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Sunday, December 03, 2006
WE ARE 2 YEARS YOUNG TODAY!
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Glaxo: Hold Aventis: Buy
Since the stunning collapse in May, markets have staged an equally remarkable recovery. From their lows, the Sensex and the Nifty have gained more than 50 per cent over the last six months, clear proof that large-caps are back with a bang.
While the nature of the rally appears to suggest that the bull party has been secular in nature, some stocks from the pharma space stand out, not so much for their ability to outperform the broad index, as for their inability. In this context, we train the spotlight on two leading pharma MNCs — Glaxo and Aventis — on which we have been consistently bullish and analyse what is in store for them.
Glaxo
For the September quarter, Glaxo's numbers were distinctly dull, with the pharma business growing by under 3 per cent. Admittedly, there were issues surrounding supplies from both a contract manufacturer in India and its parent that impacted sales performance. Some of the sales are likely to get reflected in the ongoing quarter.
A snapshot of the nine-month performance should provide a better picture. Sales of the pharma division grew by a tad less than 10 per cent, which is still lower than the overall market growth of about 20 per cent (Source: ORG; year up to September). Chronic categories have driven growth, and Glaxo's strengths in mature therapy areas have not kept pace with the market.
However, in spite of having to contend with a slowdown in topline, the margin picture continues to be pleasing; for the pharma business, margins actually inched up by over a percentage point.
Also, with the divestiture of the animal health business (effective from August 1), the overall margins improved marginally, as the former business was not as profitable as the mainline pharma segment. Adjusted for the nine-month period, the profit growth stood at 16 per cent.
In our view, it would be premature to write off Glaxo on the basis of a blip in performance in one quarter.
The current calendar may not turn out to be a great one for the company, but over the next couple of years, we expect a comeback. For starters, one can expect product launches from the parent's pipeline, specifically in the vaccines segment (in the next calendar), which holds significant potential.
Glaxo also has ambitious plans to treble revenues over the next nine years, and, to this end, it is trying to plug the gaps in its therapeutic portfolio by entering into in-licensing agreements to leverage the size and spread of its sales force. As sales from price-controlled products diminish over time, we expect acceleration at the operational level.
With the disposal of the animal health business, Glaxo also had adequate cash on hand to either pursue inorganic growth opportunities or reward shareholders with a handsome dividend, as it has done in the past.
We believe that the stock's near-term movement would be range-bound in the absence of key catalysts (unless the proposed New Pharma Policy is significantly beneficial to MNCs). Investors can retain their holdings; fresh exposure can be considered on any declines linked to broad market trends. The stock trades at about 23 times its expected per-share earnings for calendar 2007.
Aventis
The stock has been our top pick from the MNC pharma space for quite some time. The stock is a good 20 per cent off its price since our last `buy' recommendation in April, just before the market cracked. While the market has recovered, Aventis has not. We see the correction as a good entry opportunity, with valuation at about 17 times the expected per-share earnings for 2007 not all that demanding. Buy into the stock in small lots with a medium-term perspective. In the nine-month period ending September, domestic sales were up 16 per cent, broadly in line with overall market trends; export sales were down by about 9 per cent.
Coupled with an increase in costs, operating margins declined by about 120 basis points to 27 per cent. Earnings growth for the period is at a good 25 per cent.
Aventis' product portfolio focusses on chronic therapy areas such as diabetes, cardiology and oncology. There have been no product launches from the parent's pipeline for some time now, but we believe we see more of it over the next couple of years.
All products launched from the global pipeline have been routed through the listed entity; we believe this will continue, given the marketing strengths of Aventis, though any launch through the unlisted entity would sharply hurt stock sentiment.
Within the MNC universe, Aventis has a good outsourcing story in its business model, as it exports products to companies within the group (CIS region).
Exports have fallen for a few quarters now, but we expect a rebound in the quarters ahead. Commencement of exports to other locations cannot be ruled out and this could act as a kicker for the stock.
Kirloskar Oil Engines: Buy
Long-term investments can be considered in the stock of Kirloskar Oil Engines (KOEL), a leading player in the diesel engine business. The stock trades at a price-earnings multiple of 13 times its likely per-share earnings for FY08.
Given the positive demand outlook for engines, coupled with the favourable economic environment and the company's capex plans, we believe the stock has potential to appreciate. Any dips in price may be used as a buying opportunity.
The demand for power generation has been driven by the growth in services sectors such IT, telecom and retail. We believe KOEL is well positioned to capitalise on this growing demand with its proficiency in the engines segment. Moreover, the inability of some of its competitors to meet emission and noise norms set by the Government also augur well.
In the agriculture equipment market, it supplies engines to the tractor OEMs. KOEL also supplies engines to the construction and industrial machinery original equipment manufacturers (OEMs). Hence, expected growth in infrastructure and mining sector should rub-off positively on KOEL. However, in the large engines segment, growth will be largely dependent on the marine engine sales only.
