Kejri Wave – Did India just get better or worse?

Kejri Wave – Did India just get better or worse?

“The (Indian) problems ……. are all homegrown,” said Juergen Maier, a fund manager in Vienna at Raiffeisen Capital Management, which oversees about $1.1 billion in emerging-market assets. “The best hope for India lies in the end of the current government, which has brought everything to a standstill.”

 “The decision by India’s top investigating agency to probe a third billionaire-led mining deal in six months puts at risk government efforts to revive $160 billion of stalled projects.”

Kejriwal has a hectic first day gets busy with poll promises – transfers 9 top-officials, including Delhi Jal Board (DJB) CEO.

Education minister Manish Sisodia has said the government crack down on private schools that are charging exorbitant fees and taking donations. “My top priority is schools. They cannot be profit-making businesses as they are foundations of nation building.”

CNG price up by Rs 4.50 in Delhi, Arvind Kejriwal smells a rat. CM-designate Arvind Kejriwal was quick to question the timing of the hike. In a tweet, Kejriwal stated, "CNG rates hiked in Delhi. Isn't the time suspect?"

Kejriwal, the latest poster boy of the Indian politics has formed a Government in Delhi with the (at best nebulous) support of the Congress.  His Cabinet consists of former journalists, a lawyer/ activist, an architect and a leather goods manufacturer.  Kejriwal himself a bright IITian, is a former Income Tax official. 

Obviously experience of public administration is not in abundance in the new Cabinet.  But since when has that come in question when matters like the larger public good are in question?  Didn’t one see the kind of public support for all words spoken by him during his swearing-in ceremony?  The common man loved the fact that there are promises of no corruption, free water of 700 litres per day to each household of Delhi and a cut of 50% in the power tariff. 

And woe betide all of those who question the economics of some of these items.  Ask the CEO of the DJB who reportedly dared to point out that there would be a deficit of 120 cr. in the DJB finances.  That can be taken care of by a subsidy of 30 cr. a quarter by the Government, came the reported reply from Kejriwal.  And then later fired her for sticking to her line.

Like all things socialistic, there is high appeal in these promises, which may end up saving a few hundreds/ thousands from the pockets of the citizenry.  So what if these amounts are spent in eating out or buying clothes?  In the process though, does anyone care about the wastages of natural resources?  It is but common knowledge that subsidies, if directed at the right segment of society can be beneficial but if done arbitrarily can lead to tremendous wastages in the system (all things being equal, a priced item will be used more sparingly than a free/ less expensive item). 

Can India afford it?  I have my sincere doubts.  Notwithstanding all that will be doubtlessly said about the efficiencies that will be brought about by lesser corruption and better management.  Read the history of socialistic governments which all started with the best of intentions.

Anyhow, my intention is not to make this into a discourse on politico/ economic theory.  I am more concerned about the return on my investments.  One of which is IGL, a company which hitherto has not had any major political interference.  However, now with Kejriwal, a person who wants to be seen as a champion of the common man, questioning the increase in the CNG price (which incidentally was done due to the Gujarat high court order that led to a cut in its entitlement of cheaper APM gas), there will exist, in my view, a large hangover on the future profitability of the company.  Again!

And then there is the larger question.

On one of my flights back from Mumbai to Delhi, I met with an old Citibanker friend, who used to run the Citibank Delhi Treasury and now runs a USD 1.2 bn fund.  I asked him that if he has to encapsulate his learnings of the last 15-20 years of running a fund, what would it be in a single line.  His words of wisdom: “Stay away from all companies that can be affected by the Government”.

That brought me back memories of what Mr Rahul Bajaj had said in one of his interviews (read my article dated March 2013 “Talking to the Hand”).

But even if one was to avoid companies with direct potential impact of the Government, what about the economy at large?  Even if a Colgate or an Asian Paints is not directly interfered to by the Government, wouldn’t, say, a general lack of foreign investment in India (thereby causing lesser job creation) affect their products’ demand?  They might be affected less by a slowdown than say a cyclical industry like cement, but they will surely be affected nevertheless?

