Sunday, December 16, 2007
Stock splits refer to dividing the outstanding shares of a company into a larger number of shares, without affecting Stockholder's Equity or the total market value of the stock. For example, if a company declares a 2-for-1 stock split of its stock, of which has a current market value of Rs 500/share and 200,000 shares outstanding, the following results occur:
Outstanding shares: 200,000
Market Value: Rs 500
Market capitalization: Rs 100,000,000
Outstanding shares: 400,000
Market Value: Rs 250
Market capitalization: Rs 100,000,000
Essentially, in the 2-for-1 stock split, the company's outstanding shares are simply doubled and the stock price is divided in half. The market capitalization, or market value of the stock, remains the same at pre- and post-split conditions. This is because stock splits have no impact on the value of a company's stock. A stock split is merely an accounting transaction in which no equity is exchanged. Companies can split their stock in any number of ways. These splits may occur in different combinations.
When a company declares a stock split, the price of the stock may decrease, but the number of shares will increase proportionately. A stock split has no effect on the value of what shareholders own. If the company pays a dividend, your dividends paid per share will also fall proportionately.
Companies often split their stock when they believe the price of their stock exceeds the amount smaller individual investors would be willing to pay for the stock. By reducing the price of the stock, companies try to make their stock more affordable to these investors.
Usually, stock splits have a positive affect on the stock price. Over the long term, stock splits seem to have a considerable effect on the company's stock price. Although stock splits have no direct effect on a company's equity, the event of a split does forecast hints and signs of how the company is performing.
Companies usually tend to split their shares when the company has an optimistic view of its future and operations. The announcement of a stock split can be a symbol that a stock has attained a certain level of success. The fact that a company has a record of multiple stock splits usually indicates that the company is among one of the faster growing firms, since their stock has been split numerous times. Generally, a company is motivated to split their stock to attract more investors with a lower share price.
However, some people can only buy lower priced stock because they may not have the buying power to make a larger investment. Thus, they wait till a stock splits so they can afford some shares. Just because a company declares a stock split, it does not mean that the stock price will inevitably rise in reaction. There are many other variables that influence investors' decisions in the result of a stock split including economic reports, market stability, earnings, interest rates, external conflicts, etc.
Companies also split their shares if they need to broaden their shareholder base and make more shares available to investors. A motivation for this could be a company's defence to a potential hostile takeover. Stock splits make the company more liquid, allowing more investors the opportunity to purchase an ownership in their company.
The timeline of a stock split consists of four main dates: Declaration or announcement date, Record date, Payment date, Ex-dividend date. The two key dates that are important to investors are the announcement date and the payment date. The announcement date is important because no one knows for sure if and when a company a will declare a split of their company's stock. Thus, investors speculate on whether the company will announce and when they will announce. The payment date is crucial as well because this is the day before the company actually splits its share price, after which investor activity changes as the new share price targets a different audience.
Moreover, there is another factor that engenders the announcement of a stock split. Companies tend to try to keep their stock within a certain price range. Therefore, when a stock hits the company's price target, the company, upon approval of the Board of Directors and the shareholders, will announce a stock split.
A stock split simply involves a company altering the number of its shares outstanding and proportionally adjusting the share price to compensate. This in no way affects the intrinsic value or past performance of your investment, if you happen to own shares that are splitting. With lower-priced shares, a stock's liquidity increases and making it easier to trade.
As a stock price rises, some people will be psychologically unwilling to pay that 'high price' so a stock split brings the shares down to a more 'attractive' level. Again, the intrinsic value has not changed, but the psychological effects may help the stock.
|Strong demand for housing loans and stable real estate prices augur well for housing finance companies. Though the stocks are not cheap, they make good long-term investments.|
|After last week’s 25 basis point cut in the interest rate, the US Federal Reserve has slashed rates by 100 basis points in the past three months.|
|This rate cuts signify a benign interest rate environment worldwide once again as the US grapples to perk up its drooping economy and prevent the worsening credit crisis. India will also follow the trend of lowering interest rates over the next few months, say industry players.|
|Moreover, there is a belief that real estate prices, which have doubled over the past three years, seem to be stabilising now. Says Anuj Puri, chairman, Jones Lang Lasalle, "We expect prices to hold at current levels."|
|Given the combination of falling interest rate and stable prices, demand for housing loans will go up. While banks are slowing down their retail loan exposure which mainly comprise home loans, housing finance companies should benefit more.|
|Moreover, they are optimistic about maintaining or improving the key fundamental indicators such as net interest margins (NIMs) and non-performing assets (NPAs) due to improving incomes and strong recovery mechanisms.|
|The market seems to have recognised a lot of these factors over the past one to two months. Most housing finance companies have zipped past the Sensex and even the top two banks in housing loans namely ICICI Bank and SBI. Market experts believe that fresh investments should be considered on declines or at the current levels with a one year investment horizon.|
|Housing gains |
In order to control inflation, the RBI has raised interest rates and adopted restrictive measures on bank advances. Bank credit, which grew at 30 per cent a year over the past three years, has slowed down to 25 per cent this year so far.
