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Sunday, January 07, 2007

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Cambridge Technology Enterprises: Avoid

Investors can avoid the initial public offering being made by Cambridge Technology Enterprises at an offer price of Rs 38 per share. Though the business opportunities linked to the company's niche focus on service oriented architecture (SOA) are huge, the risks associated with taking an exposure in a small-size company outweigh the scope for attractive returns.

From an investment standpoint, the scale-up challenges that hinge on an acquisition-led strategy, high client concentration, prospects of vendor consolidation and intense competition from multinational and frontline Indian vendors, are likely to be significant. Moreover, the portfolio basket for investment in the IT services space has widened considerably in the past couple of years, even in the mid-cap segment. With more mid-cap IT stocks in the IPO pipeline, investors can give this offer the go-by.

The relative assessment of strengths and challenges linked to this offer are:

Strong business prospects: Since the company is focussed on the emerging area of Service Oriented Architecture (SOA), the business opportunities linked to this are immense. SOA, a flexible and adaptive model of service delivery on an open platform, is being adopted in a big way by companies such as Oracle through its Fusion Strategy, SAP through NetWeaver, and IBM via Websphere. As a part of its project contours, Cambridge Technology plans to set up competency centres for Oracle, SAP and IBM.

For the 15 months ended March 31, 2006, the company clocked revenues of Rs 18.4 crore and post-tax earnings of Rs 3.84 crore. Given the relatively low revenue base, the scope for rapid growth from these levels is fairly significant.

Scale constraints: From the scorching growth of the frontline vendors seen over the past decade, it is clear that small vendors are likely to suffer distinctly from scale disadvantage. The key constraints linked to scale are vendor consolidation affecting small-size companies, lower bargaining power in billing rates and greater pricing squeeze in a slowdown situation.

With a staff strength of 90 (which is to be expanded to 350 over the next two years), the company's ability to manage large and complex projects also remains untested.

High client concentration: According to the offer document, the top five clients in 2005 accounted for 75 per cent of its revenues and in the first quarter ended June 30, 2006, 54 per cent of the revenues came from two customers. In addition, all its revenues accrue from clients in the US, with hardly any geographic spread.

While this may be true for most small companies, it leaves them highly vulnerable to either the loss of a principal client or a slowdown situation.

Since Cambridge Technology is also focussed on mid-size clients in the US, any significant ramp up in client base may involve a sharp increase in selling and marketing expenses, as its revenue base starts growing.

Acquisition risks: Since 50 per cent of the offer size is allocated for acquisitions, the risks associated with picking the right target for acquisitions and integrating it with its existing operations are quite high.

Offer details: Out of a project cost of Rs 30.70 crore, Rs 15.50 crore or about 50 per cent has been earmarked for acquisitions. The remaining is spread between expansion of facilities (Rs 4 crore), competency centres (Rs 1 crore), reusable components library (Rs 1.95 crore) apart from other support infrastructure and working capital.

This project is being financed through the IPO proceeds of Rs 24 crore, with the promoters contribution of Rs 8.57 crore (at the offer price) and balance from the public. UTI Bank is making a term loan of Rs 4.7 crore and Rs 2 crore is the proposed investment from CellExchange Inc., its holding company till April 30, 2006 prior to corporate restructuring.

The application must be for a minimum of 150 shares and in multiples of 150 thereafter.

The offer price of Rs 38 is payable on application. The lead manager to the offer is Centrum Capital. The offer opened on December 29, 2006 and closes on January 9.

Autoline Industries: Invest at cut-off

An investment at the cut-off price can be considered in the initial public offering of the Pune-based auto component company, Autoline Industries. In the price band of Rs 200-225 at which the offer is being made, the stock would trade at a price-earnings multiple of 13-15 times the expected per-share earnings (on an expanded equity) for FY-08.

We believe the valuation to be reasonable in the light of the steady improvement in operational metrics and a good return on equity that Autoline has achieved in the recent past.

Investors can bid at the upper end of the price band. Should the discovered price be lower, investors would be allotted shares and also receive a refund of the amount paid in excess of the discovered price.

Offer background

Funds raised through the issue will be used to upgrade and expand Autoline's Chakan facility in Pune; set up another manufacturing facility at the same location; relocate and consolidate a couple of smaller units; establish a corporate office; fund acquisitions, and provide long-term working-capital resources.

Investment rationale

Autoline mainly supplies components to both two- and four-wheeler makers; its customers include Tata Motors, Bajaj Auto, and Mahindra and Mahindra.

