Petronet LNG Valuation: Schrödinger's Stock

Petronet LNG (PLNG) is the market leader in India's LNG re-gasification industry. With the Government of India explicitly pushing their alternative fuel agenda, PLNG could gain considerably in the future. But as with most companies, the promise of prosperity comes with its own set of risks.

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The Company

Petronet LNG (PLNG) is the market leader in the LNG receiving and regasification business in India. The company has set up the country’s first LNG receiving and regasification terminal at Dahej, Gujarat and another terminal at Kochi, Kerala. While the Dahej terminal has a nominal capacity of 15 MMTPA, the Kochi terminal has a capacity of 5 MMTPA.

The company is in the process to build a third terminal at Gangavaram, Andhra Pradesh. A couple of other important plants are also in the plans:

(Source: Ventura Research Report on PLNG)

Formed as a Joint Venture by the Government of India to import LNG and set up LNG terminals in the country, it involves India’s leading oil and natural gas industry players. Their promoters are GAIL (India) Limited (GAIL), Oil & Natural Gas Corporation Limited (ONGC), Indian Oil Corporation Limited (IOCL) and Bharat Petroleum Corporation Limited (BPCL).

The company has put up a presentation about itself on YouTube, which comes in handy to understand their business a little better:

Business Analysis - SWOT

Petronet LNG's business has been dissected here based on the company's Annual Reports, their Corporate Presentation, the Ventura Research Report on PLNG (A very good one) and general secondary research.

Strengths

• PLNG has the highest market share in this space and can play a huge part in bridging the demand-supply gap in LNG imports and regasification.

• PLNG already has large plants at low capacity utilization levels. If the demand for imported gas indeed picks up, the operating leverage can kick in to aid profitable growth.

Weaknesses

• When all is said and done, the regasification business is a commodity business and therefore, reliant on supply and demand of raw material (Here, gas). Any high-demand situation in gas abroad can dent PLNG’s margins quite easily. However, currently, the prices seem to have stabilized.

• Since the firm largely supplies to the Oil & Gas giants of India, bargaining power with customers is non-existent. On the other hand, the firm imports gas based on long term fixed-price contracts. So once again, bargaining power with suppliers is also quite less.

Opportunities

• As already discussed, the upcoming push towards green energy and a lack of local gas production offers a lot of value to the company on a golden plate. It’s only a matter of how large a piece of the pie the company can claim for itself.

• The company has also been applying (Although highly unsuccessfully) for City Gas Distribution License (Source 1, Source 2). If PLNG could somehow win a license, it will mark a foray into a new, prosperous, challenging segment with its own set of opportunities.

• In the past few years, the company has been negotiating gas import contracts with more suppliers (Exxon in Australia, Henry Hub in USA to name a few). Done successfully, this will spark a price war and hopefully, PLNG can get their raw materials at a cheaper price. The diversification of raw material sources also comes as an advantage.

• If and that’s a big if, PLNG can negotiate shorter term contracts instead of long term contracts, raw material prices can come down significantly. My memory slips where I read this exactly, but the difference could be as much as 50% lower.

Threats

• Many of the company's proposed and WIP construction and related catalysts for more capacity have faced headwinds. For instance, their Gangavaram project is still being completed well past the initial target. Also, the commissioning of GAIL's Kochi-Mangaluru pipeline, which will bring a considerable amount of synergy for PLNG has been delayed (Yet again). Further such inefficiencies and delays could cost the company.

• Since the LNG regasification business is at its very nascent stages, there's always the possibility that a lot of competition will emerge at later stages. We don't have a shortage of players in the Energy industry.

In totality, PLNG is a good business with a massive business opportunity in front of it. In my mother tongue Tamil, there's a famous proverb/phrase that goes: அள்ளி எடுக்குறதும், கிள்ளி எடுக்குறதும். A rough translation would be: Scooping it up, pinching it up. It is in the hands of PLNG to scoop up the opportunity or just pinch it.

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The Business

Most LNG regasification businesses follow the below Value Chain:

To put it shortly:

1. Sign long term, fixed price contracts with gas suppliers from overseas (Ex: PLNG has signed such contracts with Gaz de France and Ras Laffan LNG Company)
2. Process the purchased gas in liquefaction plants.
3. Store them in LNG storage tanks or ships.
4. Sell them to Oil & Gas clients, after which the gas will be vaporized and transported via gas pipelines (Ex: In India, the buyers are largely IOCL, BPCL, GAIL and ONGC as of now).

