Sunday, January 17, 2010
Investors with a long-term perspective can consider taking exposure in the stock of Aurobindo Pharma, a leading API and formulations manufacturer. Our recommendation stems from the company's improving sales mix and margins, improving cash flows and long-term revenue visibility from its supply agreement with Pfizer Inc.
What also underscores our optimism is the company's expanding presence in the export market and the fast-growing chronic therapy segments. At the current market price of Rs 916, the stock trades at about 10 times its likely FY-10 per share earnings. However, since the stock price has run up significantly in the last couple of months, returns from hereon may only be moderate.
Improving mix and margins
Traditionally a strong player in semi-synthetic penicillins (SSP) and cephalosporins, Aurobindo has over the years built up its strength in the formulations business too. From just about 11 per cent in FY05, the formulations business has scaled up its revenue contribution to more than half the sales revenue pie.
With manufacturing capacities in place, having invested close to Rs 1,000 crore in setting up infrastructure, the management expects the contributions of formulation to total sales to go up to more than 80 per cent in the next four-five years.
Though this may appear a tad too ambitious, it may not be unachievable given the company's historic growth rates and increasing focus of high-margin products in regulated markets. The supply agreement drafted earlier with Pfizer Inc will also fuel the growth in formulation business. The improving product mix in favour of formulations will also help the company etch a better margin picture as formulations enjoy higher margins than active pharmaceutical ingredients. Margins may also get a lift from better utilisation of its capacities.
For almost half a decade, Aurobindo had undertaken a massive expansion in capacities; with that in place now, the company may be able to improve its capacity utilisation. Here again, the long-term Pfizer supply agreement would help the company better utilise its assets.
Pfizer deal, a winner
Earlier last year, Aurobindo had entered into an in-licensing and supply agreement with Pfizer Inc to supply solid dosages and sterile products. Pfizer had acquired the rights to 39 generic solid oral dose products in the US and 20 in Europe, plus 11 in France.
The ambit was later expanded to include 55 solid oral dose products and five sterile injectable products for several countries throughout Asia, Latin America, Africa and West Asia. Apart from providing a long-term revenue stream for Aurobindo, the deal would also help improve its cash flows given the licensing and milestone-based inflows involved. While the revenue contribution from the deal is still not very significant, given Pfizer's marketing reach and the growing acceptance of generics worldwide it can scale up to more than 20 per cent levels in the coming four-five years.
The company's consolidated sales for the three months ended Sept-09 grew by 24.6 per cent over the year. The formulations business remained the lead revenue generator, making up over 49 per cent of gross sales, helped by a strong growth in the US market with new product approvals and gains in market share. APIs made up over 49 per cent, with the rest coming from the company's dossier income.
The company also improved its operating margins by over 320 basis points to 19.8 per cent (net of dossier income). In terms of product approvals, the company continued to spread it wings across markets.
In the US itself, the quarter saw the company receive 10 approvals. It currently has a total of 110 ANDA approvals (82 final approvals and 28 tentative approvals) from the USFDA. On the whole, it posted a consolidated net profit of Rs 103 crore as against the loss of Rs 38.5 crore incurred in the corresponding quarter last year (due to forex losses).
The company's cumulative $154 million outstanding FCCBs may hold the trigger to further upside. Given the improving financials and current market price, while the first tranche ($39 million due for conversion at Rs 522) may, likely, get converted into equity, the remaining debt, convertible in two tranches in May 2011 at Rs 879.1 ($33 million) and Rs 1014.1 ($106.2 million) could pose some challenge.
Here again, while the $33 million debt has a high probability of getting converted, the bonds convertible at Rs 1,014.1 could come up for redemption. While the company is not exactly cash-rich now, the accruals from the Pfizer deal could help it create a cash bank towards such an eventuality. Even so, if forced to tap other financing options to partly fund the redemptions (if any), Aurobindo may not have a problem, given its improving balance-sheet.
