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Sunday, July 27, 2008
Dr Reddy's Labs
Investors may not initiate fresh purchases for now in the stock of Dr Reddy’s Laboratories, a frontline pharma major which derives one-third of revenues from branded formulations (finished dosages).
Heightened concerns about profitability of German generics business, chiefly Betapharm (that accounts for 17 per cent of turnover), lack of significant upside in terms of exclusive product launches and slow growth in Indian formulations business cloud the earnings picture.
At the current market price of Rs 635, the stock of Dr Reddy’s trades at 17 times its 2008-09 earnings per share — this is at a discount to like-sized peers of similar scale — but may be justified due to the unexciting prospects of the company over the medium-term. Better growth opportunities are currently available in the listed pharma space.
The recent quarterly results in which Dr Reddy’s reported 26 per cent drop in net profits despite 21 per cent organic sales growth on a year-on-year basis, indicate that the company is not out of the woods yet. Barring US where the company continues to do well (sales up 62 per cent) and plans to introduce products in the over-the-counter and specialty segment, as it targets exclusive launches over the long-term, growth in major geographic areas has been at best, modest.
Operating margins (down to 12 per cent from nearly 18 per cent earlier) were affected as Dr Reddys’ selling and administrative costs grew sharply this quarter. SG&A costs may not materially decline from these levels. Some respite on revenues and margins may come from the launch of authorised generic Sumatriptan (anti-migraine) scheduled for late 2008, the benefits of which seem priced into the stock.
While the company may achieve its guidance of 25 per cent revenue growth (off a low-base), Dr Reddy’s, as an investment candidate, suffers from lack of earnings visibility, low rate of success in R&D and pressures on cost.
German trouble
In February 2006, Dr Reddy’s acquired Betapharm, then the fourth-largest German generic drug maker with a market share of 3.5 per cent, for Rs 2,550 crore. However, the ‘strategic’ German market changed from mid-2007. The government gave more bargaining power to insurance companies necessitating several price reforms and compelling the companies to operate on thin margins driven more by volume growth than profitability (EBITDA in FY-08 at $27 million against $42 million in FY-07). Compared to its German peers, Betapharm has a smaller portfolio of medicines; it is absent in certain key business segments, has not won any major Government tenders and has been slow in outsourcing manufacture to cut costs.
All this elongates the pay-back period and suggest a slow recovery for acquired businesses. These account for nearly 90 per cent of Dr Reddy’s Global Generics segment in Europe. With further price-cuts announced in June, Betapharm may continue to drag margins.
Slow in India
While the Custom Pharmaceutical Services in India has done well for Dr Reddy’s, the slow growth in the formulations business is a cause for concern. As against an industry trend of 13-15 per cent, Dr Reddy’s grew by only 9 per cent in March-June quarter with key brands witnessing a decline and unexplained delays in product launches.
While the company expects growth to pick up in the days ahead, Indian formulations, which contribute 15 per cent of the turnover (third-largest area after North America and Europe), are the most profitable market and muted performance there creates earnings uncertainty. For the company to achieve its full-year guidance of 50 per cent plus gross margins, Indian business will play a crucial role.
Perlecan back
Dr Reddy’s has decided to buy back the shares of Perlecan Pharma, its demerged drug discovery arm, for $18 million from ICICI Ventures and Citigroup. Dr Reddy’s had earlier hived off the company (with four drug candidates) in 2005 and sold the demerged entity’s stake (85 per cent) for $22.5 million.
While Perlecan has carried forward losses that may provide tax benefits, its coming back into fold will result in rise in R&D spend (though, not in near-term) with just one new drug entity eligible for out-licensing.
Axis Bank
The Axis Bank stock has outperformed its peers in the private sector with a 16.1 per cent gain in its price over the past one year, when other private bank stocks have failed to generate positive returns. A lower exposure to retail lending, where there are concerns about credit quality, has helped the stocks’ performance.
At Rs 713, the stock trades at a price-book value of around 2.8 times, which is at a discount to HDFC Bank but at a premium to most other private banks. Investors can nevertheless buy the stock, given the growth momentum in the business.
