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Sunday, June 24, 2007

US Market plunges on hedge fund woes

Worries about financial health of hedge funds and a near $70 crude hit stocks

A near $70 crude and worries about the health of hedge funds slammed US stocks today (Friday, 22 June, 2007). Renewed concerns about the impact of the subprime mortgage market prompted a major sell-off among US stocks. The annual rebalancing of the Russell indexes exacerbated the broad-based move to the downside.

Of all the 10 sectors finishing lower, Financials led the way. Selling remained the name of the game going into the closing bell. Growing fears following the subprime fallout at Bear Stearns led Investment Banks as today's worst performing S&P industry group.

All but one of 30 Dow stocks closed lower for the day. Twenty-two Dow stocks had losses of greater than 1%. The Dow Jones Industrials lost a whopping 185.58 points to close at 13360.26. Tech heavy Nasdaq shed 28 points to close at 2588.96. S&P 500 closed lower by 19.63 points at 1,502.56.

Du-Pont was the sole Dow winner. Exxon Mobil, Microsoft, Intel and Caterpillar were the major Dow laggards today.

The Dow is down 1.9% for the week. The S&P 500 is down 2% and the Nasdaq shed 1.4%.

But the widely anticipated IPO of The Blackstone Group got a warm reception amid the sell-off in today’s market. Its stock opened up about 18% at $36.45 and ended with a 13% gain. The offering raised $4.13 billion by pricing at the top of its estimated range as the sixth-richest IPO in U.S. history.

Microsoft’s 2% fall pushes Tech to the wall

When market opened in the morning, stocks opened lower across the board as rising interest rates continued to act as an overhang as the 10-year yield at 5.19% remained a concern for the economic outlook.

The market saw a brief afternoon reprieve after Bear Stearns said that all liquidations of assets from its two struggling hedge funds, which are tied to the distressed subprime mortgage market, would be put on hold.

Of all the 10 languishing sectors down more than 1% on the session, the biggest three disappointments were Financials, Technology and Health Care.

The benchmark 10-year bond reversed early losses to finish up 12/32 at 95 3/32, while its yield dropped to 5.141%.

Technology was a weak spot for the broader market for the entire day. A 1.7% decline in Microsoft made the situation even more difficult. Chip maker PMC-Sierra plunged 3.8% following reports that it will be removed from the S&P 500 next Friday.

Crude just below $70 on Nigeria strike

Crude oil futures strengthened today after the government of Nigeria failed to reach an agreement with unions to end a three-day-old general strike in the largest oil-producing country in Africa.

As per latest reports, yesterday, oil unions withdrew workers from export terminals in a bid to halt shipments. Nigerian unions increased pressure on the new government in the third day of the strike, protesting increases in taxes and fuel prices. Nigeria, a member of OPEC produced about 2.3 million barrels per day of crude oil in 2006.

Crude-oil futures for light sweet crude for August delivery closed at $69.14/barrel (higher by $0.49/barrel or 0.71%) on the New York Mercantile Exchange. Prices rose 0.9% this week and are down 2.4% from a year ago.

Trading volumes showed 2.6 billion shares on the New York Stock Exchange and 2.7 billion shares traded on the Nasdaq stock market. Declining issues topped gainers by 3 to 1 on the NYSE and by 20 to 9 on the Nasdaq.

The Federal Reserve will meet on Wednesday and Thursday next week to discuss the economy and interest rates. Among earnings reports expected, Oracle, RIMM and General Mills are the big names.

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FII in Real Estate may face 3 year lock-in

The Finance Ministry has proposed a three year lock-in for investments made by foreign institutional investors (FIIs) in real estate firms through pre-IPO placements to check speculation in the booming sector.

Such a regulation, which brings FIIs on par with foreign direct investments (FDI), would require a change in FII norms and market regulator SEBI is expected to amend regulations in this regard shortly.

The regulator is expected to take up the issue of amending SEBI (FIIs) Regulations, 1995 at its next meeting scheduled in Mumbai on June 30, said official sources.

Finance Ministry has supported the views of Reserve Bank, which wanted a lock-in period for FIIs as part of its strategy to curb the rising speculations in the real estate sector, the sources said.

The government may also have to amend Foreign Exchange Management Act to put in place the lock-in, they said.

Earlier, the Department of Industrial Policy and Promotion (DIPP) and SEBI had recommended that pre-IPO placements by FIIs must be treated as portfolio investment and should not face a lock-in.

Sources said Finance Ministry has rejected the views of DIPP and SEBI, and has asked the regulator to amend rules making it mandatory for real estate firms to have a three-year lock period for FII investments through pre-IPO placements.

In the meantime, real estate companies which had sought permission for pre-IPO placements with FIIs had been asked to wait as guidelines had not been firmed up, the sources said. Although FIIs investing in real estate sector through pre-IPO placement are likely to face a three-year lock-in, they may be exempted from other conditions such as minimum capitalisation and area development that are applicable to real estate FDIs, the sources said.

With rising property prices, the sources said, Finance Ministry and RBI want to put curbs on FII investments in the sector, claiming that a lock-in period would prevent building up of a possible real estate bubble.

