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Monday, June 05, 2006

Kotak Securities Reports

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Thanks Puja

Carbon credits spell golden opportunity for Indian companies

With the clean development mechanism (CDM) in place, a host of Indian companies are eyeing additional earnings by adopting projects that reduce the emission of greenhouse gases (GHGs).

The United Nations Framework Convention on Climate Change (UNFCCC) has designed CDM, under the Kyoto Protocol, to achieve cost-effective GHG mitigation for industrialised countries.

The Kyoto Protocol, which came into force on February 16, 2005 makes it obligatory for some 37 developed countries to reduce their emissions of six harmful GHGs, including carbon dioxide.

Reducing GHG emission

These developed countries, and the companies therein, can reduce GHG emissions through a combination of several methods. First, the companies can adopt cleaner technologies within their own firms to ensure that lower levels of GHG are emitted.

Second, they can fund projects in the industrialised countries that adopt clean technologies. Third, they can fund clean technology projects in developing countries through the CDM.

Preference for CDM

Amongst the above listed methods, developed countries have a certain level of preference for funding cleaner technologies in developing countries since it would be cheaper to adopt cleaner technologies in those nations where the level of industrialisation is not as high as in developed countries.

According to certain studies, reducing one tonne of carbon dioxide equivalent would require about $50 in developed countries, but the same can be done in developing countries for $15.

However, the developed countries cannot achieve all their emission reductions through CDM as they are mandated to achieve a certain level of emission reduction in the industrialised economies as well.

Thus, several Indian companies can earn carbon credits through a multi-layered validation process and then sell them to developed countries.

These credits are given in the form of certified emission reductions (CERs). Each CER stands for one tonne of carbon dioxide reduction and can be traded globally.

The companies or the Governments of developed countries can use these units to offset their own GHG emissions during a given period. They can also sell them to buyers in other industrialised countries that are required to meet GHG emission reduction targets.

The approval process

Indian companies wanting to trade carbon are first required to prepare a project design document (PDD) that would explain the details of the project. The PDD should explain how the project would reduce GHGs and help in sustainable development. Most of the companies tend to appoint consultants for preparing PDDs.

The PDD is then submitted to the National CDM Authority for getting a "host country approval." It usually meets on a monthly basis for giving host country approvals to the projects and is in charge of formulating the appropriate guidelines. The project is then taken to the CDM Executive Board at the UNFCCC.

The project has to undergo a validation, registration and issuance of CERs process at the UNFCCC. The project validation is done by firms known as designated operational entities (DOEs), which are approved by the UNFCCC to do so. The projects are then registered at the UNFCCC and finally, CERs are issued. The issued CERS are generally spread over specified time period of the project.

At the UNFCCC, there is a provision for relatively faster clearance of small-scale CDM projects. The small-scale projects include renewable energy project activities with a maximum output capacity of 15 MW and energy efficiency improvement project activities that reduce energy consumption by up to 15 gigawatt a year, among others. The speed of project clearance at the UNFCCC also depends on whether the project conforms to one of the methodologies already approved by the CDM Executive Board (EB).

Approved methodologies are recognised by the CDM EB as clean technology processes. Projects based on those methodologies are likely to get faster approvals. For projects based on new clean technologies, project participants are required to get their methodology approved by the CDM EB.

Projects registered so far

Indian projects registered till date are from wide-ranging sectors such as cement, sugar, paper, iron and steel, power that includes biomass cogeneration, and hydro and wind energy projects.

Till June 2, 203 projects were registered by the CDM EB at the UNFCCC, with India accounting for over 29 per cent of the projects. It is followed by Brazil, which accounted for almost 22 per cent. These projects together aim to result in an average of 56.52 million CERs a year.