Axis Bank reported strong financial results in FY-08 and continued its good performance in the first quarter of this year, even as other private banks have turned in unimpressive numbers.
This growth may be moderate, as growth in the loan book slows down on the corporate and retail side with trading operations also likely to yield lower returns. However, this may be offset by growth in fee income and rapid branch expansion in Tier-1, Tier-2 towns and the small and medium enterprise (SME) segment.
Business overview
Axis Bank has been growing faster than the industry over the past five years. Its net interest income has grown at a 45 per cent compounded annual growth rate (CAGR) from 2003-04 to 2007-08, while net profits have grown at 40 per cent. A focus on branch expansion and an established ATM/branch network have helped attract retail clients. The bank’s corporate: retail asset mix is 76:24 presently, which might insulate it from the more credit risk -prone retail segment.
To enable focussed lending, the bank has set up 24 SME centres and 39 agri-clusters. In retail, the bank offers high-end services, with specialised branches for high net worth clients.
Fee from banking and advisory services such as cash management services and cross-selling of financial products, debt syndication and placement, have made a significant contribution to income, growing by 53 per cent CAGR over the past four years.
On the costs front, the bank’s high current account and savings account over total deposits (CASA-40 per cent) may help it contain cost of funds amid rising interest rates. Axis Bank’s leading position in debt syndication and private placement may help it to capitalise on an expanding corporate debt market over the medium term.
A high level of capital adequacy (13.3 per cent) allows room for investment in risky assets such as realty and capital markets. It also circumvents the need for fund-raising in the present high cost environment to bankroll growth plans.
On the flip side, the company’s expansion plans for the retail business (specifically credit cards) entail risks.
As a new entrant, higher delinquencies will remain a risk and this is already evident in this segment’s 64 per cent contribution to the incremental NPAs, a chunk of it from the credit-cards business. On the corporate side, the exposure to rate/market-sensitive sectors such as real estate (7.68 per cent), infrastructure (7.7 per cent), capital markets (5.64 per cent) and textiles (5.43 per cent), may expose the business to risks if interest rates continue to surge.
Financials
For FY-08, Axis Bank’s net interest income (NII) grew by 76 per cent and non-interest income by 78 per cent. The surge in NII is due to the increase in advances and demand deposits.
Advances grew by 61 per cent. The operating expenses also matched the earnings growth because of the increase in employee costs, branch expansion, re-branding and advertising expenses apart from the increase in the cost of funds. For the June quarter, the bank reported a 93 per cent growth in NII and an 89 per cent growth in post tax profit, with NIMs at 3.35 per cent.
Though the bank has managed strong credit growth, the cost of funds too has increased at a higher rate than the yield on assets.
Of the bank’s investment book, Rs 20,740 crore is in the held-to-maturity category, Rs 15,058 crore is available for sale and Rs 245 crore is in held for trading. This represents a potential risk, as the bank may have to provide for erosion of a significant portion of the investment book, in the form of mark-to-market losses.
Risks
Higher cost of funds, slowdown in advances, deteriorating asset quality and treasury losses present key risks to Axis bank’s earnings. Though the bank’s June quarter results have surprised, amid a rising interest rate scenario, a moderation in growth appears to be on the cards.
Growth in non-operating core income may hold the key to growth. Focus on under-banked sectors such as micro small and medium enterprises (MSMEs) and agriculture, and the expansion into areas such as international business, offer potential.
IVRCL Infrastructures
Investors with a 2-3 year perspective can consider buying into the stock of IVRCL Infrastructures and Projects (IVRCL).
The company has managed to sustain the pace of order flows in 2007-08 — a relatively tough year which saw a slowdown in the order flows for a number of infrastructure and engineering companies.
Healthy growth in the order book combined with the company’s strength in irrigation and water projects — a segment that has received significant attention in the Government’s Budget and five-year plans — are likely to augur well for the company’s earnings growth.
Given the current turbulence in the markets, investors can consider accumulating the stock in tranches, on declines linked to the broad markets. At the current market price, the stock trades at 12.5 times the company’s estimated (standalone) earnings for 2009-10. It trades at about 11 times its 2007-08 consolidated earnings.