The government has allowed up to 100 per cent FDI in realty projects with conditions like a three-year lock-in, minimum capitalisation of five million dollars and development of at least 10 hectares of land.

At least seven realty, construction and infrastructure companies, including Omaxe, have lined up offers to raise a total of over Rs 6,000 crore from the market.

Although RBI has put various restrictions on real estate firms to raise funds overseas, many companies mopped up funds by promised hefty returns to foreign investors through investments ahead of IPOs.

As per industry estimates, nearly half of the over four billion dollars of foreign investment that was pumped in the real estate sector la

KV Kamath - ICICI Bank - Interview

ICICI shares will remain widely held and the lender is not likely to have a controlling shareholder such as Singapore state investor Temasek, the chief executive of India's second-biggest bank said on Sunday.

"Nobody has a controlling stake. The shares are widely held," ICICI Bank Chief Executive K.V. Kamath told Reuters in an interview on the sidelines of the World Economic Forum.

He said investor talk that Temasek Holdings or the Government of Singapore Investment Corp. (GIC) could accumulate a controlling stake in ICICI "is purely speculative".

Temasek owned a 7.37 percent stake in the Indian lender, while GIC owned 2.24 percent before ICICI's latest $4.9 billion share sale.

Investments in Indian banks are capped at 5 percent, but Kamath said that India's government had allowed Temasek to buy more than 5 percent in the bank as part of an economic agreement with Singapore.

The two state-owned investors have been lobbying India's government and regulators to lift an investment limit that prevents them from owning more than a combined 10 percent stake in an Indian bank.

He added that he did not expect the bank to enter into a partnership with a large foreign bank, in the way that international financial institutions have invested in Chinese banks.

"That is not on our map," he said, adding that at this stage he does not see foreign banks buying stakes in Indian banks because of regulatory restrictions.

But Kamath said he does see room for consolidation among the country's banks and that building scale was one of the biggest challenges facing the sector.

ICICI has expanded its international operation because of demand from Indians working abroad and because of Indian companies' foreign expansion drive.

Kamath said its international business made up 18 percent of its book, a figure that would climb to 25-30 percent by 2010. However, the bank is not looking for acquisitions and will focus on growing its business organically.

Rising domestic interest rates have so far not impacted the quality of ICICI's loan book, a third of which is made up of mortgages.

"So far, we are not seeing any particular impact on the quality of our assets," he said.

Indian banks have been riding strong loan growth as companies expand and Indians spend on cars in a booming economy. But rising interest rates have raised investor concern over defaults.

Data released on Friday showed that Indian wholesale price inflation unexpectedly eased to its lowest in 14 months, and analysts said the fall would give the central bank leeway to leave rates unchanged at its next monetary policy review.

The central bank has raised interest rates five times in the past year, the last time at the end of March, with the key lending rate at 7.75 percent.

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Hindalco: Steady uptrend

The stock moved up by 5.4 per cent last week to close at Rs 170 on the Bombay Stock Exchange. However, the trading volume declined by 78.89 million shares indicating that investors have booked profit at the higher level. The stock closed near a weekly high, indicating that the sale position was well absorbed in the market.

Hindalco Industries is on a steady uptrend, with the rise in the scrip price guided by market expectations that promoters may buy shares from the open market to ward off a takeover. The stock had spurted on heavy volumes early this month and it has been on a sustained rise since then.

The stock rose 18.38 per cent to Rs 170 in the past one month to Friday, June 22, 2007. The stock had hit a 52-week high of Rs 192.75 on November 1, 2006. It had hit a 52-week low of Rs 125.25 on March 7, 2007.

The low promoter holding in Hindalco (31.5 per cent) has made it a possible takeover target. The recent rumours that the Canadian aluminium major Alcan Inc could team up with Sterlite Industries to bid for Hindalco have spurred the market.

However, Hindalco’s promoters can take solace from the substantial share holding of state-run insurance firms in Hindalco. State-run insurance companies own almost 11 per cent stake, with Life Insurance Corporation of India holding 7.4 per cent.

Blue Dart: Steaming ahead

The stock zoomed to a new 52-week high of Rs 856.55 last week before settling at Rs 755.65 on Friday on the Bombay Stock Exchange. The stock rose 27.3 per cent over the last weekend price of Rs 593.79 on strong buyback buzz. The trading was brisk with the weekly volumes rising from 21.03 lakh to 24.83 lakh shares.

Blue Dart’s parent firm DHL currently holds a little over 81 per cent in the company through DHL Express Singapore, while institutional investors collectively hold 10 per cent. Individual investors have a stake of less than 5 per cent in the firm.

Blue Dart’s net profit declined 10.44 per cent to Rs 16.30 crore in Q1 March 2007 against Rs 18.20 crore in Q1 March 2006. The company’s net sales rose 19.47 per cent to Rs 181.60 crore in Q1 March 2007 (Rs 152 crore). Blue Dart Express is South Asia’s leading integrated air express carrier and premium logistics services provider.

