Wednesday, July 29, 2009


Noble intent turns ignoble

Prima facie, the government’s new policy of replacing benefits from Section 80-IA of the Income-tax Act for gas-pipeline companies with Section 35AD is bound to backfire as it is both EPS- & NPV-detrimental. Although government intent was noble, it has turned ignoble for the industry; but, all is not lost. We expect the gas-transmission industry (Reliance Gas Transportation & Infrastructure-RGTIL, GAIL and Gujarat State Petronet-GSPL) to persuade the government to alter this policy, hence leading to gas-transmission companies spending aggressively on setting-up a wholly-entrenched network of pipelines in the country. Based on its current format, the policy would impact GAIL’s fair value Rs14/share. However, if the government allows losses on the pipeline business to offset profits from other businesses, it would improve GAIL’s fair value by Rs15/share. Another alternative for the government would be revamping the complete policy and making it positive for the industry.

Section 35AD detrimental to fair value of gas transmission firms. As per Section 35AD, effective tax rate on earnings from new gas pipeline investments would not change substantially as, even earlier under Section 80-IA, such companies were paying nil tax on new pipeline investments. Moreover, tax coverage due to depreciation post the first ten years is absent in the present policy. The new policy allows 100% depreciation in the first year of operations itself, which would lead to lower earnings in the long term. Our estimates suggest that companies would commence paying corporate tax rate (34%) from the ninth year of operations vis-à-vis eleventh year earlier. Moreover, companies would pay higher taxes from the ninth year of operations under Section 35AD vis-à-vis Section 80-IA, under which depreciation benefits would have continued.

Government intent positive, but policy impact negative. The new policy is set to be detrimental to the industry. However, we believe government intended to encourage investments in gas pipeline infrastructure and provide further incentives via introduction of Section 35AD. We believe that the policy turning negative is more a result of miscalculation by the government and expect sanity before the finance bill is passed. Also, we expect the government to modify policy terms and, at least, allow losses from the pipeline business to offset profits from other businesses. This move itself would lead to Section 35AD being NPV-positive for GAIL vis-à-vis benefits from Section 80-IA earlier.

GAIL – Most upsides priced-in. Post change in the subsidy-sharing formula (when we favoured GAIL as our top pick in the sector), the stock has run up 8.4% since July 2, ’09, significantly outperforming the Sensex 7.8%. The stock is currently trading at par with our fair value of Rs336/share. Even after including Rs15/share upside as per the new policy, the stock offers minimal 4.5% upside from current levels. We believe GAIL would not significantly outperform from here going forward.

ONGC, now our top pick in sector. Based on recent positive announcements (media reports suggesting that government would bear 100% cooking fuel underrecoveries in Q1FY10), we favour ONGC as our best bet in the large-cap O&G space. We value ONGC at Rs1,250/share, which offers 19.8% upside. Notably, the stock has corrected 10% post budget due to absence of provisioning by the government for cooking fuel under-recoveries in FY10. We expect the stock to
retrace this 10% decline over the short-term. In the long-term, impending Oil India (OIL) IPO would result in positive newsflow, which would boost ONGC’s stock price.

To see full report: OIL&GAS SECTOR