|Besides, RBI has also increased provisioning for bank loans to retail and real estate sector. As a result, housing finance companies, which are more focused and understand the customer better than banks, such as HDFC, LIC Housing Finance and Dewan Housing Finance have seen their loan books and profitability improve in the first half of FY08.|
|For example, LIC Housing Finance’s loan book jumped 36 per cent and 25 per cent in Q2 FY08 and H1 FY08 respectively compared with 21.5 per cent CAGR in FY04-FY07.|
|Similarly, its net profit grew at 54 per cent in trailing four quarters ending Q2 FY08 compared with 18.5 per cent over FY04-FY07. Moreover, net interest margin – a key indicator – witnessed an expansion of 50 basis points.|
|Demand to remain strong|
Industry players are confident of achieving a loan growth of atleast 25 per cent in the medium term, which is more than what can be expected of total credit growth. The demand is likely to come more from tier-2 and tier-3 cities. This is because there is huge demand-supply mismatch in housing.
|According to the Tenth Five Year Plan, there is shortage of 22 million homes. On the other hand, even disposable incomes and affordability of people are rising as salaries go up. However, possible interest rate cuts and stable property prices are expected to have a greater impact.|
|After a 400 basis point increase since the last few years, interest rates have remained stable. Industry experts believe that interest rates in India will follow the US Federal Reserve of downward bias in interest rates.|
|Says Kapil Wadhawan, vice-chairman and managing director, Dewan Housing Finance, "The liquidity situation has eased a bit and the Fed rate cut will lead to a softening in interest rates in the next six months."|
|In the home demand equation, property prices play a more important role than interest rates. S K Mitter, director and chief executive officer, LIC Housing Finance says interest rates were never a major deterrent considering the tax incentives and overall increase in income levels of the borrower.|
|Thus, according to him soft interest rates will not be a great trigger. Mitter adds: “Stability in property prices could trigger a higher demand from the user segment due to an increase in affordability.” And this seems to be happening. Both DHFL’s Wadhawan and Jones Lang Lasalle’ Puri do not expect real estate prices to deviate much from current levels.|
|Buy on declines|
Both HDFC and LIC Housing have seen a lot of buying interest from the mutual funds in the past two months. The gap between the market capitalisation (cap) of the top three housing finance companies (comparison of LIC and Dewan with industry leader HDFC) has narrowed.
|A year ago HDFC’s market cap was 28 times and 100 times that of LIC Housing’s and Dewan Housing’s, which has narrowed to 27.3 times and 78.3 times for Dewan at present. Moreover, valuations of these companies do not look cheap for FY08 and FY09 estimated price to book value even when compared with the top two banks-ICICI Bank and SBI, which are also large home loan lenders.|
|Thus, buying housing finance stocks makes sense for investors having more than a one-year investment horizon as it is unlikely that prices will correct much.|
|HDFC (Rs 3058)|
Market leader HDFC trades at about 8 times and 7 times estimated price to book value for FY08 and FY09 respectively, which includes the value of its subsidiaries. But even after excluding its subsidiaries (asset management, insurance and banking), the book value is still high at 6.2 times and 4.8 times estimated FY08 and FY09 estimated book value.
|Its high valuation is because of its consistent financial performance over the last several years and robust asset quality with non-existent non-performing loans.|
|The housing finance major’s loan book and net profit have grown at a CAGR of 26 per cent and 22 per cent respectively in the last three years. Investors could buy the stock on declines given its consistent performance, market leadership and investments in banking, mutual funds, life insurance and general insurance subsidiaries.|
|LIC Housing Finance (Rs 376.60)|
The second largest housing finance company has improved its financial performance in the recent past. For the first time in the past 15 quarters, it crossed a net interest margin (NIM) of 3 per cent in the September 2007 quarter.