Investors can buy the shares of Geodesic considering the strong client adds in some of its key businesses, the expanding footprint in domestic e-governance deals, and relatively attractive valuations. Geodesic is a niche software products company focussed on providing instant messaging platforms. At Rs 137, the stock trades at a bargain valuation of six times its likely 2009-10 per share earnings. There are no comparable stocks to Geodesic, but at this valuation, it trades at a huge discount to technology stocks and the broader markets.
Over a three-year period, the company has seen its revenues grow at a compounded annual rate of 153.6 per cent to Rs 659 crore in FY09, while net profit grew by 133.2 per cent to Rs 242.1 crore. In the economic slowdown that was intense in the latter half of 2008 and most of 2009, the company was faced with pricing cuts and tightening client budgets, some of whom actually shut down. Yet, Geodesic has seen revenues grow by 14 per cent for the first half of this fiscal at Rs 317.6 crore compared with the same period last fiscal, while profits fell by 12.7 per cent due to increased marketing costs and forex losses.
Geodesic derives most of its revenues from developing instant messaging platforms/services, Internet radio, IP telephony and other such applications and licensing them to enterprises as well as retail users (directly or indirectly) under the ‘Mundu' brand. The company's products cater to portals and publishers, telecom operators, mobile handset manufacturers, system integrators and even retail consumers. The company has added new clients in nearly all its segments of operations. Usage of its retail offering instant messaging, VoIP platform and mobile SMS over IP has witnessed a rapid increase. With all these segments set to expand in a big way as companies and portals, offering social networking, etc., seek to cut costs, Geodesic is well positioned to tap into this opportunity.
It has a developed revenue model comprising licence fees, customisation fees, per-usage fees and recurring revenues. In fact, 55 per cent of its revenues are recurring revenues. This enables revenue visibility and better margins as well.
At home, the company has won a deal from the Madhya Pradesh Government for implementing its public distribution system using its GeoAmida Simputer. Other deals include traffic management and the NREGA (now Mahatma Gandhi NREGA). Chandamama, the children's magazine that it owns, has also witnessed a ramp-up in revenues.
Rupee appreciation and increase in wage costs are key risks to this recommendation.
Turnkey engineering solutions provider, McNally Bharat Engineering, managed to sail through a difficult FY-09, maintaining robust revenue growth and order accretion. The company also utilised the dull period to put its house in order by undertaking corporate restructuring measures and resorted to acquisition to expand its portfolio of business offerings. The current order book, diversified business profile and strong demand expected from user industries buttress earnings growth in the medium term.
Investors with a two-year investment perspective can consider investing in the stock of McNally Bharat. At the current market price of Rs 272, the stock trades at 15 times its expected consolidated per share earnings for FY-11. The stock can be bought in small lots as the markets may provide opportunity to accumulate during dips. Besides, the company has announced plans for a rights issue at Rs 140 a share. Existing shareholders can wait for the offer.
Graduating to BoP
McNally Bharat renders project services to sectors such as power, mineral processing, steel and non-ferrous metals, ports and other infrastructure activities. Material handling, coal washing and bulk-handling cranes, are some of the turnkey projects undertaken by the company.
McNally has diversified its business from merely executing material handling systems for user industries to offering complete Balance of Plant (BoP) works. For instance, the company, in 2009, bagged a BoP work for a power project as well as a complete design, engineer and structural work for a green anode project in an alumina plant. This upward integration will help showcase itself as a all-rounder in engineering services and act as a reference point for future orders besides propping up profit margins.
McNally Bharat has had an eventful FY-10 so far, in terms of its restructuring exercise and acquisition. The company transferred its product business to an 86 per cent subsidiary and retained the project business under the parent company. This move, meant to differentiate its offerings, will ensure improved business focus and allow independent leveraging for each company. At the same time, McNally Bharat would be able to generate better margins as a consolidated entity as it would tap its subsidiary for equipment to be supplied for projects thus retaining backward integration benfits. The subsidiary, McNally Sayaji Engineering, has four manufacturing units for crushing, screening, milling, material handling and other heavy equipment used in core industries. On a standalone basis, McNally Bharat's revenues and margins may be marginally muted by this realignment, as the product business enjoys lucrative margins. McNally Sayaji accounted for a fifth of the consolidated revenues for the September quarter.
