Sunday, March 07, 2010
Investors should consider bidding in the follow-on public offering from National Minerals Development Corporation (NMDC) only if it is priced at a steep discount to the current market price.
NMDC has a good exposure to the iron ore mining sector with large reserves of high-grade ore, assured demand from the expanding Indian steel industry, production costs that are far below the global average and large cash in its coffers to pump into diversification and expansion projects.
The company's impressive operating profit margins of 70-80 per cent, its zero debt status and cash of over Rs 12,000 crore on its books (as of December 2009), make the stock a preferred exposure in the listed mining space.
However, it is the stiff valuation that the stock is trading at which is a cause for concern for investors. At the current market price of Rs 416, the stock discounts its trailing 12-month earnings by about 48 times. While NMDC's Indian peer Sesa Goa trades at 19 times, much larger global competitors such as Rio Tinto, Vale and BHP Billion trade at 18-23 times.
Even if one looks at other relevant valuation metrics such as Enterprise Value (EV)/EBITDA, NMDC's stock appears very expensive. While its EV/EBITDA stands at over 40 times, that of diversified global mining majors (much larger in size) such as Rio Tinto, Vale and BHP Billion are around 13-16 times.
Apart from the one-off factors which depressed NMDC's earnings in the latest nine months, the valuations for the stock have run up to unrealistic levels due to the buzz surrounding divestment and the limited floating stock that has been available for trading. Given this backdrop, in our view, the FPO would be worth considering if priced at Rs 300 per share or lower. That would capture a price-earnings multiple of about 32 times on its normalised earnings (average of three years to current fiscal) and an EV/EBIDTA multiple of about 19 times on the same basis.
The company's cash balances of about Rs 12,077 crore (as of December 2009) alone translate into a value of about Rs 30 per share.
NMDC enjoys a near monopoly status in the Indian iron ore mining sector, with iron ore making up nearly all of its revenues.
The company has a wide customer profile. Supplies to domestic steel companies which are on an expansion spree assure it volume growth. Operating mainly through long-term contracts lends it high revenue visibility.
It has a total proven reserves of 977.5 million tonnes, with an average mine life of about 30 years. More than half of this is currently put to use. Spread across Chhattisgarh and Karnataka, the reserves are predominantly of high quality (64 per cent and greater iron ore content).
The company produced 28.8 million tonnes of iron ore in FY09, of which, about 22.6 tonnes was sold in the domestic markets while the rest was exported to Japan, South Korea and China. Exports are done through MMTC and the company shares foreign currency risk with the former.
NMDC's Indian market focus lends high stability to its revenue, given the strong steel demand in the domestic market and the expansion plans of domestic steel majors.
Key customers in the domestic market are Rashtriya Ispat Nigam (Vizag Steel Plant), Essar Steel, Ispat Industries, JSW Steel and Welspun Maxsteel. These clients account for over 60 per cent of its total sales. A good portion of sales is done through long-term contracts.
Though contracts are usually long term, NMDC has traditionally enjoyed strong pricing power even during the tenure of the contracts.
In this context, global iron ore prices which were depressed through last year, appear to be showing signs of resuming their uptrend, with recent forecasts indicating that prices may trend up by 50-60 per cent over the next one year as global contracts get renegotiated in a stronger economic environment.
Global spot prices of high grade iron ore are up by over 40 per cent since September 2009.
At present, NMDC charges around Rs 2,600 per tonne of iron ore. If its clients resort to importing the same quality ore from Australia or Brazil, costs may range between Rs 3,200 and Rs 4,000 a tonne.
With the ongoing expansion in the steel industry and a bulk of customer contracts soon due for renewal, NMDC may witness strong revenue growth of 25-30 per cent in the next couple of years.
Revenue growth may go directly to bolster the operating profit margins, given that NMDC's costs of production are among the lowest in the peer group. That could mean operating profit margins reverting to the historical range of over 80 per cent.
