Indraprastha Gas (IGL), a retail gas distribution company, has under-performed the benchmark indices as well as the oil and gas index over the last 2-3 years by a substantial margin.
The scenario continues to be bleak for IGL owing to headwinds such as higher capital expenditure and slowdown in CNG conversions impacting Earnings growth going ahead.
On account of enjoying monopolistic position in the sector and unregulated margins, IGL has been registering high EBITDA Margins in excess of 40% and RoCE ranging from 38% to 45%.
However, the period of unregulated margins is about to cease with the PNGRB guidelines ushering in regulations to limit network and compression tariffs with marketing margins being left out presuming it will be self-regulated due to competitive forces. Further, IGL’s marketing exclusivity is also likely to end post FY11.
On account of earning super-normal returns - generated returns of more than 42% on core assets in FY2008 - IGL has fully recovered its investments. IGL’s returns exceed the risk-return trade off involved in the city gas distribution (CGD) business.
Going ahead, we believe such super-normal returns would temper due to increase in gas costs, competition or the regulator interfering to cap the returns.
Outlook and valuation
The company is currently on a capex spree (it is almost doubling its GFA capacity over the next two years) in wake of the upcoming Commonwealth Games and increasing demand for CNG.
However, we continue to have concerns over IGL’s pricing policy due to which it has been earning exorbitant margins.
We have valued IGL using DCF methodology and have arrived at a fair value of Rs105. At Rs101, the stock is trading at 7.0x and 6.9x FY09E and FY10E earnings.
We believe IGL’s inability to pass through higher gas costs and declining return ratios are likely to be a drag on its performance going ahead. Hence, we remain NEUTRAL on the stock.