But perhaps the most important point to note is the divide between expected demand and the current supply of LNG. The quest for alternative fuel has been a common denominator in most parts of the world. Closer in Asia, India and China have been spear-heading the change. Even if India were to simply move towards the global average power mix, it would still mean a massive shift towards gas:

In fact, PLNG’s direct competitor, Shell, even came out with a statement expressing their enthusiasm about the LNG market prospects in India. The overarching story is that the Supply-Demand situation for gas in India is highly skewed. Supply is only a fraction of the projected demand:

Considering how the domestic gas supply isn't up to the mark, LNG regasification businesses will have to depend on imports to fill the gap.

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The Numbers

I have taken the numbers from PLNG's 2018-19 Q4 results (2018-19 Annual Report isn't out just yet) and a few data points from the 2017-18 Annual Report. Data from Screener and Y! Finance have also been used to derive some of the numbers you will see below.

Note: Risk-free Rate

The current 30-year GOI Bond Yield (Which I consider to be the Risk-free Rate for Indian investments) is trading at 6.863%

(Source: World Government Bonds)

Note: Cost of Capital

I did calculate the Beta of Petronet LNG and the CAGR of NIFTY 50 for the past 5 years (Usual components of my CAPM-based Cost of Capital), but due to the current market turmoil I believe that these figures are distorted.

(Download Petronet LNG - Beta and Standard Deviation)

In fact, if I use the above values of Risk-free Rate, Beta and Market Returns to calculate PLNG's Cost of Capital, I will end up with ~7.51% and change. That's a ridiculously low value by any measure. So I will be choosing to ignore this method for the sake of this valuation.

Instead, I will take a look at the Cost of Capital spread for Indian companies (Credits: Prof. Aswath Damodaran's 'Useful Data Sets') and pick the 70th Percentile. Put another way, I believe that PLNG's business is riskier than 70% of businesses in India (You will see justification for this later):

In essence, I will be using 14.26% as the Cost of Capital to discount PLNG's future cash flows.

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The Capital Conversions

PLNG does not have significant R&D Expenditure, Debt or outstanding ESOPs/Warrants.

Operating Lease

What PLNG does have is an Operating Lease arrangement.

(Source: PLNG's 2017-18 Annual Report)

Putting the PV of the Operating Lease and the long-term Debt together, PLNG's D/E Ratio rises from ~10% to ~30%, so the Lease expense are indeed substantial for PLNG. Of course, this also means that PLNG's Depreciation will be higher in the earlier years in our DCF, so that will help increase the FCF (Although effectively - the PV of the Lease will be removed from the final value).

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The Assumptions

The following assumptions have been made based on our discussion about the LNG regasification industry and PLNG's own business in it:

Note: High Growth Period

As discussed, I believe that a lot competition will emerge in the LNG regasification industry once the proof of rewards start appearing. So, I have limited PLNG's High Growth Period to 15 Years.

Note: Sales Growth

For Sales Growth, we have two options:

1. Long Term (10-year) CAGR in Sales: 16.66%
2. Long Term (10-year) Sustainable Growth Rate: 16.13%

Since they are quite similar, I'm going to go ahead and use the Sustainable Growth Rate. As a practice, I generally try not to exceed the Sustainable Growth Rate (Unless I have a really good reason). So, I am going to stick with 16.13% as the Sales Growth estimate for the first few years.

But as we discussed, GOI's quest for alternative fuel will enable PLNG to grow slightly higher (20% higher, in this case) during Years 5-10. Post this, Growth will taper down. After all, regardless of the opportunity size or management skill, size eventually impedes Growth.

Sales Growth in the Terminal Period cannot exceed the Risk-free Rate for any company. I generally use half of the Risk-free Rate, which would be 3.43% in this case, but I have used a slightly higher 4.58% (Two-thirds) for PLNG, considering its strategic importance for GOI.

