Sunday, April 09, 2006
An investment can be considered in the initial public offer of Lokesh Machines. At Rs 130 — the lower end of the band — the offer is priced at 20 times the annualised FY-06 per share earnings on the post-issue equity. Our recommendation is based on the positive outlook for the automobile industry, revenue visibility in terms of securing long-term contract with Ashok Leyland, good order-book, performance over the years and the ability to withstand a downturn.
Lokesh Machines makes machine tools and auto components. Promoted by a first generation entrepreneur, the company has delivered consistent performance over the last decade even when the entire machine tool industry was in dire straits. The company's ability to maintain growth during a slowdown when most engineering companies struggled to make profits, enthuses confidence in the management.
Lokesh Machines kept up with the growth momentum by diversifying its customer base, adding auto components to its portfolio, exploring export opportunities and coming up with innovative import-substitute products for the Indian market. Over the last decade, the company's revenues have grown from Rs 5 crore to Rs 75 crore in FY-05.
Auto capex, key driver
The capacity expansion in the automobile and auto component industry would be the key demand driver. Capex in these two industries alone is expected to be about Rs 5,000 crore and Rs 2,000 crore annually over the next three years. With both multinationals and domestic companies expanding, the demand for machine tools is expected to be robust.
The positive demand outlook for the commercial vehicle industry improves revenue visibility for its auto component division. The company makes cylinder blocks and heads for commercial vehicles. Mahindra and Mahindra, and Ashok Leyland are the two key customers. Though client concentration involves some risk, the favourable outlook for these companies for at least the next couple of years mitigates this risk.
Moreover, the company has been gradually diversifying and supplies to other big firms such as Bharat Forge and Honda Motors. Having supplied to big names, the company could overcome the client concentration risk over a period. The fresh capacities for cylinder blocks and heads would be exclusive for Ashok Leyland under a three-year contract. This gives revenue visibility in the near- to medium-term.
Breakthrough in exports
Over the last two-three years, Lokesh Machines has been able to break through the export market for general purpose machines. Exports accounted for about 10 per cent of the revenues in FY-05. It has export orders worth Rs 3.3 crore for FY-07, double that in FY-06, though on a small base. The total order-book, as on February 2006, was roughly Rs 31 crore, approximately half the turnover for FY-05.
Offer details: The funds generated from the IPO would be used to create additional capacities for cylinder blocks and heads and modernise the machine tool capacity. The output would be exclusively supplied to Ashok Leyland for the next three years and is renewable on a yearly basis. The new facility would add 40,000 units to its existing capacity of 1,20,000 units.
Lokesh Machines expects to raise Rs 39 crore to Rs 43 crore. The offer is to be priced in Rs 130-140 band. The bid closes on April 13, 2006. The offer is lead-managed by Karvy Investor Services and UTI Securities.
The biggest risk to the project is a delay in its commissioning beyond the scheduled December 2008.
There are others with better integration levels in their businesses and deeper pockets planning to set up similar projects closer to the markets in the US and Europe.
Therefore, a late entry for RPL's refinery could mean taking on high-quality competition right from the start.
A repeat of the story with the original Reliance Petroleum whose project was delayed by four full years could prove dangerous for the new RPL.
The original RPL, which was subsequently merged with Reliance Industries in 2002, floated its IPO in September 1993 with a stated plan of commissioning its 9 million tonne capacity refinery by the second quarter of 1996. As it turned out, the refining capacity increased three-fold to 27 million tonnes(further expanded to 33 million tonnes now) but the refinery was commissioned only in the end of 1999.
Of course, it is true that the project was implemented in 36 months because work on the ground began only in 1996. Yet, the fact is that it was delayed compared to the original schedule stated in the offer document of the IPO.
RPL will also be up against some quality competition in the Western markets dominated by multinationals such as ExxonMobil, Royal Dutch/Shell, ChevronTexaco and BPAmoco all of which are well-integrated across the chain from exploration and production to refining and marketing.
The absence of a marketing network could prove to be a handicap for RPL at a time of low refining margins.
There will be some close linkages between RPL and several of its group companies. For a start, the parent company, Reliance Industries, will offer the critical services of crude sourcing and also marketing the refined products.
The experience of Reliance Industries in both these areas will be a strong asset but the corresponding liability could be a clash of interests; according to the offer document, Reliance Industries will offer its services at cost during the implementation and operational phases of the project.
There are also other tie-ups that RPL will have such as for power (with Reliance Utilities and Power), for usage of port and terminal facilities (with Reliance Ports and Terminals) and for civil construction of the refinery (with Reliance Engineering Associates Pvt. Ltd).
These three companies are controlled by the promoters of Reliance Industries and will offer their services on terms similar to what they provide to others in the proposed SEZ, says the offer document.
Reliance Infrastructure, a wholly-owned subsidiary of Reliance Industries, will implement the SEZ.
The principle of arm's length transactions will be of utmost importance given this business structure.
Finally, from the perspective of investors, the track record of the Reliance group in mergers of group companies has to be taken note of.
The original Reliance Petroleum was floated as a separate company that also made its IPO and listed on the market.
Though it was always said that the company would be kept independent, it was eventually merged with Reliance Industries in 2002.
Others such as Reliance Polyethylene Ltd. and Reliance Polypropylene Ltd., which also came out with IPOs in the early-1990s and listed on the market, were also merged with Reliance Industries later.
While there is nothing wrong per se in mergers of group companies so long as they are done on fair terms, those who do not prefer the uncertainty associated with such moves are bound to see this as a risk factor.
