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It has been a long time now to write anything on the blog. Well, there are not many opportunities available today in the market to look at but we still found one to consider.

We were just browsing through the gas sector and found two businesses that attracted us to invest with. One was the IGL and another is Petronet LNG. IGL is trading at premium price today but Petronet isn’t.

Petronet LNG is a very new company to join our investment grade league. We never liked this business for many reasons but today it looks that the worse is over for it.

Year

2009

2010

2011

2012

2013

Quality & Performance grade

B3

C2

C2

C2

B1

The report card of this business is not that grade. It just recently got qualified as investment grade and looking at the performance of its intrinsic values, they fell down -3% last year and are expected to fall down by -29% for the year end 2014.

So why should one look at investing in Petronet today?

India is still facing with power shortage and all the economist and analysts are predicting about how India faces a big power deficit in the future years. This situation puts more pressure on the power generation companies. Apart from those pressures, they also face tough competition and also look for various commodities to use as raw material to generate cheap and cost effective power.

Power generation sector in India consumes almost 45% of total gas that is produced and imported in the country. This is expected to jump to almost 55% in three- to five years from today. Overall, India produced 110 MMSCND and imported 50 MMSCND of LNG in the 2012 -13 year. By the year end 2016 -17, India is expected to grow its production to around 250 MMSCND and the demand for gas will be approximately 500 MMSCND.

There is a massive gap of 50% expected in the next few years which will be required to fill by importing from the overseas. This opens a big opportunity in the market for new players to get involved in this business as well as for the businesses who are already in the oil & gas productions and mine and minerals businesses to get involved and reap its fruits and support their products.

Petronet LNG (PLL) was the idea evolved by BPCL, Gail India, IOC and ONGC who are the promoters and own half of this business together. PLL is involved in importing gas and building infrastructure to support their business.

PLL got qualified as an investment grade (B1) this year. The past quality ratings are not that impressive. They have come from the long way and this is the question comes up in our mind that is this a turnaround time or just another value trap.

If you go through the past 5 year’s annual report, you will find that this business was heavily loaded by borrowings (almost 1.5 times to shareholders fund) then what it is today. The positive thing we noticed was that this business is rich with its cash flows from operations. The managers of PLL have done really good job with these cash and have built up strong Balance Sheet. This was not an easy task and time consuming too. This reflects through its credit ratings from various other credit companies.

We don’t like debt in this business is because of the nature of this business. In simple terms they buy gas from overseas and supply that to their customers. They work on a very low margins, like in 2009, their operating margins before interest, depreciation and taxes was 12% and in 2013 they reported 6% for the same.

So, what is the major cost that is impacting to this business? It is LNG that they buy from overseas market. The biggest driver of fluctuation within that is the currency and also the price trends of natural gas.

The price of LNG was half then what it is today in the year 2009. We also don’t think that in the long run prices of LNG will fall. But same time we also don’t think that it will keep going up fast. Simple economics says that ‘market price’ is the mirror of what is the ‘supply and demand’ of underlying products. We think that the supply and demand for LNG will be well balanced and that will keep this commodity competitive in the market.

The second thing to understand before investing in this business is to understand the currency movement. The above chart is the comparison of PLL share price with US dollar. The dollar has appreciated by 20% against Indian rupee and same time the price of PLL tanked by 20% in last one year. If Indian rupee depreciates then the cost to import LNG will rise and impact Petronet LNG’s margins.

With the change in RBI’s leadership and also the attitude towards managing countries monetary policies, we do not think that Indian rupee will depreciate looking at next 1 – 2 years’ time frame. The other risk involved is the tapering of US fed in their stimulus. That can impact straight to all the global currencies and we are not immune to it. RBI is preparing for it today and we think that will only impact us for the short term.

The market price of PLL has fallen down to its expected intrinsic value for March 2014 (Rs 132 per share). The consensus are expecting earnings growth rate of 11% for the year 2015. If the consensus are right then we expect its intrinsic value to grow to Rs 147 per share for the year end 2015. This gives us a margin of safety of around 15%.

We are not that optimist in regards to their quarter 2 results that will be announced on the 17th October. We still think that their margins will shrink (because of massive fluctuation in the currency) but are optimist for their operating margins to improve in the third and fourth quarters.

We do not expect price of LNG to go up for a while and also do not expect Indian currency to weaken in the long run.  That makes this business worth to invest if what we believe is going to turn real. This does not mean that we are always right, what do you think? Will the operating margins will improve for Petronet LNG? Your views are most welcome.