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GAIL: In a tight squeeze

May 3, 2005

Performance summary
GAIL, the country's largest gas transmission major, has announced its financial results for the full year ended FY05. While growth at the topline level is commendable owing to higher volume of gas transmitted during the fiscal in light of new supplies, margins have been affected due to government policies. This is reflected in the slower growth in the bottomline of 4% YoY for FY05. Net profit in 4QFY05 has actually declined.

(Rs m) 4QFY04 4QFY05 Change FY04 FY05 Change
Net sales 29,724 33,084 11.3% 108,267 124,348 14.9%
Expenditure 21,770 25,760 18.3% 85,760 99,134 15.6%
Operating profit (EBDITA) 7,953 7,324 -7.9% 22,507 25,214 12.0%
EBDITA margin (%) 26.8% 22.1%   20.8% 20.3%  
Other income 3,625 3,508 -3.2% 13,628 15,016 10.2%
Interest 329 314 -4.3% 1,380 1,339 -2.9%
Depreciation 1,703 2,306 35.5% 6,611 9,399 42.2%
Profit before tax 9,548 8,211 -14.0% 28,144 29,492 4.8%
Tax 3,246 3,047 -6.1% 9,451 10,024 6.1%
Profit after tax/(loss) 6,302 5,164 -18.0% 18,693 19,468 4.1%
Net profit margin (%) 21.2% 15.6%   17.3% 15.7%  
No. of shares (m) 845.7 845.7   845.7 845.7  
Diluted earnings per share (Rs)* 29.8 24.4   22.1 23.0  
Price to earnings ratio (x)         9.1  
(* annualised)            

What is the company's business?
GAIL India is the country's largest gas distribution and transmission company with a pipeline network of over 4,500 kms across the length and breadth of the country. The company's HBJ pipeline is the lifeline for major gas consumers ranging from power and fertilizer sectors. GAIL accounts for nearly 95% of the gas business in the country. The company has also ventured into upstream gas exploration business and is a participant in the gigantic Myanmar gas fields, which are likely to commence production in 2007. Given the fact that GAIL is largely dependent on ONGC for its gas requirements, the exploration business holds prominence for the company.

What has driven performance in FY05?
Gas volumes robust:  Gas transmission during the year increased by 16% to 72.9 MMSCMD from 62.8 MMSCMD in FY04 (million metric standard cubic meters per day). This growth in volumes can be primarily attributed to the commencement of gas supply from the Petronet LNG terminal in Dahej (Petronet imports gas in liquefied from RasGas in the Middle East and post regassification, it is transmitted through GAIL's pipeline). Though the new supply of gas are priced higher (US$ 5.1 per MMBTU is the cost for Indo Gulf Fertilisers as per the agreement), considering the cost savings from the use of gas as compared to traditional fuels like naphtha, demand has not been an issue. It is not likely to be an issue going forward as well.

Segmental revenues…
(%) of sales 4QFY04 4QFY05 Change FY04 FY05 Change
Transmission - Natural gas 4,853 5,161 6.3% 19,874 21,851 9.9%
PBIT margin 56.9% 51.0%   67.4% 59.0%  
Transmission - LPG 765 778 1.7% 2,667 3,018 13.2%
PBIT margin 49.6% 25.6%   44.9% 29.4%  
Natural gas trading 16,486 20,606 25.0% 66,407 80,407 21.1%
PBIT margin 2.2% 6.3%   0.7% 2.9%  
Petrochemicals 4,092 6,463 58.0% 12,658 18,495 46.1%
PBIT margin 43.1% 46.0%   28.6% 43.9%  
LPG and liquid hydrocarbons 7,778 4,619 -40.6% 23,137 18,328 -20.8%
PBIT margin 59.5% 33.7%   45.3% 32.9%  
GAILTEL 65 55 -15.3% 205 189 -7.8%
PBIT margin -129.7% 259.1%   -42.9% -13.0%  
Overall PBIT margins 28.3% 23.2%   22.9% 20.9%  

During the fiscal year, LPG transmission was also higher by 16% to 2.1 million MT from 1.8 million MT in FY04. Though volumes are higher, the net realisation has been lower during the year owing to lowering of subsidy share of the government. GAIL is a participant to the LPG subsidy sharing scheme and despite this handicap, growth in FY05 has been impressive. As far as petrochemicals is concerned, it has been eventful year considering the global demand for petrochemicals (led by China, of course). Since polymer sales in FY05 are higher only by 17% to 319,000 MT, the rest of the growth has clearly come from better realisations. The company has been scaling down its presence in the telecom segment, which is reflected in lower revenues and losses during this fiscal. The overall topline growth in FY05 is in line with our full year estimates.

Margins - Outside the company's control:  Operating margins in FY05 have declined by 50 basis points (0.5%) despite higher subsidy share in LPG sale and the rise in input cost for its petrochemical operations. The key reason behind the same are higher gas transmission (without any significant additional expenses) and favorable petrochemical cycle. As is evident from the segmental margins, PBIT margins of the petrochemical division has almost doubled in FY05. At the same time, the trading margins have also risen, highlighting the benefit from economies of scale (more gas being supplied using the same facility). The rationalisation of the telecom division has lowered losses in FY05. In fact, this division has registered profits at the PBIT level in 4QFY05. From what it seems, the company has managed well on factors which are internal in nature. Government pricing policy is something beyond control and margins have to be viewed in this context.

Expansion limits bottomline growth:  While operating profits in FY05 grew by 12% YoY, net profit has grown at a much slower rate of 4% owing to higher depreciation charges. This could be attributed to the ongoing expansion of pipelines in the southern region combined with petrochemical expansion. Our bottomline estimate for FY05 was higher, as we expected the company to improve margins from higher gas supplies and favorable petrochemical cycle. But the increase in subsidy share has affected performance.

What to expect?
The stock currently trades at Rs 209 implying a price to earnings multiple of 9.1 times FY05 earnings (price to book value of 2.1 times FY05 book value). As we go forward, we believe that GAIL will be the key beneficiary from the National Hydrocarbon Vision plan in the longer-term. Demand for natural gas is expected to outgrow petroleum products in the next three years and given the expansion plans of corporate India, prospects remain promising at the topline level.

But there are question marks as to whether the growth will benefit GAIL at the net level. This is because of two key reasons. One, if the petrochemical cycle softens (as it has very recently), the overall profitability could come under pressure (this division contributed to 13% of the topline in and 28% of the overall PBIT in FY05). Secondly, the transmission charges payable to GAIL could be lowered in the future, which means that the already thin margins in the trading side will be squeezed. Besides these two factors, how the government policies with respect to subsidies will shape up is anybody's guess and therefore, increases the risk profile of the stock.

Having said that, we have always maintained that this business is characterised by high barriers to entry and it is not easy to replicate the kind of infrastructure that GAIL has easily. This, in our view, is a competitive advantage. Therefore, amidst risks, GAIL remains one of the preferred stocks in the energy sector from the long-term perspective (over 3 years).

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