Tata Motors, which buys components for passenger cars and commercial vehicles, is Autoline's largest customer accounting for about 85 per cent of revenues in FY-06.

From a turnover of Rs 51 crore in FY-04, Autoline's revenues have scaled up to Rs 118 crore (for the eight months of the ongoing fiscal). The sharp acceleration in topline also coincides with the success enjoyed by Tata Motors' Ace minitruck, for which Autoline is the single-source supplier of load bodies.

A part of the funds raised through the IPO would be used to raise load body capacity to about 450 per day by the end of this fiscal. With demand for Ace likely to remain robust, we believe it should add some zip to Autoline's financials.

Autoline has tried to diversify operations by acquiring a majority stake in an outfit that specialises in design engineering software; entering into a joint venture in the UAE for manufacturing products for the replacement market; and tying up with the Indian arm of Stokota of Belgium for the supply of heavy duty lead bodies.

These operations are relatively insignificant at the current juncture. Over the medium term, however, they should enable reduction in client concentration.

Over the past three years, Autoline's operating margins have improved steadily, from 6 per cent in FY-04 to about 10 per cent this fiscal. The margin picture is complemented by an improving return on equity, which has trebled from under 10 per cent in FY-04 to over 30 per cent in FY-06, an added positive from an investor standpoint.


The key risk to our recommendation is Autoline's dependence on a single customer for a chunk of its revenues, the inability to pass on escalating raw material costs to the end customer and a slowdown in the automobile industry as a whole, which would directly hurt the fortunes of players in the components business.

Offer details

Autoline intends raising Rs 75 crore through the book-built route by offering shares in the Rs 200-225 band. BOB Capital Markets is the book running lead manager to the issue, which opens tomorrow (January 8) and closes on Friday (January 12).

The wealth that IPOs hide

Imagine if you had invested Rs 9500 (100 shares at an issue price of Rs 95) in the public offer of Infosys Technologies in 1993. After adjusting for all the stock splits and bonuses over the years, your investment would now be worth Rs 29,440,000, an appreciation of a staggering 3,000 times in the 14-year period, not including the dividends that the company has paid. A host of such successful IPOs such as Bharti Tele-Ventures (issue price of Rs 45), Indiabulls (issued at Rs 19), including recent ones such as Everest Kanto Cylinders (issue price of Rs 160), Educomp Solutions and Tech Mahindra have turned in stupendous returns over the years.

Though investors often look upon initial public offerings (IPOs) as a moneymaking exercise and focus on listing gains, it pays to evaluate IPOs from a long-term perspective. A look at the factors that should be considered while buying into an IPO.

Don't go by subscriptions alone: More often than not, investors base their decisions on the subscription figures received by the offers. Given the IPO stampede that we are seeing now, the subscription figures do tend to influence listing gains, but may not be a good guide to the long-term prospects of a company. Subscription numbers are often a function of market conditions at the time of the offer. Even a good IPO may flounder in a declining market, while a fly-by-night company may rake in the money if the market is in good shape. As a long-term investor, you need to evaluate an IPO from the point of view of whether you would like to buy into the business for which funds are being raised.

Don't go by absolute price: Do you believe that an IPO priced at Rs 10 is a safer bet than one priced at Rs 1,000? Not really. In fact, focussing only on IPOs with a low absolute price may leave you with a portfolio of companies with barely any credentials. Companies with a track record of good financial performance would already have a reasonable level of earnings and are likely to price their IPOs at a high absolute price. When evaluating IPOs, try and get an idea of the valuations, or how the offer price discounts the company's potential earnings, rather than its absolute price. If the overall outlook for a sector and a detailed assessment of the company's prospects vis-à-vis its peers appear positive, even high-priced IPOs could turn out to be a good bargain. Offers of companies such as Suzlon Energy, AIA Engineering or even the recently listed Info Edge or Sobha Developers have been among the top-performing ones in recent times, but none of them would have caused a blip on your radar if you were looking for IPOs priced below Rs 100! In hindsight, these offers were a steal at their issue price, given that they listed at a substantial premium and have never touched the offer price levels again!

The business at a good price: IPO investing is based on the belief that investing during the offer gives you an opportunity to get a bargain price for that company. After all, why park money in the public offer at a fixed price, when the same stock would be available on the tap in the secondary market in about a month's time. Thus, valuations should play an important role in influencing the decision to invest in an IPO.

