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GUJARAT GAS Improving outlook on volumes

About the Company
GGL is India’s largest City Gas Distribution company, with 25 CGD licenses spread across 41 districts in 6 states and 1 Union territory across the states of Gujarat, Maharashtra, Rajasthan, Haryana, Punjab and Madhya Pradesh and Union Territory of Dadra & Nagar Haveli.

Holding Disclosure:
Together with GSPL, the parent company, total 10% of my portfolio since past 2 months. Have been adding since PE has been falling even as performance remains good/improving. As seen from screener.in, PE is at historical lows, while performance and outlook is the best ever.

Preamble:
Discovered this after having invested in Gas space about 3 years ago when first starting my investment journey. First picks were Petronet LNG, GAIL, Mahanagar and Indraprastha Gas. Exited most of them after some disappointment by the modest gains within a year. 2017-18 were turbulent times to judge value!
Mostly the bet was pre-mature and in case of Petronet LNG I could foresee that it would be a laggard in the terminals business. Was shocked by Indraprastha gas re-rating and hence re-entered.

Objective is to create a thread for collecting/sharing ideas/opinions/information. The ValuePickr way!

Disclaimer:
Most of this article is credited to this report of BOB capital markets published a week ago:
https://www.barodaetrade.com/Reports/GujaratGas-CompanyUpdate30Dec19-Research.pdf

The analysts write:
At our recent meeting, GUJGA’s management assured robust outlook on volumes driven by (a) implementation of anti-pollution measures by the state government (new CNG state buses), and (b) relatively low LNG prices.
Volumes continue to trend above 9 mmscmd, as Morbi units sustain >6 mmscmd offtake, and carry additional 1-2 mmscmd potential. We raise GUJGA’s TP to Rs280 (from Rs270), as we roll forward valuation to Mar’21.
At 12.7x FY22 EPS, GUJGA remains most attractively value among its peers.

Buoyant volume outlook:
Ceramic units in Morbi (Gujarat) continue to offtake >6 mmscmd volumes, and carry potential for another 1-2 mmscmd as new units get connected. Concerns on Morbi customers shifting to GAIL for sourcing gas seems to have alleviated, as GUJGA’s pricing remains most attractive, along with its commitment to add incremental pipeline capacity to connect more units. CNG volume growth could improve as Gujarat state transportation (GSRTC) has approved induction of 1000 CNG buses (250 in Q4 FY20). Over the long-term, management expects most of the GSRTC’s ~7000 fleet of buses to convert to CNG.

Volume potential from new areas to fructify from FY21/22:
GUJGA is aggressively pursuing expansion into newer areas, maintaining capex guidance of Rs6-7bn annually. Initial strategy is to tap potential from existing network from Rajasthan until rural Thane region near Mumbai. Simultaneously, this would help tapping volumes from new areas such as Dahej, Punjab (GUJGA has license for about 6 areas) and Rajasthan, that offer 4-5 mmscmd potential.

Undemanding valuations:
At 12.7x FY22E EPS, GUJGA’s valuations remain relatively attractive to CGD peers (~16x for IGL/MAHGL). This gap may get bridged gradually, given stability in volumes and margins.

Valuation methodology
GUJGA’s unique positioning in the CGD space makes it one of the best bets on gas volume growth potential, based on a) access to more than 80% of CGD potential in Gujarat, and b) strategic expansion into new areas (such as Dahej in Gujarat, Rajasthan, western Maharashtra and Punjab) that are contiguous to its parent GUJS’ pipeline networks.

At 12.7x FY22E EPS, GUJGA’s valuations remain one of the lowest among CGD peers (13x-17x for MAHGL/IGL). This gap may get bridged gradually, as volumes and margins sustain as elevated levels. We raise GUJGA’s TP to Rs280 (from Rs270), as we roll forward DCF valuation to Mar’21.

Key assumptions for our DCF-based fair value are as under:
 Cost of equity of 11.9% (from 11.4% earlier) and terminal growth of 5%
 Long-term average EBITDA margins at Rs5/scm

Key risks
 Lower-than-expected margins over FY21-FY22 could change our valuation outlook for GUJGA
 Below-expected volume growth.
 Change in the PNGRB regulations, or an unfavorable court ruling (against NGT ruling for ceramic units), could alter volume growth outlook.