While the contribution from subsidiaries may be significant over the long term, we would now prefer to evaluate the company on the basis of its core business of infrastructure.
In 2007-08, IVRCL’s order intake more than doubled, resulting in the order book expanding to Rs 12,800 crore.
Sub-contracting
IVRCL has been trying to overcome this issue through increased sub-contracting activity. While this strategy has resulted in robust growth in the topline, it has also contributed to a slight moderation in operating profit margin This strategy may, however, be inevitable in a sector where growth is mainly driven by volumes.
While IVRCL has continued to capitalise on its key strengths of irrigation and water-related projects, there has been a visible increase in building projects (24 per cent of order book), coming at the cost of road projects. We view this as a positive as building projects not only carries better returns, but holds lower risk.
IVRCL’s diversification into water-related projects has been significant after its majority stake acquisition in Hindustan Dorr Oliver. This subsidiary’s specialised skill sets in water treatment and processing equipment, together with IVRCL’s bidding capabilities, had helped it tap a niche in this field. This segment could be a key long-term growth driver for the company.
Increase in commodity prices (despite escalation clauses on contracts) and execution challenges faced by its realty subsidiary remain key risks over the medium term.
Nu Tek India IPO Analysis
An investment can be considered in the initial public offering of Nu Tek India, given the reasonable asking price and the potential for this business. The company enables telecom companies to expand their tower infrastructure, by providing end-to-end services. Nu Tek delivers telecom infrastructure rollout services, including civil and electrical works, for wireless communication providers.
At Rs 192 (upper end of the price band), the offer values the business at 15 times its 2007-08 earnings on a fully diluted post-offer equity base. This is the same valuation that the larger GTL demands. But Nu Tek is moving up the value chain by becoming a turnkey infrastructure rollout services provider and creating a sustainable revenue visibility.
The company’s revenues have, over the past three years, grown at a compounded annual rate of 46 per cent to Rs 96.7 crore, while the net profits have increased at a rate of 57 per cent to Rs 21.2 crore. The valuation is, therefore, not too demanding.
The growth momentum in mobile subscriber additions, a stiff spectrum allocation regime that necessitates more towers and impending regulatory measures present opportunities for Nu Tek.
Business drivers
From being a provider of civil and mechanical works, the company has evolved into an end-to-end player in the passive infrastructure services segment. Being in the services space alone has made it vendor and technology agnostic. Nu Tek also has the expertise in optic fibre rollout, thus catering to landline providers as well.
Being a turnkey player has its advantages, with initial revenues received upon completion of infrastructure commissioning as well as future annual maintenance revenues for active and passive components, thus creating a sustainable revenue stream.
Turnkey solutions now account for 57 per cent of its revenues, while maintenance revenues have grown from nothing in 2005 to 13 per cent of revenues in 2007-08. Technical support and telecom implementation contribute the rest.
Nu Tek’s client base spans telecom service providers, equipment manufacturers as well as third-party tower infrastructure players. This makes it well-positioned to tap into several opportunities for tower rollouts. The company counts several blue-chip names in each of these categories as its clients. Players in all these categories also sub-contract implementation services to Nu Tek. With mobile subscribers still being added at 6-7 million per month and the entry of new pan-India players, there will continue to be big potential for new tower rollouts.
On the policy front, a stiff subscriber-linked allocation of spectrum norms also means that operators will be looking to increase number of cell sites (towers).
But the caveat is that as tower-sharing among Indian mobile players improves from the current (1.2-1.5) levels, the demand for newer cell-sites would eventually come down. But annual maintenance revenues would continue to flow in, more so in case of higher tenancy towers offering business opportunities for players such as Nu Tek.
Announcement of a 3G policy and mobile number portability would require scaling up of both the active and passive infrastructure of mobile operators. Nu Tek, with its existing working relationship with many of these players, appears well-placed to tap a portion of this incremental market.
Another potential opportunity in this segment may come from the Defence sector, which is expected to vacate spectrum to be allocated to mobile players.
