PGNiG – Beyond Cash: the Long-Term Rewards Of Arbitration Victory Over Gazprom

We are following up our 23 March research report on PGNiG, in which we updated our view on the Company to reflect the slump in oil and gas prices and the 'corona recession,' with another update about the Company's victory in the arbitration case with Gazprom, confirmed by a long-awaited ruling by the Stockholm Arbitration Tribunal issued on March 30th, 2020. The ruling makes PGNiG's future earnings outlook much more upbeat than our earlier forecasts.

The $1.5 billion that Gazprom has been ordered to pay back for years of overcharging PGNiG on gas deliveries is consistent with our expectations, and it indicates that the arbitrators want the original pricing formula in the long-term Yamal pipe supply deal to be changed to take into account natural gas market quotations. Aside from the cash payout, the added benefit of this is that PGNiG's future gas costs, especially the costs determined by deliveries scheduled to be received in the next few months, should be lower; otherwise, the spread indicated by the old pricing formula would have remained huge for months. Assuming Gazprom's pricing is linked to market quotes from April, this would imply saving as large as $0.5bn just in 2020 (obviously this amount will go up if PGNiG decides to also adjust first-quarter billing for the new pricing rules).  Naturally this is just an estimate generated using our particular assumptions as to the oil-natural gas price ratio, and so are the forecasts regarding future savings in 2021 and 2022.

Our models aside, we do not think we would be wrong in saying that the arbitration win effectively eliminates the underlying structural risk that had loomed over PGNiG's trading segment for several years, allowing more transparency and clarity from the point of view of equity analysts. Consequently, we raise our FY2020-2022 forecasts for the trading segment by an average of PLN 0.8bn, with the biggest boost anticipated this year thanks to the current oil-gas spread. We also make adjustments for the likely cut in PGNiG's retail gas tariff in H2 2020. As for the cash payout, we opt not to include it for now because of its uncertain timing (Gazprom still has avenues to appeal the decision, like it did in the case against Ukraine's Naftogaz). However we do factor the cash into the valuation model as if received in 2021, resulting in an increase of ca. PLN 0.81 in our per-share valuation of PGN. After all this, we raise our target price for PGN to PLN 4.44 (PLN 3.58 before the Gazprom payout), and we upgrade the stock two notches to buy.

Even without the Gazprom money, PGNiG's net debt as a percentage of EBITDA is not likely to exceed 0.6x, indicating capacity to increase next year's distribution to shareholders (an expectation backed by the high equity stake of the Polish State and its crisis-strained budget); alternatively, the extra cash could be allocated to acquisitions of value-enhancing gas-producing assets at a time of intensified divestment in the sector. Finally, our outlook for PGNiG still assumes a rebound in gas prices next year, led by supply adjustments, improved winter demand, and fuel switching in the power industry, putting EBITDA back on a growth trajectory.