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1- KSE: GOOD PERFORMANCE
2- PTA AWARDS TWO NEW CELLULAR LICENSES
3- BOOSTING SMEs
4- PIA's REVENUE TO INCREASE BY 10%
5- HOW TO PROTECT INVESTORS' INTEREST

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HOW TO PROTECT INVESTORS' INTERESTS?

 

 

 

By AFTAB RAZA
Apr 26 - May 09, 2004
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In February 2004, the government offered 5% of its shareholding in Sui Southern Gas Company Limited (SSGC) to the general public, with a greenshoe option to offer another 5% shareholding in case of oversubscription. The government has received an overwhelming response to its offer, similar to that to its offer for shares of Oil and Gas Development Company Limited (OGDCL) last year. Shares for another energy sector company, Pakistan Petroleum Limited (PPL), are scheduled from April this year. However, investors need to distinguish between SSGC on one hand and OGDCL and PPL on the other with regards to show their revenues and hence returns are regulated. The annual revenue of SSGC is determined by Oil and Gas Regulatory Authority (OGRA) afresh each year, whereas the wellhead prices for the latter companies (though notified by OGRA on semi-annual basis) are governed or determined by long-term production concession agreements based on petroleum policy.

SSGC is therefore exposed to certain regulatory risks. Such risks are mainly related to the rate of return allowed by OGRA, any costs disallowed or deferred by OGRA and any loss of revenue or profits due to failure of the company to achieve certain performance targets. The existing regulatory framework based on a cost-plus arrangement with guaranteed rate of return of 17% on net fixed operating assets is under review by OGRA. A change in the revenue determination regime for SSGC, especially a lower return than 17%, will definitely affect the company's profits and hence its share price in the market. Further, if OGRA disallows or defers certain significant costs of SSGC in future as it has done in the past, SSGC may not be able to recover all its costs, at least in a timely manner. OGRA has already set targets for unaccounted for gas for SSGC and is expected to determine more targets or benchmarks for company's future performance. SSGC's performance against such targets will have a direct impact on its profits.

COMPANY'S PROFILE

SSGC is an integrated gas utility, engaged in the transmission, distribution and sale of natural gas to about 1.66 customers in the provinces of Sindh and Balochistan through its pipeline network consisting of 2,786 km of transmission lines and 23,416 km of distribution lines.

The company is listed on the Karachi, Lahore and Islamabad stock exchanges. In February 2004, the government offered 5% of its shares in SSGC, or 33.55 million shares to the general public at a price of Rs 26 per share. As the offer was 15 times oversubscribed, the government exercised its greenshoe option and offloaded another 5% shares to the applicants. The offer price represented a discount to the prevailing market price for SSGC's share (varying between 31 and 34 Rs/share) offering the investors an immediate capital gain of Rs 5-8 per share.

Before the recent public offering, the government directly held 70.73% of the company's equity while its total holding including holdings through institutions was almost 93%. The government remains the majority owner of SSGC and has the power to elect majority of the directors on the board.

The company's share price has increased from 9.1 Rs/share at the beginning of 2002 to 31.35 Rs/share on 24 February 2004, i.e. by about 245%, consistent with the overall growth (262%) in the Karachi Stock Exchange (KSE) Index over this period (from 1322 to 4788). The earning per share (EPS) has increased from 1.93 Rs/share in fiscal year 2001 to 2.16 Rs/share in 2003 (equivalent to a price to earning (P/E) ratio of 15.8). The company has paid dividend for three straight years.

TABLE 1 FINANCIAL PERFORMANCE OF SSGC

Fiscal Year

 

2003

2002

2001

2000

1999

Gross Sales Revenue

Rs million

41,572

37,061

29,237

22,931

16,349

Cost of Gas

Rs million

28,061

22,217

18,428

13,524

8,108

Transmission and Distribution costs

Rs million

3,287

2,713

2,552

2,458

1,922

Depreciation

Rs million

1,884

1,990

1,957

1,978

1,849

Profit after tax

Rs million

1,448

1,435

1,292

793

953

Profit after Tax and Adjustment

Rs million

1,283

1,353

1,561

746

961

EPS-Basic

Rs/share

2.16

2.14

1.93

1.36

1.87

Cash Dividend(%)

%

18%

17.5%

15%

   

Bonus Shares (%)

%

     

15%

15%

Share holders Equity

Rs million

9,304

8,998

8,711

8,426

7,632

Long-Term Loans Outstanding

Rs million

2,185

3,303

4,102

4,969

5,832

Net Fixed Assets

Rs million

17,222

18,083

17,947

19,650

21,024

Sales Volume (MMCF)

MMCF

254,349

234,553

206,967

198,281

177,153

 

 

This financial performance is reflected in the growth in the company's profits over the years. The profits have not, however, increased at the same pace as the sales revenue. With the sales increased by 27% and 12% in fiscal years 2002 and 2003 respectively, the profits after tax increased by only 11% and 1% (and even profits after tax and prior year's adjustments decreased by 13% and 5%) in the respective years. Many would be concerned with the company's own transmission and distribution costs (excluding depreciation) which have increased by 21% in 2002-003, not commensurate with the 8% increase in volume of gas sold during that year.