In all this then, if everyone like Juergen Maier of Raiffeisen Capital Management, were hoping for an end to the current Government (and by extension hoping for someone like Narendra Modi to be PM, given his impressive track record of attracting large investments in Gujarat over the past decade), then there could be another twist to the tale due to the rise of the activist/ socialist Kejriwal.

With only 4-5 months left for the general elections, it is entirely possible that Kejriwal’s rhetoric (backed by some sensible and some economy debilitating actions) will put a serious derailing on Modi’s campaign.  And with Kejriwal’s “My party best, all others untouchables” kind of posturing, there is a likelihood of another fractured mandate.  This time at the national level.  And that will do India no good.

Hope I am wrong.  But I am watching the developments and plan on staying away from fresh investments at this stage.

IGL Returns....

IGL Returns…..

The name may sound like a movie sequel but there is a difference. Most movie sequels I have seen are not as good as the original. But the IGL story – a negative one as per my last blog (it had multiple villains, a teary storyline and no hero!), is likely to be better in the sequel.

Need for the Sequel

The reason for the rise from the ashes kind of story line for this company is some recent developments.

First: an affidavit was filed a few days ago by the Ministry of Petroleum and Natural Gas, which supported the stand of the marketing companies, including that of IGL, that PNGRB is not empowered to fix or regulate the maximum retail price (MRP) at which gas is to be sold by such entities.

The affidavit also clarified that the board is not empowered to fix any component of network tariff or compression charges for any City Gas Distribution (CGD) entity, the argument which was upheld by the Delhi High Court last year.

Stating that various provisions of the PNGRB Act, 2006, read with the policy are “unambiguous”, the ministry said: “Regulatory oversight over marketing and sale of notified petroleum products and natural gas would include enforcement of retail service obligations and marketing service obligations by the board. However, the Board is not empowered to fix the price at which the entities will market or sell notified petroleum and natural gas. The MRP is to be fixed by the entity. The board shall monitor prices and take coercive measure to prevent restrictive trade practices by the entities.” 

This is no different than what IGL and other Gas distributing companies had been stating all along!

It may be recalled that the Delhi HC order had been given in response to IGL’s plea challenging an order from PNGRB to cut it’s network tariff by around 63%. PNGRB also fixed CNG compression tariff at Rs 2.75 a kg against Rs 6.66/kg charged by IGL. The implementation of the order would have drawn the curtains on IGL’s finances (and that of similar companies).

With the latest development, in my view the probability of the SC upholding the Delhi HC judgment has increased manifold. Indeed, the PNGRB’s appeal to SC itself may have lost its sting. 

Recall that the PNGRB had gone to the SC challenging the Delhi HC order, and the SC had asked the Government to clarify on the powers of PNGRB.  With the creator of the law (Government) clarifying that PNGRB has no role to play in the price fixation, the criteria upon which the SC would base its judgment has become simpler.

The judgment, once given (and if in favor of IGL), should shoo away the major cloud hanging over IGL’s valuation.

Second: the other major development on this stock is the one relating to the increased pricing of the APM gas.  The Government recently took that decision too and the price was hiked from $4.2 to almost double (over $8.2).  Ordinarily that should have scared investors.  Not so.

In my view, this was a significant step taken by the Government towards ensuring the country’s energy security as also towards ensuring lower outflow of Foreign Exchange, given India’s reliance on imported fuel including Gas.  A higher price ensures better profitability for the E&P companies, making it more remunerative for them to make the required investments to search for Gas within the Indian shores.  Medium to long term, a great bit of news for the industy.

As far as companies like IGL are concerned, the best thing is that unlike the PNGRB order, the APM price increase order hasn’t sprung up on them as a surprise.  Rather, the new higher Gas price is applicable only from April 1, 2014, giving enough time to them and the entire sector to adapt.