|This robust performance is expected to continue as the company expects a disbursement growth of 25 per cent and net NPAs below 1 per cent by FY08.|
|The company is raising Rs 500 crore by way of a preferential issue of shares, which will further improve its capital adequacy and help in accelerating growth. Its stake in LIC Mutual Fund is valued at Rs 12 per share. The stock trades at a reasonable valuation of 1.8 times and 1.6 times estimated book value for FY08 and FY09 respectively.|
|Dewan Housing Finance (Rs 180.75)|
Dewan Housing Finance trades at 2.6 times and 2.2 times its estimated book value for FY08 and FY09 respectively. This looks on the higher side compared with LIC Housing Finance, which has a larger asset base.
|However, the stock has positive triggers like its investments in real estate company -HDIL (Rs 45 per share), Wadhawan Retail (Rs 40 per share) and DHFL Vysya Housing Finance (Rs 11 per share).|
|Besides, its core business is also expected to do well in the coming years. The management has indicated a loan growth of 35 per cent, NIMs of 3 per cent and net NPAs below 1.25 per cent in this financial year. There is also a possibility of value unlocking in the event of listing of Wadhawan Retail, where it owns 20 per cent.|
|GIC Housing (Rs 83.35)|
Despite having the smallest asset base among housing finance companies, the GIC Housing Finance stock has gained 66 per cent and 85 per cent in the past six months and one year respectively. IL&FS has given a buy rating on the stock last month with a one-year target price of Rs 110, a return of over 30 per cent.
|The company’s strong focus on tier-2 cities augurs well due to growing demand. Moreover, the company provides a lot of headroom for expansion due to its low gearing of 6 times in FY07, unlike its peers, which have debt-equity ratio of 8-10 times. The GIC Housing stock trades at 1.5 times and 1.2 times its estimated book value for FY08 and FY09 respectively.|
|The company is a good investment considering cheapest valuation among housing finance companies.|
The markets scaled new peaks during the week ended December 14 after a gap of a month. The indices, however, cut their gains towards the end of the week on account of profit-booking in the last two sessions. Some of the good work done by the bulls thus got undone.
On the positive side, there has been no major changes in market trend so far - either in the short or the medium-term.
The market will test crucial support levels this week in case there is some more selling. The indices will have to hold these support levels in order to continue with the uptrend in the short-term.
From a low of 5,923, the Nifty soared to a fresh all-time intra-day high of 6,185 before paring gains and ending at 6,048, a gain of 73 points.
The Nifty has immediate support at 6,000, below which it may test 5,900 or slip further to 5,750. In order to regain the upward momentum, the index will have to cross the 6,150-mark. Till that time, the index may trade within a broad range of 5,750 and 6,150.
The Nifty is likely to find support around 5,950-5,915-5,885 this week and it may face resistance around 6,150-6,180-6,210.
The Sensex moved in a range of 664 points. From a low of 19,834, the index rallied to a new all-time intra-day high of 20,498 and finally ended with a modest gain of 65 points at 20,031.
The Sensex has slipped below its short-term support of 20,135. It needs to regain this level as soon as possible to resume its uptrend. The Nifty, on the other hand, stands above its short-term support of 6,000.
If the Sensex stays consistently below the 20,000-mark, it may test its medium-term support in the 19,500-19,350 zone. The 14-day DMA (daily moving average) for the index is around 19,700.
The Sensex may face resistance around 20,285-20,360-20,440 this week, while it is likely to find support around 19,780-19,700-19,620.
Investors can avoid subscribing to the initial public offering of Porwal Auto Components which is in the business of manufacturing castings. The fragmented nature of the foundry industry with a number of small players, competition from larger companies , unattractive margins and heavy dependence on one client, make the offer uninviting.
At the price band of Rs 68-75, the offer is priced at 15-17 times its likely FY-09 earnings on the post-issue equity. At the upper end of the price band, the company will raise around Rs 37.5 crore to fund its capacity expansion and set up a windmill for captive power consumption.
Business and plans
Porwal Auto manufactures ductile iron and grey iron castings and components primarily for the automobile industry. To cater to the growing demand, the company has expanded capacity up to 7400 tonnes in 2006-07.
The company plans to further increase installed capacity to 27,600 tonnes in FY 2008. 80 per cent of this installed capacity is to be utilized by 2009-10. With increase in capacity, the company expects to benefit from higher domestic demand for automobiles as well as the trend of overseas OEMs (Original Equipment Manufacturers) sourcing components from India.
But in a fragmented industry such as this, small companies will find it tough to compete with bigger players. The latter score over the smaller ones in terms of ability to execute larger orders, offer value added products such as machined castings and forgings and sub-assemblies and assemblies. These value additions also bring in better margins. Moreover, export growth for Indian component makers has come from high-end cast products and higher technology castings rather than from raw castings or forgings.