For instance, consider a company X, which is slated to make an IPO. Assume you are convinced about the company's business model and the management's ability to successfully steer its progress. In other words, you believe that investing in the company could provide good returns. At such a stage, the only factor that might influence your decision would be the valuation of the price. Is the offer priced at a discount, at a par or at a premium to its peers? If at a premium, do you think the business really offers something new or unique that justifies the premium? Answers to questions such as these should influence your assessment. If you feel that the offer is priced stiffly, you can safely stay way and consider investing through the secondary market at a later date.

Don't base decisions on listing performance: Like subscription numbers, a stock's returns on the day of listing are also often a function of short-term factors such as market conditions at the time of listing and the near term results expected from the company. Investing in any IPO locks your money for nearly a month. If during the lock-in period (the time from application until listing), the market crashes, your stock's debut could be lacklustre. If you have bought into an IPO because you believe that the project has the potential to deliver healthy growth over the long term, have the conviction to stick with your choice. Bharti Air-Tel, which saw its stock plunge below its offer price on listing, has turned out to be one of the strongest wealth creators in recent years.

Investing in IPOs, much like investing in the secondary market, requires considerable effort on your part. But if you are worried about missing out on such offers as that of Infosys Technologies, you can be rest assured that the chances of such a miss are now minimal, in the light of an improved market efficiency and the coverage most offers get from various analysts and brokerage houses, which can supplement your own efforts.

With IPOs becoming more frequent and institutions getting more selective in choosing between them, listing gains on every IPO are no longer a given. Therefore, every investor must be aware of the general market trends and the nuances of basic research. For, in the world of investments, if such ignorance were considered bliss, then bliss could be very expensive!

Battle for Hutch-Essar: An engaging

It is snowballing into a bidding war of epic proportions. The list of potential contenders for India's fourth largest mobile operator, Hutchison Essar, controlled by its Hong Kong-based holding company, Hutchison Telecommunications International, is swelling by the day. In the past week alone, Hindujas and Verizon Communications were the names tagged to the long list of suitors that now includes Reliance Communications, UK's Vodafone, Malaysia's Maxis, Egypt's Orascom and a clutch of high profile private equity players (KKR, Blackstone or Texas Pacific) willing to ally with any of them.

However, a big "if" is built into this complex equation: the Ruias of the Essar group, who control 33 per cent of the equity in Hutchison Essar, retain the right of first refusal. And they are not willing to give up control over the company without a fight, legal or otherwise.

As this mega deal heads towards a climax over the next few weeks, we focus on three key elements. One, how do Hutchison Essar's performance metrics stack up relative to its two key private sector peers, Bharti Airtel and Reliance Communications. Two, what is the kind of `control premium' that is likely to be built into the deal consideration. Three, among the contenders (leaving Essar aside), which are the ones that stand to gain the most from the dynamics of this deal.

Performance metrics

Getting down to brass tacks, the best place to start is the financial and operational metrics of Hutchison Essar vis-à-vis Bharti Airtel and Reliance Communications:

Operating profit margins: Bharti Airtel is on top, with EBITDA margins (earnings before interest, tax, depreciation and amortisation) consistently in the 35-37 per cent bracket the past six quarters. It is obvious that Bharti has been using its scale, market share and operating leverage to emerge as the most efficient among mobile players. Reliance Communications is fast catching up with Bharti on the operating margin front, logging margins in the 34-36 per cent bracket the past three quarters. Hutchison Essar, the only player without a nationwide footprint, is a laggard on the margin front. Its margins at 31-33 per cent are at least three-four percentage points lower than its peers.

Usage metrics: A year ago (July-September 2005), Bharti's blended average revenue per user (ARPU) at Rs 476 was 7-8 per cent lower than Hutchison Essar's. But if one goes by the latest July-September 2006 quarter figures, while Bharti's ARPU has slipped by 8 per cent to Rs 438, Hutch's ARPU has tumbled 18 per cent to settle at Rs 420. Reliance Communications has had the lowest ARPU among the three players, attributable probably to higher bundled minutes in its packages and lower roaming revenues, as its network is not compatible with GSM operators.

The valuation dilemma

Over the past couple of weeks, there has been a flurry of media reports on the deal consideration that different players may be willing to pay to stay in the Hutch Essar race. For instance, reports have speculated that Hutchison Telecommunications International has set $14 billion as the minimum consideration for its 67 per cent equity stake. This works out to an enterprise value (equity plus debt) of $21 billion for 100 per cent equity for Hutchison Essar.