To keep pace with the growth in the steel industry, NMDC plans to expand its iron ore production capacities to 50 million tonnes by 2014-15.
Additionally, to move up the value chain, NMDC, in collaboration with the Government of Chhattisgarh, will develop a steel plant at a cost of Rs 14,000 crore and a capacity of 3 mtpa in Jagdalpur. It also plans to set up a steel plant in Karnataka.
The steel projects may improve its revenues but can also expose it to debt and steel price cycles. NMDC also proposes to diversify as a mineral producer.
The company's diamond mine at Panna is one of the largest diamond mines in Asia. That apart, it has exposure to other minerals such as limestone, dolomite and manganese which are captively used to produce iron ore.
NMDC has seen a compounded annual production and sales growth of 20-25 per cent between FY05 and FY09.
Operating profit margins have improved from 57 per cent to 88 per cent between 2004-05 and 2008-09, as costs remained steady even as realisations shot up. NMDC's performance however suffered a setback in the recently concluded nine months ended December 2009 as its operations were disrupted by Naxalite attacks.
Sales revenues declined by 32 per cent year-on-year in the December 2009 quarter and by 25 per cent for the nine-month period. Operating margins fell from 80 per cent in December 2008 to 60 per cent in December 2009.
Nevertheless, these margins are still above the industry average of 40-50 per cent. Net profits for the December 2009 quarter also fell to Rs 859.99 crore from Rs 1,424.95 crore in December 2008.
Though the situation is now under control, NMDC is still vulnerable to such attacks. Normalised production, an improvement in sales off-take and a revision in selling prices will boost NMDC's earnings in the coming quarters.
Issue details: NMDC plans to offer for sale 33.2 crore shares of face value of Re 1, at a price band to be announced a day prior to the offer opening. This represents 8.38 per cent of the outstanding shares of the company.
Investors may refrain from subscribing to the Initial Public Offer of Pradip Overseas Ltd (POL), manufacturer of home textiles. Absence of long-term customer contracts, reliance on agencies for export orders and narrow product offering are reasons that dim the prospects of this offer.
The offer may be considered only if priced at a sizeable discount to larger listed players such as Welspun India and Alok Industries (which trade at about 6 times).
The company does not possess any unique aspect that sets it apart from its textile peers. This recommendation does not factor in gains from listing.
POL supplies to domestic and international markets, to retailers and distribution agents. The revenue contribution from exports has come down from 52 per cent in FY-07 to 47 per cent in FY-09, and further down to 45 per cent for the nine-month period ended December 09.
Exports, however, are almost entirely indirect, coming through procuring agents of foreign buyers.
Such a lack of direct relationship with the end user may render POL unable to take immediate advantage of any move on part of the end user to consolidate suppliers, or step up sourcing from a single player. POL also does not have long-term contracts with clients, and depends on trade fairs to sell a chunk of exports.
Increasing exposure to the US — from 58 per cent of total exports in 2006-07 to 67 per cent in 2008-09 — spells significant risk.
Risks also stem from POL's concentration on bed linen alone — sheets, pillow cases, quilts, comforters and curtains.
Peer companies in the listed space which make home textiles are far more diversified, supplying bath linen, besides fabric and garments, to spread risk and reduce dependence on a particular segment.
Part of the funds raised will go towards expanding manufacturing capacity by 33 million meters in a new plant in POL's proposed textile Special Economic Zone (SEZ) near Ahmedabad.
The facility is expected to be functional in the first quarter of FY-11, but execution could be dependent on the development of the SEZ itself.There will be benefits stemming from the 110-hectare SEZ. Infrastructure development within the proposed SEZ is yet to take off, and finding occupiers for the zone can be undertaken once all required approvals are in place, and may take a good while yet.
We are not, therefore, factoring revenue flows from the leases in the near term. Issue proceeds will also partly fund working capital.
POL's sales have more than tripled from FY-07 to FY-09, while net profits have just about doubled.