In the auto component segment, KOEL supplies bimetal bearings and engine valves to OEMs. However, a major chunk of its revenue is derived from spare part sales, where it faces stiff competition. Nevertheless, on the revenue front, contributions from both the engine and auto components have registered a double-digit growth. For the half-year ended September 2006, the engines segment grew by 49 per cent in revenues; the auto components division registered a growth of 17 per cent.
Delays in public spending, entry of foreign players, rising raw material costs and an inability to pass on input cost hikes fully to customers would pose downside risks to our recommendation.
IPO: XL Telecom: Avoid
Investors can refrain from taking an exposure in the initial public offering of equity by XL Telecom. The offer is being made in the price band of Rs 125 to Rs 150 per share. The company's latest foray into retail marketing of CDMA mobile handsets for high-end models is likely to expose it to fluctuating earnings performance and tighter operating margins. Besides this, the company's core business of CDMA mobile handset assembling/manufacturing technology in partnership with Kyocera, an international brand, is a high-volume, low-margin business, dependent largely on the R&D efforts of its technology partner.
In our view, the expansion in the solar photovoltaic modules business to cater to orders from Europe and the company's entry into ethanol (mixed with petrol) business to service public sector oil units are opportunistic forays, and may not provide any long-term competitive advantage. Moreover, the ethanol business remains subject to regulatory vagaries and order flows from public sector majors.
The XL Telecom stock also appears priced on the higher side at 14.5 times (upper end) its per share earnings for the year ended June 30 vis-à-vis other growth stocks trading at this price earnings multiple with relatively lower risk.
Business units
The company has a CDMA handset assembling/manufacturing unit, a switching mode power system (SMPS) facility that has been operational since 2000, a solar photovoltaic module manufacturing facility, and an ethanol fuel facility with a production capacity of 1.5 lakh litres per day. The supplies from this facility to the PSUs started in 2006.
Through this public offer, expected to garner Rs 59.3 crore (at the upper end of the price band), the company plans to set up surface mounting technology lines to produce PCBs (printed circuit boards) used for CDMA mobile and FWPs (fixed wireless phone) at a project cost of Rs 20.4 crore.
It also plans to expand the solar photovoltaic module plant at a cost of Rs 8 crore to cater to a European order. It has entered into an exclusive distribution agreement with Forta In Ex SL, a Spanish company with a minimum commitment of 3MW per annum, valid for three years, with total commitment of 12 MW. The total contract value is estimated at Rs 220 crore.
In addition, XL Telecom proposes to repay the term loan from IDBI for Rs 9 crore and provide for long-term working capital for fixed wireless phone business (for which it has a partnership with Axesstel of US).
While the growth from the CDMA handset sales business has been robust for the past few years, most of the scale and margin benefits are likely to accrue to telecom service providers such as Tata Teleservices, BSNL, MTNL or Reliance Communications. For other players in the telecom chain, including XL Telecom, it will remain a high-volume, low-margin business. For instance, for the year ended June 30, on revenues of Rs 395 crore, the company recorded an operating margin of 6.8 per cent.
In this backdrop, the recent decision by XL Telecom to go directly to customers through a retail business model for high-end mobile phones is likely to expose them to vagaries of the marketplace. In the absence of any internal R&D, they will remain largely dependent on their partners/service providers to meet customer expectations for new and fancy phones. For low-end models, however, the telecom carriers/service providers will continue to source them in bulk from the company.
Offer details: The post-diluted equity of promoters will be 62.37 per cent. The offer to be listed at BSE and NSE opens on December 4 and closes on December 7. Anand Rathi Securities and Centrum Capital are lead managers to the offer.
IPO: Ess Dee Aluminium: Avoid
Steep valuations, operational challenges and execution risk fail to lend credibility to Ess Dee Aluminium's initial public offering.
Operates in a niche market
Proposes to augment capacity by five times
Dependence on single supplier and few customers
Valued at 21-24 times forward earnings
Investors may consider giving the initial public offer (IPO) from Ess Dee Aluminium a miss, as challenges appear to outweigh the opportunities over the medium term. Steep valuations, operational challenges and project execution risks suggest a cautious stance on the pubic offer.
Player in a niche market
Ess Dee Aluminium makes aluminium foil-based packaging products, mainly for the pharmaceutical packaging industry. Fast moving consumer goods (FMCGs) are the largest consumers for the packaging industry. The pharmaceutical packaging segment remains largely untapped; several innovations are taking place in packaging, especially in the over-the-counter (OTC) segment. For Ess Dee, this presents a good opportunity.
The company has facilities in Daman, Goa, Thane and Baddi (Himachal Pradesh). As a good number of pharmaceutical units operate out of these places, proximity is likely to help the company generate more sales and keep logistics cost low.
