Sunday, February 07, 2010
A relatively low asking price and a focus on government projects make the offer from ARSS Infrastructure Projects a reasonable bet, but only for investors with a high-risk appetite.
A construction contractor in the Railways and roadways segment, the company plans to raise Rs 103 crore from this issue to fund working-capital and joint ventures.
In its price band of Rs 410-450, the offer is at a valuation of 8.6 to 9.5 times the estimated FY-11 per share earnings on a post-offer equity. Reasonable valuations notwithstanding, given the risks to the business, investors are advised to exit the stock if it touches about a 21 per cent return.
ARSS has a high exposure to Railways (which offer higher margins) and roadways, a sizeable order book, strong sales and profit growth, and a secure client base in government contracts. The company also uses joint-ventures to bid for and execute bigger projects and build on execution capabilities. Strong margins and post-issue lower debt-equity are other positives for the company.
However, the order book has several contracts with a relatively short execution period. ARSS will have to keep up the pace of securing fresh orders to maintain current rate of growth.
A promoter facing criminal investigations, past instances of default in payment of power bills, default in servicing debt and decline in working capital turnover pose significant risk.
ARSS executes construction contracts in Railways (laying and linking of tracks, earthwork and construction of bridges) and roadways (widening and strengthening of roads), with a recent move into irrigation. Geographically concentrated in Orissa, the company has moved into regions such as Tamil Nadu, Rajasthan, Jharkhand and so on. Almost 90 per cent of the contracts come from government-based institutions such as Ministry of Railways, Orissa Public Works Departments, and so on, providing a secure repeat client base. The company also has in-house design capacities.
Current order-book stands at Rs 2,877.5 crore (4.6 times 2008-09 revenues), and is well-diversified with 41 per cent in the Railways segment, 40 per cent in roads, 3 per cent in irrigation and the balance in other smaller works.
The order book is represented by over a hundred contracts, a smaller average contract value (about Rs 21 crore), and bulk of the order book is executable by FY-11 providing near-term earnings visibility. However, maintaining current growth rate depends on the company's ability to continually secure fresh contracts which provide similar margins.
ARSS has used joint ventures with players such as Kalindee Rail and Patel Engineering to execute projects where it lacks capability. Such ventures could help it build on its own expertise and allow a bidding capacity for bigger and more varied projects.
Besides, gradual build up of expertise could help it eventually qualify for projects on its own strength. About Rs 5 crore from the issue proceeds will go to funding such joint ventures and Rs 86 crore towards working capital.
Turnover of working capital, however, has gradually declined from 3.36 in FY07 to 1.67 times (as of December 09). Huge increases in inventory could partly explain this slide.
The order book just about doubled in FY-08 over the year before, but work-in-progress (WIP), a part of inventory, jumped about nine times. This has continued in FY-09 as well where WIP more than doubled against an order-book growth of 64 per cent.
Sales recorded a strong 118 per cent three-year CAGR while net profits put up a 149 per cent growth. Given a higher component of railway projects, and price escalation clauses built into a majority of the contracts, operating margins have been maintained above 10 per cent FY-07 onwards, standing at 12.5 per cent for the nine months ended December 09.
Net profit margins as well have stayed at about 8 per cent. Funding position appears comfortable with debt-equity on a post-issue basis on the lower side at 1.23 times, and interest cover at 2.7 times (December 09). The company has, however, defaulted on interest and repayment of loans in FY-06, FY-04 and FY-03.
The issue is open from February 8-11. IDBI Capital Market Services and SBI Capital Markets are the lead managers.
Investors with moderate risk and return expectations can consider taking exposure in the abrasive and industrial ceramics manufacturer, Grindwell Norton. Pick-up in capex spending by user industries, ability to retain significant market share and profit margins, despite competition and pricing pressures, and technology support from the French parent shore up the earnings prospects for this company.
At the current price of Rs 144, the stock discounts its likely per share earnings for FY-11 by 12 times. The valuations are at a steep discount to peer Carborundum Universal.