The company has the most extensive domestic network covering over 14,000 locations, and services more than 220 countries and territories worldwide through a sales alliance with DHL, the global brand name in express distribution services.

F&O settlement, Fed meet hold the key

The stock market closed with a weekly gain of 305 points for the Sensex, but next week will be crucial as an all-time high derivatives open interest settlement falls during the week. The US Federal Reserve meet scheduled in the week can provide cues to the global markets. Speculation related to the first quarter corporate results will also play a role.

“There may not be big positive surprises in the first quarter results,” said Vibhav Kapoor, group chief investment officer, IL&FS. Another fund manager said that “the impact of a stronger rupee will be seen in the results”.

Technically, the market is hovering around its strong resistance level. The Sensex had reversed from this level recently without even crossing an all-time high, though the Nifty had crossed its all-time high. Squaring off of long positions and profit- bookings may see some downside, but the Nifty has strong support between 4,100 and 4,000 levels.

Situation in the derivatives segment is such that “a lot of put calls have been written around the 4,200 levels. Hence, derivatives may see a close below that level and the target is 4,160-4,170”, said Siddharth Bhamre, fund manager, Angel Broking.

During the last weekend, open interest was around 67,000 crore and the Nifty around 4,100. But short- covering helped recovery and new long positions were created. The market may not see a big fall as put calls were bought at 4,200 in the July series. Foreign institutional investors have made big purchases here for hedging. Their strategy will decide the trend. Current open interest is around 74,000 level.

Meanwhile, June proved to be one of the most successful months for raising funds from the primary market. Despite two mega issues, the market was not affected. This shows that there is enough liquidity in the market.

S Subramanian, head, investment banking, Enam Financial Consultants, said, “In the current month, $10 billion worth of funds are being raised from the Indian and the US capital markets.”

DLF has already raised more than $2 billion from the domestic market. ICICI Bank is raising $5 billion through FPO and ADR ($2.5 billion). Sterlite raised $2 billion through ADR on the NYSE. This is the second largest offering by any Indian company in the US ADR market. More than $1 billion is being raised by UTI Bank and HDFC Bank. Of the $10 billion, Enam managed issues worth $7 billion.

Since FII investment is huge in the two mega issues and because they pay only 10 per cent of the money when shares are allotted, their balance payment will be due. It is to be seen if they are bringing in fresh money or booking profit to make the payment.

Globally, the US Fed meet will give some cues, though big surprises are not expected. But on Friday, the US markets closed lower, breaking a longer trend of a higher weekly close. This may lead to the lower opening levels on Monday in the local market too. In the US, subprime mortgage worries have surfaced again leading to a fall in the share prices of financial services companies. There are concerns that banks will be saddled with losses on mortgage bonds.

Real Estate Stocks to decline ?

Once real estate prices correct, stock prices of sectors that have benefited from the boom will also decline.

The housing and construction boom of the past four years has created a lot of wealth and spread it around more than any phenomenon of the past five decades. Ever since banks started to target retail clients in 2003-04, millions of middle-class citizens have leveraged future earnings to buy property.

At the same time, growth in IT/ITES has driven commercial property. If you'd bought real estate in 2004, you would have probably doubled your investment by now. What's interesting is that returns from other beneficiaries are even higher than returns from real estate itself.

The real estate developers were the stock market success story of 2006-07 with half a dozen multi-baggers. The cement and construction industries and the finance industry have also been major beneficiaries of the boom.

If you'd bought the few listed real estate companies in 2004, your percentage returns would be four-digit. Cement and construction companies have delivered high triple-digit returns. The top rung banking and housing finance stocks have tripled since 2004.

There has been an asset bubble – that is inevitable when real estate doubles in value and more, in three-four years. It now appears that real estate itself is cooling. Lower interest rates and smoother paperwork enabled the boom – higher interest rates have caused cooling.

The recent sale of sticky home loans to asset reconstruction companies is a signal that NPAs are hurting. Real estate prices have softened little but we've got classic signals that suggest further softening in metro markets, at least.

Demand for new home loans has eased substantially – quite apart from defaults. In new real estate, while the price line is officially steady, cash-down buyers are getting 10-15 per cent discounts. Inevitably that will lead to lower prices.

The real estate market itself may clear, given price correction (15-20 per cent) that adjusts for rate hikes and eliminates speculators. Now, does the upside price-sensitivity translate into similar downside sensitivity?

If a 100 per cent rise in real estate prices set off 300 per cent increases in listed companies that benefited from the real estate boom, will a 10-15 per cent fall or a zero-growth scenario lead to a crash in those listed companies?

That's a scary though but it is something a trader should consider. Price declines in these industries can be exploited. Most of the big boys are available in F&O, which means that you can hold short futures positions for months on end. Fundamental shorts are a distinct possibility.

We've already seen 30 per cent corrections in the developer industry in February-March 2007 on the basis of lower 2007-08 projections. Cement also took a hammering especially after the lunatic dual excise rate.

Perhaps the corrections in these two industries have already factored in softer real estate prices. However, I would be tempted to short both sectors given another rate hike.