So…

Story line sans the suspense

What does that do to the prospects of IGL?  Recall my previous blog wherein I had stated the 3 main causes of worry over IGL.  2 of them (SC appeal and APM gas pricing) have been solved and the 3^rd one (marketing margin) wasn’t a great worry anyway as PNGRB never looked keen on pushing in that direction. In fact the latest Government affidavit also seems to have cleared the lack of clarity on that front.

Meanwhile, for doubting Thomases like me, the deteriorating Rupee too had become a cause of worry – not so much because the company is unable to pass on the additional cost to the consumer, but because with every rise, the price arbitrage that CNG had with Diesel, was fast disappearing.

Just to recall, the following is how it looked for the company as regards the costing and margins:

- APM gas is ~68% of the total gas requirement

- Total blended cost of gas is around Rs 17-18/scm and EBIT is around Rs 5/scm

- APM gas costs ~ Rs 11/scm and LNG is around Rs 32/scm (hence 68%*11 + 32%*32 = ~17-18) 

- Doubling of the APM gas component will move the cost up by Rs 7-8/scm (68%*11*2 + 32%*32 = 25 compared to earlier cost of Rs18). This would translate to an increase in the selling price of CNG by 11-12/kg.

The existing price of CNG in Delhi is around Rs 42/kg.  Hence an increase of Rs 11/kg would take the CNG at par with Diesel (Diesel is also being hiked regularly by Rs 0.45 per month).

True.  However, the interesting aspect is that the existing conversions from Petrol cars to CNG, are still continuing at the rate of 4000-5000 cars per month.  Ergo, this shows that CNG continues to hold its appeal as an alternative to Petrol if not against Diesel.

Besides the cars, the ‘captive business’ – commercial vehicles, buses and auto etc., which have no option but to run on CNG will continue providing the ballast to the CNG business. 

As a matter of fact, this part of the business is expected to get a fillip from a large number of new bus acquisitions by both Delhi Transport Corporation (DTC) and Delhi Integrated Multi-Modal Transit System (DIMTS). As compared to an addition of only 400 buses in FY13E, DIMTS and DTC are likely to add more than 3000 buses in FY14 as per independent analysts who have met the managements of the two organizations.

Additionally, as against the Supreme Court mandate (Nov’11) of adding 45K new auto rickshaw permits, the actual addition has only 5K.  Now, the Delhi Transport department is running with a target to add at least 10K permits p.a. over next couple of years. A larger figure was also confirmed in an interview with Rajiv Bajaj of Bajaj Auto, the premier supplier of Autos.

And of course there is PNG, which is almost an annuity business given the stickiness of demand, especially that of households.  The company continues to do major investments on laying pipelines and other infrastructure to provide PNG to the end customer.  Just to provide a perspective, IGL has only 400,000 PNG customers in a market size of 4 million LPG customers – all potential converts to PNG given the economic dynamics of PNG vs LPG (in the new dispensation). The only thing holding back the company from connecting the whole of Delhi by PNG is the plethora of regulatory/ bureaucratic approvals from local agencies as well as own capacity to implement.

What the above implies is that the volume is undeniably available – let us assume that the volume growth will be anywhere from 10%-15% over the next few years.  That’s a position many companies would love to be in.

What about the implication on volumes once APM gas price is doubled?  As I have elaborated above, much of the demand for CNG (buses, autos etc.) is inelastic.  The other part of the demand (cars and PNG) still finds this economically more advantageous than the alternative (Petrol/ LPG).  In fact in many places including in Gujarat and even nearby Meerut etc., the selling price of CNG is ~Rs 60 (compared to the existing price of Rs 42 in Delhi and Rs 52-54 even after the eventual doubling of the APM prices).  This proves that the market is willing to pay a higher price for the product.

What else could go wrong?  Could APM gas allocation to IGL be reduced or removed given the pressure over the Government to allocate more gas to the Fertilizer and Power industries?  Little chance of that in my view, given that City Gas distribution companies like IGL are not major users of APM gas anyway.  But in any event, the most such an event could do is make the selling price to around Rs 60 – a price at which as I have mentioned above, there is continuing demand.

