Transgaz: Story goes on, but with higher risks

Important developments with an impact on the company’s business have occurred over the last few months, calling for a revisit of our forecasts and valuation model.


I. Tariff update


The update of tariffs, starting in April 2013, is in our view the most important event for Transgaz, especially because of the fact that a long-awaited change in the structure, with a larger weight granted to the fixed component (capacity reservation tariffs) has finally been implemented. This will result, based on our estimates, in additional revenues of over RON 250mn per year from the regulated business, which, in 2013 and even 2014, will offset higher operating expenses incurred as a result of gas price liberalization and the monopoly tax.


Our view, however, is that major tariff increases are at least likely in the coming years, given the expected social pressures in the context of the assumed gas price liberalization. The gas bill should effectively increase by about 60-65% up to the end of 2014 for industrial consumers and until the end of 2018 for households only as a result of domestic gas price convergence, with the imported gas price and with the other components of the final gas price to customers (i.e. transportation tariff, distribution tariff) remaining unchanged. Moreover, gas consumption will most likely stagnate in the coming years given the substantial price increase.


II. Monopoly tax


In January 2013, the government approved a set of taxes affecting energy companies over the period February 2013-December 2014, including a monopoly tax levied on quantities of gas/electricity transported and distributed. In the case of Transgaz, the tax is RON 0.1/MWh for quantities transported to distribution grids and RON 0.85/MWh for quantities delivered directly to end-customers.  The latest annual report reads that 67% of gas transported goes to the distribution grid. Therefore, when computing the monopoly tax charge, we employed a 67/33 split between natural gas transported to distribution grids/gas transported to end-customers. Consequently, we computed expenses of RON 40mn for 2013 and RON 47mn for 2014.


III. International transit   


Gas transit was carried out via three dedicated pipelines based on contracts with Russia’s Gazprom and Bulgaria’s Bulgargaz. Owing to the fact that these pipelines are not connected with the domestic transportation infrastructure, this activity has not been regulated and contributed about 20% to sales and 40-45% to EBIT (based on our calculations).


Given that, in 2009, the European Commission initiated infringement procedures against Romania for not granting free access to all interested operators to the transportation network, the regulatory authority decided in mid-2012 to implement a bidding system for capacity allocation for the transit pipe serving the contract with Bulgargaz. As regards the other two pipelines servicing the contracts with Gazprom, discussions on how they will be operated in the future are ongoing.


We prefer not to speculate on how the transit business will be run in the future. What is certain is that, if revenue-cap methodology were to be applied, operating profit would be hit, as the assets corresponding to this business line, and based on which the profitability would be linked, are quite low.


In our forecast scenario, we have assumed contracts with Gazprom remaining in force while revenues from transit through the pipe serving Bulgargaz remain at levels quite close to those recorded in recent years.


IV. Gas price liberalization


The Romanian government assumed a calendar for liberalizing the gas price, with prices charged by domestic producers (the largest being Petrom and Romgaz) to reach RON 119/MWh by end-2014 for industrial consumers and by end-2018 for households. Transgaz will be affected in two ways: 1) technological consumption costs and 2) benefits to employees of ~6,500cm of gas/year/employee. Both expenses are recognized in tariffs and thus the company should recover them, but with a delay, namely via next year’s (i.e. following the year when the gas price is raised) tariffs. For this reason, we expect a contraction of the company’s EBIT in 2014 and especially 2015, followed by a slight recovery. We have assumed that tariffs will be adjusted below the levels that would be justified in order for the company to cover the higher expenses incurred. As already mentioned, our view is that the regulator will be tempted to increase tariffs by less than they should be or even to avoid updating tariffs, in order to further reduce pressure on the final gas price in the context of gas market liberalization.



V. Business outlook


Over the long term, there are a few question marks regarding the company’s business outlook and stock dividend character. The extensive CAPEX needs for funding two major projects - the Nabucco West pipeline and/or development of the NTS in order to bring to shore natural gas from Black Sea deep water explorations - will put significant pressure on the company’s indebtedness. With or without state support, large interest expenses are to be incurred, eroding profits and threatening the stock dividend status, with appealing historical dividends being the most important characteristic of this issuer.


Tariff story


After three and a half years, the Energy Authority decided to adjust tariffs starting in April 2013. The tariffs for capacity reservation have been raised 5.5x to RON 1.2/MWh/h for firm services and 6.3x to RON 1.08/MWh/h for interruptible services, whereas the transportation tariff was cut 7% to RON 6.96/MWh. As a result, the weight in regulated revenue of the capacity reservation component, which is more stable and not linked to the volume of gas transported, as is the case for the transportation charge, increases from ~4% to around 30%. In this manner, revenues from the regulated business line became more predictable and less sensitive to the volume of gas transported.


The new tariffs are available for April-June; theoretically, starting in July, when a new gas year begins, tariffs should again be adjusted. Tariffs are set on an annual basis, within a five-year time frame, based on revenue-cap methodology. Currently, the third regulatory period (July 2012-June 2017) is in progress. Although the Energy Authority set the parameters for new tariffs (i.e. regulated rate of return, regulated revenue, RAB) before the beginning of the current regulatory period, it decided not to implement any changes until a new entry/exit tariffs system is implemented. As things are moving quite slowly in that direction, in March 2013, ANRE decided to adjust tariffs for the remainder of the current gas year, in the existing binomial format, with tariffs for transported volume and reserved capacity. In order to be conservative, we have assumed that the new set of tariffs will remain in force for the next gas year as well (July 2013-June 2014).


Forecast scenario


We expect a significant advance of sales this year of over 12%, supported by the change in tariff structure starting in April, which - as already mentioned - lowers the sensitivity of revenues from the regulated business to the volume of gas transported. Based on our calculations, the increase in revenues from the regulated business thanks to the recent change in tariffs is about RON 200mn this year and over RON 250mn in 2014.


Higher income from gas transportation to domestic consumers, prompted by tariff changes, not only offsets lower business volume (-4% y/y) and declining revenue from gas transit, owing to LC appreciation against the USD and EUR, but also successfully covers the monopoly tax charge, as well as the expected higher technological consumption expenses due to the gas price increase. We thus expect the company’s operating profit to grow 20% this year to RON 460mn and to slightly decrease in 2014, to RON 456mn. We are aware of the sensitivity of our EBIT forecast to assumptions regarding maintenance expense development.


Overall, we forecast the company’s sales increasing at a CAGR of 4.7% over the period 2012-18e, thanks to higher regulated revenues due to the change in tariff structure, with a higher weight granted to the fixed component. In order to be conservative, we assumed that the fixed component will not exceed 40% of revenues from the regulated business (around 30% after this year’s change in tariffs).



Peer group comparison


Transgaz is traded at significant discounts compared to its peers, which is partly justified by the higher regulatory risk, with the Energy Authority filing over the last year to update tariffs on an annual basis, as revenue-cap methodology would imply. However, even considering the regulatory risk, the discounts are quite exaggerated, in our view, if we consider the company’s robust balance sheet, with low debt, a strong operating performance and its stock dividend profile.