Gail’s troubles—due to falling oil prices—at its gas trading, LPG and chemical segments (on lower revenue, sticky and high gas prices) are huge, and seem likely to persist for a while. Earnings run rates can still fall well below consensus estimates. The longer-term upside—growth from large imported volumes—is also at risk now, as customers refuse to sign up for relatively high-cost gas. With eroded back-ended ‘DCF value,’ and near-term risks, we downgrade Gail to Underperform.
Material earnings risks: Gail’s earnings have been significantly impacted by falling oil prices. Demand for LNG has worsened, despite lower spot LNG prices. Falling LPG prices hurt Gail’s realisations—segment Ebitda (earnings before interest, taxes, depreciation and amortisation) is likely to remain flat even if the company is now exempt from paying subsidies.
The 7.5mt Rasgas take-or-pay LNG volumes (of which Gail is liable to take 60%) is now prohibitively expensive; it is linked to 60-month average oil prices. Falling polymer prices also hurt revenues. To make matters worse, Gail seems forced to take Rasgas as chemical feedstock (as other customers balk at the cost). Gail had suggested (in the Dec quarter) that it will find other takers for Rasgas volumes, but that has not happened.
As this situation persists, Gail’s earnings can be materially eroded. Even after assuming a $65/bbl (barrel) oil price for FY16, and zero subsidy payments, we see Gail’s EPS falling from R27 in FY15 to R24 in FY16 (R38 in FY14a).
Longer-term growth also under a cloud: Gail has contracted to purchase 5.8 mtpa of Henry Hub (HH) linked gas for delivery starting 2017. Delivered into India, these volumes were expected to provide Gail strong operating leverage through: filling up currently empty pipelines, and adding to marketing margins. HH gas of $3 per mmbtu (million metric British thermal units) should be delivered into India at about $9/mmbtu. In a $100/bbl oil world, this would have been very advantaged, but in a $50/bbl world, it is more expensive than liquids.
While Gail has signed take-or-pay contracts to liquefy these volumes, customers are only likely to come back to the negotiating table post a meaningful increase in oil prices. Gail could divert a portion of its HH cargoes to countries closer to the US (saving on shipping costs and making this gas economical), but: (i) such sales are likely to be on a spot/opportunistic basis, and (ii) will not help improve India utilisation. The de-risking of Gail’s imported gas portfolio is now less certain, and can take longer.
The govt has recently proposed policies for subsidising gas to power plants and for the pooling of gas to urea plants in India. Details of the policies are unavailable, but it is expected that Gail will have to sacrifice marketing margins and pipeline tariffs—at least for gas sold to power plants. While these schemes can provide some near-term volume assurance, they come with earnings risks. Net upside for Gail is unclear, and may be small.
Without assured growth, valuations appear stretched: Near-term earnings risks for Gail are not new, though the oil price collapse has exacerbated the issue now. We were willing to look through that due to the significant long-term growth prospects Gail had on the back of imported gas volumes, which provided strong support to the DCF (discounted cash flow). With this growth now less certain and little else available to drive earnings in the medium term, focus may shift to near-term earnings run rates. Gail has historically averaged 11.6 times forward earnings (peak of 16.5, lows of 8.1 over the last 10 years). We shift our valuation from a DCF to a 10 times P/E (price-to-earnings) on FY17 EPS (earnings per share) —TP (target price) falls from R485 to R320. We downgrade Gail to Underperform from Neutral.