Gail India

Gail's high valuations appear unjustified in view of uncertainties over earnings and its long-gestation investment plans

   ALTHOUGH Gail India continues to remain a fundamentally strong company, its rich valuations are now indicating a limited upside in the short term. The company is entering a heavy investment phase in its core business to quadruple its gross block in five years. At the same time, the subsidies and E&P (exploration and production) expenditure have raised uncertainties over its earnings. Fresh investments should be avoided at the current valuation.

BUSINESS:

Gail operates India's largest natural gas pipeline network with a current length of 7,200 km and a transmission capacity of 150 million metric standard cubic metres per day (MMSCMD). It also produces over 1.3 million tonnes of liquid hydrocarbons including LPG and 4.1 lakh tonnes of polyethylene per annum.
   In a bid to secure its raw materials, the company has also invested in 30 exploration blocks including operatorship in two. The company is investing in the entire value chain of the natural gas business and owns promoter's stakes in Petronet LNG and seven city gas distribution companies including Indraprastha Gas. The company has also floated a subsidiary, Gail Gas, for CNG stations along highways. Its 70% subsidiary, Brahmaputra Cracker, recently obtained financial closure for its 280,000-tpa polymer unit in Assam with an investment of Rs 5,460 crore.
   The Petroleum and Natural Gas Regulatory Board (PNGRB), constituted in October '07, has laid out rules for determining tariffs for existing and new pipelines with effect from November '08. When the change takes place, Gail will have to account for its impact on profits with retrospective effect.

FUTURE PLANS:

The company is expanding its pipeline network substantially to add another 6,600 km of pipelines within the next three years. In addition, it is investing in its E&P blocks besides investing in its joint venture projects such as Brahmaputra Cracker and ONGC Petro Additions. The projected capital expenditure for the next five years is Rs 49,155 crore - almost thrice its current gross block.
   In the near term, the rising production from Reliance Industries' KG basin fields will bring in additional transmission revenues for the company, while any E&P success could add to future growth visibility. But rest of its projects will take long to generate returns.

FINANCIALS:

Over the last three years, the company has spent an average of Rs 270 crore annually on the E&P business towards survey and dry well expenditure. So far, in the first nine months of FY10, it has written off Rs 108 crore. As a result, the company is likely to write-off another Rs 150 crore in the March '10 quarter. The company has been cash rich with over Rs 3,000 crore of annual operating cash flows. However, its ambitious investment plans for the next five years will necessitate it to raise debt of Rs 28,700 crore in the next five years. Since FY04, Gail is sharing subsidy on LPG and has so far contributed Rs 8,200 crore on a cumulative basis. Subsidy sharing has always remained the most influential factor for Gail's profits and which will remain equally uncertain in future as in the past. A reduction in subsidy burden was the key driver of Gail's good performance in the December '09 quarter. Over the last five years, the company's net sales have grown at a cumulative annual growth rate (CAGR) of 15% and net profit at a CAGR of 10%. In the nine months ended December '09, the company's profits are only marginally higher than that of the year-ago period.

VALUATIONS:

At the current market price, the scrip is trading at a price-to-earnings multiple (P/E) of 17.7. This is comparable with its smaller peers such as Gujarat Gas, Gujarat State Petronet and Indraprastha Gas. Based on the estimated earnings for FY11, the scrip is trading at a P/E of 14.1. Considering the uncertainties attached to the earnings, this valuation is not attractive for fresh exposure in the scrip.