The long-term debt to equity ratio has been reducing continuously, from 0.59 in 2000 to 0.23 in 2003, reflecting partial retention of earnings and repayment of long-term debts. Clearly, such lower debt to equity ratio does not seem to be an optimal capital structure in the present scenario of low interest on loans. However, this high leverage also shows the company's growing ability to borrow loans at attractive terms and hence to improve returns for the shareholders.

REGULATION OF SSGC TO DATE

Until 2000, the government was regulating the gas sector. Since 2000, the newly created Gas Regulatory Authority, renamed in 2002 as the Oil and Gas Regulatory Authority (OGRA), has been regulating the gas sector by issuing gas transmission/distribution licenses, setting tariffs and enforcing compliance with the licence conditions.

To date, the annual revenue requirement for SSGC has been determined (by the government till 2000 and by OGRA thereafter) on a cost-plus mechanism which allows SSGC to recover the cost of gas purchased from production companies on actual basis, the company's own transmission and distribution costs and a return of 17% on the average net fixed operating assets. This pricing mechanism is based on the provisions agreed with the Asian Development Bank (ADB) for securing loan facilities, which entitles SSGC to an annual return of 17% on assets, before deduction of corporate income taxes, interest and other charges on debt. Attainment of stipulated profits is guaranteed through adjustments of the Gas Development Surcharge (GDS) between SSGC and the government which acts like a subsidy when actual sales are not sufficient to cover the revenue allowed by the above pricing mechanism.

The revenue requirement for 2001-2002 and 2002-2003 were set on retrospective basis when some or all actual data for these years were available. For 2003-2004, OGRA has determined the revenue requirement on a prospective basis. The prospective setting of revenue requirement is a challenging task for both the regulator and the company as it requires realistic projections of various intricate data to be made for the forthcoming year. However, this new regime also provides certainty for the all the parties concerned, especially for the company to be aware of its performance targets well in advance.

The revenue requirement has increased from Rs 29,455 million in 2001-2002 to Rs 45,260 million in 2003-2004, showing an increase by 25% in 2002-2003 and 22% in 2003-2004

The cost composition of the revenue requirement for 2003-2004: about 81.4% of revenue is accounted for by pass-through cost of gas, 7.4% by transmission and distribution costs, 4.5% by depreciation, 0.9% by other charges, and 5.8% by the allowed return on assets. The composition of revenue in the previous years is not very different from this, though the cost of gas proportion in the revenue has been increasing (due to increase in wellhead prices for production companies) and return on assets contribution to revenue has been declining (partly due to decrease in asset base over years).

Though the rate of return of 17% on net fixed operating assets has been used in revenue determination, however OGRA has been increasingly applying certain downward adjustments to company's operating costs and asset base (and hence deprecation allowance) for the purposes of revenue determination.

REGULATORY RISKS FOR INVESTORS

The recent developments in relation to the regulation of SSGC raise a number of issues for investors:

1. RATE OF RETURN RISKS

Presently the rate of return allowed to gas utilities (SSGC and Sui Northern Gas Pipelines Limited (SNGPL) is a fixed return (17% and 17.5% respectively) on their operating assets as provided in their loan agreements with ADB and the World Bank. However, the OGRA Ordinance 2002 requires the regulatory authority to determine in consultation with the federal government and the gas utilities, a reasonable return for each gas utility. During the past, determinations of revenue requirements for SSGC, various large customers of SSGC and consumers' associations also expressed concerns on the 17% rate of return on assets considering this rate too high in view of the prevailing economic conditions in the country.

 

 

In view of the above, OGRA decided to review the existing pricing system for SSGC and SNGPL. In 2003, OGRA undertook a study with the help of its consultants to determine a reasonable rate of return for the two gas companies. The study has been completed and the consultants' report is presently under review by OGRA. The regulatory authority is expected to consult with the government and the two gas companies on the recommendations of the study to determine an appropriate rate of return which will apply to determine the revenue requirements for the two gas companies in the next fiscal year or year after that. This risk was specifically highlighted by the government in its offer for sales of shares.