Banks are doing well in terms of stock prices. In fundamental terms, they shouldn't be. The interest rate hikes of the previous year have already hit both volumes and bottom lines. The highest growth in credit disbursal between 2003 and 2007 was from home loans. That segment is clearly impaired.

But in game-theory terms, banks are likely to continue delivering a decent performance. Every bank of respectable size must recapitalise to meet Basel II norms. ICICI's FPO has just got the ball rolling. This creates a "you scratch my back, I'll scratch yours" situation.

Every financial institution has a vested interest in ensuring all FPOs are successful. Extending the logic, the RBI has an interest in ensuring that bank FPOs go through. Whether it can persuade the political establishment to enable this process is a different matter. But banks won't get a hammering – until the FPOs have gone through.

This implies that unless interest rates start travelling downwards, the entire banking sector will be significantly over-valued by the time FPO action tapers off.

This has implications for banks – the sooner they get their FPOs in, the better. It has implications for FPO investors – you should book profits quickly in FPO allotments because the money will skip onto the next FPO.

It has long-term trading implications. Traders should ignore higher rates and be long on banks in apparent defiance of fundamentals until the FPO action ends. After that, "double-minus" – close long positions and go short unless rates have dropped. If the logic is broadly correct, banking will be a focal point for two years. First, prices will go up, then down.

ELSS is the best bet

Given a choice, retail investors should prefer ELSS (Equity Linked Saving Schemes) to other open-ended equity funds. For those with a long-term investment horizon, it is the best way to participate in equities. It is also the best option whether for availing tax benefits or making regular investments.

Why is that so? Take a situation where a bearish phase leads to redemption pressures affecting open-ended schemes. While complete statistics are not available, it has been seen that often in situations where the market turns bearish, open-ended equity funds bear the brunt of redemption pressures.

While ELSS are open-ended, they have a lockin period of three years. This often discourages short-term investors, including corporates and high networth investors, from putting money into ELSS. On the contrary, this can be considered a blessing in disguise as ELSS are generally not infested with short term investors.

Since investment in these fund were done to avail tax benefits, the ticket size was usually lower and assets were spread across many investors. The advantage is that no single/few investors rule the roost and fund managers are also not forced to sell stocks that they might otherwise want to hold.

In the recent fall in share prices (and also a small rebound), ELSS schemes have taken a greater beating than the rest. In the last one year, returns from such schemes were slightly lesser than those from plain-vanilla diversified equity schemes.

While ELSS gave a return of 42.2%, diversified equity funds gave a 44.1% return. One of the arguments which is being forwarded is that some of the ELSS have a greater leaning towards mid-cap stocks which took a greater beating vis-à-vis large caps in recent times. Yet, if you are a long-term equity investor, ELSS funds could be the best investment vehicle. Of course, it goes without saying that the scheme you choose should also have a good track record.

Investors in NFOs (New Fund Offering) need to tread carefully though. More importantly, an investor should prefer funds with larger AUM. While a smaller asset base no doubt makes fund management simpler, it also is susceptible to exit by large investors.

Another problem lies in its expenses – initial issue expenses that the fund houses are allowed to charge to the scheme.

The Securities Exchange of India (Sebi) more than a year back came with norms to include NFO related expenses in the entry load and not charge it to the scheme for the open-ended equity schemes. Ironically, many of the NFO collections were made before Sebi made this announcement. And it would continue with the old rules.

Previously, if you subscribed to an NFO, mutual funds will charge you issue expenses every year for the subsequent five years. Taking the worst case scenario, if a mutual fund charged initial issue expenses to the extent of 2% of the collections, then the expense ratio of the fund could be 3% ever year.

This is in addition to the normal cap of 2.5% p.a that Sebi allows mutual funds to charge for other recurring expenses. As an equity investor, if you think you have over-invested into equities, then it’s the right time to pull out from NFOs. Do your due diligence and check the NFOs which have underperformed in recent times and also have charged higher issue expenses, and then prune them.

HDIL: Invest at cut-off

Established business in the Mumbai Metropolitan Region (MMR), land reserve in the prime areas of Mumbai and the relatively attractive offer price band are the key positives for the initial public offer of Housing Development and Infrastructure Ltd (HDIL). Operations in slum rehabilitation projects which involve uncertainties and track record of deriving a chunk of revenues through the sale of development rights or floor space that it receives through the slum rehabilitation schemes are risk factors to the IPO.

As the IPO is priced is at a discount to players of similar size, investors with a risk appetite can consider investing in HDIL with a two/three-year perspective. At the offer price band of Rs 430-500, the price-earnings multiple is 14-16 times its per-share earnings for FY-2007 on the existing equity base (and 16-19 times on the post-issue equity).

Fund utilisation

HDIL, a real-estate company of the Wadhawan group, builds residential, commercial and retail projects and also undertakes slum rehabilitation schemes in Mumbai. The company derives most of its business from the lucrative MMR market. The company plans to raise Rs 1,200-1,450 crore, the chunk of which is to be utilised on ongoing projects; less than 10 per cent of the funds will be used for the acquisition of land and development rights.

lucrative market

HDIL has a land reserve equivalent of 112 million sq ft of saleable area, 40 per cent of which is under construction or development.