Some of the projects that are already registered or are in the process of getting registered are JSW Steel, Gujarat Ambuja Cement, ACC, MSPL's wind power project, Shree Cements, Tata Sponge Iron Ltd (TSIL), through its waste heat recovery-based power plant at Joda; Reliance Industries, which has two projects based on reduced steam consumption at Hazira and Jamnagar, Birla Corporation, JK Cement, Grasim Industries, Shree Bhawani Paper Mills Limited (rice husk-based cogeneration project), Shree Renuka Sugars, Shree Pandurang Sahakari Sakhar Karkhana (Shree Pandurang SSK) sugar unit, and Triveni Engineering

Market may remain uncertain

A look at how the indices fared at their closes: Sensex 10451 (+3.77%); Nifty 3091 (+4.36%); Nasdaq 2219 (-0.02%); Dow 11248 (-0.11%). On June 01 2006, FIIs were net sellers of stocks to the tune of Rs282.20 crore (purchases worth Rs2,317.80 crore and sales of Rs2,600 crore) while domestic mutual funds were net buyers of stocks to the tune of Rs125.59 crore (purchases worth Rs496.74 crore and sales of Rs371.15 crore).

Uncertainity in the market is likely to prevail even as the indices bounced back sharply and registered strong gains on Friday. Nervousness over FIIs remaining net sellers of equities, sharp intra-day volatility and weak global commodity markets are some of the factors that could make the investors jittery from taking fresh positions. However, reports of aggressive buying by a Japanese fund that has actually seen inflows of $250-300 million over the past couple of days may bring cheers to the market. Among the local indices, the Nifty could test higher levels around 3155 and on the downside it may have support at 2952. On the other hand, the Sensex has a likely support at 10275 and may face resistance at 10597.

Key US indices ended with modest losses on Friday as investors expressed concerns over the weak jobs report and allayed fears that it may lead to slow down in the economic growth. While the Dow Jones declined by 12 points at 11248, the Nasdaq ended a tad lower at 2219.

Indian ADRs tracking the domestic market sentiment largely finished with gains on the US bourses. Among the major gainers Wipro, Dr Reddy's, Tata Motors and VSNL surged over 3% each, while Infosys, Satyam, ICICI Bank, HDFC Bank were up around 1-2% each. However, MTNL, Patni Computers and Rediff ended at lower levels.

Global crude oil prices edged higher, with the Nymex light crude oil for July series adding 42 cents at $72.75 a barrel and the London Brent crude jumping by $1.64 to close at $71.03 per barrel.

Capital Market - Recos

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ET - Hot Picks for the week

Reliance Industries
Research: Motilal Oswal
Recommendation: Buy
CMP: Rs 957 (Face Value Rs 10)

RIL has outperformed the market over the last six months by 26%, on the back of robust financial performance, E&P related announcements (Mahanadhi and CBM reserves) and value unlocking through the RPL public issue.

The current stock price fairly reflects our SOTP valuation of Rs 934/share, which is based on the company's core business earnings, the value of its E&P reserves declared till date and the value of its stake in RPL and IPCL. These are discovered reserves whose size is yet to be announced.

Media reports indicate, potential reserves of 7 TCF gas and 1bn barrels of oil. Phase III exploration is in progress and could lead to materialisation of 8.2 TCF of potential upside indicated during the announcement of the first 2.35 TCF in-place reserves.

Potential reserves are estimated at about 9 TCF. Expected announcement – Sonhat: 3-6 months, Barmer 1 & 2: 18-24 months. Motilal Oswal assigns a very high probability to the materialisation of the KG Basin reserves (valued at Rs189/share).

Also, RIL is making forays into the retailing and SEZ development businesses. These businesses, which command higher valuations than its core commodity business, would be the next big growth drivers. Given RIL's strong execution skills, the company should achieve its aggressive targets for these ventures.

Motilal Oswal's basic SOTP value is Rs934/share and they estimate upside potential of Rs424/share over the next 12-24 months from the E&P business.

Core business fundamentals could only improve from current levels. Investments in new businesses – retailing and SEZ development – would be the next growth drivers. The stock trades at a P/E of 14.4 times FY08E and EV/EBITDA of 8.8x FY08E.

Research: Networth Stock Broking
Recommendation: Buy
CMP: Rs 520 (Face Value Rs 10)
12-Month Price Target: Rs 814

Merck is the 51% subsidiary of Merck KGaA – Germany, popularly known for vitamins (particularly vitamin E). The pharma business has been contributing around 56% to the topline (with sustained segmental margin of 30%) and the rest by the chemicals division.

Recently, with the disposal of the life science and analytics business (which was 30% of total sales) from the chemical division, the pharma business becomes even major, contributing over 70% of total revenue. Merck's priority brands have reported appreciable double-digit growth in last 12-month period ending March '06.