While there is no doubt that a fancy control premium ranging anywhere from 10-20 per cent will be paid to gain controlling interest in Hutchison Essar, but an enterprise value of $21 billion and beyond may lead to stretched valuations, bordering on overpayment, with payback extending way beyond 2012. A reality check on valuations throws up two key elements:

In June 2006, HTIL had bought a 5.11 per cent equity stake from the Hindujas at $450 million. This translated into an equity value of $8.8 billion (or a conservative enterprise value of $10-11 billion). This clearly is a far cry from the enterprise value of $21 billion that is being contemplated as a part of this deal.

Even at the current market price of HTIL (factoring in the recent run-up), the valuations of Hutchison Essar (at $15-16 billion) are running ahead of Bharti's or Reliance's based on some of the key metrics such as EV/EBITDA or EV/Subscriber or EV/Revenues. If a control premium of over 20 per cent becomes payable, these metrics are likely to get stretched even further.

However, given the huge interest in Hutchison Essar, there is a possibility of control premium trending much higher than expected. There is likely to be a scarcity premium attached to this deal as Hutchison Essar may be the only company among the top five players that may be up for grabs in the foreseeable future. And since Essar enjoys the right of first refusal and may be willing to match any of these bids, there may be a premium to this element also.

Aggressive bidding

Of all the bidders (excluding Essar), the tussle for control is likely to be between Reliance Communications and Vodafone. On a comparative scale, Reliance may be far more aggressive in its bidding war, as it stands to gain much more on a relative basis. For instance, the Hutchison Essar deal fulfils Reliance Communications' aspirations of switching to GSM, given its existing constraints in CDMA technology. In a build versus buy kind of situation, it is likely to prefer a buy as it gets them quality access to spectrum, especially in 900 MHz and this deal also entails a minimum overlap in circles (restricted primarily to West Bengal) that both the players operate in currently.

Second, as an Indian company, Reliance Communications may also be able to buy out a 100 per cent equity stake in Hutchison Essar, unlike Vodafone, which may have to restrict its exposure to 74 per cent under the FDI guidelines and also shed the 10 per cent effective equity stake it had acquired in Bharti Airtel last year.

Finally, if Reliance Communications succeeds in the buyout, it will comfortably march past Bharti in market share, creating adequate scope for capitalising on scale economies in future.

Mutual Funds in 2006 — Aggressive managers score

A shift to large-caps... Picking up value stocks... Loading up on `defensives'. Those were some of the strategies diversified equity mutual funds adopted to cope with the volatile market in 2006. Unfortunately, none of them worked. The year gone by proved one of the toughest in recent times for mutual funds as they struggled to keep pace with the capricious markets.

But despite the volatility, the equity market ended 2006 on a high note, with the Sensex and Nifty returning 47 per cent and 40 per cent respectively. But mutual fund investors have some reason to be disappointed. The average return of diversified equity funds over the period was 33 per cent.

Lagging The Market

Diversified equity funds hugely under-performed the market last year, a rare occurrence in the Indian context, especially in a rising market. Just 25 equity funds of the sample of 145 diversified funds — less than a fifth — outpaced the Sensex. The funds fared relatively better against the Nifty, with 46 of them delivering a return of more than 40 per cent. A disappointing performance, nonetheless.

This was an unusual year when diversified funds under-performed both during the rally as well as in the corrective phases. Only 12 funds managed to contain declines to less than 30 per cent during the free fall in May-June. Earlier corrections saw a greater proportion of diversified funds contain declines to a level less than the market. Interestingly, even in the unrelenting rally preceding the correction (January-May 10), less than half of the funds in the diversified category beat the benchmark indices.

Sensex, A Tough Benchmark

But the Sensex was a particularly tough benchmark to beat in 2006. The rally was so narrow that 19 stocks in the Sensex basket delivered returns below the average 47 per cent. That means a portfolio with concentrated exposures in Reliance, Infosys and ICICI Bank would have fared better than one that held the entire basket.

Barring the BSE Capital Goods Index, which recorded a 56 per cent return, the Sensex was the top performer across BSE indices, including the BSE Bankex and BSE IT. Not surprisingly, most funds that emerged at the top of the performance charts had concentrated holdings in engineering and infrastructure. Given the shallowness of the rally, funds should have abandoned all attempts at diversifying in order to beat the index and, should instead, have focussed on just a couple of sectors and a few stocks. Few did so, however, and in the end, it was the aggressively managed funds that trounced the indices.

Rolling With The Tide

Year 2006 rewarded funds that took risks. Those that held concentrated positions in stocks and sectors or frequently churned their portfolio in tune with ephemeral market fancies did better than funds that stuck to the tried and tested.