Therefore, the company can start deriving revenue flow in the medium term from ongoing projects, even if there are delays in the take-off of planned projects.

Of the total land reserves, 83 per cent is in the lucrative MMR, the commercial capital where there is much demand, especially for commercial and retail space.

This locational advantage lends much visibility to the earnings potential for the company's completed projects. We are, therefore, confident about the absorption of the built projects in this region.

Another positive feature of the land reserve is that the company owns 70 per cent of the total developable area and the possession of land by way of sole development rights is negligible. This primarily means low probability of disputes or stalling of projects by court cases where the company only has development rights and not land ownership.

Business segments

Of the saleable area developed by the company so far, close to 50 per cent is derived from land improvement, wherein the company creates infrastructure on the land it holds and then sells the parcels. This business, which is otherwise not a very lucrative proposition, has yielded reasonable margins because of the high value land granted under the Slum Rehabilitation Scheme (SRS). But the fact remains that only 50 per cent of what the company has done so far can be termed as core real-estate development.

However, looking at the ongoing and planned projects, the company appears to be concentrating on the residential and retail segment and to this extent, its operations would be dominated by real-estate development.

This would be essential for the company to not only build and retain its brand image among competitors in the Mumbai region but also improve margins. For instance, the company's commercial and residential segment saw the highest growth compared to selling of land or development rights in 2007. As a result, the OPM surged from 31 per cent to 54 per cent between FY-06 and FY-07.

HDIL has so far followed the build-and-sell model even for its commercial and retail properties.

While this may not be in line with international practices, we feel that for companies such as HDIL, which also lock their working capital in developing SRS in Mumbai, there may be higher requirement of capital, and this is better met by building and selling, rather than leasing property.

However, this model has its disadvantages, as it would lead to bunching of revenues in some years. . This would also result in fluctuating operating costs and negative cash flows.

HDIL has, however, offset this to some extent by regular sale of transferable development rights that it earns thorough the slum rehab projects.

HDIL is into SRS projects, which are typically uncertainty prone as they involve evacuation of dwellers and providing them with alternative housing. HDIL however has a reasonable track record of re-settling 25,000 families under this scheme, thus inspiring some confidence.

Moreover, these projects have formed only 15 per cent of its construction activity so far. But we view this business as a tactical way to build low-cost housing and earn high-value land in return.

The IPO is open from June 28-July 03. Kotak Mahindra Capital and Enam Financial are the book running lead managers.

Suryachakra Power: Avoid

Investors can give the initial public offering of shares by Suryachakra Power Corporation (SPCL) the go-by. The risks of investing in this offer outweigh the potential returns, especially at the offer price of Rs 17-20 per share. Revenue and earnings potential from biomass-based power generation is not very attractive and the company has no experience in this business. Add to this the problems in the operations of the company's existing diesel-based 20 MW station in Andaman & Nicobar islands, and the picture is complete.

Diesel to biomass

SPCL's diesel power plant in Andaman was commissioned in 2003 with a cost overrun. The Andaman & Nicobar (A&N) Administration is yet to approve the higher cost and SPCL is being paid on a provisional basis based on the original estimate. The company is also liable to pay liquidated damages of Rs 3.15 crore to the A&N Administration for the delay.

The A&N Administration retains the right to deduct this from the payments due to SPCL for the power supplied by it. The cash flows could come under strain if the right is exercised.

The Plant Load Factor, or capacity utilisation, of the plant, which is designated a base-load plant, has been sub-optimal and touched a high of 62 per cent in 2006-07. It is in this backdrop that the company is now foraying into biomass-based power generation through three subsidiary companies — Lahari Power & Steel, South Asian Agro Industries and M.S.M. Energy. Lahari and South Asian Agro are implementing two biomass-based plants of 9.8 MW each in Chattisgarh while M.S.M. Energy is setting up two units of 10 MW each in Maharashtra.

While Lahari's and South Asian Agro's projects are expected to be commissioned in July and September 2007, respectively, that of M.S.M's is likely to go on stream by August/September 2008. The main fuel for the biomass plants will be agricultural waste such as rice husk and cotton stalks. The company is yet to tie up for regular supply of the fuel. The biggest disadvantage is that this is the maiden foray of the company into this business.

Power trading — non-starter

One of the subsidiaries has also secured a power trading licence from the Central Regulatory Authority and plans to enter this business. Though there is good scope in the power trading business, it may be difficult for a small player to break into the industry, which has such major players as PTC India and NTPC Vidyut Vyapar Nigam. The cap on margins in trading at 4 paise a unit imposed by the regulator has already made the business unattractive and the only way to make money will be to increase trading volumes. It is doubtful if SPCL will be able to do that.

Promoters' record

The promoters of SPCL were earlier in the aquaculture business and two of their listed companies — Suryachakra Sea Foods and Kalyan Sea Foods — fell into difficult times when the aquaculture projects were banned by the Supreme Court in 1996. These companies were subsequently delisted by the BSE, and the Securities and Exchange Board of India slapped penalties on them for non-compliance. Some cases are also pending in different courts against the promoters and some of the group companies for not repaying loans, including one filed by the Marine Products Export Development Authority (MPEDA).

