Weekly Newsletter - Nov 16 2009
Sunday, November 15, 2009
Sustained growth in the production of white goods, as suggested by the consumer durables index (in the IIP) indicates that air-conditioners (ACs) are back in demand, after a slump last year. This provides a good case for investing in the stock of Lloyd Electric and Engineering, a manufacturer of AC coils and fully-built AC units, mostly on a contract basis. Jump in the company’s sales and operating profit margin in the September quarter also suggesta recovery, after a lacklustre FY-09. Lloyd Electric’s clients include leading brands such as Samsung, Voltas and Electrolux.
Investors can consider the stock of Lloyd Electric with a one-two-year perspective. At Rs 56, the stock trades at eight times its trailing one-year earnings.
While the discount to larger players such as Voltas and Blue Star may be justified given Lloyd Electric’s smaller size, the company’s earnings growth is likely to outpace the valuations currently awarded.
The company’s sales grew at a compounded annual rate of 24 per cent over the last five years to Rs 585 crore in FY-09. Lloyd Electric’s heat exchanger coils now go into all major branded ACs such as Voltas, Blue Star, LG Electronics and Samsung.
This apart, the company is also into making of AC units for rail coaches and the normal window and split-type AC units for the retail market.
Last year, the company set foot in the European coil market with the acquisition of Luvata Czech. Luvata Czech sells heat exchangers for AC and refrigeration units. This acquisition has not only helped mere geographic diversification but also provided access to high-end technologies in coil manufacture.
After a blip in FY-09 (with sales down 12 per cent), the company has seen a significant recovery in sales in the last two quarters, coinciding with the revival in the consumer durables index — a constituent of the Index for Industrial Production (IIP). The pick-up in demand for air-conditioners from the household segment has worked well for Lloyd Electric.
Though the company’s direct share in the retail market isn’t high, its sales have been growing as a result of coil demand from branded AC players. After a 6 per cent decline in the March quarter and a flat growth in the June quarter, the company’s sales grew 30 per cent in the September quarter.
The company’s European operation is also expected to gather steam once slowdown worries subside and corporate spending resumes. This would provide further traction to sales growth.
In the domestic market, the lull in demand in the office space — a key driver for the company’s revenues, appears to be making a slow revival especially in the metros. Industry reports suggest that the demand for office space is likely to be higher by 53 per cent in 2011 compared with 2009.
Lloyd Electric has benefitted from the increased government spending. The company has large metro rail orders from the Government. More metro projects/addition of metro rail coaches can be expected to translate into higher orders for Lloyd Electric, given its prior qualification in this segment.
Profit derives support
Lloyd Electric has been making efforts to reduce costs.But the unprecedented rise in commodity prices swallowed the savings made in FY09. Besides, lower demand for its product may also have forced the company to lower prices. Lloyd Electric’s operating margins fell 3 percentage points to 9 per cent in FY-09.
The company’s contract business, however, appears less vulnerable to cost increases as majority of contracts have been booked on a cost-plus margin basis. Lloyd Electric’s business of manufacturing AC units for OEMs also support overall profit margins, given its backward integration of using coils produced in-house.
FY-09 was a bad year for the company with profits eroding by close to 60 per cent to Rs 20 crore on fall in sales and rise in commodity prices. However, between 2004 and 2008 profits after tax grew 70 per cent annually.
Investors with a two-three-year perspective can buy the stock of Unity Infraprojects (Unity). Primarily a construction contractor, Unity’s project portfolio comprises infrastructure and civil contracts. At Rs 479, the stock trades at 8.8 times its trailing 12 month per share earnings, at a discount to peers such as Ahluwalia Contracts and Patel Engineering.
Trading well below its IPO price in 2006, the company now asks for far more reasonable valuations. Besides, a diverse and growing order-book, increase in infrastructure contracts, and steady margins have improved its earnings prospects over the last couple of years.
Order-book size has almost doubled in the first half of FY-10 to Rs 4,040 crore, up from the 12 per cent growth of FY-09, indicating increasing ability to secure a larger number of contracts. At 39 per cent, civil contracts spanning townships, hospitals, airports, commercial and residential buildings, make for the bulk of the order book. 15 per cent comes from the transportation space, where the company undertakes construction contracts for road widening, micro tunnelling and road development. Water supply and irrigation contracts account for the balance. The order book, at 3.1 times FY-09 sales, has an average execution period of around 30 months, allowing medium-term earnings visibility. There is also an almost even split maintained between private and government contracts over the past three years allowing the spreading of risk while maintaining the ability to capitalise on opportunities thrown up by both segments.