Part of this growth can be attributed to a lower base effect since the company was a result of restructuring exercise by the original company in 2007.
While this growth may appear healthy, both operating and net margins have been sliding primarily on account of raw material and interest costs.
From a 12.4 per cent operating profit margin in FY-07, FY-09 saw margins dip to 10 per cent, slightly improving to 10.3 per cent for the nine-month period ended December 09.
Cotton, which forms bulk of the raw material, is on a price upswing and margins may thus be further pressurised.
The company does not have long-term supply contracts for procuring raw material. It has a set of weavers from which it procures material, which reduces its own capital expenditure when compared with bigger textile players who have integrated manufacturing processes. But this move could also mean that it has lesser control over costs of raw material.
Interest costs have ballooned from FY-07, moving from 2.4 per cent of sales in FY-07 to close to 4.8 per cent in FY-09, resulting in net margins declining to 3.5 per cent for FY-09, from the 5.5 per cent two years earlier.
Net margins did improve to 4.2 per cent in the nine months ending December 09 as interest costs reduced to about 4 per cent of sales, but that could be on account of banks lowering interest rates.
Proportion of debt under the technology upgradation scheme of the Government, which typically come with low interest and long-term payment period, is minimal. If its SEZ is to take off, it will call for higher capital investment, even as revenues from the SEZ take time to flow in.
The offer is open from March 11 to March 15. On offer are 1.06 crore shares. The pricing has not been announced while we went to press. Anand Rathi is the lead manager of the issue.
Investors seeking a defensive option for their portfolio can consider adding the GlaxoSmithkline Consumer Healthcare (GSK Consumer) stock.
Despite the company's strong volume-driven growth, dominant market share and focus on promising FMCG segments, the stock trades at a discounted valuation.
The current market price of Rs 1,496 discounts estimated 2011 earnings by about 18 times (Nestle and Dabur India trade at 24-26 times).
In a scenario where players in large FMCGs such as soaps and laundry are facing competitive pressures, GSK Consumer appears better placed due to its presence in under-penetrated FMCGs with limited competition.
The company closed Calendar 2009 with sales growth of 25 per cent, managed almost evenly across the four quarters, with matching profit growth.
This was underpinned by strong volumes, which grew 15 per cent plus in both Boost and Horlicks and 30 per cent in the biscuits category in the December quarter. Continuing impetus to rural spending may aid prospects, given that both of its product segments – malted food drinks and foods – have room to expand rural reach.
Several years of operating in just one product segment had kept the stock's valuations low, but a frenetic pace of new launches over the past year (Horlicks Lite, Actigrow, ProHeight and recently Foodles) promises to remedy this.
Though rising prices of inputs (malted barley, milk), as also rising ad spend pose a threat to margins, a 61-per-cent market share in its key segment gives the company considerable pricing power.
Investors can consider exiting the stock of power equipment player ABB India. Premium valuations, longer execution cycles and continuing cost overruns with fixed contracts are factors that diminish the earnings visibility over the next one-two years. At the current price of Rs 823, the stock trades at 49 times its 2009 earnings; the PE for CY-10 too is a steep premium (29 times) to peers such as Crompton Greaves or Siemens.
ABB India's fourth-quarter sales and revenues declined 13 per cent and 42 per cent, respectively. For the full year too, revenue and profits declined, for the first time in at least five years. Operating profit margins for the quarter slid to 8.8 per cent, from 14.4 per cent a year ago. Severe pricing pressure and operating level losses in the power system segment led to this erosion. Cost overruns in fixed contracts and early exit from rural electrification contracts led to higher costs. Its reluctance to cut product prices and cost-related issues have been eroding this technologically-strong company's market share.
ABB's orders, at Rs 8,700 crore in end-2009, were 8 per cent higher than the previous year's. Although the latest-ended quarter saw strong inflows, a low base in the previous year (order inflows declined in the December 2008 quarter) was a key reason for the robust growth number.
