A relook at Indraprastha gas

March 13, 2007

I received an analyst report on Indraprastha gas (see here) from uresh patel yesterday. The report has a sell rating.

Normally once one has made a decision and proclaimed it in public (via a post in my case), it is diffcult to accept information which goes against your conclusion. With that in mind, I have been trying to look at the report as objectively as possible and see if it refutes my assumptions.

On a broad basis the following points are made by the analyst for the sell recommendation

1. IGL has substantial margin risk as it is supplied gas on a subsidised basis. However the subsidized gas is 40% of the total supply. I have taken this scenario into account in my valuation and worked out the DCF calculations with the operating margins dropping from 40% to 32% by 2010 and net margins dropping to 14 %. Gujarat gas which is a similar company has net margins of around 11%, has a much larger commerical customer base and hence taking Gujarat gas a base case, I have assumed IGL will have a slightly better pricing power. So I agree with the analyst on the margin risk and impact on the net margins.

2. The analyst highlight risk to the topline due to competiton. I could not find any specific competitors who are planning to enter the delhi market. I could be wrong on that. In addition, IGL is planning to expand into noida and gurgaon. They are also exploring markets in haryana. These plans are very crucial for the company. If the company were sit tight and do nothing in terms of growth, then the topline will stagnate or even decline in face of competition. I find that hard to believe in case of IGL which has clearly stated aggressive plans in the PNG segment and new markets. In addition they have the cash to do so. So I am not sure why IGL will not have topline growth or choose not to do so. However any growth

3. Margin risks due to diesel pricing – The analyst have analysed the margin risk due to diesel prices falling from here. I have no opinion on this factor as I cannot predict what will happen to petroleum prices. This is a wild card and could hurt margins for some time. As a result I see this as a risk, but cannot evaluate it and predict it. In addition, the analyst case is based on the scenario that oil prices will drop in the future and hence that would reduce the discount and hurt margins. I am sure if anyone can predict that.

4. Regulatory risk – I missed this out completely. On reading the report, i think this could be a key risk going forward. One has to look at the petroleum sector and now cement to get a feel of it.

I think the key difference between my analysis and the one in this report is the difference in the expected topline growth. I have assumed a topline growth of greater than 10% due to the new initiatives. The analyst has assumed less than 10%. As a result my intrinsic value estimates are closer to 150-160. However if the growth comes lesser than 10%, then instrinsic value drops to 100-110. This is without even considering the regulatory risk. Any adverse development on that front could cut down the intrinsic value further

I would be analysing my assumptions further and would take a decision based on that.


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