While the company's earnings grew at a compounded annual rate of 10 per cent over the last three years, muted growth in 2008 and partly in 2009 pulled down the overall performance.
Given the increased activity in auto, auto components and steel and non-ferrous sectors — key end-users of the company's products — we expect earnings growth to scale up over the next two years.
A low-debt profile and utilisation of internal accruals also augur well, given the expectations of a climb in interest rates by end-2010.
Demand for abrasives
Grindwell Norton derives over 70 per cent of its revenues from sale of abrasives, predominantly used in industries such as automobiles, auto components, steel, foundry and fabrication as well as a number of other manufacturing industries.
The planned increase in capacity with the entry of overseas players in sectors such as auto and steel, could see significant traction in demand for Grindwell Norton; the company is part of the Saint-Gobain group, which is a world leader in bonded abrasives.
In the local market, Carborundum Universal and Grindwell Norton together garner around 65-70 per cent of the abrasive market, with the former, in a slightly more dominant position. However, the abrasives market is not entirely insulated from competition, despite heavy investment.
Small players catering to specific low-end products, high-end precision tools offered by players from Europe through local marketing networks as well as Chinese imports post a competitive challenge. As a result, the abrasive market faces pricing pressure.
However, backing of the group's brand name could well act as a good reference for players such as Grindwell Norton, when it comes to dealing with bigger clients in the metal and auto industry.
Besides, cost-advantage by way of manufacturing units in India as well as backward integration into silicon carbide, a key raw material for abrasives, provide some edge for the company. With the aid of its parent, Grindwell Norton has also expanded in to export markets.
That the abrasive division is limping back to normalcy after a tough year in 2008, is evident from the segment's revenues for the 12 months ended December 2009 (the company plans to change its accounting year to March). Abrasives sales of Rs 366 crore for the above period is, in fact, 10 per cent higher than that of the year ending December 2007; in other words, the company has managed to beat a year of peak performance.
Operating profit of the segment, though, remains lower than the corresponding level in 2007, suggesting that pricing power could be weak.
Key demand drivers
The company's ceramics and plastics segment which produces silicon carbide and high performance refractories has witnessed robust growth and maintained profit margins, thanks to its key demand drivers — metallurgy (iron and steel) and construction industries, apart from internal consumption of silicon carbide for the abrasives division. However, this segment would be sensitive to any steep increase in input costs.
The segment could nevertheless benefit from improved volumes from any global increase in commodity demand, as the usage of its products in steel manufacturing as well as in refractories used for processing metals is quite extensive. For the 12 months ending December 2009, sales grew by a tepid 5.6 per cent to Rs 530 crore while net profits expanded by 11 per cent to Rs 61 crore.
Pick-up in business was, however, evident with a 30 per cent growth in sales and 42 per cent jump in profits in the latest ended quarter over a year ago.
Investors can avoid the initial public offering of Hathway Cable & Datacom, a cable distribution and broadband services provider, given the inherent challenges in driving realisations in both the segments that it operates in and the severe competition from well-entrenched players with alternative delivery platforms.
At Rs 265 (upper-end of price band), the stock trades at an EV/sales (enterprise value to sales) multiple of 5.7 times based on its FY09 numbers on a pre-offer equity base and a EV/subscriber of Rs 3,842.
The cable industry may face several scalability hurdles, what with the limited growth in television households, the pace conversion of analogue networks to digital ones and within that conversion of free-to-air viewers to pay-channel mode, all being subject to uncertainty.
Hathway has been in operations for over a decade now and has grown over the years, especially in the last two-three years largely by taking the inorganic route to expansion. Acquiring MSOs (multi-system operators) and LCOs (local cable operators) has enabled the company to grow at a fair pace in terms of revenues. With a negative return on networth and spiralling interest costs (only a small portion of debt is to be repaid from the offer), an acquisition spree, though the only way to grow in this business, may not help strengthen financials.