Insurance companies have traditionally offered guarantees on their products through bonuses or loyalty additions. But the market correction of 2008 has opened the gateway for “guaranteed NAV” products under unit-linked insurance plans. These plans typically guarantee the investor the highest NAV (the guarantee is not on returns) on the fund in the initial seven to eight years and manage to deliver this through a hybrid structure that uses debt and equity investments.
LIC's Wealth Plus is the latest entrant to this genre. It guarantees the highest NAV over the first seven years or the NAV at maturity, whichever is higher. The policy term is eight years; life cover to the investor is available for another two years after completion of this term. This plan has a term of eight years compared with the existing products' 10 years. The plan's mandate allows it to invest between 0 and 100 of its portfolio in debt and equity investments, based on market conditions.
Investors should note that in any financial instrument guarantee comes at the cost of returns. Guaranteed NAV ULIPs too fall within this ambit. By switching between debt and equity, these products try and protect the NAV from the sharp corrections in the equity market. However, this requires the manager to maintain either a debt-oriented portfolio with a limited equity exposure or to cut equity exposure, if the stock market starts to fall sharply.
Either strategy will mean that the fund cannot hope to match the high returns of a pure equity or even an equity oriented fund over the long term.
Investors in LIC Wealth Plus should expect returns that are broadly in line with monthly income mutual funds (80 per cent debt: 20 per cent equity) or debt-oriented mutual funds (70:30 allocation).
While the former have managed about a 9 per cent annualised return over five years, the latter managed about 11 per cent (after charging about 1 per cent towards fund management fees).
The returns from the ULIP have to be reckoned after adjusting for charges such as fund management, policy administration charges and the guarantee charge, which IRDA caps at 3 per cent annually.
That would leave unit-holders with comparable yields of about 7 per cent (if equity exposure is limited to 20 per cent) and 9 per cent respectively (after allowing one per cent for fund management fees).
The risk cover arising from the plan may be an additional advantage.
Returns could be higher or lower depending on how the equity markets pan out.
The guaranteed ULIPs launched last year have NAVs that are between 50 and 70 per cent higher, due to their high initial equity allocation and good timing. Such returns may not be easy to repeat under current market conditions.
Let us assume this plan starts with a high equity exposure in the first year and (assuming the stock market rises steadily) manages a 20 per cent return in the first three years. But then it shifts to debt and starts earning 8 per cent for the next five years, the NAV can go up to Rs 25, an annualised return of 12.1 per cent.
The returns in hand will be 9.4 per cent after deducting 2.7 per cent expenses. The product will periodically re-calculate its liabilities, which is equivalent to outstanding units multiplied by maximum NAV recorded till the last trading day of the week.
Assets will be rebalanced regularly to meet this target.
The financial muscle of LIC ensures that it can meet any liability. The fund is also carving out 0.35 per cent of the fund value annually (as a guarantee charge calculated on daily basis) towards this liability. This should also provide comfort for investors.
Investors with adequate risk cover can considered single premium and those without surplus and lesser risk cover can consider regular premium.
For investors, minimum age at entry is 10 years and the maximum is 65 years. The policy holder has to pay premium for the first three years in monthly or annual mode.
Under the annual mode, minimum premium payable is Rs 20,000 and in monthly ECS mode it is Rs 2,000 a month. The plan also offers a single premium option where the minimum payout is Rs 40,000.
In case of death of the policy holder, the nominee will receive the sum assured together with the fund value as a death benefit.
The risk cover allowed is based on the age and premium mode. For a regular premium payment, the minimum is five times the annualised premium and the maximum is 10 times if the age at entry is up to 50 years.
Above this, risk cover is restricted to five times the annual premium. For single premium mode, there are three slabs. If age at entry is 40, five times is the cover. For 41-50, it is 2.5 times, and anything higher entitles the investor to 1.25 times.