Investors can avoid this offer, which is highly priced, carries disproportionately high risks, and offers no major promise for capital appreciation.

Spice Communications: Avoid

Investors can refrain from subscribing to the IPO of Spice Communications being made in the price band of Rs 41-46. The company is a pure-play mobile services provider in Punjab and Karnataka, with a combined subscriber base of about three million. Faced with high debt and vendor dues, Spice hopes to raise funds for the twin purposes of part-repayment of debt and future expansion. Though the asking price values Spice at a discount to competitors, such as Bharti and Idea, the company's track record, cost-structure and trends in business growth in recent years suggest that it may not be well-placed to capitalise on the growth opportunities in mobile services, amidst intensifying competition.

Of the IPO proceeds of about Rs 520 crore (at the higher end) and the pre-IPO placement of Rs 112 crore, half is to go towards part-repayment of debt (which stands at about Rs 1,200 crore), and the rest to pay licence fees for starting NLD (national long-distance) and ILD (international long distance) services and repayment of vendor dues (Rs 63.6 crore and Rs 177.6 crore respectively).

Business overview

Spice has been in operation for over 10 years now (inception 1997) and is yet to turn PAT (profit after tax)-positive. The balance-sheet shows accumulated losses of over Rs 684 crore as of December 2006. Other regional players such as Aircel and Idea fare better on the above parameters. Aircel, Bharti Airtel, and Idea, which also commenced mobile services in 1997-98, turned profitable within six-seven years and acquired a national footprint.

Spice appears to have lagged its peers in optimising its network operating costs, possibly signalling that it may not be getting the best deals from its network equipment vendors. At 40 per cent of revenues, the proportion of network operating cost for Spice is a clear 15-20 percentage points higher than that for Idea and Bharti. An increasing trend in these costs over the last three years is also of concern, for future profitability.

Second, trends in Spice's subscriber additions over the last year do not compare favourably to competition. It has only managed to add about 82,000 subscribers a month in Punjab and Karnataka, while Airtel has managed to add nearly 2.5 lakh subscribers per month. BSNL and Hutch have added more than a lakh subscribers a month over the past year in these two circles. Spice ranks fifth among the six mobile service operators in Karnataka, but is better-placed in Punjab, where it is second in terms of subscriber numbers. Aircel, which added 1.5 lakh subscribers a month in the last year, despite being a regional player, has managed to retain its leadership position in terms of subscriber base in both the Chennai and Tamil Nadu Circles. For Spice, the modest subscriber additions and a rapidly-falling ARPU (average revenue per user) over the last couple of years are threats to revenue growth.

Third, a substantial portion of this IPO is to go towards part-debt repayment, vendor payment and licence fees to commence NLD and ILD services. Though this would reduce interest costs, the company may be left with little to be deployed in a national rollout of mobile services. In any case, with only part repayment of debt, interest costs will remain at relatively high levels.

Expansion plans

The company has applied for licences for mobile services in 21 new circles. This signals a move to try and move from a two-circle operation to a 23-circle operator, which appears quite ambitious. Apart from the constraints imposed by Spice's financial position, it is also important to note that getting spectrum allocation is a difficult proposition, given the existing competition for spectrum. That apart, some circles (such as West Bengal and Haryana) already have five GSM cellular (most others have four) and two CDMA (Code Division Multiple Access) operators and, hence, the prospects of Spice acquiring fresh licence(s) and entering new circles appears difficult.

Second, the company's foray into providing NLD services would make far better sense if it were a national player — to carry its own traffic to other circles. Regional players usually lease bandwidth from other national GSM (Global System for Mobile Communications) players for roaming and inter-circle traffic carriage.

Spice plans to have NLD infrastructure in 15 locations, whereas it has operations in only two circles. This might help reduce roaming tariff for its customers in the long run, but would involve periodic capex spending on upgrade and expansion of network to accommodate the increased traffic. Considering the paucity of funds that the company already faces, it could find it difficult to bankroll expansion over the long run.

Third, it will face stiff competition in existing as well as any new circles from national players. In the light of the multi-billion dollar nation-wide network expansion announced by each of these players, aggressive subscriber additions, and falling ARPUs, Spice may not have the wherewithal to withstand the competition. These factors indicate the possible high execution risks.


At the upper end of the price band, the offer values Spice at a substantial discount (40-45 per cent) to Idea Cellular on an Enterprise Value/subscriber basis. On other metrics such as EV/EBITDA and EV/Sales, the offer does not build in a significant discount to Idea or Airtel, despite the latters' much larger scale of operations and superior cost structure. Spice's EBITDA (earnings before interest, depreciation and amortisation) margin, at 24 per cent, is lower than the others players (the industry average is around 34 per cent). Recent reports also indicate that the Idea-Spice merger has been called off on account of disagreement over higher valuations.

