Perusahaan Gas Negara, Solid choice for rotational play

PGAS’ long term outlook remains bright despite concerns over its short term gas supply. As Indonesia’s largest gas distributor with an 85% market share, it is well positioned to venture into other gas-related businesses as well as undertake upstream takeovers. We see PGAS as a defensive rotational play given its strong domestic exposure, which partly insulates it against inflationary effects. We re-initiate coverage with a BUY and a SOP-based TP of IDR6,500.

Positive outlook
While Perusahaan Gas Negara (PGAS)’ efforts to grow its liquefied natural gas (LNG) business are ongoing, its existing and potential gas supply blocks are still its key growth drivers. As Indonesia’s leader in gas distribution and transmission with market shares of 83% and 51.7% respectively, it should be in a healthy position to venture into other gas-related businesses.

Even amid tough economic conditions and growing inflation concerns, we like PGAS’ defensive nature due to the following: i) its huge cash pile and solid balance sheet have enabled it to pay attractive dividends, ii) it has captured the market by locking in long-term contracts, iii) it is not exposed to the volatility in international gas prices as it is a domestic player with strong B2B customer relationships.

Targets and risks We estimate PGAS’ 2013 and 2014 distribution volumes at 848 million standard cubic feet per day (mmscfd) (+5% y-o-y) and 949 mmscfd (+12% y-o-y) respectively, while factoring in a moderate long term margin spread of ~USD4 per million British thermal unit (mmbtu). However, we do not see any solid earnings drivers for 2013-2014 other than its existing and potential new gas blocks.

Meanwhile, the group’s potential gas block acquisitions amounting to USD1bn, short term pipeline projects valued at USD250m-USD500m and the USD300m floating, storage and regasification unit (FRSU) project in Lampung may potentially boost its earnings in 2015.

Defensive play
PGAS is a solid pick for a rotational play amid a rising budget deficit, growing inflation and weakening rupiah. We are positive on its upstream oil and gas (O&G) blocks and LNG assets. We find its 2014 P/E of 15x, which is near its five-year historical forward P/E, attractive as this provides some upside. We recommend a BUY on the stock, with our SOP-based TP at IDR6,500.

Ease In Entering New Businesses

Stability is key
PGAS demonstrated the ability to adjust its selling price from an average of USD8.8/mmbtu to USD9.8/mmbtu to customers in West Java back in April, which lends weight to our forecast that its distribution margin spread will remain stable at ~ USD4/mmbtu in the long term. The margin spread is not as high as 2012’s USD4.3/mmbtu as there are no more high gas charges to customers who exceeded their quotas, since distribution channels and gas supplies have risen as the result of the gas price evaluation.

Furthermore, our distribution volume forecasts of 5% y-o-y and 12% y-o-y growth for 2013 and 2014 respectively is deemed conservative, mainly due to its new supply from Conoco Phillips. We believe that a 10% increase (or 40 mmscfd) in supply from Conoco Phillip’s existing contracted amount of 400 mmscfd is plausible.

Rich balance sheet
As the recent depreciation of the rupiah could pose as a risk to Indonesia’s macroeconomic stability, Bank Indonesia has raised the deposit facility (Fasbi) rate by 25 bps to 4.25% and bumped up its benchmark rate by 25bps to 6% from 5.75% previously. This should benefit PGAS as it would be able to deposit its consistently growing net cash and enjoy more favorable rates. Note that its net cash position of USD940m in 1Q13 has not been allocated for potential large upstream block acquisitions yet.

Furthermore, the softening yen will benefit PGAS, as 70% of its long term debt is in yen loans and the remaining 30% is in USD denominations. The less robust macroeconomic environment in Indonesia, which implies inflationary concerns, is not expected to impact the company’s fundamentals.

Stock valuation near five-year historical forward P/E
The stock is currently trading at a 15x 2014 P/E, which is near its five-year historical forward P/E. PGAS’ share price has been going up amid high market liquidity and rotation play on defensive stocks, out-performing the Jakarta Composite Index (JCI) by 18%. In addition, the company has been able to pass on its rising gas cost to customers by increasing its average selling price (ASP) in April.

Upstream venture
PGAS acquired participating interests in two gas blocks in March-May 2013, comprising:
i. 20% of the Ketapang block in East Java worth USD71m. The operator will be Petronas Carigali SB, which owns 80% of the project. The block has 84 million barrels of oil equivalent (mmboe) of 2P reserves valued at USD4.5/BOE. The project is currently approaching its production stage and full production could generate 25k barrels/day and 50 mmscfd.

ii. A 30% stake in the Bangkanai project in Central Kalimantan worth USD27m, with an option to invest up to USD30m to develop the block. PGAS acquired the stake from Salamander Energy Ltd. The block possesses 2P reserves amounting to 24 MMBOE valued at USD4.6/BOE.

PGAS’ combined interest in the two blocks amount to USD98m, which is minor when compared to the total amount it has allocated for acquisitions. In fact, it plans to increase the allocation for acquiring upstream blocks to USD1bn. As the remaining arrears are not fully disclosed yet, we are not factoring them into our estimate for now but consider them as a potential upside factor.

Upstream acquisition a wise move
As PGAS’ cash pile stood at USD1.67bn in 1Q13 and its net cash position was solid, its decision to allocate such funds for upstream acquisitions is a positive growth strategy. We see its USD1bn allocation to acquire O&G assets this year as a wise move to grow earnings in the long term. However, we also believe that the true value of an upstream acquisition lies in the target’s ability to secure future gas supply and improve the Group’s bargaining power with suppliers.

PGAS is known as a defensive stock at this current stage. Risks are inevitable in large acquisitions of upstream projects, but investments of such a scale (accounting for a healthy portion of its total businesses) are necessary for the company to gain alpha exposure.

Liquid natural gas (LNG) terminal construction update
PGAS’ second FSRU project was at the keel-laying stage at the Hyundai Heavy Industries shipyard in South Korea at end-Feb 2013. The FSRU will be located in Lampung. The project is progressing on schedule and is expected to be completed in mid-2014. The new USD300m 100%-owned FSRU will be able to receive 2m tonnes of LNG per year.

As part of the expansion, PGAS plans to establish a ~80 km pipeline in Lampung at an investment of USD250m-USD500m. Together with the FSRU, the pipeline will help ensure the supply of gas for customers in the West Java-Southern Sumatra areas.

In an effort to protect its LNG investments, the Government has allocated domestic LNG to be supplied to FSRU terminals across Indonesia. PGAS’ new 100%-owned FSRU has the right to receive 10 cargo allocations per year (equivalent to around 0.6m tonnes/year), which is roughly 30% of its full capacity. The company has noted that its LNG segment is still seeing low demand in the short term given the high LNG prices.

However, its long term prospects should be bright, even as the company goes through a learning curve, since experts believe that Indonesia will import LNG from other Asian countries by 2018 in order to meet increasing domestic demand.

Valuation
We derive our TP of IDR6,500 based on SOP, which breaks down PGAS’ DCF and the values of its upstream assets and LNG business. Although its distribution and transmission business accounts for 97% of the company’s equity value, we see upside potential for its other ventures, which may potentially make up a higher portion of our SOP valuation. In our DCF calculation, we are assuming a long term growth rate of 6% and WACC of 10.5%. Our assumptions in determining the equity value for its upstream assets and LNG business are conservative.