Going forward, with steady performance by the existing brands with relatively larger market share and fresh revenues coming in from new product launches, we expect Merck to deliver over 10% growth in the pharma business during '06 and '07.

In Q1 CY06, Merck sold out it's highly uncompetitive and low margin business of lifs science and analytics (LS&A) (which was part of its chemical division), which would strengthen the margin and profitability of the remaining chemical business as well as the overall business of the company. This deal brings in a one-time profit of R.66 crore (about Rs 40 per share).

Such exceptional items as a result of this sale may enrich the bottom-line in '06. With the likely launch of new products, improving operating margin (consequent to the sell of LS&A division and rising share of high margin pharma business), scaling up exports and efficiencies, Merck would generate PAT of Rs.66.204 crore and Rs.73.6.5 crore in '06 and '07, respectively.

At the current market price of Rs.565, the stock is available at a PE of 14.4 times and 12.9 times its CY06 (E) EPS of Rs.39.3 and CY07 (E) EPS of Rs.43.7 respectively.

In addition, the company currently holds cash amounting to Rs.310.crore, i.e. almost Rs 184 per share, which may trigger couple of acquisitions (both brand/business) shortly (in line with Merck's strategy to expand pharma business). Considering the growth potential and stout cash position, we recommend buy with 12-month price target of Rs 814.

Indraprastha Gas
Research: Angel Broking
Recommendation: Buy
CMP: Rs 118 (Face Value Rs 10)
12-Month Price Target: Rs 160

In Q4FY2006, Indraprastha Gas (IGL) clocked a 16.3% growth in net sales on the back of growth in gas supplies and price increase.

Net profit remained flat at Rs 29.5 crore due to higher tax provisioning, which increased from 27% to 34.6% and high base effect (in Q4FY2005) on account of one-time gain of Rs 4.5 crore due to write-back of excess provision for transportation. CNG volumes for the quarter witnessed a 6% growth while PNG volumes grew by 54%.

IGL commenced supply of LNG in February '06 and sold 25,000 scm of LNG. VAT levied on PNG has not been passed on to the customers and thus margins in PNG have reduced. Staff cost increased 44% on account of wage revision.

Due to the delay in regulation mandating conversion of LCVs to CNG, IGL initiated measures to get LCVs to voluntarily convert to CNG.

This effort has yet to reap the desired results and hence we reduce our FY2007 estimates. Angel Broking have reduced FY2007E EPS from Rs 10.6 to Rs 8.9.

The earnings downgrade is just a postponement of earnings from LCV conversion by a year or so. In view of the continued belief on LCV conversion and rapid expansion in the NCR region, Angel Broking maintains a `Buy' on the stock with a target price of Rs 160 despite the earnings downgrade.

Research: India Infoline
Recommendation: Buy
CMP: Rs 164 (Face Value Re 1)

All-round business segment performance drove topline growth of 28% yoy. While the profit growth on the face of it looks subdued at 2%, normalising it for the one-off luxury tax write-back, growth stood at 24%.

This could have been higher but for the margin squeeze on account of rising raw material cost, which pulled down margins by 260 bps. The strong growth in the cigarette business indicates continuing strong volume growth as well as impact of price increases undertaken in the early part of the year.

Outlook for the non-cigarette businesses such as hotels and paper also remains positive with continued demand buoyancy. The other FMCG businesses are also rapidly expanding, while losses are being gradually curtailed.

ITC's hotels business has continued its strong growth momentum aided by acquisition of Ansal Hotels, addition of Grand Central, Mumbai (recorded net profit in FY06 - the first full year of operations) and improving occupancies. As per the company's strategy of maximizing presence in the key business locations, it is constructing a luxury hotel in Bangalore and has finalised architectural plan for the proposed hotel at Chennai.

ITC is planning to enter the HPC (home and personal care) market by launching its soaps and shampoos under a brand name - Superia. The products are likely to be priced competitively to take on competition from HLL and P&G. HLL is the market leader in the shampoos and detergents segment (market share of ~56%) despite the competition from P&G and other players.

However, ITC can become a tough competitor for HLL, given its strong distribution network in the rural (6,000 e-choupals and seven choupal saagars) and urban
markets. Also, strong cash flows from the cigarette business can be invested in advertising heavily to build the personal care portfolio in the initial stage.