Investor's Eye: Thematic Report (Closure of switch call from ITNL to IRB with 18.5% returns); Update - GAIL India (Annual report review)

 

Investor's Eye [September 21, 2012]  Sharekhan www.sharekhan.com

Summary of Contents THEMATIC REPORT Closure of switch call from ITNL to IRB with 18.5% returns   Key points Closing switch call from ITNL to IRB with 18.5% returns; outperforming Sensex and BSE-500: Our Switch Idea to shift from IL&FS Transportation Networks Ltd (ITNL) to IRB Infrastructure (IRB) released on June 22, 2012 has played out well, delivering 18.5% returns in three months. It has also outperformed the benchmark indices (Nifty, Sensex and BSE-500 all of which have appreciated by 9.5% to 10.5%) over the same period. So far we have closed nine switch calls with a success rate of 100% and an absolute average return of 21.7% as compared with an average return of 6.9% given by the Nifty over the same period. Rationale for closing the switch call No negative outcome of the legal issue bridges the valuation gap: With serious allegations made against the promoter of IRB (the promoter was linked to the murder of an RTI [Right to Information Act] activist), the IRB stock had taken a huge beating and was trading at an abnormal discount to its comparable peers including ITNL. The sharp correction in IRB had created a huge divergence of more than 2x standard deviation between the valuations of IRB and ITNL. ITNL usually trades at a 5-20% premium to IRB. This premium gap at the time of our call had widened to 40% offering a compelling buying opportunity. However, as stated by us in our switch initiation report, the allegations against the promoter have remained unfounded and the valuation gap has bridged now.  Time to book profit, though we remain positive on IRB: Since our call, IRB has appreciated by 20%, giving good returns to its investors. Thus, we believe one should book profit now. However, we continue to like the company from a medium-term to long-term perspective as it is the largest toll road operator and would be one of the beneficiaries of the tall target set by the National Highways Authority of India for projects to be awarded in this fiscal.  Prefer ITNL to IRB in the long run: Though we like both ITNL and IRB, but ITNL scores over IRB based on many parameters. ITNL is the largest road operator followed by IRB. It enjoys strong parentage and owns a well-diversified portfolio both geographically and in terms of annuity and toll project mix. Moreover, ITNL offers superior returns as compared with IRB. Lastly, with the interest rate cycle now expected to turn around, ITNL would benefit as its interest outgo is higher than IRB's.    STOCK UPDATE   GAIL India Cluster: Apple Green Recommendation: Buy Price target: Rs410 Current market price: Rs386 Annual report review Key points Maintains earnings despite higher subsidy burden, tariff revision and unfavourable revenue mix: GAIL India (GAIL) was able to maintain a flattish growth in earnings in FY2012 despite a surge in its subsidy burden (up 50%) and a one-time expense related to a tariff revision with retrospective effect in its gas transmission business (an adverse impact of Rs550 crore). The lower production of gas domestically also affected its transmission business, as a result of which the revenues got skewed in favour of the low-margin natural gas trading business. Gas sourcing remains a challenge; sourcing attempts visible: Given the declining gas production from the domestic sources (especially the Krishna-Godavari-D6 field), meeting the gas demand remains a challenge. Yet the gas supply volume remained flat during the fiscal, as the company obtained gas from other sources. The company has made several visible attempts in the past to secure gas supply and scouting for gas overseas on long-term and spot bases.   Expansion drive continues, added debt on books: During FY2012, GAIL commissioned various pipelines expanding its network to 1,337km. The activity was part of its long-term capital expenditure (capex) plan to add 7,500km of pipeline at a capex of Rs30,000 crore in the next three years. It incurred a capex of Rs6,752.8 crore to develop the pipeline in FY2012. It also expanded its petrochemical capacity at a capex. A significant portion of the capex is being funded through internal accruals as the company has generated more than Rs3,000 crore from operations in FY2012.  Return ratios remained downward biased: The return on capital employed (RoCE) declined by 350 basis points year on year (YoY) to 17% in FY2012 while the return on equity (RoE) declined by 190 basis points YoY to 18%. A lower contribution from the high-margin business also dented the return ratios during the fiscal. Dividend pay-out ratio maintained at ~30%; reflects yield of 2.3%: GAIL maintained its historical dividend pay-out record of around 30% (higher compared with 27% in FY2011 but in line with the historical trend of about 30%), which is Rs8.7 per share. This reflects a dividend yield of 2.3%.  Valuation and view: The Petroleum and Natural Gas Regulatory Board (PNGRB) has recently taken some tough actions in the oil & gas sector which remain a key concern for the sector. Further, the regulator has proposed a paper on unbundling of the transmission and marketing businesses of gas sellers (the concept paper has been floated and the regulator has invited comments from the industry by October 15, 2012). It would be premature to estimate how the move may affect GAIL, if implemented, but sentimentally it could be negative. We estimate the company's earnings would grow by 9% in FY2013 and by 5% in FY2014. Based on the sum-of-the-parts (SOTP) valuation method, we retain our price target of Rs410/share on the stock.  Click here to read report: Investor's Eye   Sharekhan Limited, its analyst or dependant(s) of the analyst might be holding or having a postition in the companies mentioned in the article.

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