Kotak ’downgrades’ GAIL stock after a stellar nearly 70% run in 2023. Here are 3 major reasons why

GAIL (India) share price declined 5 per cent in early trade on Tuesday, January 2, a day after the brokerage firm Kotak Institutional Equities downgraded the stock to a sell from a reduce. GAIL share price opened at ₹167.55 against the previous close of ₹166.30 and fell 5 per cent to the level of ₹158.05 on the BSE. Finally, the stock closed 1.47 per cent lower at ₹163.85.

Kotak Institutional Equities has downgraded the stock of GAIL (India) to a 'sell' from a 'reduce' while raising the target price (fair value) to ₹125 from ₹120 due to the strong gain of the stock last year.

GAIL share price surged 68.6 per cent in 2023, strongly outperforming the equity benchmark Sensex which rose about 19 per cent. In the previous session on Monday, January 1, the stock hit its 52-week high of ₹169.35.

Kotak observed that GAIL share price had a good run, linked to high oil prices before. However, despite oil prices dropping, GAIL's stock stayed strong because of hopes for higher transmission volumes. Kotak believes India's future gas demand looks weak in both the medium and long term, despite recent high gas use.

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The brokerage firm said its assumptions for GAIL’s key businesses have been as such liberal.

"We have increased transmission volume assumptions further by 1-3 per cent to an optimistic 128/134 mmscmd for FY25/26E. Offset by higher costs (lower APM allocation) and 48 per cent reduction in the KG basin pipeline tariff, the EBITDA increases are nominal at nearly 1-2 per cent," said Kotak.

Here are three major reasons why Kotak has downgraded GAIL stock:

1. Optimism-driven rally

Kotak pointed out that GAIL is realising a nearly 18-20 per cent higher tariff versus approved by PNGRB (Petroleum and Natural Gas Regulatory Board) for its INGPL (Integrated Natural Gas Pipeline) network which is a positive. However, the brokerage firm believes that the strong run is driven by optimism.

"We believe that the strong run is driven by optimism. A few months ago, the stock was strong, as oil prices were firming up (despite limited benefits from higher oil prices, in our view). Recently, India’s gas consumption has been at record highs and there is optimism about the transmission business now," said Kotak.

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2. More pipelines may not mean more volume; RoCEs will get lower

Kotak expects GAIL's transmission volume to rise further and assumes GAIL will continue to recover higher tariffs on INGPL.

"Compared with 107/118 mmscmd in FY23/1HFY24, we assume GAIL’s transmission volume at optimistic 121/128/134 mmscmd in FY2024/25/26E. We note that GAIL is completing several new pipelines, with investments of over ₹30,000 crore in FY2024-25E," Kotak said.

Kotak underscored that driven by the INGPL tariff rise, higher realisation versus approved tariff and strong volume, GAIL's post-tax RoCEs (return on capital employed) will recover from less than 4 per cent in FY23 to nearly 8 per cent in FY24.

However, Kotak added that despite its assumption of GAIL continuing to recover higher tariffs on INGPL of nearly ₹70/mmbtu versus approved ₹58.6/mmbtu, it expects GAIL’s post-tax transmission RoCE (return on capital employed) to decline to below 7 per cent in FY26E.

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3. Petchem capex a worry

Kotak pointed out that in the petrochemical segment, GAIL reported EBIT loss for the past five quarters.

"In the second half of the financial year (2HFY24), though feedstock costs should decline on lower HPHT (high pressure and high temperature) ceiling, domestic PE prices are down 4-5 per cent. Return to profitability looks difficult," Kotak said.

"For the LPG segment, profitability should return in 2HFY24. However, at the current APM price, GAIL’s breakeven LPG price is near ₹43-44/kg and losses can return during the summers (1HFY25). Despite weak profitability, GAIL’s further large capex in the petrochemical segment has been a key worry," the brokerage firm added.

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