While the company too has plans to increase the supply of finished castings and scale-up its machined castings production, it will face stiff competition from established players. The company also needs to diversify its risks by supplying to other segments of the auto industry such as passenger cars and two-wheelers (to combat any slowdown in one particular segment ).
Currently, nearly 90 per cent of its revenues come from supplies to Eicher Motors for its commercial vehicles. L&T case equipment, Shakthi Pumps, Man Force trucks and a few others chip in with the rest. Eicher’s new joint venture with Volvo for the commercial vehicles business, may also create some uncertainty if the latter reviews the supply chain.
For the year ended 31 March 2007, the company recorded sales of Rs 34 crore, which grew by about 32 per cent from the previous year. This was primarily due to capacity increase. Net profits decreased by about 8 per cent to Rs 75 lakhs. Margins may also be under pressure in the short-term due to finance charges
Investors can stay away from the initial public offer of Aries Agro, a manufacturer and marketer of plant micronutrients.
Though micronutrients have good demand prospects in the Indian context and are not subject to the regulatory constraints that fertilisers face, the business is characterised by high competition.
The offer price also appears high in relation to the multiples enjoyed by companies in the fertiliser and agricultural inputs business.
At the price band of Rs 120-130, the offer price values the company at between 18 and 20 times its FY-07 earnings per share, on a fully diluted equity base.
Much larger players in the agri-inputs space such as Rallis India (11 times), which have a presence in this segment, trade at cheaper multiples.
The offer proceeds are to fund working capital, towards the acquisition of an overseas material supplier, purchase of mobile vans for marketing products as well as capacity expansion.
The substantial scaling up of capacities over the next year could provide justification for the offer price over the medium term.
However, the intense competition in this business poses significant execution risks to the scaling up of operations.
Aries Agro derives the bulk of its turnover from the marketing of micronutrients under the names — Agromin and Chelamin, which are its leading brands.
Aries also has a small presence in the crop protection and veterinary products business. Micronutrients, which are required in relatively smaller dosages to supplement macro-nutrients (nitrogen, phosphate and potassium — usually delivered through mainstream fertilisers), help improve the yield and output of agricultural and horticultural crops.
The company focusses on chelated micronutrients (combinations of metallic nutrients such as zinc, iron and copper with certain chemicals) that have higher efficacy and allow better absorption by the plant.
The micronutrients business has considerable potential in the Indian context. Factors such as low yields of major foodgrains and horticultural crops, high soil alkalinity and intensive cultivation are the key demand drivers for micronutrients.
Aries has built an extensive distribution network which reaches 375 districts across 20 states, through a network of 4700 distributors. This is backed by a portfolio of 37 products consisting of micronutrients, chelated nutrients and insecticides.
From being a small player, Aries has substantially ramped up its manufacturing capacities in FY-07, with capacities rising from 12,000 tonnes to 21,600 tonnes in FY-07.
Net sales have climbed from Rs 26 crore to Rs 73 crore between FY-04 and FY-07 while net profits have risen from a minuscule Rs 0.09 crore to Rs 8.69 crore over the same period.
Both numbers have been helped by a substantial trading component to sales.
The company has now lined up an ambitious expansion, with 79,200 tonnes of additional micronutrients capacity proposed to be added to the existing facilities across locations.
Limited pricing power
The market for micronutrients such as zinc, iron and copper in India, is expected to double over the next two decades. This suggests sustained single-digit growth in demand over the next few years.
Unlike fertilisers, micronutrients are not subject to any price controls by the government and, thus, allow greater operational freedom to producers.
However, players such as Aries Agro would still be constrained by limited pricing power, due to competition from imports as well as the host of local/regional brands, as the product offers limited differentiation possibilities.
The business has low entry barriers, involves small capital investments to put up capacities, limiting the company’s ability to withstand pricing pressures and scale up sales.
The relatively high pricing of the offer also may not leave room for disappointments on this score.
Investors can avoid the initial public offering of Precision Pipes and Profiles (PPAP), which manufactures automotive sealing systems.
While the company appears to have grown impressively over the years, future growth prospects may not be as bright, given the ongoing slowdown in the automobile industry.
The volume-driven nature of its business and the negligible potential for after-market sales, also peg up uncertainty. In the price band of Rs 140-150, the offer is priced at about 15-16 times its likely FY-09 per share earnings on a diluted equity base.
This appears pricey given PPAP’s presence at the lower end of the value chain in the automobile industry.
At a time when established auto component manufacturers are finding the going tough despite their presence in niche and high-value products, PPAP’s business, restricted to lower end automotive sealing products appears not so attractive.
The company is highly reliant on domestic sales, with a marginal exposure to the overseas market. While the company intends to increase its exports share, it could take a couple of years for significant revenues to come by.