Offer details: The company proposes to offer 131,111,111 shares amounting to a 16.39 per cent stake in the price band of Rs 41-46 per share. Enam Financial Consultants and UBS Securities India are the book-running lead managers, and Karvy Computershare Private Limited is the registrar to the issue.

Trader's Corner

Have you ever noticed that you tend to listen keenly to some analysts on the business channels on televisions whereas your mind switches off while others are speaking. A close scrutiny will show that the analysts whom you follow closely will hold ideas similar to your own. If you are a bull, then you will listen to all the analysts who predict a never-ending bull-market and turn a deaf ear to those who disagree.

This is a form of selective listening that is employed by most traders. A selective listener is one who hears another but selects not to hear what is being said, either by choice or desire to hear some other message. Traders very often fall prey to this habit. They mentally block the opinions and analysis that goes against their own.

Though all of us start with the noble intention of imbibing as much information as possible relating to the market, company, industry, product et al, it has often been observed that the nature of the open position that we hold sifts the information and only that which supports our decision is accepted by the mind.

Traders who are holding short positions in Nifty will gravitate towards the analysts who are predicting a fall in the market. Those going long on Reliance Industries will devour all the positive news pertaining to the company while pooh-poohing negative news.

This tendency gets aggravated when traders are hanging on to loss making positions and are seeing the loss increasing every day. Instead of facing the situation and cutting the loss short, they will look around for opinions that support their holding on to the position even if it is a futile exercise.

The first step towards breaking free of this habit is to be aware of this deficiency. Once this awareness has been ingrained, one would be able to absorb all the information relating to the position and taking a balanced view on it. If there is a need to book a loss then it should be done without trying to avoid the situation by looking for alternate opinions.

The other way to circumvent this issue is by making a brief note of all news, opinion and analysis concerning the stocks in your portfolio, both positive and negative. A review of this list with a consciously neutral mind should help in making the right decisions.

Market View

The earnings season along with the latest economic data suggest the RBI's efforts to ensure price stability without hampering growth prospects appear to be bearing fruit. Corporate India is benefiting from the buoyant domestic and overseas demand. While the sharp rise in rupee does impact export-oriented companies, our interactions with leading companies indicate that the short-term effect will be on the lower side due to hedging. The widening trade deficit and high oil prices might pull down the rupee over the medium term. If there is any further sharp rise in commodity prices including oil, input cost pressures on margins could increase. Corporate India has witnessed sharp productivity improvement in recent years and this along with demand buoyancy could help select companies offset higher costs through volume increases. Buoyancy in capital and consumer spending could result in better pricing power, enabling pass-through of higher costs. Even as domestic borrowing costs have been rising, we believe that buoyant equity market along with relatively lower overseas interest rates should help Indian companies in mitigating the impact.

Franklin Templeton Investments

The bull-run in the past four years has captured the under valuation of equities, which has resulted in exponential gains during this period. There have been apprehensions about valuations running ahead of fundamentals, but that does not mean that the up-cycle has fizzled out. With the market fairly valued currently, investors need to moderate their expectations. Long term, we believe the up trend may continue given the prospects of corporates delivering above average earnings. Hence, the premium valuations are not completely out of place. With the results season over, the market may be range-bound in the near term as it seeks to consolidate its gains, assess the impact of interest rate hikes on future profit growth. Fresh supply of Rs 30,000 crore in the equity market through the IPOs of DLF and ICICI Bank could dampen the market, as it will take time to absorb this huge supply. The unfolding of the monsoon scenario could also impact the market momentum. Having said that, analysts reckon that with the inflation coming off to around 5 per cent levels, the pressure on RBI seems to have eased considerably. The market has so far shrugged off the fears of the ripple effect of Chinese market slump in the region. However, considering the extent of integration of global markets, volatility on account of unforeseen global events cannot be ruled out. Therefore, our recommendation to investors is as follows;

In a fair value market, maintain a neutral allocation towards equities.

Do not try to time the market, as the high short-term volatility cannot be ruled out.

Asset allocation and Systematic Investment Plans are the best way to safeguard against volatility. They ensure optimal returns and not the maximum return in volatile markets.

Investors should look at a mix of large and mid cap funds for 3-5 years horizon on systematic investment basis.

Graphite India: Buy

Investors with a one-to-two year perspective can consider taking an exposure to the stock of Graphite India.

At current market price, the stock trades at about seven times its likely FY08 per share earnings on a fully diluted basis. Increasing demand for graphite electrodes coupled with a hardening of electrode prices, spell good times for Graphite India, a leading electrode manufacturer in the country. This apart, the increasing preference for steel manufactured through EAF (electric arc furnace) route the world over, in turn is likely to propel the demand for graphite electrodes.

Industry estimates, which peg the contribution of steel produced through the EAF route at about 38 per cent by 2010 compared to the 33 per cent now, point to strong demand prospects for graphite electrodes. Revenues are also likely to get a boost from exports, which contributed to about 68 per cent of the total revenues for FY07. Graphite India has facilities to generate captive power, which given the energy intensive operations, leads to cost savings. Savings from reduced freight cost and the zero impact of anti-dumping duty due to Graphite's presence in Germany is a positive.

