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Out of gas
Shares of Indraprastha Gas got beaten out of shape after the oil regulator’s decision to slash tariff rates. Should you bottom-fish?

Shabana Hussain

rude shock jolted investors in Indraprastha Gas, the sole supplier of compressed natural gas (CNG) to Delhi and its suburbs, on the morning of April 10. Minutes after the market opened for trading, IGL’s stock, which had closed at #347 the previous day, crashed by 46% to ₹188 after the Petroleum and Natural Gas Regulatory Board (PNGRB) had asked the company, the previous night, to lower its network tariff and CNG compression charges in Delhi by 60%.

The order was like a bolt from the blue; even IGL claims it was clueless about the tariff cut. The company has since gone to the Delhi High Court against the order. An IGL statement says it has been denied the principle of natural justice because PNGRB did not give it a personal hearing before passing the order, despite repeated requests. 

Now, the board has asked IGL to comply with the order immediately. What’s worse, the board has fixed the tariffs retrospectively from April 2008 and ordered the company to refund the excess amount charged to consumers since then. Analysts say that if the order is implemented with retrospective effect, IGL may have to take a hit of ₹1,000-1,800 crore. “IGL has sold 3.7 billion standard cubic metre (SCM) of gas in the last four years,” says Edelweiss analyst Niraj Mansingka. “Assuming consumers are refunded #5/scm, it adds up to #1,845 crore, which wipes out IGL’s FY12 estimated net worth of ₹1,200 crore.”

Retro trouble

Moreover, refunding the amount will be a nightmarish task — CNG and PNG (piped natural gas) are retail businesses and it will be hellishly difficult to identify customers, especially for the CNG portion. Analysts are mulling the possibility that the court might decide to do away with the retrospective part of the order. Says Ashutosh B, analyst, Nirmal Bang, “The buzz in the market is that the retrospective effect will be exempted and, going forward, the company will have to follow the new, revised tariff.” 

Blast from the past

Even though PNGRB can regulate only network and compression charges, it will limit the scope for high marketing margins

Investors are feeling less ambiguous. They slammed the stock after the order came in. “This is a major negative for the stock,” says Yogesh Patil, analyst with KR Choksey. “Operating profits of the company could decline by more than 50% and net profit for FY13 could fall by as much as 80%.” 

Brokerage firm Edelweiss has gone so far as to say IGL will face a perpetual loss if it is forced to refund the charges retrospectively. “If the order is followed, the company’s FY13 profit may fall by 41%,” says Mansingka. 

The stock is down 37% to ₹218 since the order came in. That’s quite a change from the days when IGL was a favourite pick among analysts for its monopoly in the National Capital Region, low dependence on imported (read: expensive) liquefied natural gas (LNG) and strong pricing power.

Good going but…

IGL was set up in 1998 as a joint venture between the state-owned Gas Authority of India (Gail), the public sector BPCL and the Delhi Government, following a Supreme Court directive that clean fuel be mandatorily provided for all public transport vehicles in Delhi. IGL’s business model is simple. It sources gas from suppliers such as Gail, transports it through its pipeline network, and sells CNG to vehicles and PNG to homes and industries. City gas distribution companies earn revenue from three streams: network tariff, compression charges and marketing margin.

Sanjay Bakshi, visiting professor, MDIMargins are maintained by passing on gas price hikes to the consumers. CNG contributes 80% of revenues and IGL’s overall volume growth has hovered at 18% every year because of the increased demand for it from private vehicles. In the last year, private car conversions to CNG have risen from 2,500 cars a month to 6,000 cars a month — it makes sense because CNG is 60% cheaper than petrol, 32% cheaper than diesel and 49% cheaper than auto LPG. The company will do even better when private bus clusters, the Gramin Bus Seva and high capacity buses run on CNG. In fact, the Railways is exploring CNG usage in DMUs (diesel multiple units) on a larger scale. 

PNG, the other part of IGL’s business, competes with LPG cylinders, which are more expensive despite being subsidised. But penetration of PNG is low — IGL had 245,000 domestic customers (1%), and over 500 commercial and industrial (18%) customers on March 31, 2011. “The PNG business represents a long-term opportunity,” Edelweiss’ Mansingka says.