Besides the restructuring, McNally Bharat also acquired the coal and mineral processing business of German-based KHD Humboldt for a total cash outflow of Rs 80 crore. This acquisition is expected to augment McNally Bharat's skills in coal and mineral processing, cement as well as in the power sector. Besides, the acquired company's marketing presence in Europe, Australia, China and South America may help McNally bid for Engineering, Procurement and Construction contracts, especially in developing countries.
McNally Bharat was among the few capital goods companies to successfully combat the slowdown in 2009. While the company has been on a fast-track mode, clocking sales and earnings growth of 42 per cent and 85 per cent annually in the last three years, it managed an impressive 76 per cent revenue growth (to Rs 968 crore) in FY-09 as well.
Its order accretion in the first half of FY-10 too remained unaffected with orders bagged in this period moving well past the inflows of FY-09. Its order book as of September stood at Rs 3100 crore, over thrice FY-09 revenues. Comfortable debt levels and funds from rights issue and private equity (for subsidiary) are likely to ensure smooth order execution.
McNally Bharat's operating profit margins of about 8 per cent have dipped to the 6-7 per cent range in recent quarters as a result of still-high raw material costs and outsourcing expenses. The higher raw material cost could be on account of booking revenues on older projects. However, going forward too, an increase in commodity price can threaten the company's margins, as a good proportion of orders, according to the management, are on a fixed-contract basis. The outsourcing expense may, however, see some moderation as the company has set up its own construction division.
Orders in the L1 bidding stage include BoP projects, with the company already securing its first order in this space. Winning these orders could help build a portfolio with superior profit margins.
Investors can consider accumulating the Allahabad Bank stock, which is a defensive pick in the banking space. The bank has posted higher-than-industry credit growth so far this fiscal with lower slippages, thereby increasing its market share in advances. The Allahabad Bank stock is trading at a significant valuation discount to its peers.
At current market price of Rs 133, the stock is trading at a price earnings multiple of nearly 5 times on estimated FY10 earnings and a price to FY10 adjusted book value (estimated) of 0.88.
The bank had formulated strategies to increase low cost deposits and reduce dependence on whole-sale deposits while improving yields and fee income. These have started yielding results, with the bank witnessing sharp improvement in operating efficiency (cost-income ratio of 38 per cent for September 2009 against 49 per cent a year ago) and asset quality (net Non Performing Assets (NPA) of 0.35 per cent). Fee income as a proportion of operating expenses has also increased from 31 per cent to 42 per cent for the half year ended September 30, 2009. Fee income may get further fillip as the bank becomes 100 per cent core banking solutions (CBS)-enabled.
Strong loan growth
Allahabad Bankhas high concentration in the North and Eastern parts of India. The bank has a strong presence in rural and semi urban areas (accounting for 60 per cent of the network). The low-cost deposit base improved to 36 per cent as of September 30, 2009.
The loan book grew at a compounded rate of 29 per cent during the period 2004-09 while net profit growth was inconsistent and grew at an annual rate of 9 per cent. Credit growth as of September stood at 17.7 per cent against the industry credit growth of 12 per cent.
The loan growth of the bank was primarily driven by the small and medium enterprises and corporate advances. While the credit growth this year may be moderate, we expect credit growth to pick up beyond this fiscal.
The low rate of profit growth during the last few years was a function of higher cost of funds, provisioning for NPAs and depreciation. Two of these three issues have been sorted out by the bank. One, the bank has been reducing its dependence on high-cost wholesale deposits. The proportion of wholesale deposits to total deposits has come down from 25.5 per cent to 12 per cent on a year. Two, the bank has made adequate provisions for NPAs (79 per cent).
