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Growth likely to remain challenging in the near term

We met with the senior management team of Gujarat Gas Ltd (GGL) for an update
on recent business developments and future outlook. Key takeaways:

* Volumes witnessing continued headwinds: Volumes in Q2FY23 look discernibly constrained, with the combined impact of high input costs, logistical issues, propane pricing discount to gas, and the ~1-month shutdown at the Morbi ceramic cluster. This implies overall volumes in Q2FY23 would likely trend at ~7.6mmscmd vs the 9.8mmscmd in Q1. H2FY23 volumes are guided to be better with some pick-up in LPG prices (propane) due to winter, ahead of the estimated inventory fill-up in Europe, an increase in exports and some recovery in domestic volumes

* Margins to see a fairly interesting see-saw between volumes and pricing: While Q2 and even Q3FY23E margins may remain stronger than historical levels owing to limited spot LNG requirements, hence lower gas costs, we are cautious on prospects for the full year. Our caution is due to: the potential for return of Morbi volumes, high domestic + CNG costs, and uncertain ‘propane to gas’ economics, which would drive margins lower. Management has guided for a modicum of normalisation in LPG prices for winter due to stronger demand and some recovery of demand in China. However, given the widening discount to gas, we see GGL’s pricing power remaining constrained for industrial segment in the near term. We therefore expect a lopsided EBITDA/scm trend over FY23E, with H1 to see the metric at an average of as much as 8/scm, while that for H2 may fall to as low as Rs4/scm, keeping the full-year average still at >Rs5/scm.

* Capex (annualised) guidance is maintained at Rs11bn-12bn: We expect CNG infrastructure build-out to continue, with addition of 125-150 stations per year, especially in newer areas of Amritsar/Bhatinda/Ahmedabad extension, Thane (rural), Indore, Ratlam, Sirohi as well as previously commissioned areas. Progress and rampup in many of these areas has been slower than expected due to a combination of the following factors: pandemic, economic downturn, unfavorable economics vs alternate fuels, and minimal Policy support.

* Long-term outlook remains strongest among peers: We believe the potential of all the in-development and newly developed areas mentioned above, remains material and can support 11-12% volume CAGR over the next 7-8 years (including ~5% normalised growth from Morbi). Current margin profile is vitiated by a record divergence in LNG and LPG prices, but we feel normalisation of the same is long overdue and will likely happen over the next 18-24 months, creating sourcing cost comfort. Nevertheless, the near-term headwinds on volumes and margins are too strong to be ignored, hence we remain cautious of growth over the next 12 months. We have revised FY23E / FY24E EPS by -0.1 / -2.3% and reduced the target price to Rs535/sh. Downgrade to ADD.

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