Sundaram Midcap, Franklin India Opportunities, Magnum Global and HSBC India Opportunities were among the year's winners. While Sundaram Midcap and Magnum Global are known for their aggressive approach in the mid-cap space, the other two tend to take concentrated exposures to sectors.

Many of these funds did take a hard knock during the corrective phases. Franklin India Opportunities, for instance. The fund, which figures in the top five of the ranking list, took its investors on a wild roller-coaster ride. Between January and the May peak, the fund returned about 44 per cent. In the month of correction that followed, it went on to shed close to 40 per cent of its net asset value, one of the bigger losers during that period. From there, it made an astounding recovery, gaining 75 per cent between its June 14 low and end-December.

The fund actively churned its portfolio to switch between prevailing themes. In April, media and automobiles accounted for about 30 per cent of the assets. The portfolio is barely the same now with 30 per cent in construction. But the active management appears to have paid off.

Investors who stayed with these funds through the ups and downs have been compensated for the risks assumed so far.

Infrastructure, IT Themes Dominate

Infrastructure, capital goods and software, in fact, dominated the portfolios of almost all diversified funds that figure in the top ten of the performance charts. Infrastructure theme funds, such as UTI Infrastructure, Sundaram Capex Opportunities and Reliance Diversified Power, with returns close to 60 per cent, delivered a superior performance relative to even the top performing diversified funds.

Magnum Comma was a theme fund that turned in a notable performance. This fund, focusing on commodities such as oil, materials, metals and agriculture, figures prominently in the top quartile, its 47 per cent return matching the Sensex. The fund's early entry into cement stocks and low exposures to sugar stocks ensured that it stayed at the top in a tumultuous year for commodity stocks.

Not all sector funds shone, however. Investors may have been better off taking direct exposures in ICICI Bank and HDFC Bank than holding on to banking sector funds, which turned in a sedate performance relative to the BSE Bankex. Healthcare and FMCG focused funds, of course, took a backseat as the sectors under-performed the market.

Mid-cap Funds, A Mixed Bag

With no smart money chasing mid-cap stocks, most mid-cap indices sharply lagged the bellwethers. But Sundaram Midcap, Magnum Global and Magnum Midcap delivered returns that beat the Sensex, largely due to their focus on the right sectors. Sundaram Midcap's decision to increase its cash holding during the mid-cap correction placed it in an enviable position. But cash has been a drag on performance during the market recovery.

Franklin Prima, HDFC Capital Builder and HDFC Long Term Advantage were the mid-cap funds with a good track record that figured at the bottom quartile of the performance rankings and under-performed the BSE Midcap. This was because of their sector choices, which went against the tide.

Good Guys Finish Last

Funds that turned conservative in May (because of rich valuations) and chose to load their portfolios with value stocks and defensive sectors such as FMCG were in for a rude shock as they took a beating in the correction.

Value funds such as Birla Dividend Yield Plus and UTI Master Value, which also sport a long track record, languished at the bottom of the rankings. These funds were under-performers even during the pre-May rally. Most of them were underweight on oil, which turned out to be a surprise winner in the months following the correction.

With investor appetite for growth stocks increasing, the focus on value stocks with the intention of protecting downside has just not paid off.

A Tough Year

Staying with the tried and tested approach to mutual fund investing may not have delivered the best results in 2006. Several funds with a good long-term track record lagged this year and theme/sector funds outpaced diversified equity funds. However, the scorecard for the year may not be reason enough to completely redraw your mutual fund portfolio.

Funds that topped the charts this year are predominantly suited to investors with a higher risk appetite. While aggressive investment strategies deliver outsized returns in a market that is in a rapid ascent, they could take an equally hard knock during a correction.

Therefore, while strategies focused on containing downside risk for investors have not paid off this year, they could do so over the long term. Value and mid-cap funds have been under-performers, but they still deserve a place in one's portfolio.

Tata Motors: Buy

The commercial vehicles (CV) industry is in the midst of an unprecedented demand surge with an over 35 per cent growth in the first nine months of this fiscal.

Riding this sharp growth curve is Tata Motors, whose CV sales growth at 48 per cent in the April-December 2006 period is running ahead of the overall industry.

The icing on the cake for Tata Motors (TML) is the equally good growth (23 per cent) in its passenger cars business, where the Indica Xeta and Safari Dicor have been driving volumes.

TML is set to put out an impressive report card for the third quarter; the fourth quarter can only be better in terms of sales volumes in both CVs and cars as, traditionally, demand accelerates towards the end of the fiscal.