Cable business challenges
Between FY-06 and FY-09, the company grew its revenues at a compounded annual rate of 38.5 per cent to Rs 673.2 crore. Despite having a reach that is much higher than most other cable operators (estimated base of 8.2 million cable homes) Hathway lagged behind Den Networks in terms of revenues. This suggests that ARPUs (average revenues per user) are quite low for the company, a fact reinforced by its stated figure of Rs 55.8 per month.
Of its total subscribers, only a million of them are on digital cable, which is the key reason for these low ARPUs.
There are several inherent problems in the cable distribution business, which affects all companies in this business. One, there is always the menace of local cable operators understating revenues, which cripples financials for a player such as Hathway, till such time as most analogue connections are upgraded to digital ones, which could be time-consuming.
Second, even if large-scale digitisation of its cable network is achieved, the company still faces the challenge of getting its viewers to subscribe to pay channels, which is the key revenue driver. This is because a viewer has the option of not taking a set-top box and viewing only free-to-air channels. Regulatory controls on pricing also pose a threat with the regulator in fact mandating a Rs 77 package with 30 free-to-air channels. Third, the growth of the industry itself may not be that encouraging. A recent report from PricewaterhouseCoopers indicates that the number of TV households would grow at just 2.7 per cent annually over 2009-13 to 135 million. Further, the report states that the number of cable households would grow from 71 million in 2008 at just 2.4 per cent annually from 2009 to 80 million by 2013.
A FICCI-KPMG report predicts a higher 5.7 per cent annual growth rate.
Sure, the telecom regulator has mandated conditional access in 55 cities by 2011. But, experience suggests that the adoption of conditional access even in the metros has been slow, with most of the households content with free-to-air channels. A TRAI report gives out the fact that only a little over eight lakh set-top boxes have been installed in the four metros put together as of June 2009.
There may, therefore, be limited success in large-scale digitising of cables and driving revenues as a whole. Then there is competition from alternate platforms such as DTH (direct-to-home). Within just three years of its launch, this platform now boasts of as many as 18 million subscribers, thanks to large well-entrenched players such as Dish TV, Tata Sky, Airtel Digital TV, Big TV and Sun Direct, all having deep pockets. Videocon is a recent entrant to this race.
The platform, given its inherent advantage technologically, has greater scope for driving revenues for operators. Latest hit movies being made available within a month of release at a fraction of multiplex ticket rates and several other value-added services or tailored packages help enhance ARPUs.
It may, therefore, be fair to believe that this would be the preferred mode towards digitising cable viewing.
Hathway also has a broadband business that contributes about 16 per cent of overall revenues. Given the under-penetration of Internet and, more specifically, broadband in India, there may be ample scope for expansion.
Indeed, Hathway cross-sells its broadband services to its cable subscribers. But here again, operators with strong wireline networks have made significant inroads by providing DSL broadband services. BSNL, the largest broadband service provider in India, Reliance Communications, Bharti Airtel, and Tata Communications have taken a lion's share of the internet subscribers between them.
With the increase in the shipments and usage of laptops in India, most of these companies have also been able to drive growth through sale of data cards.
With a wireless last-mile being the preferred route for all technology adoptions in India, these companies may also benefit from winning WiMax licenses for providing wireless broadband access. All this would reduce the addressable pie for Hathway.
Hathway is looking raise about Rs 735 crore by sale of around 27.75 million shares at a price band of Rs 240-265. About Rs 200 crore would go to selling shareholders, Monet and MSPI Mauritius. Acquisition of customers, investment in developing the cable and broadband infrastructure are the stated objectives towards which the issue proceeds would go.
Shareholders can consider booking profits on their holdings in Dr Reddy's Laboratories (DRL). The stock has since our last ‘buy' recommendation gained over 60 per cent. While a strong set of numbers in the just-ended December quarter, potential exclusivity revenues from products such as Prilosec OTC, Allegra D24 and Arixtra and the likely expansion in market reach through its alliance with GSK promise growth potential, the stock appears to have priced in most of these potential positives.
