GAIL (India) Ltd. Battles Subsidies and Production Decline En Route to Higher Profits

The first stages of a government relaxation of natural gas subsidies and an upturn in supplies is likely to help GAIL (India) Ltd. post a positive earnings surprise.

Natural gas is becoming the focus of a lot of chatter in the United States, where new discoveries in shale formations across the country have led to a sudden jump in supplies and created a horde of questions, ranging from new uses and new pipeline transportation networks to the possibility of exporting liquefied natural gas and how to address environmental concerns. In India, natural gas already is used more extensively than it is in the United States, however – as a cooking fuel, to power automobiles and to generate power. Robust domestic demand for natural gas is contributing to what may well be a larger-than-expected profit on the part of one of the largest players in India’s natural gas market is GAIL (India) Ltd. (GAIL.NS), more formally known as Gas Authority of India Ltd.

GAIL, a public sector undertaking (or PSU) that is publicly traded but in which the government owns a majority stake of 57% of shares, boasts the largest natural gas pipeline network in India. In addition to its distribution facility, it owns and operates more than 6,800 miles of pipeline capacity connecting India’s western regions and its north, as well as linking the south to the eastern coast. India’s own natural gas output has been declining for the last three years, slipping from a peak of 4.79 billion cubic meters per year in early 2010 to 3.24 billion cubic meters per year by January 2013, as depicted in the chart below, as existing wells become less productive.

That is something that has weighed on the outlook for GAIL, as does the fact that the government subsidizes the price of natural gas for the benefit of the poorer segment of India’s population, which affects the profitability of its distribution operations. GAIL shares the subsidy burden with the government, and the percentage of that burden that falls on GAIL varies over time. Those factors may well be less of a drag on the company’s performance than might originally be suspected, however. To start with, while the government still remains focused on subsidizing natural gas, India’s finance minister, P. Chidambaram, has recently publicly described the need to trim the government budget deficit as critical. That means that government subsidies for natural gas are likely to decrease. Meanwhile, the government offset some of that that with small price increases during 2012, which created a tailwind for GAIL’s earnings from its gas distribution arm.

GAIL will benefit from anything that boosts the amounts of gas now flowing through its extensive pipeline network, since it charges a toll on every cubic meter that it transports. The impact of the decrease in domestic natural gas production on GAIL’s pipeline revenues was offset to some extent by an increase in imports from the Middle East and new exploration projects and refineries coming online around the country will also prove to be a boon for GAIL. One of these is the recently-commissioned Dabhol LNG terminal, which will receive, imported natural gas from Russia and the Middle East, has begun production but has not yet reached full capacity.

Analysts seem to be taking note of this more positive backdrop and the increase in their estimates for GAIL’s earnings for the fiscal year ending March 31, 2013 has pushed the I/B/E/S consensus earnings forecast slightly higher over the last 90 days, from just below 34 Indian rupees (Rs) to Rs. 34.48 compared to actual earnings of Rs. 35.03 in the prior fiscal year. But the StarMine SmartEstimate, which reflects the most recent analyst forecasts and those by analysts with an above-average track record for accuracy, stands at Rs. 35.95 , giving the company a Predicted Surprise of 4.3%. Coupled with the fact that nine of the ten most recently published estimates call for GAIL’s annual earnings to exceed the consensus, that suggests that the company is likely to report a positive earnings surprise when it reports its annual results in the final days of May.

The increased bullishness on the part of analysts also has been reflected in their willingness to recommend GAIL’s stock as a ‘buy’. At present, the company has four more ‘buy’ and ‘strong buy’ recommendations than it did just 30 days ago, and there are five fewer ‘hold’ and ‘sell’ recommendations on the stock. Moreover, the StarMine Relative Value (RV) Model, on which GAIL scores 86 out of a possible 100, suggests that the stock isn’t overvalued at its current price of Rs. 337. One of the factors the model takes into account is the company’s forward P/E ratio multiple: currently, GAIL trades at only 9.3 times estimated 12-month earnings, below the 10-year median of 10.8.

True, the company’s profit margins have been falling as its distribution operations have come under pressure from the government subsidies and the pipelines have suffered from declining throughput. But GAIL’s revenues have risen 25% over its last two fiscal years, helping to offset the decline in margins with higher sales, and the increase in LNG prices that the government approved is likely reverse those falling margins, or at least to keep them steady. That is likely to help buoy both GAIL’s fiscal year earnings and its future estimates when the company reports its results on May 27.

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