In addition the bank has also re-priced assets and improved yields on advances. The net interest margin (NIM) of the bank has improved from 2.62 to 2.88 per cent in a year, with net interest income growing 28 per cent. Allahabad Bank's net profit for the half-year ended September 2009, grew by 370 per cent over the same period last year with write-backs and treasury gains bolstering profits (it took write-offs last year).
There is still scope for improvement in the NIM of the bank as a larger proportion of high cost deposits get re-priced at a lower rate.
Overall, from here on, the net profit growth for the bank would get support from improving credit offtake and better margins, even as it may face some pressure on its treasury portfolio.
Allahabad Bank is the one of the few banks to witness a fall in its gross NPA ratio from 1.81 to 1.73 per cent , from March to September 2009. The improvement in provision coverage to 79 per cent from 59 per cent helped the bank reduce the net NPAs significantly.
Despite government holding 55 per cent in the bank which is close to the mandatory 51 per cent, the bank is currently comfortably placed in terms of capital adequacy ratio (CRAR) (14.9 per cent) with core capital contributing more than 9 per cent. The bank also has additional head room to raise more than Rs 1,800 crore, which, along with the internal accruals, would be enough to fund a loan growth of 20 per cent for the next few months and yet maintain CRAR at over 12 per cent. The Indian government is also set to recapitalise public sector banks for which Allahabad Bank is a likely candidate.
Allahabad Bank has a very high proportion of government securities in its investment portfolio. While some profit booking may have been done in the December quarter, the bank may have to provide for the mark-to market losses, as gilt yields touch a 15-month high.
During the first half of this year, Allahabad Bank converted a proportion of its securities in the available-for-sale category to held-to-maturity, thereby shielding itself from a spike in yields to some extent. Only Rs 4,065 crore of government securities are now exposed to market yields. However, the duration of the investment portfolio is on the higher side, leading to concerns of treasury losses. The bank's non-gilt securities are in the form of liquid mutual funds and certificates of deposit which are not as vulnerable to interest rate spikes
The markets continued to display range-bound movement for yet another week. The Sensex touched a high of 17,777, but steadily moved lower to 17,276. The index finally closed the week with a nominal gain of 14 points at 17,554.
IT stocks, thanks to better-than-expected Infosys numbers, outperformed this week. TCS zoomed 13 per cent to Rs 792. Wipro surged nearly 10 per cent, and Infosys rallied nearly 9 per cent. ACC, Grasim and Reliance Communications were the other prominent gainers. SBI, on the other hand, was the major loser, down over 6 per cent at Rs 2,144. Hindalco, ICICI Bank, Sterlite, Hindustan Unilever, Reliance Infrastructure, Sun Pharma and HDFC were the other major losers.
The Sensex has not given any clear indication as of now. The index is currently moving in a 600-point band of 17,255-17,830. A breakout at the lower end of the range could see the index slip to 17,100-16,990-16,875. Whereas the upward breakout could see the index move to 17,940-18,055.
The NSE Nifty moved in a range of 131 points, from a high of 5,301, the index slipped to a low of 5,170. Last week, we had mentioned key support at 5,180. The index just rebounded around this particular level. There seems to be a limited upside from the current levels. 5,300 is likely to act as a significant resistance, followed by 5,340. On the downside, the index may find support around 5,200-5,170. A breakout below 5,170 could see the index fall to 5,085.
The momentum indicators are currently in favour of some more downsides. The nine-day Relative Strength Index and the Stochastic Slow are trending downwards. Also the Moving Average Convergence Divergence is on verge of turning bearish. However, one should wait for a clear breakout for any directional view on the indices.
Conservative investors can avoid subscribing to the initial public offer of Jubilant Foodworks (JFL), the operator of the national pizza chain, Domino's Pizza. Though the business has managed strong growth rates so far, the asking price for the offer is stiff.
The issue is priced within a band of Rs 135-145, with annualised FY-10 per-share earnings at Rs 4.02, resulting in a price-earnings of 34 to 36 times on a post-issue basis. Globally comparable food retailers such as McDonalds, Papa John International's and Dominos Pizza ( the parent company) are available at PE multiples of 13 to 15.
