Similar to last several quarters, GAIL’s reported quarterly numbers continue to have several one-off factors. Adjusted for these, we think the numbers were better than they appear at first blush. We continue to be sanguine on a much better second half and see sharp ~50% earnings growth in FY17F.
Q2 had several one-off factors:
* Gas transmission had a one-off gain of Rs 1.8 bn (R0.4 bn in Q1) on account of a ship or pay revenue accrual primarily from IOC.
* The gas marketing segment had one-off provision of Rs 1.5 bn on account of a difference between earlier non-APM and APM (administered pricing mechanism) prices that GAIL has not yet recovered from customers. Adjusted for this marketing segment, earnings would have been flat q-o-q.
* The LPG segment was impacted by a lower availability of ONGC gas during Q2, and also a shut-down at the Pata/Vijaipur LPG plants for ongoing integration of Pata petrochemical capacity.
* Similar to Q1, Petchem was in loss, as GAIL is in the process of integrating existing capacity with expanded capacity. This has impacted existing production (Q2 production down 29% y-o-y), while depreciation and interest charges have increased as GAIL had capitalised the expanded Petchem capacity in April itself. We think profitability for each key segment would improve from second half.
* Gas transmission: Volumes are likely to further improve gradually (like Dabhol terminal has restarted, spot LNG demand for power sector is stronger, LNG prices remain benign). More importantly, the regulator is committed to revise all pipeline tariffs by March 2016. As we noted earlier, the proposed ‘volume divisor’ change in tariff itself can raise the tariff by 20-33% for most pipelines.
* Gas marketing: Adjusted for a one-off factor in Q2, GAIL has clocked R3.4 bn Ebit in marketing in Q1 and Q2. The volumes will likely get better in second half, as the Dabhol terminal has resumed operations and demand from power and other sectors remains good.
* LPG and Liquid Hydrocarbon: With ONGC production back to normal, GAIL’s LPG production is likely to revive. More importantly, as GAIL gets 100% domestic gas, it will be a key beneficiary of a nearly 18% domestic gas price reduction from 1 October. We think domestic gas prices will decline further in April 2016.
* Petchem has disappointed, but can surprise from Q4: In our view, GAIL has disappointed on a long period of plant commissioning and integration. From earlier expectations of Pata-2 production commencement from September-October, expanded capacity is now likely to commence production by December 2015, and GAIL expects to reach a 70% utilisation rate in Q4FY16, and near 100% in FY17F. As expanded capacity comes online, we think profitability can sharply revive, especially if GAIL is able to use a higher share of lower priced spot LNG.
Near-term investor focus will remain on RasGas take-or-pay issue; we see low risk of take-or-pay being implemented; impact low even if take-or-pay is implemented: With the price gap high between LT RasGas contract and spot LNG prices, the large deferral of LT cargoes continues (32% in 9M since Jan-2015). Take-or-pay obligation to RasGas on lower offtake will be determined at the end of the calendar year. This issue remains a key overhang on GAIL. While contracts have take-or-pay provisions across the chain, they could be difficult to exercise, in our view.
Similar to Petronet LNG (that has back-to-back contracts with GAIL/IOC/BPCL), GAIL has back-to-back contracts with its downstream customers and can recover the bulk of take-or-payments, if these are implemented. Also, as take-or-pay provisions provide for make-up gas in subsequent periods (based on operational flexibility and, importantly, on prevailing likely much lower prices in the future), we think the impact on even the downstream consumers will not be much.
For example, for GAIL, we expect an impact of just 1.0-1.5%, due to interest outgo on advance payments. In our view, after a large deferral of LT volumes, RasGas and stakeholders will take a pragmatic view and reach an early agreement. We believe that, while the basic oil linkage (currently 12.67%) is unlikely to change, relief may come from doing away with floor pricing and raising downward volume flexibility (currently 10%).