>GAIL: Investment View & Q3FY12 Result update

■ Volume growth a challenge. We believe that volume growth would be under pressure as the gas production from the KG-D6 field of RIL continues to decline and other domestic gas field developments on the eastern coast are delayed. Import capacity is running at almost peak capacity with limited scope for higher throughput near term. Overall, we anticipate a largely flat transmission volume during FY12 and FY13. The company is also struggling to evacuate its petrochemical production due to heightened competition following the commissioning of a naphtha cracker at Panipat in North India by the Indian Oil Corporation.


■ Uncertainty on under-recovery remains a risk: We believe that the current calculation of GAIL's share of subsidy is based on total losses incurred by the oil marketing companies on LPG alone as has been requested by GAIL. While, there is no certainty that this formula would continue in future, as the government would struggle to close the ballooning subsidy gap (cINR1,300bn in FY12e), we have assumed that GAIL would continue to pay subsidies such that it maintains only a normative profit for the LPG segment. Our underrecovery assumption has increased for FY12 and FY13 due to higher crude oil assumption at USD112/bbl and
USD105/bbl, respectively based on the current forward curve. We expect the subsidy burden to ease in FY14 as we expect crude oil prices fall to USD92/bbl, in line with our house view.


■ Marketing margin issue pending with PNGRB: The government has entrusted the task of determining the gas marketing margin to the Petroleum & Natural Gas Regulatory Board (PNGRB). We believe this would remain an overhang on the stock until the regulator decides on a fair marketing margin for India where demand for natural gas far outstrips supply.


Q3FY12 RESULT UPDATE
GAIL reported Q3FY12 net profit of INR10.9bn in line with our and consensus
estimates. However, the subsidy to oil marketing companies (OMCs) was provisional and
could change after the government announces the allocation over the next few weeks. While
GAIL has maintained its transmission volume despite lower domestic gas thanks to imported
LNG, we anticipate flat transmission volume over FY13. The blended tariff for the quarter was
INR993/’000scm, which we expect to increase by 3% in FY13.


■ Transmission volume to remain flat. We expect GAIL to get c4mmscmd lower gas from KG-D6 field of RIL during FY13e, which would be partly substituted by c2 mmscmd from the western coast; new volume is expected to earn the higher tariff of the new pipeline while the KG-D6 volume was flowing through the old HVJ pipeline that has the lower tariff. Overall, we anticipate GAIL to transmit 118.8mmscmd gas during FY13e as against 117.8mmscmd in FY12e.


■ Uncertainty on subsidy and marketing margin to be an overhang. We expect the subsidy to OMCs to be capped at earnings from its LPG business as has been the trend in the past, but the actual amount could vary depending upon final allocation by the government. Additionally, the government has recently asked regulator to determine the marketing margin on gas sold by marketing entities. This could impact the marketing margin of GAIL. The marketing margin of cUSD0.24/mmbtu contributed c20% to its net income in Q3FY12. We lower our earning estimates. We lower our FY13e EPS estimate by c15% to account for 3-4% lower transmission volume, and 92% higher subsidy assumption for FY13.


■ Valuation and risks. We value GAIL on the PE of its core business and 10% holding
discount market value of investments. We reduce our target price from INR500 to INR405 but
retain Neutral rating in view of recent correction in stock. We value the core business at 11.6x
FY13e core EPS to reflect 11.5% cost of capital, 6% growth and 16% ROE, which is also in
line with the last six months’ multiple. We believe investment risks include any downward
revision in GAIL’s tariff, a higher-than-expected share in under-recovery, or different
marketing margins. Potential catalysts include new gas supply visibility, or discovery in its
exploration blocks.


To read the full report: GAIL 
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