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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.

Indraprastha gas ltd (IGL) is currently the sole provider of CNG and PNG in the NCR region. IGL was promoted by GAIL and BPCL ltd in 1998. It currently operates 146 CNG stations in the NCR region. In addition the company is setting up PNG infrastructure to supply Natural gas to commercial and residential consumers.

As per the Supreme Court directive all buses, commercial vehicles and Light good vehicles have to run on CNG. In addition there is a substantial cost advantage of running cars and 3 wheelers on CNG. As a result there is now a trend of private cars converting to CNG. These factors ensure a high level of demand stability for IGL and reasonable growth prospects due to continuing conversion of cars to CNG and due to growth in PNG consumers.

In addition IGL is now expanding into the adjacent areas of noida and ghaziabad. It is also doing a feasibility study in haryana.

IGL’s CNG sales is less than 50% of its compression capacity. As a result IGL has substantial operating leverage and would be able to grow revenues with low capital expenditure.

Competetive advantage
IGL is currently the sole provider of NG to the transportation sector and to commercial and residential consumers. The gas industry all over the world is characterised by local monopolies. Typically there is a single company supplying gas to the final consumers, as it is not viable to have two competing pipelines in a given geographic area. As a result IGL would likely remain a monopoly in the NCR region. In addition GAIL which can be a strong competitor is actually a promoter of the company.
The company is one of those rare cases where there is a substantial monopoly and a government/ court mandated requirement of its product. This gives the company a substantial visibility of demand.

Financials
The company has had a ROC of 25%+ since inception. In addition like other gas companies it has a very low working capital requirement. The NPM margins at 19% are twice that of other gas companies such as gujarat gas. Also the company has zero debt and a small amount of cash on the balance sheet which will grow due to strong free cash flows. The main investment of the company is mainly fixed assets which is mainly the gas infrastructure.

Valuation
The company has an EPS of around 9.5 and the FCF (free cash flow) is around the same amount. As a result at the current price it sells at around 11-12 times free cash flow. A company with such strong competitive advantage, high ROC and good growth prospects of 8-9 % per annum , can conservatively be valued at 16-18 times PE. As a result the company is selling at 30-35% discount of conservatively calculated intrinsic value

Risk
The key risk for the company is the supply risk. IGL gets 50% of gas at APM rates. On checking I found that the APM price for gas are around 40-50% lower than market rates. As the government plans to bring market based pricing for gas in due course of time, the gas cost for IGL would increase in the next few years. The net margins for the company, which are at 20%, would reduce when this happens if the company is not able to pass the complete increase to the consumer.

Additional points
The current price seems to discount the above scenario. I personally feel that IGL would be able to pass some of the price increase, although there would definitely be some impact to the net margins. This would not necessarily impact the absolute profits, but could result in slow down of the growth in net profits.
Assuming that 3-5 years later IGL starts paying market price as per govt policy, the gross and net margins will drop for IGL. Taking GGCL NPM of 11% as the base line ,IGL can have a NPM of 13-14 % due to better retail mix and higher pricing strength. Also some amount of cushioning will happen as volumes increase.

Comparitive valuation
In comparison with guj gas, IGL has higher margins and better ROC. Also IGL is 20% cheaper than Guj gas. Against a NP of 90Cr for Guj gas, IGL will have rough profit of 130 Cr. Also mcap for both companies is same. By comparitive valuation IGL should be valued same as Guj gas , if not more.