The DoT has proposed an optic fibre network to enable and provide alternate mode of communication for the defence, in this case. Nu Tek is already working on another project for the Defence that was sub-contracted to it by Bharat Electronics.
As and when the vacation of spectrum is formalised, Nu Tek may be able to cash in on the new opportunity. The company’s foray into Turkey, a rapidly expanding telecom market, and Dubai may be watched for growth prospects.
Risks
Competition from strong turnkey players such as GTL and other third-party infrastructure providers such as American Towers and Quipo Telecom, may pose pricing pressures. The execution of Nu Tek has not been on a grand all-India scale, but in smaller clusters over several circles and scaling up to pan-India levels may not happen quickly.
The average receivable days has gone up steadily to 113 currently, thus increasing working-capital requirements. In a high interest rate scenario, this may escalate interest costs.
Offer details
Nu Tek plans to raise Rs.86.4 crore, including an offer for sale of one million shares by an existing shareholder at a price band of Rs.170-Rs.192.
The company is looking to deploy the proceeds towards capital expenditure, overseas acquisitions and augmenting working capital.
The offer is open from July 29 to August 1. IIFL and SPA Merchant Bankers are the book-running lead managers to the issue.
Transformers and Rectifiers
Investors with a long-term perspective can consider buying the stock of Transformers and Rectifiers (T&R). Robust growth in revenue backed by stable margins, healthy growth in order backlog and the likely commissioning of new capacities by the end of the current quarter add visibility to the company’s growth prospects.
At the current market price of Rs 303, the stock trades at a reasonable valuation of about 10 times and 7 times its likely FY-09 and FY-10 per share earnings. Investors can, however, consider buying the stock in lots given the present turbulence in the stock market.
Strong revenue growth
The first quarter numbers of T&R belie fears of any significant slowdown in the T&D space, given that there were concerns regarding execution slippages in power projects. In the quarter-ended June 2008,
T&R has more than doubled its profits on the back of a 53 per cent growth in sales. Margins, however, came under slight pressure because of increase in raw material price; EBITDA margins dipped by 90 basis points to 14.4 per cent. Net profit margins improved by 3 percentage points to 11.3 per cent helped by a higher ‘other income’ and lower interest cost in the quarter.
The management has guided towards maintaining EBITDA margins at about 18-19 per cent.
This may well be achievable since over 74 per cent of its current outstanding order book has price escalation clauses, whereas for the balance 26 per cent (primarily short-term orders), T&R has already secured raw material supplies, thus locking into current prices.
There could, however, be some pressure on the realisation front, given the increasing levels of competition.
Average realisation per MVA of the transformers sold in the first quarter has dipped to Rs 4.9 lakh from Rs 5.3 lakh last year. Increasing competition apart, drop in realisation may also have been due to varying sales mix during the quarter. This variation is a result of SEBs’ requirement of higher range equipment vis-À-vis the industrial buyers but with similar price points.
That said, the management expects realisation to remain stable from hereon with slight moderation next year, when its new capacities are likely to become fully operational (16,000 MVA).
Order book
Pegged at about 1.3 times its FY-08 net sales, the company’s order backlog of about Rs 384 crore (executable in the current financial year) also reiterates its growth potential.
In terms of segmental break-up, over 82 per cent of the outstanding order-book is constituted by the power and distribution transformers, while furnace and rectifiers, and exports make up 14 per cent and 5 per cent respectively.
With newer capacities likely to become operational by September end, the contribution from the power and distribution segment may rise further as T&R proposes to manufacture higher voltage transformers (220kV and later 400kV) in its new facility. Once fully operational, T&R’s installed capacity will increase to 23,200 MVA (one of the largest in the industry).
Concerns
The company derives a chunk of its revenues from the SEBs, whose payment cycles are longer than the industrial consumers.
While so far the company has been able to recover its dues from the SEBs on time, there has also been a commensurate increase in working-capital requirements. That T&R now has a healthy cash balance (post-IPO) may provide some respite to its working-capital requirements.
Any delay in power generation capacity-additions, however, will remain a primary risk to the company’s earnings.
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