For the quarter ended March 2007, Graphite witnessed a 22 per cent increase in revenues, helped by firm prices and improved capacity utilisation of its Durgapur plant. However, on the operational front, margins declined by about 500 basis points during the quarter. While rise in raw material and staff cost could be reasons for the shrinking of margins this quarter, exceptional charges from accounting for higher fuel costs also reduced margins. Going forward, higher realisations on graphite electrodes, are expected to more than offset the hike in input (needle coke) prices. Therefore, the pressure on margins is likely to ease in future. Any reversal in production trends in steel, unexpected changes in exchange rate pose risks to our recommendation.

Patni Computer Systems: Book profits

The Patni Computer stock has registered sharp appreciation in recent times, moving to the Rs 560 levels, before cooling to around Rs 510. The stock now trades at a valuation of about 28 times its CY-06 earnings and is at a premium to its peers in the sub-$1-billion club. The recent run-up in the stock price is attributed mainly to reports of a possible stake sale by the company's co-promoters to a PE (private equity) firm.

However, subsequent events suggest that a transfer of stake between promoters also remains a possibility. As this will not trigger an open offer requirement, the stock price may cool in the near term.

Given that the outcome of these developments is uncertain, investors can book profits on part of their holdings to lock into current gains.

Business Overview

Patni's services portfolio broadly spans across insurance, financial services, manufacturing, telecom and media, and the product engineering industry verticals. Application maintenance and development is the biggest revenue earner, while some revenues are also derived from enterprise application systems and embedded technology services.

Patni has also made forays into Infrastructure Management Services (IMS) and Business Process Outsourcing, thus establishing itself as a player involved across the entire IT services value chain, much like big-league software service providers. However, certain trends in the company's financials for the latest quarter are of concern.

Business developments

On a sequential basis, Patni's revenues have grown at a modest 1.1 per cent. Adjusting for currency changes, the revenue realisation in rupee terms was actually Rs 8 crore lower than the preceding quarter. Operating and net profit margins have remained more or less flat.

There has been a significant decline in the revenue contribution from the telecom vertical, from 19.4 to 14.7 percent quarter-on-quarter, attributed to a vendor rationalisation process undertaken by a key telecom client. The manufacturing and financial services verticals have also seen a marginal decline in contribution to revenues.

On the services side, Application Development and Management (ADM) has declined significantly in terms of revenue contribution — from 70.1 per cent to 65.6 per cent on an sequential basis.

ADM is the biggest revenue contributor for most IT services companies, in general, and Patni, in particular. Part of this decline can be attributed to the loss of the telecom client. But if this trend continues, non-ADM services may have to show higher growth rates to compensate. Third, though 26 clients have been added this quarter, there are no million-dollar clients in the list. This indicates a relatively higher number of smaller value clients, which may pose challenges in terms of scattered resource allocation and increased costs.

Another significant risk factor arises from Patni's high attrition levels, which stood at 27.9 per cent for the latest quarter; high compared to industry standards (sub-20 per cent levels). The company has increased its offshore salaries by 15-20 per cent and by about 4 per cent for its onsite employees. While the company expects that this move will control attrition to a certain extent, the increased wage bill may dent near-term margins. Wage inflation will also be influenced by the company's plans for a fresher to the lateral recruitment ratio of 60:40 (industry standard is about 75:25).

The company's billing pattern has also tilted further towards time and material billing, and away from fixed contracts, which suggests greater dependency of billing rates on utilisation levels. Significantly, utilisation percentage has fallen 90 basis points over the last quarter.

The positives

The positives to Patni's current operations arise from the increasing contribution of the product engineering vertical to revenues, reduced dependence on GE as a client and the fact that it has hedged part of its revenues against sharp rupee appreciation.

The change in business mix, in terms of a 18.6 growth in product engineering services practice on a sequential basis (overall revenue contributions stands at 16.8 per cent) during the quarter augurs well. This being a service that is higher in the value chain, with better billing, is likely to help overall revenue growth. The revenue contribution from Patni's top client — GE — has reduced from 13.5 per cent to 11.1 per cent on a sequential basis, lowering client concentration.

The last quarter has also seen an increase in revenue contribution from the US. However, currency related risks are partly mitigated by the company's hedging policy. The company has hedged around $200 million worth of its CY-07 contracts at an exchange rate of Rs 43.86-46.85 a dollar. Patni also plans to ramp up its operations in Chennai and Noida and in Germany and the Netherlands. These investments may help expand the scale of operation and take it a step closer towards becoming a player with a global delivery model.

Reports suggest that two of the company's three promoters are planning to sell their stake (about 29 per cent) to interested buyers. An acquisition of this stake by private equity or other software majors may lead to further upside in stock (depending on the pricing of the deal), as this may trigger open offer requirements.

On the other hand, with reports suggesting that the key promoter Mr.Narendra Patni has the first right of refusal on the stake sale, suggest that the deal could also evolve as an inter-se transfer stake between promoters, in which case, there will not be any open offer requirements.

In light of these events, investors may lock into some gains now. Any future restructuring moves relating to management or business, may be triggers to re-enter the stock.