amortisation) and it could be under siege from competition. GAIL has about 85 per cent share of the transmission market in the country but this is likely to drop significantly once Reliance Gas Transportation Infrastructure Ltd. (RGTIL) starts operations, moving gas from the KG Basin fields.

RGTIL will obviously get the first right to transport the KG Basin gas and it is already implementing an east-west pipeline originating at Kakinada (Andhra Pradesh) and terminating in Gujarat; it is also likely to construct the other major trunk pipelines to Mangalore via Chennai and Bangalore and to Howrah from Kakinada.

GAIL has signed an MoU with Reliance for onward transport of the KG Basin gas via its Hazira-Bijaipur-Jagdishpur trunk pipeline to the North but the terms, such as the quantity and the price, are unknown now. It would, therefore, be premature to project an increase in volumes based on this MoU.

Gas transmission volumes were 2 per cent lower at 77.28 million metric standard cubic metres per day (MMSCMD) in 2006-07 compared to the previous year and this was despite an overall increase in gas availability and consumption in the country. Gujarat State Petronet Ltd. (GSPL), a subsidiary of Gujarat State Petroleum Corporation, is growing fast in the mature gas market of Gujarat and has already linked up the southern part of the State with the western end. GSPL has succeeded in taking away some of the volumes from GAIL within the State.

GAIL's gas transmission volumes have been showing a declining growth trend the last three years; they grew 14 per cent in 2004-05; 10 per cent in 2005-06 and fell by 2 per cent in 2006-07. As competition intensifies, from 2007-08 the trend of slowing growth is only likely to intensify especially as GAIL is effectively out of some of the major trunk pipelines being planned to transport gas from the KG Basin to the western and southern parts of the country.

Margin erosion

Higher prices for gas used as feedstock for the petrochemical and LPG divisions caused a dent of Rs 800 crore on the bottomline during 2006-07. GAIL has been forced to pay market prices for captive consumption of gas as the production from the Bombay High declines and is fully consumed by the priority consumers in fertiliser and power sectors. GAIL now pays around $4.75 per million British thermal unit (MMBTU) compared to $2 per MMBTU two years ago.

The polyethylene capacity is set to increase to 4.10 lakh tonnes per annum (3.10 lakh tonnes now) from the second quarter and the incremental capacity will be driven mainly by gas sourced in the spot market at rates that are substantially higher than what GAIL pays now. Buoyant polyethylene prices protected margins last fiscal but they may not be enough to cover up for the higher input costs for the incremental capacity.

Meanwhile, the sword of subsidy-sharing hangs over the LPG business. GAIL's subsidy burden rose more than 45 per cent in 2006-07 and a continuation of the one-third sharing mechanism would mean a similar outgo this year as well.

Problem in gas sourcing

The biggest problem that GAIL will face compared to its competitors, RGTIL and GSPL, is that it has no assured gas supply source in place for the future. While RGTIL and GSPL can source from their parents' reserves in the KG Basin field, GAIL has only the Bombay High gas and regassified LNG from the Dahej plant of Petronet LNG that it markets.

GAIL has rights to market 60 per cent of Petronet LNG's gas sourced on long-term basis and a third of the gas sourced in the spot market. Though gas volumes from Petronet LNG are slated to increase they will be at substantially higher prices likely in the range of $6-8 per MBTU. The company appears to be banking on gas piped in from Iran and from Myanmar, but both these projects appear non-starters for now. While the Iran pipeline is mired in political uncertainty, Myanmar has signalled its intent to convert the gas from its offshore field where GAIL holds a 10 per cent equity stake, into LNG and ship it out.

LNG imports from the Gorgon project of Chevron in Australia and from Algeria through Dabhol and Shell's Hazira LNG import terminal are the other options being explored but the Gorgon project may not ship out its first LNG before 2012.

The picture can change dramatically though if GAIL strikes gas in any of the 27 blocks where it has secured the rights to explore. This is not an unlikely possibility given that five of the blocks are in the same KG Basin area where Reliance has struck gas and three more are in the Mahanadi basin. Such a development will be critical for GAIL to maintain its predominance in the market.

Demerger?

GAIL will have to hive off the transmission business soon as regulations and the regulatory board are in place. This adds to the uncertainty for shareholders because transmission earns more than half the profit and the left-over businesses of gas trading and processing are low margin and commodity businesses respectively.

Given these circumstances, the stock appears overvalued at current levels. It has already shed 10 per cent in the last week but further downside appears likely. Shareholders may exit now and watch the stock for acquisition at lower levels.

(This article was published in the Business Line print edition dated May 13, 2007)
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