Note: Operating Margin

PLNG has had a fluctuating Margin profile in the past. But as we discussed in the 'Opportunities' section, there is a good chance that PLNG will negotiate better Margins or at least more stable Margins for itself.

So instead of going for the long-term Average Margins, I have chosen to stick with the near-term average Margins, which turns out to be 9.26% or so. I have also assumed that PLNG will be able to improve this Margin a little (10%) for Years 5-10, before mean-reverting to its own long-term average Margins of 6.62% in the Terminal Year.

Note: Tax Rate

In her statements post-budget, the Finance Minister Nirmala Sitharaman said the following:

"We have brought it [corporate tax] down in order that now 99.3 per cent industries are all covered by the 25 per cent rate and, therefore, hardly any is left behind. We shall cover them sooner".

So, I have assumed that PLNG's Long Term Average Tax Rate of 29.28% will converge to GOI's target tax rate of 25% over the years.

Note: Capital Turnover

PLNG does have a lot of Capex plans stuck in a limbo. But this also means that a lot of Operating Leverage is just lying in wait to be utilized. So, I have assumed that PLNG's Capital Turnover will be higher than the historical averages for the first 10 Years.

Note: Opportunity Cost

As already explained, I will be using 14.26% as the Cost of Capital to discount PLNG's future Free Cash Flows.

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The Diagnostics

'The Diagnostics' section will tell me if there is anything grossly incorrect with my assumptions:

There are some yellow flags, the reasons for which are already justified. But there are no red flags to be seen here. So, let's move on.

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The Cash Flows

This is how PLNG's Cash Flows will evolve based on our assumptions:

Put another way, this is how PLNG's Business Life Cycle will look like based on our assumptions:

And with that, we have everything we need to determine the Value of PLNG.

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The Value

Petronet LNG is fairly valued like below:

I believe PLNG's stock is fairly valued at Rs. 256 a piece, indicating a 7% undervaluation at the CMP. You may notice that I have used a Margin of Safety of 30%, usually the highest percentage I use in my Valuations. Why did I use a 30% Margin of Safety? Please do read on. There's a good reason why this blog post is titled the way it is.

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The Sensitivity of Value

'The Sensitivity of Value' tool shows different Value for PLNG based on varying assumptions for Terminal Growth and Cost of Capital:

So if you are indeed fully determined to purchase PLNG's stock, Rs. 185 or below would be excellent to consider as the target purchase price range.

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The Model

If you think something is off with my assumptions, you can download the valuation model and correct the mistakes yourself:

(Download Numbers and Narratives - Petronet LNG)

Feel free to comment down below about any substantial deviations from my calculated value. A constructive conversation goes a long way.

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Schrödinger's Stock

After the usual valuation is done as above, I normally perform a Monte Carlo Simulation to arrive at a range of values for the stock. This would be done based on the company's risks (Say, differing Margins or differing Reinvestment needs). But I have refrained from doing this exercise for PLNG.

Because, let's be honest. The biggest risk for PLNG comes from the fact that 50% of the company is held by India's 4 largest Oil & Gas giants, who also happen to be the company's sole customers:

(Source: PLNG's 2017-18 Annual Report)

Of course, I cannot exactly place a finger on how this would impact PLNG's business. But all I do know that this structure is not in the interest of the Minority Shareholder. In fact, the management is on record saying the following:

"..have some good economic ties with the SAARC nations, so we are simply furthering the objective of Government of India also and, of course, the commercial consideration, returns all these are to be ensured while doing all of these things."

Clearly then, furthering the interests of GOI / building a relationship with the SAARC nations is more important to PLNG than the Minority Shareholder's interests.

I don't have the faintest idea of how to account for this in the Valuation process. Maybe PLNG will be asked to give up their Margins in the future for the sake of nation-building (We already know that his happens with the existing Energy PSUs). Maybe PLNG will be asked to make terrible reinvestment decisions on the behest of the GOI. Just like Schrödinger's Cat, anything is possible until it happens.

(Source: ScienceHook)

I have indeed applied a Margin of Safety of a high 30% before arriving at the Fair Value of the company. But will this be enough to cover for the risks facing the company? Does the quasi-PSU nature of PLNG demand even more caution? Dear reader, you should attempt to answer these questions yourself before looking at Petronet LNG as an investment.