Everest Kanto Cylinders: Buy

Investors can consider taking fresh exposure to the stock of Everest Kanto Cylinders (EKC), a leading manufacturer of high-pressure CNG (compressed natural gas) and industrial cylinders.

While we had earlier suggested that investors book profit on the stock, the recent spurt in oil price, combined with EKC’s change in raw material sourcing strategy, presents a case for renewed investment. Besides, the shift towards high-margin products and the commencement of production in the company’s Dubai and China (by early January 2008) units also underscore our changed stance.

At the current market price of Rs 330, the stock trades at about 20 times its likely FY09 per share earnings, assuming a full conversion of its foreign currency convertible bonds into equity. This valuation, though seemingly at a premium, is likely to be supported by the company’s established market presence and capacity expansion plans that would position the company to benefit from the growing global CNG market. Investors, however, can buy the stock in lots given the volatility in broad markets.
Buoyant demand trends

The global demand for CNG applications is set to increase on the back of a firm oil-price outlook. This is likely to rub off positively on EKC, which derives about 68 per cent of its revenues from the CNG segment. Catering to demand from countries such as Malaysia, Thailand, Gulf countries and CIS (Commonwealth of Independent States) nations, EKC appears well placed to tap the growth potential in the CNG space in overseas markets since it has the necessary approvals from its target countries.

Notably, demand from the domestic market may also increase with the Supreme Court mandating the use of CNG as auto fuel for heavy vehicles in 28 highly polluted cities. The proposed extension of City Gas Distribution projects may offer an opportunity for growth.

In the light of such an expected ramp-up in demand, EKC’s aggressive scaling of capacity appears well-timed, lending confidence regarding its ability to meet future demand. Capacity expansion across its units, setting up of greenfield project in China, introduction of new product line (Jumbo cylinders) in the Gandhidham unit and the opening of a second unit in Dubai suggest improved prospects. However, given the high gestation period, it could take a year or two before full benefits accrue from the added capacities. Concerns of excess capacities in the medium-term are also alleviated by the current high order book.
Broad-based sourcing

Change in raw material sourcing strategy also supports our case for investment. While there were concerns on EKC’s complete dependence on Tenaris, a global manufacturer and supplier of seamless tubes for raw materials, the broad-basing of sourcing to Chinese and Japanese manufacturers appears to have de-risked the same. However, the management expects the sourcing levels to be maintained at current levels (about 65 per cent from Tenaris), since the materials sourced from Chinese players may not suit the requirements of higher capacity cylinders.
Expanding margins

For the half-year ended September 2007, EKC doubled its earnings on a consolidated basis and expanded its operating margins by about 3 percentage points to 25 per cent. Improved realisations for the CNG cylinders and pruning of cost can be attributed to the margin expansion.

Going forward, margins are likely to expand further, given EKC’s plan to increase production of Jumbo Cylinders, which enjoy higher margins. Further, change in product mix tilted towards higher production of CNG cylinders over industrial ones may also add to the margins. While the overall volumes could remain at current levels, the management expects the change in product mix and improving realisations to yield better earnings in future.

Earnings may also get a lift from the proposed increase in export contributions from the India-based units. In this regard, the company’s active hedging policy and strategy to bill both imports and exports in either dollar or Euro denominations provide comfort against forex risks.