At the current market price of Rs 1,132, the stock trades at about 23 times and 19 times its likely FY-10 and FY-11 per share earnings, leaving little room for significant near-term upsides. Besides, the recent non-cash write-down of intangible for its German arm and lowering of the current year revenue guidance by the company will also check any near-term gains for the stock.
Strong business dynamics
The strengthening base business of Dr Reddy's (minus exclusives), with a focus on US, Europe, Russia, CIS and India provides for a sustainable source of revenues in the coming years. The company put up a strong show in most of these markets even in the latest quarter. Minus the exclusivity sales of Imitrex that helped prop up revenues last year, the company recorded a decent 17 per cent growth in overall revenues during the quarter. Growth percentage would have been even higher had it not been for the lagging contributions from its US business. DRL's US revenues suffered on account of voluntary product recalls, FDA inspection and late launches. But with all these issues resolved now, the US revenues can be expected to be back on growth track in a couple of quarters.
The management expects its US operations to drive the global generics growth in the coming years. Given its fairly strong ANDA pipeline and a stream of exclusive product launches lined up for the next couple of years, the US business does seem to hold the key to drive DRL's growth aspirations. The management expects to achieve $3 billion of revenues by fiscal 2013.
But even as the US market may be the key to future growth, DRL's improving prospects in the Russian and domestic market cannot be ignored. In the December quarter alone, it managed to grow its domestic revenues by about 34 per cent. While a low base would have also helped, what's notable is that the company has taken to launching products to support growth (18 last quarter).
Having traditionally lagged most of its peers in this respect, the company's strategy to launch products to drive domestic growth may help it keep up the momentum. So far this fiscal, DRL has launched 56 products across various therapeutic areas.
Supply-chain improvement, a strong field force and the company's rural market initiatives may further help expand its domestic footprint. Another market in which the company has been able to scale growth rates higher than the industry average is that of Russia. Helped by a combination of price hikes and volume expansion, the company managed to grow its Russia income by about 45 per cent in the quarter. Though the company may not be able to maintain similar growth rates in future — price hikes were linked to devaluation of the ruble — Russia will continue to be a key growth market.
DRL's PSAI segment (pharmaceutical services and active ingredients) also promises growth potential; the segment registered a 17 per cent growth during the quarter largely led by India and RoW markets. The cumulative DMF filings as of Dec 09 are 388.
Future growth drivers
Dr Reddy's has a fairly strong pipeline of over 62 new drug applications pending approval by the US FDA (Food and Drug Administration). Of these, 35 are Para IVs and 13 are FTF opportunities. The company expects to launch two limited-competition products in the US in the next financial year — the generic version of GlaxoSmithKline's antithrombotic drug Arixtra (expected in FY11) and a generic version of Sanofi-Aventis's Allegra-D 24 (expected in first quarter FY11, $120 million market size). In addition to this, the management has guided for at least one high-value (low-competition) opportunity every year for the next 5 years.
DRL's marketing alliance with GSK is expected to launch its first set of products in Mexico in the April-June quarter. Though the alliance may take two-three years to become a significant revenue spinner, it will help DRL spread its wings in markets it otherwise has little presence in.
Betapharm, however, may continue to be a drag on the company's earnings. The change to a tender-based model in Germany has pressured its profitability, forcing DRL to take non-cash hits on intangible assets and goodwill. The carry-forward value of intangibles for Betapharm has now reduced to €93 million (acquisition price €480 million in Feb 2006).
While the management does not expect any further fall in the value of its brands, it has not completely ruled out the possibility either. Any further impairment of intangibles, therefore, would pose a risk to earnings. Delays in the launch of products also pose a risk to expected earnings.
Fresh investments can be considered in the Power Finance Corporation (PFC) stock that appears a good defensive bet within the financial sector.
