Transportadora de Gas del Sur: Tremendous Q2, But Offers A Mediocre Yield At Best (TGS)

onurdongel This article analyzes Transportadora de Gas del Sur S.A. (NYSE:TGS) 2Q24 results and earnings call. It also reviews the company’s valuation compared to its future earnings potential. The main point from 2Q24 earnings is the impressive effect of the tariff adjustment of 700% (in Argentinian pesos) for the transportation segment. This segment, which was generally a breakeven business for TGS, printed close to ARS 70 billion (about $55 million depending on the exchange rate used) of operating profit in a single quarter. The rest of the segments operated within guidelines. I maintain my view for the growth midstream, and mature liquids segments. The more challenging segment is regulated transport. The initial 700% tariff adjustment was supposed to be followed by automatic inflation adjustments, but these were quickly rolled back. A new, potentially long-term tariff scheme is expected for YE 2024, or early 2025. Based on what we know now, projecting future capacity in midstream, and forecasting current profitability for transport as a ceiling, I believe the company is fairly valued. I would not consider it an opportunity given the high risk in the Argentinian regulated sector, which requires a higher rate of return. 2Q24 results Impressive transport improvement: The main topic of the 2Q24 earnings release was the impressive performance of the transport segment. The segment went from breakeven to $55 million in operating profits. As a reminder, the transport segment includes the regulated concession of the southern Argentinian gas transport network, from which TGS derives its name. This segment’s contracts have been changed at least a handful of times in the past ten years, improving and reducing the segment’s profitability. The main problem for the segment is dealing with price adjustments. In the Argentinian context, one year without adjustments can imply a 50% or more reduction in real pricing power. During the last administration, TGS contract prices were not adjusted regularly; when adjusted, they were modest. This meant the segment operated at breakeven by design. In early March, the new government announced a 675% price increase for the segment. We must consider that Argentina’s inflation in the TTM for 2Q24 was close to 300%, which implies a 100% increase in real terms. With operating costs mostly fixed in real terms, all that improvement flowed to operating income. Liquids and midstream in steady state: In my past articles about TGS, I always commented that liquids and midstream, being less regulated, are more stable than the transport segment. The liquids segment is mature and tied to capacity. It is a processing business that generally makes a cost-plus margin on converting natural gas to liquids, so international hydrocarbon prices do not cause considerable volatility. Volumes went down a little in 2Q24, but operating profits were marginally worse only (6% lower). In the 1H24 time frame, operating profits grew by 20%, but again, these fluctuations are normal with volume fluctuations. The midstream segment has a clear path for growth, processing, and transporting gas from the Vaca Muerta basin. Revenues increased by close to 40% in the 1H24 period, and operating profits improved by 65%. The improvement came from increasing transport and treatment capacity in the Tratayen plant, plus the Argentinian peso devaluation, which increased the dollar-denominated value of the services in Argentinian pesos faster than inflation. Refinancing: A final point should be made about the company’s refinancing of $500 million in notes maturing in 2025. They were paid with new notes for a similar amount, maturing in 2031 and paying a fixed 8.5% (8.75% effective). TGS has almost $500 million in cash and securities, so solvency was never an issue, but this helps project financing costs better into the future. Looking ahead Going in reverse order, the financing costs of the business are pretty well established by the new note issuance. Interest cost should hover around $42 million, more than offset by interest income from the company’s cash and securities stash. The liquids segment should not move meaningfully from an operating income range between $120 to $140 million. I have worked with this range since 2021, and they have worked so far. The midstream business will continue to expand and attract most of TGS’ CAPEX. TGS plans to double its processing capacity in Tratayen by 2025, which should provide room to double the segment’s business. Finally, transport is always a coin in the air. The new government has had a pragmatic approach to the energy sector, especially to the portions that impact energy bills and, therefore, on inflation. Whereas the March regulation applied automatic inflation adjustments, these were canceled just a month later. Since April, Argentina has suffered at least 20% inflation, but the government only announced one 4% adjustment applied in August, with non-automatic inflation adjustments to follow. The segment lost 15% or more of its income-generating capacity in just four months. The government may announce new adjustments or may resort to the old practice of dampening service prices to slow down inflation. This isn’t easy to predict. More importantly, TGS is undergoing a comprehensive tariff review process that should establish a new payment framework for the long term. The process should be finished by the end of this year but could get an extension for longer negotiations. A new framework may provide more certainty, but readers should remember that the Macri administration negotiated a new framework in 2017 that lasted less than 2 years in force. The 2017 “long-term” framework was abolished by the same government that established it. Valuation not attractive even under bullish assumptions Forecasting what will happen in Argentinian politics is a difficult task. Fortunately, we do not need to do so in this case because even under relatively optimistic assumptions, TGS only provides a moderate return from earnings. First, we add $130 million from liquids. Then, we optimistically assume that TGS’ plant capacity expansion for midstream leads to a doubling in operating income from the midstream segment. The segment would generate about $150 million in operating income per year starting in 2026. Finally, we assume that the company’s transportation segment can maintain the current elevated profitability of about $220 million annually. I explained why forecasting this is difficult. Further, $220 million in operating income represents a pre-tax return on assets (EBIT / PP&E) for the transport segment of about 22%. Many would say that is an extremely high return for a utility-like business. Still, if we use the above, we reach an EBIT of $500 million. After 35% income taxes in Argentina, this results in NOPAT of $325 million. Today, TGS trades at an EV of about $3.7 billion (market cap of $3.7 billion and financial assets matching debts). This implies an EV/NOPAT multiple of 11.4x or an earnings yield of 8.7% on bullish assumptions. That is, the Transportadora de Gas del Sur S.A. investor buying today, even assuming that the transport segment can maintain the current super-profitability for the long term and double the midstream business in 18 months, would still receive basically the same yield as the bondholders. Further, the investor would receive an 8.7% yield under bullish assumptions on a heavily regulated business in a country with a history of not enforcing contracts in this area. In my opinion, the return does not justify the risk, and for that reason, I maintain my Hold rating on TGS.

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