Note:
GSPL owns 55% of Gujarat Gas. Gujarat govt owns 5% and only 25% is free-float for public.
Apparently there is an old “special situations” thread about an open-offer in 2012 when GSPL wanted to fully acquire this

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My investment thesis:
As mentioned above it did seem that the Gas space would see increased activity, since few years ago, amid pollution and cost concerns where Gas has advantage and the Govt making lots of noises and big long term deals for Gas. Most of the CGD (City Gas Distribution) players have been giving good numbers, though only IGL has been loved by the markets.

Among all CGD plays, I chose to pick only Gujarat Gas (+ GSPL, in 70:30 allocation ratio). After browsing through CGD companies on ValuePickr, there was realization that they were bidding aggressively and winning CGD rights over others. So they were trying to grow but no certain profitable growth. “Gujarat” brand name helped since they were backed by the state-entity GSPL. Apparently GujGas is the retail and CGD arm while GSPL is the infrastructure arm. LNG terminals are mostly on west-coast and lots in the Gujarat area.

Along with robust numbers it appeared that PE was exceptionally de-rated which gave considerable up-side and low-risk. GSPL apparently has been a bit of a bad-boy and has not completed the pipeline to Punjab, now with a delay of 1-2 years, but they are now targeting completion within a year, apparently GAIL has been given orders to link their gas-generating fields and pipeline to this trunk pipeline of GSPL. I bet it also helps that Gujaratis are in the right places, right now.

Rating upgrade from CRISIL covers several points of interest: (2 weeks old)

https://www.crisil.com/mnt/winshare/Ratings/RatingList/RatingDocs/Gujarat_Gas_Limited_December_24_2019_RR.html

Detailed Rationale
CRISIL has upgraded its rating on the long-term bank facilities of Gujarat Gas Limited (GGL) to ’ CRISIL AA+/Stable ’ from ‘CRISIL AA/Positive’.

The upgrade reflects CRISIL’s expectations of an improvement in GGL’s credit profile over the medium term. Sustainable improvement in cash accruals is expected to improve GGL’s financial risk profile notwithstanding the sizeable capital expenditure (capex) programme.

GGL has reported a healthy growth in operating profit led by higher gas sales volumes and benign cost of re-gasified liquefied natural gas (R-LNG), in the first half of fiscal 2020. The volume growth was mainly driven by higher gas sales in the Morbi industrial area. In March 2019, the National Green Tribunal (NGT)'s order of banning the use of coal gasifiers in Morbi (Gujarat) region led to migration of industrial customers, mainly ceramic tile manufacturers, to piped natural gas from coal. Commercialisation of new geographical areas (GAs) will further support the volume growth.

GGL has annual capex plan of Rs 700-800 crore, to be largely funded through internal accruals. GGL has received the authorisation to set up city gas distribution (CGD) network in 7 new GAs won under the Round 9 and Round 10 bid conducted by the Petroleum and Natural Gas Regulatory Board (PNGRB). Further, it plans to expand the network within existing GAs as well. The project risk on account of sizeable capex and newer geographies is partially mitigated by GGL’s long standing experience in CGD business.

The rating continues to reflect the company’s sizeable scale of operations as the largest CGD entity in India, its healthy financial risk profile and stable profitability levels. These strengths are partially offset by its exposure to volatility in R-LNG and domestic natural gas prices and exposure to regulatory risks.

Analytical Approach
CRISIL has combined the business and financial risk profiles of GGL and its subsidiaries/associates to arrive at the ratings.

Please refer Annexure - List of entities consolidated, for details of the entities considered and their analytical treatment for consolidation.

Key Rating Drivers & Detailed Description
Strengths
*** Largest CGD player in India with diversified customer profile**
GGL’s strong and established market position in the CGD industry in India is indicated by its industry-leading presence in 23 districts spread across Gujarat, Dadra and Nagar Haveli, and Maharashtra. Further, the Company has also won bids during the 9th and 10th CGD bidding round to set up CGD networks in 7 new GAs in the states of Gujarat, Rajasthan, Haryana, Punjab and Madhya Pradesh. New GAs should help attain geographical diversification while expanding the scale of operations. The company’s user base comprised around 14 lakh domestic households, 3626 industrial units, 12,397 commercial establishments and 347 CNG stations, as on September 30, 2019, thus providing strong revenue diversity.

