GAIL is increasing its pipeline network from ~7000kms in FY10 to ~14,000 kms by FY14. This should result in increasing their transmission capacity from ~150mmscmd to ~300mmscmd.GAIL with their cross country pipelines should maintain its leadership position in India. We expect their transmission volume to increase with increasing supply in India from domestic and imports.

Natural gas can be used for almost all purposes– industry/power/transport. Natural gas is emerging as the preferred fuel of the future in view of being an environmental friendly and economically attractive fuel. Given that the share of gas in the energy basket is rising and percapita consumption is among the lowest, the latent potential demand for gas remains large.Presence of robust demand and rising supply scenario augur well for GAIL, the largest gas transmission company in India. GAIL currently transports ~70% of total natural gas and is planning to double its pipeline network to match-up with rising gas supply in future.

Contribution from gas transmission to go up

With availability of more indigenous gas post RIL KG-D6 availability and increased LNG supplies, GAIL’s transmission volume is likely to increase from 83mmscmd in FY09 to 198mmscmd by FY13E (CAGR of 14.7%). Slow ramp-up of RIL gas remains the key concern for GAIL, however, we feel that with higher availabilities of spot LNG the gap would be bridged to a large extent.

Capacity bottleneck at the HBJ pipeline was one of the major constraints in FY11 which we believe should get over by Jun’11 post commissioning of DVPL-GREP expansion (Phase II). We expect gas volumes to increase at a slower pace from FY10 to FY13 and then to rise substantially on the back of increased availability from KG basin (RIL, GSPC) and increased LNG availability (Kochi, Dhabol, Shell).

Higher tariffs from new pipelines will result in increase in average tariff from Rs813/ kscm to Rs1,046/ kscm in FY13 (CAGR of 6.1%). Volume growth coupled with tariff increase should result in contribution from transmission segment in PBIT to increase from ~50% in FY10 to ~56% by FY15.

Aggressive capex plans

GAIL is executing an aggressive capex in the area of gas transmission, petro-chemicals, E&P and CGD. It plans to incur capex of Rs270bn in the three years from FY11 to FY13. Major component of capex is targeted for gas transmission infrastructure followed by petrochemicals. Around half of the capex will be funded by loans and remaining half by internal accruals.

Targets to double capacity in next three years

With the robust capex plan, GAIL targets to double its gas transmission pipeline infrastructure to 14,000kms with total transportation capacity of 300+mmscmd (FY10-150mmscmd). Polymer capacity is targeted to triple to 1.2mn MT by FY15. In high growth CGD space also the company plans to increase its presence in 50 cities in next three years.

Robust cash flow from operation (CFO)

GAIL is expected to generate ~Rs140bn of cash flow from operations from FY11 to FY13. For the aggressive ongoing capex, robust CFO should contribute for half of the total fund requirement. Net debt/ Equity is likely to peak in FY13 at around comfortable level of 0.7. Post FY14, high cash generation and slowdown in capex should result in decreasing debt level.

Healthy returns

Increasing proportion of gas transmission business in topline with higher transportation tariff for new pipeline is likely to improve the operating margins for GAIL. High depreciation and interest charges on the back of aggressive capex should result in continued downtrend for ROCE and ROE till FY13. However, we expect return ratios to stabilise at ~20% levels with upward bias from FY13 onwards.

Increasing presence in booming CGD space

GAIL Gas, a wholly owned subsidiary of GAIL has won authorisation for four out of six cities in the first round of bidding. It has bid aggressively in next rounds as well for which results are awaited. Apart from GAIL Gas, GAIL through its eight JVs is present in ~23 cities across India. GAIL management has emphasised that they have aggressive plans to increase number of cities under their portfolio in the coming years. The company targets to have there presence in ~50cities for combined CGD is a high growing segment in India with immense potential due to favourable economics compared to its competitive fuels. On a conservative basis we have valued GAIL Gas on book value for our valuation purpose, however, we feel that going forward with increasing number of cities under portfolio it should be one of the major growth drivers for GAIL.

Increasing ground in E&P space

To further diversify its portfolio and moving in the value chain, GAIL is investing heavily in E&P space. As on Dec’10 the company has made total investment of ~Rs22bn. They have presence in 29 blocks in partnership with different companies with operator status in only two blocks. Management aspires to have five revenue generating blocks by FY15 from just one in FY10.

Subsidy sharing – Remains a concern

GAIL being one of the upstream companies, shares subsidy burden for losses incurred by downstream companies on retail petroleum products. As per the recommendation made by Dr. Kirit Parekh Committee, GAIL should be excused from the subsidy sharing as it is not a producer. However, in the current scenario of hardening crude oil prices in the international market and increasing pressure of govt’s fiscal, exclusion of GAIL’s from subsidy sharing looks unlikely. There is no fixed subsidy sharing mechanism and it changes every year with the prevailing condition. We have considered subsidy contribution to continue in current years, however, any positive changes in the policy will substantially change our earning estimates.

Near term bleak outlook for Petro-chemicals business

GAIL is increasing its polymer capacity from 0.4mmtpa and targets to reach ~0.8mmtpa by FY14 and ~1.2mmtpa by FY15. Demand for polymers is expected to remain robust in India on the back of strong GDP growth, however, margin pressure should continue for another 1-2years on the back of increasing global capacity mainly across Middle-East and China.

RECOMMENDATION

We have valued GAIL’s standalone business based on DCF. For investment and E&P business we have valued at 20% discount for quoted investment and at book value for unquoted investments.

At CMP of Rs456, GAIL is trading at PER of 14.5x & 13.4x and EV/ EBITDA of 10.3x & 10.7x for

FY12 & FY13 respectively. However, adjusting for investments, the stock is trading at 11.2x FY12E earnings. We initiate coverage on GAIL with ‘BUY’ recommendation and target price of Rs547 for one year time horizon (Rs445 from standalone business and Rs102 from other investments and E&P blocks)

CONCERNS

Delay in project commissioning: GAIL is doubling its transmission capacity from ~7,000kms to ~14,000kms by FY14. In our assumption we have taken increasing contribution from transmission business. Any delay in project execution will have negative impact on our revenues and profitability estimates.

Muted availability of natural Gas: Slow ramp-up of RIL KG-D6 was the main concern for Indian gas story in FY11. Now it is expected that RIL should be able to increase its volume to 80mmscmd not before FY13. Any further delay in ramp-up of domestic volumes or decreased availability of LNG will create challenge for GAIL.

Negative surprise from PNGRB: Transportation tariff for new pipelines is yet to be approved by PNGRB. Lower than assumed tariff will adversely impact our revenue and profitability estimates.