“If we compare the four city gas distribution companies, IGL’s margins are the highest because other companies use costlier imported LNG,” says Rina Sanghavi, analyst, SPA Financial Advisors. IGL sources 74% of its gas requirement from domestic suppliers. Domestically produced gas is priced between $4.2 and $5.3 per million British thermal unit (mmbtu), less than half the rate at which the fuel is imported in liquid form via ships at $10-18 per mmbtu, due to costs related to transportation and conversion to CNG. But, with the stoppage of Reliance Industries’ KG-D6 gas supplies since September 2011, IGL has had to depend more on expensive imported gas.

Bottleneck

In the last one year, IGL has increased the retail price of CNG six times and PNG twice to compensate for rise in input costs but the company will no longer be able to do this if tariff regulation is allowed by the court. Industry watchers fear the only money IGL will be able to make will come from the growth in volumes.  Or, “It’s possible that IGL could charge the same amount from its consumers by increasing the marketing margins to compensate for the reduction in other charges,” says brokerage Nirmal Bang’s analyst Ashutosh. “If this happens, earnings may not be impacted so much.”

However, “The problem is that there is no clarity,” says SPA analyst Sanghavi. “A few months back, the government said the regulator will decide the marketing margin charged by IGL and now they have gone and cut network tariff and compression charges. It’s not clear whether all the three tariffs — network tariff, compression charges and marketing margin — will be controlled.” The PNGRB Act per se does not give the regulatory body power to control the marketing margin but the government has asked it to do so. “The PNGRB Act allows it to regulate only two items for IGL — the network tariff and the compression charge — and IGL is disputing this itself,” says Sanjay Bakshi, visiting professor of Management Development Institute (MDI). 

Ugly contraction

IGL's margins will take a major hit

IGL also faces threat from other companies once the monopoly granted to it ends this year. Analysts don’t see this as a real risk because they don’t think many players are waiting to enter the city gas distribution business — the sector has high entry barriers, requires heavy investment for licence fees, and for building the distribution network and buying or leasing land for CNG stations. Sourcing of gas could also be a problem because of falling domestic gas production, which means new entrants will have to import expensive gas. 

IGL has never faced any of these problems. The company leases land from the government at competitive rates and sources gas from its own promoter, Gail. Citi Investment Research analyst Saurabh Handa says in a report, “Access to relatively cheap domestic gas through allocations by the government and the potential exclusivity in tie-ups for gas sales are key competitive advantages, which will ensure minimal loss of volumes once the three-year marketing exclusivity period ends in 2012.”

Fair chance

IGL’s court hearing over the PNGRB tariff reduction order has been postponed to May 3. It’s only one of many instances in which IGL has dragged its regulator to court. In fact, IGL and PNGRB have been at loggerheads right from the time the regulator was set up in October 2007. “When PNGRB tried to regulate IGL, the matter ended up in the Supreme Court (Voice of India vs Union of India & Others),” says Bakshi. “In that particular case, among other things, the Supreme Court decided that IGL had been denied ‘natural justice’ because PNGRB had issued an order without giving IGL a chance to be heard. It seems history is repeating itself because, in the present case too, IGL is claiming that it was not given a chance to be heard by PNGRB.”

Analysts say the stock is a risky bet right now because anything could happen. The case could drag on in court for months, the company might decide to comply with the regulator, or it might approach the government to intervene in the matter. “Section 42 of the PNGRB Act states that the Central Government can, under certain circumstances, issue policy directives to the Board and its [the government’s] decision shall be final,” says Bakshi. This basically means PNGRB has no real powers. “For IGL, that’s a trump card because the remedy lies not just with the courts and the Appellate Authority but also with the government,” says Bakshi. “Whether or not it will play that card, I do not know.” 

Going forward, the company’s valuation will solely depend on the outcome of the contested tariff cut. Meanwhile Edelweiss and Nirmal Bang have put the stock under review and KR Choksey has a ‘sell’ with a price target of #230. While too many uncertainties surround IGL right now, there is a good chance that the company will get a favourable verdict from the court given the balance of arguments. In which case, the hammering the stock has taken may look unjustified. Besides, IGL also has a very strong business with high entry barriers. That said, the stock could correct some more with the overall weak market. Buy at its current price of ₹218 and on dips.

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