Friday, April 25, 2014

GAIL - Great business but then again the under recoveries

GAIL was founded in 1984 and currently owns a good part of the gas pipeline network in India. It also has subsidiaries doing CNG in cities. With no further ado, the company is marred by the under recovery mechanism where if the profits rise the government uses the mechanism to drive up oil marketing company recoveries. This at the offset makes it a difficult one to invest in. Overall it is an excellent business to be in - because once you have the pipeline the customers have no choice but to go with you. The cost of setting up another pipeline for a competitor is a huge regulatory, execution, license and investment hassle. GAIL is considered by many as a safety stock and in flights to capital this might do well. Even buffet likes utilities like this one but mid-america energy and their ilk don't have to deal with subsidies. Lets analyse if despite the subsidies this company will be able to deliver good returns.

1. How big is the moat?

Grade A moat
  • It is next to impossible for another company to do what GAIL is doing today. Their network is massive and expanding rapidly. Capital investments are so large that very few others have the capital to do it. Even if they do the license hurdles and approval issues will be massive.
  • The consumption of fuel is likely to go up per capita as income increases. Given the massive rises in crude oil prices gas is likely to be taken up as a viable alternative. India's per capital fuel consumption as of 2011 is abysmally low and it ranks in the bottom 10% or so.

2. Risks

  • The under recovery mechanism is at the whim and fancy of the government

3. Financials

  • CFO is similar to Net income
  • ROE is low at 15% and has gone up to 18% in the past. The thing is that in an economy where the risk free rate is 3% this would be a great ROE. But in India where the risk free rate is 7% to 8% you should expect the ROE to be 18% to 20% minimum for a utility.
  • Dividend % of earnings is around 30% to 35%
  • Profits have gone up by 11%+ CAGR on consolidated basis since FY2009 till FY2013. The profits have been flat for the last year.
  • Debt/EBITDA is at 2x at the end of FY2013 which is high for a company like this. Even though utilities due to the demand elasticity are fairly safe on this count.
    • The increase in sales and profits has come at the expense of Debt/EBITA being driven up from 0.82 at the end of FY2009
  • Return on invested capital has fallen to 10% from 15%
  • Working capital management is excellent:
    • Inventories are below 3% of sales
    • Debtors are around 5% of sales

4. Soft factors

  • The president of India owns 56.11% of the company as of Mar 2014. FIIs own 17.35% of the company which is fairly high for a government company like this.
  • Corporate governance seems to be good

5. Pricing

  • There is little to discuss here as the under recovery mechanism puts me off. But if you really want to know I think PAT will grow at no more than 10% per year. Even if we assume it grows at this pace for 5 years and then for 5% I would say the security is cheap at 6.3 times earnings and its trading at 12 times or so. Also even if it were that cheap I would still worry that government can at any time start using GAIL's profits to fund subsidies. Debt management would also be a concern.