TGS - Transportadora de Gas del Sur Trades At Fair Value And Is Not An Opportunity

2023-12-06 14:11:35 ET

Summary

• Transportadora de Gas del Sur operates half of Argentina's natural gas network and has a natural gas derivative liquids processing facility.
• TGS' recent 9M23 performance aligns with previous forecasts, with the transportation segment at breakeven, the liquids segment experiencing a 32% decrease in operating profit, and the midstream segment showing growth.
• The company's future forecasts suggest potential operating profits of $390 million in FY25, leading to a fair value assessment and a recommendation to hold TGS shares.

Transportadora de Gas del Sur ( TGS ) is one of the leading O&G players in Argentina. The company operates half of the country's natural gas network (including most of the network transporting from the Vaca Muerta basin) and has a natural gas derivative liquids manufacturing facility.

I wrote about TGS previously and recommended buying it in November 2021 , while recommending a hold in January 2023 .

Even though the company's shares exploded after Javier Milei's election in Argentina (in line with most Argentinian stocks), my conclusion from this review is that TGS trades at fair value at these prices. The main reason for that conclusion is the company's growth forecasts under what I consider reasonable assumptions.

Past expectations have proven correct

In this article, I will review the company's recent 9M23 performance and compare it to the forecasts I proposed for each of its three business segments in January. I recommend readers refer to that article first in case they need a refresh of the business.

In January, I proposed three forecasts: that the transportation segment would continue to wane, that the liquids segment would return to mean profitability, and that the midstream segment would continue growing. The three forecasts are still valid for the 9M23 period, as represented in TGS' financial statements for 3Q23 .

Starting with the transportation segment, I forecast that the government would continue to delay price adjustments to this regulated segment. This would cause the company's operating profits to fall when adjusted for inflation, with the possibility of entering negative territory.

Indeed, the Argentinian government granted the company a 95% price increase (in Argentinian pesos) in April 2023, compared to 108% YoY inflation between April 2022 and 2023. Further, since then, the government has not adjusted the regulated prices of transportation, and Argentina has suffered from an additional 66% inflation in April-October 2023. The result is that the transportation segment is at breakeven.

For the liquids segment, I expected that with the global collapse of natural gas prices after the supply shock of the Russo-Ukrainian war, the segments' profitability would return to the pre-pandemic average operating profit of $120 million per year, instead of the previously registered $240 million.

Again, the company's liquids production has not decreased, and yet TGS' operating profit from liquids fell 32% in adjusted Argentinian pesos, to $120 million for the 9M23 period. The conversion to dollars is done using the export rate of ARS 350 per $1, given that one-third of the company's sales in this segment are exports, and that there are no price restrictions in the local market.

Finally, I expected the midstream segment to continue growing as capacity was expanded in the treatment plants at the gates of the Vaca Muerta basin in Tratayen.

Indeed, TGS has continued investing in this segment, which represented 70% of the transferred construction in progress in 2023, for a sum of $70 million. Another $160 million was invested in construction in 2023, which I believe represents further capacity expansion in Tratayen.

The company was also awarded the operation and maintenance of the new Gasoducto Nestor Kirchner (NK pipeline, or GPNK, depending on the source), for a daily capacity of 11 million m3/day, for the next five years. This new business should have been added to the transportation segment, but I believe that because it has better terms than the transportation segment (a concession that dates back to the early 90s), it was added to the midstream segment instead. Neither the company nor the National Energy Company ENARSA have released data on the contract. However, in the 3Q23 earnings presentation , there is a line under midstream that was not present in the 2Q23 presentation , called services provided to ENARSA for AR$ 1 billion.

The company's midstream segment transported an average of 17.8 million m3/day of gas and treated an average of 12.8 million m3/day. These figures are 50% above 2Q22 figures (13.5 and 7.7 million m3/day, respectively). Revenues and operating profits in adjusted pesos are also up 50%.

For the 9M23, the segment generated an operating profit of ARS 20 billion or approximately $57 million, which annualized would imply close to $75 million, getting closer to our stated forecast of $100 million for FY24.

Going forward

How did the recent events, including the election of Javier Milei, change the forecasts I made at the beginning of the year?

We can begin with the simplest segment, liquids. It is the simplest because there are no plans for its expansion, and it has operated with relative stability through several political periods. Last January, I expected the segment to generate an average of $120 million in operating profits a year, which I believe is still true.

The midstream segment will grow to a treatment capacity of close to 22 million m3/day by the end of FY24. This represents an 80% increase from the treatment capacity used in 3Q23. Could this represent a double in operating income as well? This seems to be what happened between 3Q23 and 3Q22. If that's the case, we could be talking of as much as $170 million in operating profits from this segment by FY25. Demand will probably not become a problem given that the GPNK alone is expected to carry 20 million m3/day, and that the only competitor, MEGA, is not investing on its 40 million m3/day plant to expand capacity ( according to MEGA's 3Q23 financial statements , in Spanish). This is without considering further expansions in government-owned pipelines (like the second stage of GPNK or the reversion of the Northwest pipeline).

Finally, the transportation segment, which is the most heavily regulated, via price controls established by the government. At this stage of Milei's new government, predicting how the contracts regulating this segment will be modified is very difficult. The possibility of the contracts generating breakeven like they do today is remote, but exactly how profitable this segment will become is difficult to predict. During Macri's government, the return on assets of the segment exceeded 40%, which is unjustified given that the assets are mostly already in place and the contracts are low risk. In January, I speculated a conservative ROA of 5%, which could be a little higher today given the rate environment but below 10%, given the mature characteristics of this business.

In that case, and with an asset base of approximately $1 billion, we can speculate that a long-term arrangement for the transportation segment could generate between $50 and $100 million in operating profits. Again, it could also generate $240 million like it did during Macri's government, but that return seems unsustainable.

Adding up the three segments, we arrive at an EBIT in FY25 that could reach $390 million in the upper portion and $340 million in the lower portion ($120 million from liquids, $170 million from midstream, $50/100 million for transportation). This represents a NOPAT of $220 to $250 million.

Conclusion

If we evaluate the company with an EV/NOPAT multiple, we arrive at a 9 to 10x multiple, given the company's current $2.2 billion EV.

If we move down the income statement and compare earnings with the company's market cap, the situation does not change much. The company only has $100 million in net debt, and its financial assets are invested in bonds. Therefore, the company has not shown significant net interest expenses (less than $10 million in the 9M23 period). The multiple is therefore the same with a prospected P/E ratio of 10x (market cap of $2.1 billion on earnings of $212 million).

I believe this is a fair value, considering that my terminal estimations are expected by 2025, including a large degree of speculation, and that the company does not have further large expansion projects besides the treatment plant in Vaca Muerta.

It is true though that the company can also work as a lopsided bet on a very energy business-friendly Milei government, similar to what Macri did. I prefer not to speculate on this basis, and therefore rate TGS as a hold again.

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