One can expect that the rate of return allowed to SSGC would be based on either its own cost of capital or the cost of capital of similar companies with optimal capital structure and rate of return on equity and interest rate on loans prevailing now or expected over a couple of future years. In 2002, the National Electric Power Regulatory Authority (NEPRA) with the help of its consultants determined that 12% is a reasonable rate of return on assets for Karachi Electricity Supply Corporation (KESC). There are many similarities between the shareholding structures and businesses of SSGC and KESC and the government's privatization plans for these companies. Except for the existence of 17% rate of return for SSGC, there may not be enough strong arguments for allowing a higher return to SSGC than KESC. Rather, given the financial position of KESC, one would argue for a higher return for KESC. It can therefore reasonably be expected that the future rate of return for SSGC will be lower than the existing 17% return on assets. Such a lower return, if materialized, will affect the future profitability and hence share price of SSGC.

2. DISALLOWING OPERATING COSTS OR PROVISIONS

The revenue requirement for SSGC is calculated to cover, among other things, reasonable and justified operating costs of SSGC. In the past, OGRA has disallowed certain operating costs or provisions of the company, being not efficient or prudent, while determining the revenue requirement. In future, such disallowed costs not being covered by the revenue will of course be borne by the company thereby reducing the returns for investors.

3. DEFERMENT OF ASSET ADDITIONS TO ASSET BASE

Capital expenditures or asset additions incurred by SSGC during a year come into the calculation of revenue requirements in two ways: increase the asset base on which the rate of return is applied, and; increase the depreciation allowance. Both tend to increase the revenue requirement for the company. Recently, OGRA has not allowed certain asset additions or projects to be rolled into the asset base for the calculation of the revenue requirement in the years when they occurred but deferred such capital expenditures to be compensated by the future revenues. These were the projects which were not commissioned or not expected to be commissioned in the year to which the revenue requirement was related. This approach clearly reduces the company's revenue requirements. Even if the company is compensated later for the return and depreciation lost during the previous years, this approach will affect the company's cash flows and can affect the returns for investors, first by reducing the cash available for dividend payout, and second by requiring the company to absorb the additional cost of financing these projects until recovered later by the revenue cap set by OGRA. From a regulatory perspective, this approach also discourages SSGC to undertake long-term projects.

4. PERFORMANCE TARGETS OR BENCHMARKS

The regulator has set clear-cut targets for SSGC in respect of the reduction in line losses or unaccounted for gas (UFG): 6.5% by end of 2003-2004 and 6.0% by 2004-2005. Failure to achieve of these targets will reduce the revenue requirement and hence the profits of the company. However, SSGC has been successful in reducing UFG from 8.36% in 2000-2001 to 7.0% in 2002-2003. The company expects it will reduce UFG to 6.5% by 2003-2004. If this materializes, the company may be able to achieve the target of 6.0% of UFG set by OGRA for 2004-2005. The company is allowed to retain any profits arising from achieving UFG below the targets. The regulator has also been working on a benchmarking study to set a number of performance benchmarks for the gas utilities. Again, failure to perform well against such benchmarks poses a risk for the company's revenue and profits.

HOW TO SAFEGUARD INVESTORS' INTERESTS?

The above risks clearly require the management of SSGC to improve its performance in order to maintain or improve its profitability and returns for its shareholders. A large number of small investors have recently invested in the company's shares. However, with their dispersed shareholdings as well as relatively smaller representation on the board of directors, these investors may not be able to influence the company's management to improve its performance and to make a convincing case during the revenue determination process for higher returns and for appropriate treatment of its costs, provisions and capital projects.

Karachi Stock Exchange (KSE) has been involved to some extent in the OGRA's tariff determination process for SSGC by submitting its written comments for maintaining 17% rate of return. However, KSE has not often attended the public hearings to make a stronger case for investors. The recent divestment of SSGC's shares to the general public has increased KSE's responsibility requiring it to play a more active role during the revenue determination process undertaken by OGRA.

During the revenue determination, KSE or other investors' representative bodies should present detailed analysis based on company's financial performance and returns from other similar securities in order to support their arguments for higher rate of return for SSGC. Of course, OGRA endeavors, as required by the law, to take into consideration the interests of all stakeholders particularly SSGC's customers and shareholders and to strike an appropriate balance between various conflicting interests.

In order to secure investors' investment on a long-term basis, one should ask OGRA to design a long-term framework of revenue calculation for SSGC (and SNGPL). Multi-year tariffs can provide the required certainty to the investors of SSGC by clearly setting out the allowed rate of return, operating costs and asset base for the next 3 to 5 years, while permitting periodic adjustments to cater for increase in cost of gas, inflation and company's performance against the pre-defined targets. Similar arrangement has been made for the electricity utility, KESC, in preparation of its expected privatization. The multi-year revenue cap can provide a company strong incentives to reduce its costs, and hence earn and retain profits for its shareholders.

Although the multi-year revenue cap approach can successfully work for state owned utilities, it is recognized the continuing public ownership of an entity may ultimately place a limit on the efficiency improvements that can be achieved by the entity. Therefore, further divestment of SSGC shares, preferably with the introduction of a large and utility-experienced investor as a strategic investor with management control, is essential for SSGC's continuing efficiencies and returns for the investors at large.