Investors can adopt a wait-and-watch approach to the IPO and consider investments after listing.
PPAP makes automotive sealing systems and exterior products for the automobile industry. Its products range from weather strips, windshield moulding to skirt air damper and body-side moulding.
Catering to clients such as Maruti Udyog, Honda SIEL, General Motors and Toyota Kirloskar, the fortunes of PPAP have grown in tandem with its clients. It witnessed a compounded earnings growth of about 34 per cent annually, backed by a 28 per cent growth in sales during the last four years.
PPAP also caters to the white goods industry, manufacturing PVC-based customised profiles to companies such as Godrej, Voltas and Videocon; the segment contributed to about 5 per cent of revenues.
PPAP does not enjoy a significant exposure to the export market (less than 4 per cent of its revenues). However, the company proposes to increase its exports and has entered into a manufacturing agreement with the Australia-based Power Data Corporation for exporting the company’s ‘Electrical Outlet System’. On the operational front, the company has expanded its margins by improving utilisations.
For the year ended March 2007, the operating margins expanded by three-percentage points to about 25 per cent.
The company proposes to use the proceeds from the issue towards setting up two new manufacturing plants for auto components and electrical outlet system products for Power and Data Corporation of Australia. It also plans to use the proceeds to expand capacity (to about 30 lakh kilos) in its existing plant from the current 12 lakh-levels.
The offer is open from December 17-20. The company seeks to raise Rs 75 crore through this offer. UTI Securities and Nexgen Capitals are the lead managers to the issue and Intime Spectrum Registry is the registrar.
Investors with a two-three year perspective can consider investing in the stock of Tantia Constructions. Strong order book, superior operating profit margins and well-entrenched presence in the eastern region are positives for this company. At the current market price, the stock trades at about 10 times its expected earnings for FY09 – after factoring in equity expansion due to conversion of FCCBs. This is at a discount to similar sized peers.
Tantia Constructions is primarily into building railways, roads, bridges and urban infrastructure projects. The company has also forayed into power transmission projects and airport contracts, albeit in a small way. Its current order book of Rs 1,300 crore (about 5 times revenues for FY07), not only provides visibility for earnings growth, but also reflects the company’s measured way of taking up projects. For a small company such as Tantia, an order book of 8-10 times annual revenues may increase execution risks, as scaling up of resources in a short span could prove challenging.
Tantia’s strong presence in the eastern and north-eastern region has two main advantages. There are fewer players interested in bidding in these regions due to difficult terrain. Tantia with its expertise in tunnelling has had an edge in bagging projects in this region. Further, among the various regions in the country, the eastern region holds much potential for infrastructure spending, as it has seen the least amount of development work compared to the other regions. The likelihood of improved spending is already reflected in the increasing budget allocation for the region in recent times.
Tantia’s presence in the above geography and its strength in high margin businesses such as rail and urban infrastructure had enabled the company to maintain superior profit margins over similar sized peers. While operating profit margins have been in the 10-11 per cent range, the margin surged to 16 per cent in the September quarter. This may be the result of a revenue mix tilted in favour of high margin projects such as rails, as well as an increase in the order size (with a good number over the Rs 100 crore-mark).
Tantia’s sales growth for the above quarter, however, remained muted and net profits took a dip. While the slowdown in sales may be due to longer duration projects in hand, the net profits largely declined due to higher interest costs, which almost doubled compared to the same quarter last year. We expect funds raised through FCCBs to ease the level of debt on the balance sheet. Nevertheless, increases in raw material and interest costs remain the key risks to earnings. Removal of tax benefits under Section 80 IA may also impact net profits in the short term.
Investors can consider taking fresh exposure to the stock of Everest Kanto Cylinders (EKC), a leading manufacturer of high-pressure CNG (compressed natural gas) and industrial cylinders.
While we had earlier suggested that investors book profit on the stock, the recent spurt in oil price, combined with EKC’s change in raw material sourcing strategy, presents a case for renewed investment. Besides, the shift towards high-margin products and the commencement of production in the company’s Dubai and China (by early January 2008) units also underscore our changed stance.
At the current market price of Rs 330, the stock trades at about 20 times its likely FY09 per share earnings, assuming a full conversion of its foreign currency convertible bonds into equity. This valuation, though seemingly at a premium, is likely to be supported by the company’s established market presence and capacity expansion plans that would position the company to benefit from the growing global CNG market. Investors, however, can buy the stock in lots given the volatility in broad markets.