*** Sustained improvement in operating performance, driven by rise in gas volumes sold and stable realisations**
GGL is the largest CGD player in India, with strong and established market share. The company has been able to sustain improvement in its operating performance, despite volatility in RLNG and domestic gas prices. The domestic gas prices rose 19% during fiscal 2019, while the spot RLNG increased by 10%. Despite this hike, the company was able to pass on the increased cost to its customers, and maintain a healthy gross profit per standard cubic metre (scm).

Operating performance during first half of fiscal 2020 further improved, contributed by rise in the gas volumes sold and improved margin levels. Gas volumes sold grew by 43% to 9.3 mmscmd (from 6.5 mmscmd in fiscal 2019). Significant growth in volumes was mainly contributed by sales recognised in the Morbi industrial area, wherein the NGT has banned the usage of coal gasifiers. CRISIL expects such volumes to sustain going forward. Operating margins improved to 17% during first half of fiscal 2020 (from average 13% earned in the past) mainly due to decline in the spot LNG prices. The sourcing mix had tilted towards the cheaper spot LNG to meet the incremental demand of industrial customers. CRISIL however expects the margins to normalise to 12% - 14% going forward, with revival expected in the spot LNG prices.

*** Healthy financial risk profile**
GGL’s financial risk profile is driven by healthy cash accruals, comfortable debt protection metrics, and adequate liquidity. Cash accruals increased to Rs 640 crore during fiscal 2019 from Rs 515 crore in fiscal 2018. The company also reported healthy cash accruals of Rs 627 crore during first half of fiscal 2020. Gearing improved to 0.86 times as on September 30, 2019 as compared to 1.18 times as on March 31, 2019 and 1.49 times as on March 31, 2018. The annual cash accruals generated is expected to be sufficient to fund the capex plans of the company over the medium term, and accordingly the Debt/EBITDA position is not expected to exceed 2.5 times.

Weakness
*** Exposure to regulatory risks**
Regulation of natural gas, including CGD, is still in the initial stage in India and hence there is considerable uncertainty regarding the regulatory norms for natural gas allocation and distribution. Though the uncertainty in regulation is expected to subside as the industry attains maturity, any unexpected change in regulations regarding allocation of natural gas and pricing of end-product can adversely impact CGD players like GGL.

*** Exposure to competition from alternate sources**
Post the end of the marketing exclusivity period for the allotted GAs, the company remains exposed to competition that could set in from the other CGD players. ~70% of GGL’s volume mix accrues from the industrial/commercial segment, which is generally price sensitive to the pricing of alternate fuels. However, GGL has demonstrated a healthy track record of supplying gas in the allotted GAs, wherein it has been able to maintain its customer base and margin levels, despite competition setting in from alternate fuels.

Liquidity Strong
Liquidity is strong with cash and bank balance of Rs 478 crore as on September 30, 2019 as compared to Rs 289 crore as on March 31, 2019. Net cash accrual, healthy at Rs 640 crore during fiscal 2019, has further improved to Rs 627 crore during first half of fiscal 2020. Annual cash accruals generated is expected to be sufficient to service the debt repayments due of Rs 164 crore in fiscal 2021. Expected annual capex of Rs 700-800 crore is expected to be mainly met through internal accruals. Liquidity is further supported by largely unutilised working capital bank lines.

Outlook: Stable
CRISIL believes GGL will continue to depict a steady growth in operating performance, backed by healthy volume growth and stable realisation levels.

Rating Sensitivity factors
Upward Factor
*Improvement in the financial risk profile, with a net debt/EBITDA below 1 time
*Reduction in project risk with early commercialization of newly won GAs.

Downward Factor
*Material impact on operating performance on account of significant delays in project execution
*Large debt-funded capex or acquisitions, leading to net debt/EBITDA position exceeding 2.5 times.

About the Company
GGL is India’s largest City Gas Distribution company, with 25 CGD licenses spread across 41 districts in 6 states and 1 Union territory across the states of Gujarat, Maharashtra, Rajasthan, Haryana, Punjab and Madhya Pradesh and Union Territory of Dadra & Nagar Haveli.

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