This public offer of equity shares by Reliance Petroleum Ltd (RPL), the group's first visit to the primary market in the last 12 years, can be considered favourably for investment. The project is well-planned and backed by good reasoning, and the group's experience of commissioning and running the large capacity, state-of-the-art refinery at Jamnagar is a big positive.
The biggest risk to our recommendation would be a delay in commissioning the refinery by the set deadline of December 2008 as time-to-market will be critical for this export-oriented project.
Multinational competitors are already talking about the same opportunity that RPL has spotted and it is only a question of time before they embark on similar projects to supply high-quality fuel to the American and European markets.
RPL is a 80-per cent subsidiary of Reliance Industries and given the track record of the group in merging subsidiaries with itself, a similar action in the case of RPL some time in the future cannot be ruled out, especially because the two companies are in similar businesses.
Investors should also note that performance-linked appreciation in the stock is more than three years away and an investment now should necessarily be with a long-term perspective. Our recommendation is not linked to possible speculative gains on listing.
WHY ANOTHER MEGA REFINERY?
The new 29-million-tonne (5,80,000 barrels-a-day) refinery will be housed in a special economic zone adjacent to the existing refinery of Reliance Industries and supply exclusively to the export market, specifically the United States and Europe.
It will be a technologically advanced refinery, more advanced than the existing one, and will be capable of processing the heaviest and sourest of crude oils to produce high quality refined products. The associated feature of the project will be a polypropylene plant of 9 lakh tonnes.
The entire project, designed to capitalise on the twin aspects of increasing demand in the West for high quality products that meet stringent emission standards and the widening gulf between the global prices of heavy and light crude oils, rests on two major pillars.
First, the best quality crude oils have already been discovered and tapped. These crude oil grades trade at high premium in the world market and are low on sulphur and light in density. The newer crude oil finds and hence, future output, would be of lower grades that are high on sulphur (sour) and heavy in density.
Most of the existing refineries worldwide that were set up in the latter part of the last century are designed to process high quality crude oil grades.
To process the heavy, sour crude grades that are now increasingly floating in the market, these existing refineries have to invest in upgrading their secondary processing and conversion capabilities. There is a place for new refineries that are complex enough to process the so-called "dirty" crude oils and yet produce the highest quality petrol and diesel to meet the stringent emission norms that are constantly evolving.
And that brings us to the second pillar. Quality norms for transportation fuels in the US are set to become more stringent with ultra-low sulphur diesel and petrol free of MTBE (methyl tertiary butyl ether, a carcinogen), which the old refineries are not capable of producing.
This opens up an opportunity for those willing to invest in new facilities designed to make products capable of meeting the advanced norms. Europe and large markets in Asia such as Korea, Japan and China are following suit with similar norms.
The combination of refineries that can process low-grade crude to produce high-grade products is the window of opportunity (read accompanying story) that RPL is seeking to exploit. Of course, it does help that the gap between product demand and refining capacity worldwide is narrowing and refinery utilisation rates are running at their highest levels in the last two decades. Demand could outstrip refining capacity in the next few years as tightening product norms lead to shutdown of old refineries that cannot match the new requirements. But how are the margins?
This is the interesting part of the entire business. Heavy and sour crude oil grades trade at a sharp discount to the superior light and sweet variety and this gulf has been widening the last couple of years. In 2005 the price differential between the Arab Light and Arab Heavy grades, for instance, was as high as $5 a barrel.
Gross refining margin, that is the difference between the total value of finished products and the cost of the crude oil, can be lucrative where a refinery has the capacity to use the cheaper low-grade crude oil to produce the superior-grade products that sell at a premium.
This is exactly what RPL is endeavouring to do. The product slate of RPL's refinery will be tilted more in favour of high-margin, in-demand products such as petrol, diesel, kerosene, alkylates (high-octane additive to gasoline that commands a premium in the market) and petroleum coke.
The only catch here is that the capital costs of setting up such a high-complexity refinery is higher than a normal one. Compared to a capital cost of $24/barrel/day for the existing refinery of Reliance Industries, the new one of RPL is expected to cost $28/barrel/day.
This is where the benefits of being located in a special economic zone (SEZ) kick in. The project will be entitled to duty-free imports of capital equipment and crude oil; it will be exempt from duties on exports of products; from excise duty on products purchased from within the country; from service tax on taxable services rendered to it by others and, finally, from all stamp duties on land transactions and loan agreements.
In addition to the above, 100 per cent of profits derived from exports will not be subject to income tax in the first five years and this will fall to 50 per cent in the next five. These benefits, put together, will go a long way in boosting the refining margins and reducing the capital cost for RPL's project.
WHY A SEPARATE COMPANY?
The main reason for implementing the project through a separate subsidiary company appears to be its location in a SEZ. The different business model of the company, catering as it does to a predominantly export market, and the opportunity for unlocking value through a separate vehicle and give an opportunity for investors to participate in it, are put out as other reasons for implementing the project through a new company.
From the perspective of a Reliance Industries shareholder, it is good that the project is not on its books for the simple reason of its size and quantum of investment. Though Reliance Industries will still be investing Rs 8,280 crore to acquire 80 per cent of RPL's equity, the debt of Rs 15,750 crore will not be on its balance-sheet.
Importantly, the risks associated with setting up and commissioning a Rs 27,000-crore project will not weigh down on the balance-sheet or the stock price of Reliance Industries.
In all, 135 crore shares will be on offer of which 45 crore shares are available for retail investors. The price band will be between Rs 57 and Rs 62 and retail investors have the option of paying Rs 16 per share on application. The offer is open from April 13-20.