Buoyant demand trends
The global demand for CNG applications is set to increase on the back of a firm oil-price outlook. This is likely to rub off positively on EKC, which derives about 68 per cent of its revenues from the CNG segment. Catering to demand from countries such as Malaysia, Thailand, Gulf countries and CIS (Commonwealth of Independent States) nations, EKC appears well placed to tap the growth potential in the CNG space in overseas markets since it has the necessary approvals from its target countries.
Notably, demand from the domestic market may also increase with the Supreme Court mandating the use of CNG as auto fuel for heavy vehicles in 28 highly polluted cities. The proposed extension of City Gas Distribution projects may offer an opportunity for growth.
In the light of such an expected ramp-up in demand, EKC’s aggressive scaling of capacity appears well-timed, lending confidence regarding its ability to meet future demand. Capacity expansion across its units, setting up of greenfield project in China, introduction of new product line (Jumbo cylinders) in the Gandhidham unit and the opening of a second unit in Dubai suggest improved prospects. However, given the high gestation period, it could take a year or two before full benefits accrue from the added capacities. Concerns of excess capacities in the medium-term are also alleviated by the current high order book.
Change in raw material sourcing strategy also supports our case for investment. While there were concerns on EKC’s complete dependence on Tenaris, a global manufacturer and supplier of seamless tubes for raw materials, the broad-basing of sourcing to Chinese and Japanese manufacturers appears to have de-risked the same. However, the management expects the sourcing levels to be maintained at current levels (about 65 per cent from Tenaris), since the materials sourced from Chinese players may not suit the requirements of higher capacity cylinders.
For the half-year ended September 2007, EKC doubled its earnings on a consolidated basis and expanded its operating margins by about 3 percentage points to 25 per cent. Improved realisations for the CNG cylinders and pruning of cost can be attributed to the margin expansion.
Going forward, margins are likely to expand further, given EKC’s plan to increase production of Jumbo Cylinders, which enjoy higher margins. Further, change in product mix tilted towards higher production of CNG cylinders over industrial ones may also add to the margins. While the overall volumes could remain at current levels, the management expects the change in product mix and improving realisations to yield better earnings in future.
Earnings may also get a lift from the proposed increase in export contributions from the India-based units. In this regard, the company’s active hedging policy and strategy to bill both imports and exports in either dollar or Euro denominations provide comfort against forex risks.
Investors can buy the stock of Ipca Laboratories with a two-year perspective. Fully integrated operations, a strong presence in the anti-malarial segment, a growing focus on the US generics market and solid research skills are the company’s positives.
At the current market price of Rs 645, the stock trades at a modest valuation of about nine times its expected FY-09 earnings. This is at a discount to like-sized peers such as Orchid Chemicals, Torrent Pharmaceuticals and Matrix Laboratories.
A diversified business strategy — both segment and geography-wise — helps Ipca achieve significant size and growth in formulations and bulk drug/intermediates.
Strengths in manufacturing and its low-cost advantage have helped Ipca maintain steady margins in its branded formulations business. This has given it a platform to leap into US generics through a partnership-enabled model with Ranbaxy. Under this profit-sharing alliance, Ipca is developing a number of generic prescription pharmaceutical products while Ranbaxy takes care of regulatory approvals and marketing. The duo has already received five USFDA approvals and looks set to increase this number in future.
Another key area that lends further earnings potential is research and development where Ipca spends four per cent of its turnover. It has entered into a collaborative-cum-licence agreement with Central Drug Research Institute for the further development of their compound 99/411, a synthetic substitute for malarial drugs. Ipca’s domain knowledge in malaria underpins its R&D efforts.
Ipca, one of the top 20 domestic pharmaceutical companies, saw healthy operating profit margin of 20-22 per cent (since FY-07) after stagnating in the high teens for three years.
This change was driven by higher focus on diverse geographies such as Europe, Latin America and Africa; scaling up of international formulations business and a conscious foray into difficult-to-make bulk drugs. Ipca’s net revenues grew by a Compounded Annual Growth Rate of 15 per cent and profits by 30 per cent, in the last six years.
To prevent itself from missing out on the US formulations opportunity, Ipca joined hands with Ranbaxy, identifying over 22 molecules for development. This partially contributed to the acceleration of formulation exports, which jumped by over 30 per cent in 2006-07.
We believe that the Ipca’s US generics story is yet to unfold fully as it gains eight per cent market share for the approved drugs by 2010. In future, the company might derive a higher proportion of its revenues from high-margin formulations.
On the domestic front, Ipca looks good to maintain a reasonable success rate with around 20 per cent growth, driven by new launches over the past two years. Its model is much more de-risked now. Over 20 of its brands contribute 60 per cent of the domestic formulation revenues as against merely six in 2005.
