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Gujarat Gas (GUJGA) faces a tough choice: prioritise volume growth or maintain margins over the next 12 months. The conversion of about 55% of available units in its major consumption hub of Morbi to dual fuel use poses a challenge. GUJGA has already lowered prices in the region to remain competitive and margins in FY23 held up due to lower gas costs, increase in propane prices, and reduced volumes. However, we believe FY24E presents greater challenges as Asian LPG prices have dropped by a significant percentage from May to July 2023, affecting propane prices. These price changes may impact Q2FY24E pricing and pose material challenges for GUJGA. Pursuing volume growth may require a price reduction of Rs3-4/scm in Q2FY24E, which could significantly impact margins for the company in FY24E. Keeping in mind the equation between propane and LNG prices over the next 12-18 months, we believe downside risks to earnings are possible, and hence, now factor in some of these in our FY24/25E EPS. Revised EPS estimates are thus 21.6/13.1% lower vs previous estimates and TP also reduces to Rs494/sh (from Rs585). Downgrade the stock to HOLD (from BUY), with risk reward turning unfavourable at current levels.

* Chasing volumes may be a risky bet in a weak pricing environment: The sustained decline in LPG prices (hence, propane prices at Morbi) is a major driver of volume pressure for GUJGA over the next 12-18 months. We believe while the management is keen on prioritising volumes, the pricing to do that may be steep, with our scenario suggesting a Rs3/scm cut for H2FY24E can lead to a cut in EBITDA/scm to Rs5.5/scm vs Rs6.7scm in H1FY24E (vs EBITDA/scm of Rs7.8/scm in FY23).

* FY24E price mix between propane and gas is not in favour of margin boost: Extrapolating the current weakness in LPG prices (LPG prices have declined to US$400/t for Aug’23 vs US610/t six months ago) to the next 12-18 months, equivalent propane prices for the key region of Morbi (44% of GUJGA volumes) may trend at Rs29-30/scm. This necessitates further reduction of Rs5-6/scm in industrial prices of GUJGA which may dent margins materially over H2FY24E, even assuming a moderate US$14-16/MMBtu spot LNG price during that period.

* Valuations are not cheap, risk reward not in favour; downgrade to HOLD: Despite the recent 6% fall in the stock price (last 4 months), GUJGA does not present a compelling risk-reward ratio, in our view. We have taken cognisance of the weakness in operating environment and have revised our FY24/25E EPS estimates down by 21/13%, respectively, to factor in lower margins. Consequently, long term volume growth and margin assumptions also see a downgrade, leading to a reduction in TP to Rs494/sh. Downgrade to HOLD.

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