Through the proceeds of the issue, Ess Dee proposes to fund its expansion plan. The company plans to augment its foil-rolling capacity from 3,600 million tonnes per annum (MTPA) to 18,000 MTPA. It is operates at a capacity utilisation rate of about 53 per cent at its Goa unit and about 65 per cent in Daman. While there is plenty of scope to improve the current utilisation rate, the additional capacities, when they are likely to fully go on stream in mid 2007-08, are likely to exert some pressure on supply.
Second, the size of the project appears reasonably large compared to the size of existing operations. The project involves an outlay of about Rs 115 crore. This is about 6.5 times its net worth as on March 31 and five times its current level of capacity. Hence, the ability of the management to see through expansion of this scale remains to be proved.
Operational blocks
The company imports 100 per cent of its requirement of aluminium sheets, which constitute the largest component of its raw material cost. The entire requirement is sourced from a single supplier in Bahrain. Hence, the sourcing and exchange rate risks are relatively high. Being a small player, the company may find it difficult to pass on the increase in cost to its customers.
For the proposed project, it intends to import second-hand machinery to the tune of 40 per cent of the total cost of plant and machinery. As they are not covered by warranties and generally score low on efficiency, the company may end up paying more on operating costs.
Sales concentration risk
The high dependence of Ess Dee on its subsidiary for selling its products is also a key risk. It sells about 57 per cent of its production to its Flex Art Foil (a 100 per cent subsidiary engaged in conversion of printers stock into printing designs), which sells printing designs to its customers. Ess Dee's five other customers account for about 28 per cent of sales volume.
Steep valuation
As Ess Dee operates in a niche area, there are no listed peers in this space that it can be compared with. However, for the purpose of relative valuation, we take Bilcare and Gujarat Foils as its peers. Though both cater to the needs of pharmaceutical packaging industry, Bilcare offers a host of solutions and Gujarat Foils supplies aluminium foils to the packaging industry as a whole.
Ess Dee has fixed a price band of Rs 200 to Rs 225 per share. This works out to a multiple of 21 times its likely 2006-07 earnings and 24 times on the higher end. This appears steep compared to its peers who command a multiple of about 15 times forward earnings. Further, the equity overhang post expansion is likely to dampen valuations.
Offer details
On offer are 69.6 lakh shares at a price to be decided through a 100 per cent book-built process. The offer opens on December 4 and closes on December 8. UTI Securities and Enam Financial Consultants are lead managers to the issue.
IPO : Nissan Copper: Avoid
Small scale of operations and substantial jump in equity base may prove to be a handicap for the company over the medium term.
An investment in the initial public offer (IPO) of Nissan Copper may be avoided, as the scope for capital appreciation appears limited over the medium term.
The small scale of operations, the greater vulnerability to price swings, the substantial jump in equity compared to its existing base and the rich valuations are factors that underpin our view on the IPO.
Nissan Copper manufactures copper pipes and tubes for supply to users in construction, air-conditioning, engineering and gas application industries.
The company proposes to increase its capacity from 10,800 tonnes per annum (TPA) to 18,600 TPA. The demand for copper products appears strong driven by rising requirements from user segments.
And so, the capacity expansion plan appears justified. That the clientele of the company includes Siemens, Voltas and Electrotherm India is a positive.
Risks
However, the risks for the company are likely to outweigh the opportunities, and this may have an adverse impact on profitability.
While it sources copper scrap from the domestic market, for copper cathode (both raw materials for making copper pipes/tubes) it relies substantially on imports.
It is not clear what proportion of imports are long-term contracts. Hence the risk of the company being exposed to cost pressures is fairly high.
The size and scale of operations also places it at a disadvantage. Being a secondary player, its bargaining power is likely to be limited compared to primary players where the degree of concentration is far higher. The effect of this is likely to be severe, especially in the event of a cyclical downturn.
The higher outgo in the form of interest and depreciation may affect its profitability over the next few years.
Post-expansion, equity base will expand by more than four times.
The growth in earnings is likely to lag the expansion in equity, at least till such time when additional capacities start contributing fully. The payback period may get extended if the metals cycle takes an unfavourable turn in 2007-08.
The price band for the offer has been fixed at Rs 33-39.
At the lower end, it values the stock at about 14 times its likely 2006-07 per share earnings and at the upper end, about 16 times.
This, in our view, is highly demanding compared to, say, Hindustan Copper or Precision Wires that trade at a multiple of 10-12 times forward earnings.
Considering the challenges mentioned above, generating earnings to support the current valuations is likely to be difficult.
On offer are 2.5 crore shares. The objects of the issue are to part finance the expansion and fund the working capital requirements.
The offer opens on December 4 and closes on December 8. Keynote Corporate Services is the lead manager to the issue.
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