Increase of field force (over 1,600) and new products aimed at speciality areas such as heart, lung, brain and pain-related ailments have begun to bear fruit. With an aggressive brand-building exercise initiated two years back, branded formulations is where Ipca is poised to see higher revenues as its ‘focus patients’ are likely shift from non-branded medicines.
In Europe, Ipca has used its strategy of forging relationships with big drug-makers such as Iceland’s Actavis resulting in assured increase off-take of bulk drugs. Region-wise, this is the largest contributor to revenues.
Simultaneously, Ipca has submitted drug dossiers and developed region-specific medicines that it hopes will play a larger role in the next five years. In Africa, which is a ‘future market’, Ipca has ramped up its offering. With over 250 registered products, Africa grossed Rs 70 crore in export revenues and is expected to exceed Rs 80 crore in 2007-08.
The probability of acquisitions in overseas locations are higher for Ipca, which has until now grown organically. These acquisitions can lead to upsides in the stock price.
While Ipca raised debt of around Rs 40 crore to furnish significant capital expenditure at the end of F-Y07, its net change in cash position has improved considerably from the earlier year which will enough generate free cash flow enabling bigger acquisitions in future.
Ipca is also working on a number of molecules based on the Chinese herbal Artemisinin at a time when the global anti-malaria market is waiting for a new and cost-effective drug. When developed, these drugs could be breakthroughs in cost-effective management of multi-drug resistant malaria. Currently, Ipca appears best placed in this space to achieve success. This might also open up a parallel earnings stream of research-backed activities.
In this light, Ipca’s recent open offer for 30 per cent stake in a domestic company — Tonira Pharma, assumes strategic significance. Tonira gives a rich basket of 25 bulk drugs and crucial intermediates along and the know-how to prepare polymorphs of complex chemicals.
Is bungee jumping or a thrill-a-minute roller-coaster ride your idea of having a good time? If it is, then small-cap investing may be your preferred route to stock market riches. Unlike sedate blue-chip stocks that need to be held for several years to turn in a three-digit return, small-cap stocks can turn multi-baggers in a matter of months, especially if aided by a raging bull market (needless to say, small-caps are equally prone to nose-diving at the first sign of a ma rket reversal).
If you have the risk appetite to invest in them, take note that the party in small-cap stocks is already well underway. You may have to act quickly to capitalise on the recent wave of optimism towards the less-known names of India Inc.
Small-caps were barely ahead of their larger counterparts in the stock market rally between June 2006 and August 2007 that saw the Sensex surge by 42 per cent. But they have been the life and soul of the party in the most recent phase of the rally.
Since August 2007, the BSE Small-cap Index, with a return of 60 per cent, has easily trounced the Sensex (44 per cent). These index returns actually understate the case. Over 50 stocks in the BSE Small-cap index have doubled in this three-month span, while 12 have gone up three-fold or more.
As with large-caps, multi-baggers within the small-cap space feature several stocks with astronomical PE multiples.
This is a clear sign that gains in some cases have been driven by speculative froth rather than by hard fundamentals. Reliance Industrial Infrastructure, Nalwa Sons, Marksans Pharma and Walchandanagar Industries are some of the chart-toppers that fall into this category.
Another unusual trend in the recent small-cap rally is that stocks with high institutional interest haven’t delivered better gains than those with low institutional holdings.
Many of the stocks from the top performers list (State Trading Corp, Reliance Industrial Infrastructure, Lloyd Steel) have marginal or nil stakes held by FIIs.
This reinforces the belief that the recent rally in small-cap stocks has been driven largely by individual investors, whether of the retail or high-net-worth variety, rather than by institutional buying.
Fundamentals do work
But this is not to say that selecting small-cap stocks based on their fundamentals has not been a rewarding proposition. Investors who did buy into small-caps with good businesses would have pocketed hefty gains in the past three months.
Companies in niche businesses such as equipment finance company — SREI Infrastructure Finance (154 per cent return), earth-moving equipment maker-TIL (149 per cent), Alphageo — a provider of seismic survey services (145 per cent) and investment bank IL&FS Investmart (128 per cent) are such examples.
These companies owe much of their gains to a re-rating (expansion) in their PE multiple, as investors recognised and priced in bright growth prospects for their business.
It is also a misconception that the small-cap basket consists only of obscure companies with an uncertain pedigree. The small-cap index is home to some companies that do occupy leading positions in their respective businesses — ICRA (rating services), Gokaldas Exports (garment exports), Rallis India (crop protection) and PVR (multiplexes) are cases in point.