Contribution of civil contracts has reduced in favour of those in the infrastructure space; transportation made up a mere 5 per cent of the order-book in FY-07. This segment, especially micro tunnelling , may see more activity in the coming quarters and help support profit margins.
The company will remain focussed on urban infrastructure; schemes such as JNNURM leave ample opportunities. Unity will also move into electrical contracts.
Unity does not have projects on a build-operate-transfer (BOT) model. Instead, it bids in consortium with developers as a preferred engineering procurement construction (EPC) contractor. It, however, does not have in-house design capability and outsources the same. Unity also undertakes projects on a joint-venture basis, securing last week an Rs 1145-crore water supply tunnel project with IVRCL Infrastructures and Projects.
Such partnering with varied developers, while helping the company secure larger orders or enter new geographical areas, may eventually provide it with technical qualification to bid on its own. The company has earlier partnered Nagarjuna Constructions, Patel Engineering and Pratibha Industries, among others. Unity also has interests in real-estate development which is not a significant contributor to revenues and plans to go slow on these projects.
Compounded annual growth rate of sales and net profits over a three-year period stand at 85 and 84 per cent respectively. The company kept up sales growth of 28 per cent for the first half of FY-10 compared with the same period in FY-09. Net profits similarly increased 11 per cent.
Operating margins have hovered around 14 per cent over the past three years and into the first half this year as well. With price escalation clauses in 85 per cent of the contracts, the company appears to be able to maintain margins at this level.
Debt on books has seen massive increases, standing at Rs 432 crore as of March ’09 against Rs 90 crore seen two years ago; interest costs almost doubled in FY-09 over FY-08. Gross margins are, thus, left at 10.6 per cent for FY-09 against the 11.6 and 12.4 per cent in FY-08 and FY-07. Margins have remained lower in the first half of FY-10 than the same period in FY-09.
However, share of interest costs in sales has remained at 2.5 to 3 per cent, suggesting debt has helped generate sales.
Net profit margins were 6.2 per cent for FY-09, down 100 basis points from that in FY-08, slipping to 6 per cent for the first half of this year. The company can raise up to Rs 250 crore through a Qualified Institutional Placement issue; if undertaken, it could help trim debt and boost margins.
Given the sluggish climate of FY-09, some projects have been delayed, albeit no outright cancellation of projects. The company is also highly concentrated in the West, primarily in Maharashtra and Mumbai with close to 58 per cent of contracts in the west.
Investors with a two-year perspective can consider investing in the stock of the home appliances major — Whirlpool of India.
Continuing the trend of strong growth through the downturn, the company saw its September 2009 quarter sales (volume) expand by an impressive 37 per cent. The visible uptrend in consumer durable sales in recent months, the company’s entrenched position in the key durable segments and its improving profitability suggest that the stock is a good addition to the defensive investor’s portfolio.
At Rs 119, the stock is trading at 15 times its trailing 12-month earnings.
The company plans to enter small towns with an investment of Rs 100 crore a year over the next few years. Expansion into the Tier 2 and Tier 3 markets at a time when consumer spending is rising may help the company sustain robust top-line growth.
Whirlpool of India turned profitable at the net level only in 2007-08. Growth in profits has continued at an impressive pace since then. In FY09, profits after tax doubled to Rs 70 crore. Strong sales volumes, rising revenues from after-sales services and a tight rein on costs have helped Whirlpool’s profit growth in recent years.
Rigorous brand-building activities have enabled the company to sustain a robust 17 per cent compounded annual sales growth over the last five years. Microwave ovens have been the fastest growing segment with volumes growing almost 50 per cent on an annualised basis between 2005 and 2009.
Other segments in the order of growth are air conditioners, washing machines and refrigerators.
FY09 was a challenging year for the company with sales growing at a slower space, due to the cutback in consumer spending and higher commodity prices which impacted input costs. However, the situation has improved over the last two quarters.
While profit margins have expanded on falling raw material costs, the April-June quarter saw a 13 per cent sales growth and the July-September period saw a strong 32 per cent growth, signalling a clear revival in consumer spending.