Furthermore, logically speaking, the Government’s efforts in propping up the Gas potential of India by increasing the gas prices as well opening up the Shale gas policy should result in more gas in a couple of years – hopefully at prices that are lower than today.  Why?  Because in my view, fillip to the gas exploration efforts all over the world will make gas prices fall (they already are) and also because India will be less exposed to the vagaries of Foreign exchange fluctuations, given the localized production.  That really augurs well for the medium term prospects of the company.

Action!

With this, we can focus more on the normalized valuation of the company as opposed to figuring out the ifs and buts of uncertain items like court judgments and input pricing.

The current valuation of the company is at ~6X cash flows (EV of ~4000 cr. and a cash flow of ~600 cr.).  For a company which has such a fine business model, a monopolistic and large market, a good management as well as pricing power, wouldn’t you give at least a valuation of 10-12X cash flow (even in these troubled times)??

If the answer’s yes, then this would value the company at upwards of Rs 6000-7000 cr., providing a minimum 50% upside to current levels.

IGL returns, the sequel is likely to provide good returns from IGL! 

And that’s my kind of movie…

Talking to the Hand

Talking to the Hand

Mr Rahul Bajaj, chairman of the Bajaj Group and a former parliamentarian has a penchant for not holding back his punches.  At a public forum (and in the presence of a Union Minister) at the World Economic Forum in Nov 2012, he not only accused the government of policy paralysis and weak governance but is also reported to have said: ""We decided many years ago, decades ago, that we will not do business where we have to deal with the government. We don't manufacture, we don't buy things for the government... We are in motorcycles, the financial services... We do not want to have anything to do with their bidding process".

He seems to have said openly what many in the Indian business say in private.

As per basic Economic theory, in a free market economic system, resources are allocated through the spending decisions of consumers combined with the supply decisions of producers. When demand is high, the potential profit from supplying to a market rises, leading to an expansion in supply to meet the rising demand and vice versa.  Adam Smith conceived the existence of an invisible hand of the market as a metaphor to describe this self-regulating behavior of the marketplace.

But very often, it is almost as if the invisible hand of the market forces is made to talk to the Government’s visible hand.

Government as the saver-spoiler

Per its mandate, the Government can always intervene whenever it feels that it needs to protect the Consumer or Businesses from the free Market forces. 

QE, stimulus measures, TARP, trade restrictions, pricing restrictions (e.g. Indian Pharma), Forex interventions – there are several forms in which the Governments world-wide force their hand.  Much as we love to loathe the government interference, one has to admit that the Government does have a fiduciary responsibility to intervene when things go out of hand.  Whether they are effective or not (or more devastating than useful) is another matter altogether.

But one aspect of the discussion is whether Government intervention is a nice to have on a more generic basis…you know.. like on a Macro basis.  And entirely another whether we as investors should have anything to do with companies that have negative exposure to Governmental intervention. 

One specific company that I have in mind for the discussion is Indraprastha Gas Limited (IGL).

Before the Regulatory storm hit IGL, it was considered in the value investing circles as a Buffett stock.  It had a ready market: a monopoly over supply of CNG (later also PNG) in Delhi and much of NCR, combined with the statutory requirement that all public transport buses, auto, taxis etc. need to ply on CNG (which as a fuel, has a pricing advantage over Petrol).  And it had pricing power: it had demonstrated an ability to pass on any increase in its Gas procurement cost to the Consumer (unlike the downstream oil companies who, being under Government control, could not raise prices of fuel without first checking with the Government).  Good growth, great returns, good management, negative working capital… the works.

Then, in April 2012, PNGRB, the Government appointed body for Petroleum and Natural gas, gave an order that shook up not only IGL, but the entire City Gas Distribution (CGD) industry.  PNGRB mandated that IGL had to cut its tariff by ~ 63% (on a retrospective basis from 2008!) and return the excess collected by it back to the consumers.  In effect, this would have meant a serious challenge to the networth of the company while eroding its operating margin completely.  This is what happened to the IGL stock.

An over 50% fall in a matter of hours.