High valuations apart, the issue is also primarily an exit route for strategic investors with just 20 per cent of funds raised actually accruing to the company. This creates uncertainty about funding for the company's future expansion plans, which are key to its growth prospects. Accumulated losses, high interest costs (should the company take recourse to further debt) and potential hikes in raw material costs are other factors that dim the prospects of this offer.
JFL runs the Dominos Pizza chain in India through an exclusive franchise agreement with Dominos International (DI). Recently renewed, this agreement will continue for another 15 years. JFL currently operates 286 outlets, across a geography of 59 cities. JFL plans to open about 15 more outlets by end-FY10, and is required to open at least 25 stores a year after that per its agreement.
DI holds sway in the operations of the business. tore openings and franchise agreements can be undertaken after obtaining certificates in prescribed formats. Major advertising and promotional campaigns require review by DI; suppliers need to be designated by DI or approved by it. JFL's subsidiary profitably operates five outlets in Sri Lanka, and JFL has the right to open Dominos outlets in Nepal and Bangladesh as per the franchise agreement. It has, however, no outlets in either country.
A good portion of new stores are slated for smaller towns and cities where demand is beginning to take off as income levels and spending habits pick up.
JFL has taken steps to expand the Dominos menu, adding variety as well as distinguishing items such as its choco-lava cake. Though pricing may not be given the ‘affordable' tag, it is below that of closest competitor, Pizza Hut. More importantly, Dominos commands sizeable brand recall and majority market share in the pizza home delivery segment.
Growth in terms of volume and sales has been healthy. From an annual 8.99 million pizzas sold in FY-07, volumes have jumped to 21.74 million in FY-09. Sales, therefore, recorded a 42 per cent three-year compounded annual growth, while net profits grew 49 per cent.
A centralised sourcing and distribution system in four centres across the country, combined with back-end facilities in smaller cities, has largely aided operating margins. Dedicated transport fleet and cold-chain systems allow efficient distribution; inventory turnover period is less than a week. Operating margin has been at 13 per cent in FY-07 to FY-09, it further improved to 16 per cent in the first half of FY-10 on account of controls in manufacturing costs.
Of the Rs 58 crore of the offer that goes to JFL, Rs 35 crore is marked for repayment of debt. With a pre-issue debt-equity ratio of 2.4 times (Sept '09), repayment will help bring this ratio down to 1.2 times, post-issue. Interest costs have hitherto been the biggest dampener on margins, cutting net profit margins to 4 per cent in FY-08 and further to 2 per cent in FY-09. In this backdrop, the company is unlikely to use capital raised to fund expansion of outlets. It has previously bankrolled expansion through a combination of internal accruals and debt.
Despite the positive picture presented by JFL, there are a good many risks. For one, with a good portion of the offer proceeds not flowing into the company, should debt be taken on in the future to fund expansion, it could reduce margins and constrain cash flows.
Two, JFL has an accumulated loss of Rs 62.3 crore as of September 2009, against average yearly profits of about Rs 6 crore, , precluding dividend payouts in initial years after listing.. Once losses are written off, the company would face increased taxes, squeezing net margins.
Three, going forward, inflationary pressures could lead to raw material cost increases. Margins, thus, could slip, else JFL may increase retail prices of its products, which could hurt sales.
Current assets, including cash, also do not cover dues to sundry creditors. Of the capital raised that accrues to JFL, almost 40 per cent goes towards issue expenses and general corporate purposes which may be varied and difficult to ascertain.
Dominos Pizza, while enjoying brand equity in the door-delivery segment, still faces tough competition from dine-in eateries, other national lower-priced fast-food chains such as McDonalds, KFC and so on, besides small, local eateries.
These factors, therefore, argue against paying premium valuations for this offer. It may thus be avoided, but price corrections post-listing bringing about more reasonable valuations may be used to enter what is an attractive business with no other listed competitor.
The issue is open from January 16 to 18. On offer are 22,670,447 shares, of which 4,000,000 shares are a fresh issue. Kotak Mahindra is the lead manager.