Whirlpool of India is all set to tap the rising demand for more affordable white goods, from the urban centres as well as the tier-II centres. The company plans to raise marketing spends on product development and advertising and promotions, while enhancing penetration in the smaller urban markets.
Better cash flows, with improved margins and the falling debt burden (0.6:1) have freed up funds for brand building activities. The company’s operating costs have declined by 3 percentage points in FY09 on cost reduction initiatives.
Investments with a long-term perspective can be considered in the initial public offering of the global tour operator Cox and Kings (C&K). The company’s strong brand image, wide geographical reach — both within the country and across major global markets — synergies of operations between its various subsidiaries and the economies of scale it thus enjoys are positives to the offer.
Despite last year’s declining trends in the global travel and tourism space, C&K managed to not just grow it revenues but also improve its operating margin and profits. C&K’s strong domestic market position helped by improving discretionary spends by Indian consumers and its newly acquired presence in high potential markets of the US and Australia offers it bright growth prospects.
The highly fragmented domestic travel market, with few organised tour operators, also leaves sufficient scope for market share gains. The valuation, though a tad stiff given the current market conditions, is at a discount to that of Mahindra Holidays and Resorts (29 times its likely FY10 per share earnings).
The offer price of Rs 316-330 discounts the C&K’s likely FY-10 per share earnings by 22-23 times on post-offer equity base. The company’s superior growth rates, high operating margin in this business and the likely scarcity premium for the business do offer room for premium valuations.
The company’s domestic business straddles leisure travel, corporate travel, forex and visa processing. While it designs packages for both individuals and groups for their domestic and international travel-tagged outbound travel, it also offers destination management and ground handling services for foreign tourists visiting India.
C&K has also built a web of subsidiaries that complement each other’s business offerings. For instance, while on the one hand, its overseas presence through its subsidiaries help attract business for the domestic inbound business, on the other, it also helps keep a check on service levels and costs.
Similarly, its UK subsidiary, ETN, that does destination management for European sites stands to gain from its acquisitions in Australia and the US, both of which enjoy a high outbound travel volume to Europe. The high synergies and travel volumes afford the company better bargaining power with airlines and hotels, in turn, helping it competitively price its products and services.
Other ventures such as Maharaja Express, a luxury train to be launched in January 2010 in collaboration with IRCTC and visa-processing business for which it has received approvals from six countries, also offer long-term growth potential.
On the whole, C&K has presence in 19 countries. In India, which made up more than half its overall revenues last year, the company has 255 points of presence covering 164 locations through a mix of owned and franchised sales shops, general sales agents and preferred sales agents.
The company, may need toimprove its reach in order to keep competition at bay. Its franchise distribution model holds potential in this regard. Not only does it offer a cheaper expansion mode, it may also help convert potential competitors into partners; the established client relationships of converts offering an added advantage.
C&K may also have to fight with vacation ownership companies for consumers’ wallet share. In that, however, tour operators appear relatively better placed as besides being asset light, they offer a wider basket of travel destinations.
Results and IPO proceeds
Over the last three years, C&K has grown its revenues and profits at a compounded annual growth rate of about 66 per cent and 80 per cent, respectively. In the same period, it managed to expand its operating profit margin by 10 percentage points to 42 per cent. Attributable mainly to increasing interest burden, the company’s NPM fell to 22 per cent from 28 per cent. With C&K seeking to use a portion of the IPO proceeds (Rs 129.6 crore) to repay loans, its interest outgo can be expected to come down significantly. C&K also plans to earmark IPO proceeds for acquisitions (Rs 150 crore), invest in overseas subsidiaries and upgrade corporate office.
The company seeks to raise Rs 584-610 crore from the issue, which also comprises an offer for sale of 3,046,640 equity shares by Lehman Brothers Opportunity Ltd, Deutsche Securities Mauritius Ltd and Merrill Lynch Capital Markets Espana.
The offer is open from November 18-20.
Investors can consider booking profits in ITC shares, as the stock valuations (30 times trailing earnings, at Rs 254) seem to have outpaced the medium-term growth prospects. Forays into businesses less profitable than the core tobacco business and the likely moderation in growth rates for tobacco are the primary reasons for the recommendation.
ITC holds close to 70 per cent of the domestic market for cigarettes with the segment’s contribution to the topline averaging 65 per cent and profits 85 per cent for the four years ended March 2009. With strong pricing power to pass on excise duty hikes, operating margins have averaged a healthy 25 per cent, much higher than rivals such as Godfrey Philips. In-house production of cartons, filters and paper, coupled with efficient raw tobacco procurement, have made ITC a highly integrated player.