The small-cap space also features several “sunrise” businesses — multiplexes, construction equipment, logistics, financing and broking, seen as having a high linkage to the India growth story. Some of these sectors don’t find a representation in large-caps. This makes for rich pickings in this segment of the market. Companies in businesses such as metals, capital goods and financial services have been the frontrunners in the recent small-cap rally. The trend is now showing signs of expanding to engulf companies in businesses such as logistics, realty and media.
FIIs deepen exposures
Research apart, how can investors identify sound small-cap stocks to add to their portfolio? If safety of capital is your prime concern, institutional interest in the stock may be a good filter to apply (despite recent market trends).
Eight out of every ten stocks in the BSE Small-cap index featured at least a marginal holding by FIIs or mutual funds, based on their latest shareholding pattern. This suggests that only a few stocks in the small-cap space are yet to be unearthed by FIIs or domestic mutual funds. Should investors take exposures to the under-owned stocks, in the hope that they would attract institutional interest at a later date?
While this strategy may work quite well for large-cap stocks (which are high on the shopping list for institutions), this may not be a good approach to take to investing in small caps, for two reasons.
For one, institutional investors haven’t sharply expanded their investment universe within the small-cap basket over the past year, despite ample opportunity; instead they have chosen to increase exposure to their existing holdings.
The markets have swung from 10,000 levels last June to over 20K in recent weeks. Yet, the number of small-cap stocks that have FIIs/mutual funds on board has registered a relatively small change in this period.
Domestic mutual funds, if anything have been even more circumspect than the FIIs, not at all entering any new small-caps in this period. On the other hand, there are several instances of companies where institutions have significantly increased their stakes.
These trends suggest that both FIIs and mutual funds have been cautious about adding new small-cap names to their portfolio. Instead, they have preferred to stick to businesses and stocks they are familiar with.
Given that the rally in small-caps has been underway for some time now and that valuations of these stocks have climbed considerably, it may be best for retail investors to stick to safe ground, when it comes to small-cap investing.
At this juncture, stocks that have seen a significant increase in institutional interest, either from FIIs or domestic funds, may be a good hunting ground. Logix Microsystems, Lloyd Electric, South Indian Bank, SREI Infrastructure Finance and Nitco Tiles are some of the stocks that have seen a significant accretion to FII holdings over the past year. Madhucon Projects, McNally Bharat, Subros, TV Today, Greenply Industries and TV Today have seen domestic fund managers hike their stakes significantly between last June and this September.
No pain no gain
While the return potential offered by small-cap stocks cannot be gainsaid, those keen to enter such stocks should also bear the following in mind:
Earnings disappointments from small-cap companies can lead to sharper declines in their prices than would be the case with large-caps.
As such, companies are typically under-researched and there are uncertainties about their prospects; their ability to sustain earnings growth from quarter to quarter thus becomes an important reference point for investors in such stocks.
That the recent rally in small-caps has been driven largely by re-rating (expanding PE multiple), rather than by earnings growth, makes the gainers particularly vulnerable to any disappointment.
As a reversal in a small-cap stock can be quite swift and accompanied by thinning volumes, investors should probably adopt a target price-based approach to taking profits in small-caps.
If small-cap stocks can deliver manifold returns in a matter of months, the downside can be equally swift.
On every occasion when the Sensex has suffered a sharp setback over the past five years, the BSE Small-cap index has taken a much sharper plunge.
In the stock market correction of May-June 2006 the BSE Small-cap index nose-dived by 27 per cent, when the Sensex corrected by 12 per cent.
Investors keen to shelter from such storms should set aside a fixed portion of their portfolio for small-cap stocks. Re-balancing at periodic intervals, to contain small-cap exposures, may be necessary.
Finally, the current valuation levels enjoyed by small-cap stocks as a class, also raise flags of caution. The rally between August and now has ramped up the PE multiple of the BSE Small-cap index from 16 to 25 times (on past earnings), in a matter of three months. This has substantially narrowed the valuation gap between the large caps, as represented by the Sensex, and the small-caps.
Given that small-caps do deserve to trade at a discount to the large-caps, this leaves limited room for further ‘re-rating’ of the former. This suggests that the action may now be restricted more to “value” picks among small-caps.
It is also worth noting that the last major corrective phase in the markets (in May 2006) came about when the BSE Midcap and Smallcap indices moved into a valuation premium to the Sensex.
The rapid rise of some of the small-caps, heightened speculative activity, and the fact that the PE multiple of the BSE Smallcap index is now at a new high, should all be considered as warning signs by investors tempted to go overboard with small-cap investments