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Improving macros supportive: Upgrading multiple

* GAIL has been our large cap top pick in the O&G sector since we upgraded it to Buy in Aug’19, after being neutral on the name over the previous five years. We upgraded the stock on premise of increased availability of gas, which would aid gas transmission and trading businesses of the company. However since last one year, the volatility in the trading segment has brought down 1 year forward PE from 13x to 9x currently.

* Although decreased demand especially due to Indian lockdowns have started to have an adverse impact on LNG prices, nonetheless crude linked LNG prices remain strong; while expected commissioning of the fertilizers plants is expected to eliminate concerns on the trading segment, thereby warranting a re-rating of the stock. Furthermore, rising oil prices, along with all-time high petrochem margins bode well for the stock.

* Receding concerns on US HH contracts, thus, make us raise standalone PE to 10x from 8x earlier and value the core business at INR159/share (at adj. EPS of INR15.9). With investments worth INR46/share, we arrive at a target price of INR205/share (implied PE of 13x which is in line with long term average). Reiterate GAIL as our top pick with ~35% of potential upside.

Huge volatility in trading segment – is the thing of the past

* Brent at USD69/bbl (May’21 average) has raised the price of oil-linked LNG to ~USD9/mmBtu (13% slope), similar to that of current spot LNG prices (which are also at ~USD9-10/mmBtu for July delivery). These make the pricing for US HH contracts favorable for GAIL.

* At the end of Dec’21, GAIL had started supplying gas (~2.3mmscmd totally) to various fertilizer plants – ~0.8mmscmd to Mangalore Chemicals & Fertilizers, ~1mmscmd to the Ramagundam plant, and ~0.5mmscmd to the Gorakhpur plant. Company guided gas consumption at these plants to reach ~5mmscmd (implying additional gas consumption of ~2.5mmscmd) by end of 1QFY22, de-risking ~50% of US HH volumes sold outside of India.

* Even Matix is likely to reach full capacity in coming weeks and would consume ~2.5mmscmd of gas at its peak capacity. The Barauni and Sindri fertilizer plants are expected to be commissioned by end of CY21 and would consume ~1.9mmscmd of gas each by end-FY22. We expect spot LNG prices would continue to support the trading business in FY22 (unlike abrupt fall in prices seen in FY21) even if the aforementioned plants see some delay owing to the second wave of lockdowns/restrictions in the country.

Strong LPG/petrochem profitability in the current environment

* LPG business: Higher realizations (-) lower feedstock cost (=) better profitability. With improvement in demand, LPG prices are expected to rise. Feedstock for LPG production for GAIL is the domestic APM, the price of which will remain the same in April-Sep’21, leading to lower feedstock cost.

* Petchem business: margins to remain strong in near term. Petrochem margins are all time high. Although several new capacities are planned in China and ME, we expect delays in them owing to recent rise in COVID cases globally, thereby supporting margins for longer. Although, we build in petchem realizations lower by 10% in FY22-23 v/s in FY21, our model sensitivity suggests a change of ~6% in FY22-23E EBITDA/EPS for every 10% change in realization.

Large spurt in transmission volumes expected

* In base case also, due to better availability of gas and completion of new trunk pipelines, GAIL is expected to clock a CAGR of ~6% in gas transmission for next 5-6 years. Upsides could come with better than expected utilization of upcoming LNG terminals. From KG-basin itself over next 2-3 years, both RIL & ONGC are expected to produce an incremental 43mmscmd of gas.

* However, conservatively, we forecast transmission volume of 120/125mmscmd in FY22/23 vs 105mmscmd in FY21E and 112mmscmd in 4QFY21E. We highlight that an increase of 10mmscmd in transmission volume would result in ~7% rise in FY22-23E EBITDA/EPS.

* In next 4-5 years, a total of 21mmtpa of incremental LNG regas facility (~87% of imports in FY21) would be available (Kochi-1.5mmtpa, Dabhol-2mmtpa, Mundra-2.5mmtpa, Dahej-5mmtpa, Swan-5mmtpa, Chhara-5mmtpa). Although all might not be utilized immediately post availability, it would ultimately aid transmission volumes for GAIL.

Valuation and recommendation – top pick

* Main concern on GAIL was due to the US HH contracts. But commissioning of the three fertilizer plants by end-2021 would mitigate the concerns. In the meantime, spurt in spot LNG prices as well as petrochem margins would help the stock in the short-term.

* GAIL is trading at 5.9x FY23 EV/EBITDA and 9.1x FY23 PE. We forecast a modest INR973/1,022/mscm of marketing margin on LNG in FY22/23E compared with 1,327/973/mscm in FY19/20 (FY21 was a loss making year for the segment). As per our estimate, an increase of 10% in implied trading margin would result in ~2% rise in FY22-23E EBITDA/EPS.

* Despite the ~23% outperformance in CY21’td and ~49% in last six months, the stock trades at ~28% discount to its 1 year forward long term PE average. We don’t ascribe any valuation so far to GAIL Gas. However, if volume pick up commences in the CGDs, especially Bangalore, then it may result in additional value.

* With potential of earnings revision by ~15% as highlighted above, we reiterate GAIL as our top pick in the large cap category. The biggest risk to our call is a sharp decline in oil price before the fertilizer companies commence operations.

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