The company's loan book grew at a strong pace of 20 per cent in 2009 despite lower demand for credit witnessed by the banking sector. At current market price of Rs 252, the PFC stock is trading at 10.5 times its estimated FY11 earnings and two times its estimated adjusted book value, which does not reflect the strong earnings growth posted by the company.
Near-zero non-performing assets and a high proportion of floating rate assets (87 per cent) allow PFC to pass on interest hikes and minimise credit risk. Strong earnings growth (36 per cent for nine months ended December 31, 2009, adjusted for extraordinary items), superior profitability (Return on Equity of 17 per cent) and the insatiable funding requirements of the power sector make for bright growth prospects.
The outlook for power financing looks promising given that investments of Rs 10 lakh crore are expected in the power generation alone over the next eight years. PFC being the market leader may corner a chunk of this pie.
With a minimum 70 per cent of every power generation project to be funded with debt, PFC may continue to witness high levels of sustainable loan book growth over next few years. That power companies have preferred the domestic market to overseas borrowings also benefits PFC.
The gap between PFC's sanctions and disbursements stood at around Rs 1.25 lakh crore by December 2009 due to project delays until previous quarter. However, in the third quarter, the disbursements outpaced sanctions, indicative of improving investment environment for power project development. Loans sanctioned (not disbursed) amount to 1.72 times its loan book.
A sovereign credit rating gives it opportunity to borrow at reasonable rates. The majority of liability profile is fixed allowing it to lock-in at low interest rates. Going forward, the asset-liability mismatch, however, is a lingering concern with loan tenures of over 15 years, while liabilities typically have the highest tenor of 10 years. Currently, the average maturity is 5.8 years for loans compared to 4.55 years on borrowings.
With interest rates hardening, PFC's margins may be held (4.2 per cent for nine months ended December 2009). Currently, the State electricity boards are the key borrowers, but the proportion is coming down. Incremental sanctions are likely to be driven by the private sector. PFC may also look at chipping in for the equity portion of power projects, which may bolster returns on investment.
Fee income may improve as new Ultra Mega Power Projects are awarded. The consultancy and APRDP (Accelerated Power Development and Reform Programme) also improve the fee income. The company is also entering coal mining and equipment financing.
PFC has a comfortable capital base (currently 17.6 per cent) allowing it to expand its loan book seamlessly without raising additional capital
Weak global cues and selling by foreign institutional investors (FIIs) saw markets end weak for the third straight week. Moreover, they continue to register lower highs and higher lows during the period, which is a negative sign.
The Sensex touched a high of 16,553, but eventually ended with a loss of 442 points at 15,916. At the week’s low of 15,725, the index was down almost 10 per cent on year-till-date basis. With the Budget just three weeks away, any hope of a pre-Budget rally relies strictly on the fact that the major indices are close to long-term (200-day daily moving average) support levels.
Among index stocks, Jaiprakash Associates and SBI plunged 7 per cent each to Rs 128 and Rs 1,914, respectively. DLF, Hindustan Unilever, Reliance (at 52-week low), NTPC, Hindalco and BHEL were the other major losers. Hero Honda and Sun Pharma were the only prominent gainers among Sensex stocks.
Having broken their quarterly support, the markets are now likely to remain weak till the end of March. The Sensex will have to sustain itself above 16,625 in order to change the trend. However, the index is now very close to some other crucial support levels. The monthly support stands at 15,665, the long-term (200-day daily moving average) stands at 15,525, while the yearly support is at 15,380.
Weekly support levels for the Sensex are at 15,600-15,500-15,400 while resistance on the upside is at 16,230-16,330-16,430. The Nifty moved in a range of 259 points — from a high of 4,951, the index dropped to a low of 4,692. The index finally ended with a loss of 125 points at 4,757 and is down 495 points in the last three weeks.
Next week, the index is likely to face resistance at 4,855-4,885-4,915 and may find support around 4,700-4,625-4,595. The mid-term (50-days) average of the Nifty is currently above the short-term (20-days) average, which is a negative sign. Trend lines have turned negative on monthly charts as well. However, trend lines are positive on the weekly chart.