The market has acknowledged this fact as the TML stock has risen by more than 12 per cent in the last ten trading sessions to Rs 933 now, which is a PEM of about 20 times the annualised second quarter earnings. Investors can consider taking fresh exposures in the stock. However, those considering fresh investments should keep in mind the fact that appreciation from these levels may be slower and over an extended time frame.

Rocketing CV sales

The effective implementation of the Supreme Court ruling on overloading made last year and the continued investment in infrastructure projects, including public investment in road construction, has generated and sustained demand for heavy commercial vehicles.

In light commercial vehicles, the runaway success of the Ace, where the company is not able to produce enough to meet demand, has been a predominant factor driving growth. TML is now seeking to translate Ace's success in foreign markets through its joint venture with a local assembler in Thailand, the second largest market for pick-up trucks in the world. TML is also seeking to leverage its partnership with Fiat to take the Ace to Latin America, where Fiat is an established player.

Good support from cars

While the compact car business is growing impressively, there are some worries in the mid-size entry-level segment where the Indigo and Marina are seeing a fall in volumes. TML is now developing the successor platform to the Indica and the tie-up with Fiat should be of help, especially on the engines front. The joint venture will produce three engines — one diesel and two petrol — developed by Fiat and for use by both partners.

The market is set to become more competitive with the entry of newer models, especially in segments where TML is operating.

The Indica platform will soon near the end of its life cycle and, therefore, the successor and also the so-called `Rs 1 lakh car' become important and will determine the future for the passenger car business.

Dropping margins

Rising input costs of materials such as steel and energy caused a small fall in operating margins in the second quarter to 11.5 per cent compared to 12.05 per cent in the same period last year. The inability to pass on cost increases fully to the market means that the third quarter margins may also be under pressure. Growth in earnings may, therefore, be slower than in revenues in the third and fourth quarters.

However, TML continues to run a successful cost reduction programme and has been efficient in managing inventory and receivables thus easing the pressure on margins.


A slow down in infrastructure spending which could affect CV offtake remains the biggest risk though there appears no such possibility in the near term. That said, the probability of the growth rate remaining above 30 per cent in the next fiscal appears low; it will most likely moderate to more sustainable levels of around 20 per cent.

For one, the base effect will begin to kick in and two, the slack caused by the overloading ban would be fully absorbed in the next couple of quarters.

Interest rates are an uncertain variable and if they harden further could begin to affect demand for both cars and CVs.

Input cost increases are another variable to watch out for and could exert pressure on margins despite the effective cost reduction programme. The private container trains project of the Railways, flagged off last week, needs close watching; if successful, it could take away some of the business of long-distance road transporters.

While these are medium- to long-term risks, the near-term appears clear and investors can enter the TML stock.

Valecha Engineering : Buy

Valecha Engineering's strong order book, improved balance sheet and plans for diversification augur well for its earnings growth. An investment can be considered in the stock with a 2-3 year perspective. At the current market price the stock trades at eight times its expected earnings for FY08 and is at a significant discount to peers.

Valecha is an engineering, procurement and construction (EPC) contractor for roads, piling works and airport runways. The company's order book of over Rs 800 crore is over four times its FY06 revenues. Road projects account for 70 per cent of the orders. While road projects are low-margin in nature, the company has managed to maintain its operating margins at 7-8 per cent on the back of better margins from piling projects. Until 2005, the company was unable to ramp up its order size as its diminutive net worth acted as a constraint in bidding for larger projects. In 2006, it managed to expand its net worth by 3.5 times. The company now appears well placed to bid for larger orders given its technical qualification and the improved capital adequacy. Increase in the size of orders may also pep-up operating margins. The company has executed airport runways in cities such as Mumbai and Chennai. With the airport privatisation activity gathering steam, the company appears well placed to bag similar orders from developers of airports.

While Valecha is less diversified than bigger players such as IVRCL Infrastructures, it now plans to diversify to BOT annuity, real estate and hydropower projects through special purpose vehicles. We expect real estate to play an active role in revenue contribution in the long term while the proportion of road projects may come down. The risks to the investment stem from the fact that Valecha is a small-cap stock with a market capitalisation of about Rs 140 crore and may be quite vulnerable to a corrective phase. The stock has declined by about 45 per cent since May in line with market trends and concerns about margin pressures on smaller construction companies. However, Valecha could contain such pressures through price escalation clauses built into its contracts. Moreover, the stock's decline has made valuations more attractive

Merrill Lynch - Reliance Industries

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