The premium allocation charge (PAC) is based on the annual premium. If it is below Rs 2 lakh, the charge will be 12 per cent but it reduces to 11.25 per cent of the premium paid. Under single premium mode, the PAC is 5 per cent up to an investment of Rs 4 lakh, and anything above this attracts 4.5 per cent. The plan pegs its annual fund management charges at one per cent, but it charges 0.35 per cent of the fund value as guarantee charges.
Investors with a two-three year horizon can take exposures to the initial public offering of DQ Entertainment (International), given the inherent dynamics of steady growth in the outsourced services of animation processes from overseas entertainment companies, which the company is well-positioned to tap.
At the upper end of the price band (Rs 75-80), DQ Entertainment asks for 26 times its annualised current year per-share earnings, on a pre-offer equity base. This could be diluted by another 20 per cent, post-IPO.
A robust order book (that is three times annualised FY-10 revenues), a broad-based client base across the US and Europe and a strong focus towards creating IP-led growth are key positives for the company. Animation companies such as DQ Entertainment are a play on the outsourced services model, where much of their prospects lie currently, akin to the success story of software companies.
In that sense, the labour-cost arbitrage between India and the western world is still the main driver towards outsourcing animation services to countries such as India. Outsourcing of animation services itself is still in quite a nascent stage. Although the growth of the animation industry worldwide is expected to be around 10 percent, the portion within the pie that could be outsourced to Asian countries such as India could grow at a much faster pace.
DQ Entertainment was incorporated only in April 2007. In 2008-09, the company saw its revenues grow by about 60 per cent over FY-08 to Rs 150.9 crore, while net profits more than doubled to Rs 16.1 crore. The half-year profits of the fiscal stood at Rs 10 crore, largely due to a tight leash that was maintained on employee costs and SG&A expenses.
The animation process essentially comprises of four steps: IP development, pre-production, production, and post-production.
Of these, the first two processes are accomplished by the clients, mainly movie production houses and broadcasting channels, themselves in the US or Europe. That is, the conceptualisation of animation stories, characters, the script and layouts, among other procedures, are done abroad. It is the labour-intensive production and post-production processes that are outsourced. These include actual 2D and 3D animation, added special effects and making the final product ready for distribution in various digital forms such as theatrical reels, DVDs and broadcast tapes.
It is in these areas that companies such as DQ specialise. The company derives over 90 per cent of its revenues from delivering these animation services for clients, which also includes developing animation video games.
The company has an order book of Rs 456.7 crore, executable over the next couple of years. This gives reasonable revenue visibility for DQ Entertainment.
Another key factor that may augur well for the company is the large base of around 90 clients. These include marquee names such as Disney Group, Nickelodeon, BBC and NBC Universal among others. The company derives 41.5 per cent of its revenues from US based clients and 51.2 per cent from the European ones. The rest of the revenues accrue from India.
A Nasscom report pegs the growth of the global animation industry to be at a compounded annual rate of 10 per cent to become a $100 billion industry by 2012. The domestic animation opportunity is yet to take off in a big way, but as with IT players, there is a huge untapped opportunity for offshore players such as DQ Entertainment.
Apart from this, the company also derives a small portion of its revenues from developing co-produced animation series for which there is sufficient offtake.
For example, The Jungle Book, a 52 episode animation series, has been sold to several broadcasters in the US and in the Europe and Middle East Africa (EMEA region), spanning multiple languages.
The co-production model allows for distribution rights revenues to accrue for the company.
The rupee appreciation vis-a-vis the dollar or euro is a key risk to realisations. An increase in the minimum alternative tax rate is another risk, especially as the STPI scheme has not been extended. This may strain margins till the company shifts operations to a SEZ over the next 12-18 months.
DQ Entertainment is offering over 16 million shares through this issue and hopes to raise Rs 128 crore. It plans to utilise the proceeds towards investment in co-production agreements (Rs 55 crore) and development of office infrastructure at an SEZ in Aindhra Pradesh (Rs 39 crore). The issue is open from March 8-10. SBI Capital Markets is the book-running lead manager to the issue.