IGL duly took the case to the Delhi High Court and won it in June 2012, upon which, the PNGRB took this up with the Supreme Court of India (SC), which is where the case presently is.  The next date for hearing is listed for April 4^th 2013.  Issue 1.

To complicate matters further, there has been a simmering dispute inter-se the Government, PNGRB and gas distribution companies on something called a marketing margin which is a part of the final cost charged by the Gas distribution companies (including GAIL, RIL as well as the CGDs).  The Government and PNGRB desired transparency and uniformity in the charge and the latter needed to have the freedom to control it depending on their requirements and circumstances.  There is no final word on this.  Yet.  So this is the 2^nd Damocles sword hanging over IGL’s head, so to speak.

Mind you that the marketing margin is a fairly critical element because technically, even if the Supreme Court case was to go against IGL, they could hike the marketing margin to safeguard their margins.

And as if these 2 issues weren’t enough, another recent complication is the APM gas allocation.  The price of natural gas produced by National Oil Companies, namely, Oil & Natural Gas Corporation Ltd. (ONGC) and OIL India Ltd. (OIL), is sold at Administered Price Mechanism (APM) price – which is lower than market price – for the purpose of usage in high priority industries such as power, fertilizer, CGD etc.  This price was last revised in 2010 when it was doubled from $1.9 per million metric British thermal unit (mmbtu) to $4.2mmbtu.

Unfortunately, the low prices of gas under APM have had the effect of discouraging these companies from making investment in further exploration.  Helped by this realization and doubtlessly some energetic lobbying by Reliance Industries (they also want a revision), there are moves afoot to double the price of APM gas to $8-8.5mmbtu sometime this calendar year.  It has been reported that the Ministry of Petroleum and Natural Gas has forwarded the note to the Cabinet citing the Rangarajan Committee’s suggestions along similar lines.

No doubt that such an action’s larger implications on matters such as inflation – that too in an election year, will be discussed seriously at the Cabinet.  But the Government seems to be eager to show that it can take bold policy actions.  And this matter has assumed an urgency since this was obliquely mentioned by the FM in the recent Budget speech.

So there you go..  An example where Governmental action – if and when it happens on the APM pricing – is clearly good for the long term benefit of having prices that are market driven and not artificially created (the new rate of $8mmbtu is closer to market price than $4.2).  And certainly there are winners, viz., the Gas producers who were till recently at the wrong end of the stick.  But there are losers too (all users of APM gas, viz., gas based power, fertilizer and CGD companies – and by extension, all consumers of the final product, be it power, fertilizer or CNG/ PNG – as most certainly, the producers will need to pass on the cost).

Back to the implications of all of these items on IGL.

So we have discussed 3 uncertainties on the company’s future: a) the dispute with PNGRB (currently at SC) b) the dispute of the marketing margin and c) pricing of the APM gas.  All having the imprint of the Government hand on them.

As regards the SC case, I understand that there is a lot of rumor mongering in the market regarding the final verdict – most of which suggests that the verdict will happen soon and IGL will win hands down.  How that has emerged, I have no idea since the company officials themselves privately and otherwise show no such bravado.  And they are in touch with the legal proceedings.

As regards the other 2 items of uncertainty, there is no saying when the Government is going to move (or not) on them.  Suffice it is to say that there are larger forces at play on such decision making.

However, negative or positive outcomes of each of these issues could move the stock substantially and hence I submit that these are not low risk/ high uncertainty outcomes where the profit could be large.  On the other hand, these are high risk/ high uncertainty outcomes where one needs to be very careful.

I would thus ascribe probabilities on each of these outcomes and a value to the stock on each such consequence.  Here is what I have done:

You can work on more situations and ascribe different probabilities or values to it.  But either way, my decision would be to look for an exit to the company as evidently the probabilistic workings (above) based on currently available facts, don’t show a material upside to the current price.

Sad end to a favorite holding but with too many uncertainties – each with large negative implications, I would rather leave something on the table for someone else who is willing to assume that risk.

Once again Mr. Bajaj – I have to agree with you.  I don’t like talking to the Government hand either..