While the implications of the GST tax regime are unclear, further increase in taxes appear unlikely, given that current rates are already stiff. Despite ITC’s dominance in the cigarette business, challenges remain.
Under the current taxation structure , licensed products are at a disadvantage to smuggled or unlicensed low-end filter cigarettes and the grey market. This restricts the potential for uptrading, with fewer consumers being able to make the jump from beedis and chewing tobacco to filter cigarettes, but facilitates the reverse. That is one reason why cigarettes account for just 14 per cent of tobacco consumption in India.
The government’s efforts at creating awareness through a public smoking ban and graphic images may so far not have had a big impact on tobacco products. However, the broader consumer trend towards health and wellness is a negative for long-term growth in cigarettes.
All said, ITC may remain the market leader in the cigarette business, growing in high single-digits in terms of volumes. ITC’s ‘mindshare’ among consumers, not to mention a distribution system that will require years to replicate, is going to be hard to dent by rivals such as Philip Morris and Godfrey Philips. Over the medium term, the business is likely to remain the major cash cow, continuing to fund efforts to diversify into other businesses.
To diversify its revenues and profits, ITC has charted several forays into consumer products such as garments, confectionery, consumer staples, bakery products, snacks and stationery products.
However, the new businesses do have a long gestation period and establishing a market share has required big investments in advertising and distribution. The non-cigarette FMCG business showed a loss margin of 12.7 per cent on sales of around Rs 1,600 crore for the half year ended September 2009.
In the FMCG business, ITC has over the past couple of years moved from segments such as matches, snacks and consumer staples such as atta into the more highly competed soaps and personal products.
While ITC does enjoy a competitive edge in bakery products or consumer staples by virtue of its well established agri-product supply chain, the same cannot be said of the soap or personal products segments that are more brand-driven and far more saturated. Building a brand reputation in this business may entail high spending, considering well-entrenched competitors such as HLL, Colgate Palmolive and P&G whose operating margins range between 13-16 per cent.
The early signs for ITC’s biscuit brand, Sunfeast, and snack brand, Bingo, have been encouraging with estimates of its market share at 11 to 13 per cent. But, here again, well endowed incumbents such as Britannia, Parle, Pepsico’s Frito Lay have moved zealously to guard their turf.
While ITC has managed to win share in Round one of the battle, the business may continue to call for high investment and features lower margins (between 9 and 12 per cent).
One segment with the profit margins to give tobacco a run for its money is hotels. ITC operates 100 hotels under four brands generating close to Rs 1,100 crore of business in FY-09 and an average segmental profit margin of 35 per cent over the four financial years ended 2008-09, in line with the industry averages. Business slipped by over 20 per cent between FY-08 and FY-09 on account of the deteriorating business conditions, coupled with the terrorist attack.
Here, ITC’s focus on the premium and business travel segment, ensures that the strong signs of recovery across the economy will translate into better occupancy over the medium term. The company may be well-poised to capitalise on expected demand growth by virtue of being an early mover and an established brand.
paper and packaging
This segment generated revenues of over Rs 2,800 crore in FY-09 with internal sales accounting for 41 per cent and operating margin has averaged around 19 per cent for the last four years. Growth expectations are similar between 7 and 15 percent for various products.
The agribusiness segment, procures rice, soya, coffee, wheat, tobacco, potatoes for trading and internal consumption.
ITC’s much-admired e-choupal, which is part of this segment, essentially provides information to farmers, procures directly from them and also doubles up as a mechanism for distribution of FMCG products and other services. For now, operating margin in this segment tends to swing quite sharply with the commodity prices and is likely to remain on the lower single-digit figures. In the half-yearly FY-10 results the segment saw a spike in segment margin to 14 per cent on the back of several commodity prices rising significantly from the lows in the second half of FY08.
ITC’s balance-sheet generates annual operating cash flows of about Rs 3,200 crore, allowing the company to make sizeable investments over the medium term into its diversification forays.
But even the winning outcome, with higher market share and volumes in non-cigarette businesses, is likely to leave ITC with lower net profit margins and lacks the dominance that it currently enjoys in tobacco. The size of the moat surrounding the ITC fortress is likely to shrink over the medium term