Perusahaan Gas Negara, Debate On Merger With Pertagas Heats Up

The controversy over the PGAS-Pertagas merger plan is heating up. PGAS and Pertamina have conveyed their respective views on the proposal to the Government, but this has led to concerns whether any decision would be motivated by politics rather than in the national interest. We draw up scenarios of any potential synergies arising from merging the two prominent SOE companies. Amid the euphoria, we think PGAS’ earnings would not be hurt in the mid-term.

The chronology of events
In 2011, the ESDM Ministry enforced an open-access policy in accordance with Act No. 19/2009, which requires that the distribution and transmission of pipes be shared. PGAS disagreed with the policy and had twice asked for postponement of its implementation (1 Nov 2012 and 1 Nov 2013).

It argued that infrastructure had to be mature before open access could be enforced to replicate practices from advanced countries. In contrast, Pertamina as the shareholder of Pertagas, had supported the regulations from the beginning and has requested access to PGAS’ pipelines in order to deliver more natural gas to its customers. This, however, has led to a dispute between the two companies.

Debate on merger sends temperatures rising
The SOE Ministry has accommodated both parties’ arguments against the merger options (please see the back page), ie: i) PGAS merges with Pertagas and the newly established firm is partly/fully controlled by Pertamina, ii) PGAS is to fully acquire Pertagas. We hold the view that the market will react positively should the Government announce that PGAS will fully acquire Pertagas as this will strengthen the country’s pipeline infrastructure.

Although there is yet to be a thorough valuation of Pertagas, our preliminary analysis indicates that PGAS has a sufficiently strong balance sheet to buy Pertagas.

No impact on near-term earnings
We expect open-access to be an overhang, especially during the election period. We do not expect PGAS’ near-term earnings to be hurt by regulatory uncertainties. Although we expect some political noise over the national gas policy, we suggest that PGAS should maintain its market dominance even after the merger. Maintain BUY call and TP for the time being.

Full Open-Access Still Far From Being Enforced

Government advocates gas liberalization
In 2011, the Ministry of ESDM implemented an open-access and unbundling policy in accordance to Act No.19/2009 that requires the distribution and transmission of pipes to be shared while activities involving gas transportation & trading would be separated. Pertamina, as the owner of Pertagas, supports the Act’s proposal to liberalize gas via open access and unbundling.

However, PGAS has suggested that infrastructure has to reach maturity before open access and unbundling could be implemented. This difference in view has given rise to a dispute between the two prominent companies.

PGAS: Infrastructure maturity the key for gas liberalization
Infrastructure maturity refers to the advanced stage that almost all areas of a country’s gas infrastructure should have reached. Several studies show that Indonesia is still at a premature stage in fully implementing open access. To illustrate, for a country like Indonesia which has more land than Italy and is far more populated, its pipe length is equivalent to only 7% of Italy’s.

Structure of gas industry
There are 4 types of structures in a country’s gas industry (please see Exhibit 1) are:
1.) Vertical integration. The upstream and downstream activities are controlled by a single entity and the gas is supplied in a bundled manner.
2.) Natural gas production (upstream) competition. There is competitive upstream O&G production and many players in the field, but the downstream segment still operates in a bundled manner. Indonesia’s gas industry is currently at this stage.
3.) Open access and wholesale competition. There is competitive upstream O&G production as there are many players in the field, and all upstream activities are separated from the downstream side and there is competition in the supply of substantial gas volume. Several companies are using the bundling system, but all pipe infrastructure is shared.
4.) Unbundling and retail competition. This is the end point of full gas liberalization, with competition among upstream players and gas distributors right up to the household users. The ESDM Ministry’s Act No.19/2009 expresses its aim of achieving this type of gas structure in Indonesia, but this has yet to materialise and is hardly possible to be implemented within a short timeframe.

Regulatory issues should not hurt earnings, at least in the meantime. We do not expect open access to be fully enforced, at least in the short-term, partly owing to the election fervour that will grip Indonesia this year. Also, based on case studies, it would take decades before a country can fully implement a gas liberalization system.

The Options In Forging a Union Of Two Prominent Entities

Several merge options
On 7 Jan 2014, Pertamina and the SOE Ministry set out several options for a PGAS-Pertagas merger, which is targeted for completion in August this year. However, we think that those proposed schemes may face approval constraints as PGAS’ minority shareholders would have to suffer a dilution. Furthermore, we see a potential valuation mispricing from the proposed merger. As we see approval constraint, we expect PGAS’ operations to go on as usual in the meantime. Below are the possible structure options post-merger:

1. Full control by Pertamina, which will have a golden share. This scenario involves Pertamina having control of the PGN-Pertagas merger via a golden share. It is worth noting that holders of a golden share could have control over at least 51% of voting rights.

2. Full control by Pertamina through majority stake. The scheme is to divert the Government’s shares in PGAS to Pertamina, after which Pertamina would fully control the management of the merged company. With Pertamina in control of the merged companies, it would encourage open-access, but we still see issues relating to its implementation.

3. Similar to first scheme, but without the golden share. This type of scheme gives equal voting rights to all shareholders. However, we think that this scenario will give rise to conflict of interest among shareholders.

4. PGAS to acquire 100% of Pertagas for USD4bn-6bn. We suggest that this scheme is the best possible option and would meet national and shareholders’ interest at the same time. Meanwhile, the execution of the transaction is much simpler than Scenario 3 as there will be no general offer. PGAS may merge the books of its subsidiary post-acquisition.

PGAS has vast experience in the industry as well as adequate funding to carry out the acquisition. Once Pertagas is acquired, we think that pipeline transportation would expand aggressively throughout Indonesia, thus enabling consumers to obtain relatively cheaper energy. The main hurdle in this scenario would be the acquisition value of Pertagas, which Pertamina values at USD4-6bn, which translates into 32.5x-48.8x P/Es based on its 2012 net profit – a sum we deem too expensive.