Sunday, December 27, 2009
Investors can retain their share holdings in Firstsource Solutions, a BPO player, considering the company's healthy vertical and geographic mix, the revival in the deal momentum and benefits that accrue from macro trends such as vendor rationalisation by clients.
At Rs 34, the share trades at 17 times its likely 2009-10 per share earnings. This is at a premium to most mid-tier IT companies, but at a steep discount to peers such as WNS and EXL Services. These two companies are listed in the US and trade at over 43 times earnings. Firstsource generates revenues at higher operating margins (close to 15 per cent) than these players.
With operations stabilising in verticals such as banking and financial services and client ramp-ups witnessed over the next two years, there may be sufficient room for capital appreciation.
The company had a challenging 2008, with pricing cuts and declining volumes and losses due to FCCB borrowings on the back of a depreciating rupee, but seems to have witnessed significant revival in volumes and stable pricing over the last three quarters. FCCB losses have also come down significantly.
For the first half of this fiscal, the company's revenues grew 16.8 per cent to Rs 973.2 crore, while from a loss in the first half of last fiscal, the company posted net profits of Rs 67.1 crore this time around.
In FY-09, Firstsource had seen its revenues grow by 33 per cent over FY-08 to Rs 1,749.4 crore, while net profits fell by 77 per cent to Rs 30.7 crore.
Client ramp ups
Firstsource derives its revenues from three verticals — healthcare, telecom and media and BFSI — by providing voice and transaction processing services. From excessive dependence on BFSI two-three years ago, the company now has a fairly healthy mix of revenues generated from verticals. Healthcare accounts for 37.6 per cent of revenues, while telecom and BFSI contribute 38.1 per cent and 22.4 per cent respectively. MedAssist, the US- based revenue cycle management company in the healthcare sector, that it acquired a couple of years ago, has enabled it to tap and expand its client base.
With the healthcare reform legislation on the anvil in the US, there is expected to be an expansion of Medicaid, a healthcare programme for low-income groups that would require high enrolment services, an area which is Firstsource's key competency.
The company has witnessed a ramp up in revenues from its top five customers over the last three quarters, suggesting that volumes are starting to revive. Reinforcing this fact is the momentum in new deal wins by Firstsource such as that signed with a large telecom player in the UK and domestically with Idea Cellular.
In the UK, the highly successful iPhone, with its high-end features and value-added services, is being used as key means by players to drive realisations.
With Vodafone, a leading player there, also recently joining the race, the subscriber base is set to ramp up. With its existing presence and association with key telecom players in the UK market, Firstsource appears well set to benefit from increase in back-end work volumes.
This apart, vendor consolidation undertaken by large clients in the US and the UK has been favourable to Firstsource, giving it more business.
In its BFSI vertical, which is stabilising, there is ramp up in volumes in the key collections segment as a result of delinquencies of the US- and UK-based customers. The company has won a new client which gives it entry into the relatively safer prepaid cards segment.
The company also derives over 12 per cent of its revenues from India, a key growth market for BFSI and telecom verticals. The deal signed with Idea Cellular reiterates this point. With many new players coming into the market and looking to rollout services quickly, outsourcing of back-end work would be a strategy, resulting in opportunities that players such as Firsrsource are well-placed to tap into.
A recent IDC report states that India's domestic BPO market is set to grow at 33.3 per cent annually from $1.62 billion recorded in 2008 to revenues of $6.82 billion by 2013. This is expected to be led by BFSI, telecom, utilities, travel and hospitality segments.
Rupee appreciation against the dollar beyond the levels of Rs 45, at which the company is hedged, could pressure realisations. Although most Tier-1 IT companies have indicated that pricing pressures have abated, the situation with mid-Tier IT and BPO companies is still unclear.
Investors with high-risk appetite and long-term investment horizon should hold on to the Jaiprakash Power Ventures (JPVL, until recently named Jaiprakash Hydro Power) stock.
The merger of the group's power assets into the company may give it access to new capacity additions of about 1000 MW of hydro power in 15 months time, with further additions thereafter which could contribute immensely to the bottomline.
Despite the earnings dilution and high valuation premium being paid compared to peers, the increase in merchant power off-take from its capacity additions may more than compensate for the dilution beyond the next fiscal — FY-12. The benefits of the amalgamation may, however, accrue over the long term and carry challenges such as timely execution and adequate funding.
The recently renamed Jaiprakash Power Ventures has been created through the merger of the former Jaiprakash Power Ventures with Jaiprakash Hydro Power in the swap ratio of 1:3 (three shares of Jaiprakash Hydro for one of JPVL). The record date is set on January 04, 2010. As a precursor to this merger, Jaiprakash Hydro Power has already been renamed Jaiprakash Power Ventures.
The stock already appears to have factored in the near-term impact of the merger. The current market price of Rs 74.25, for Jaiprakash Power Ventures discounts its estimated FY-10 earnings by 65 times; but that works out to 16.5 times its estimated FY-12 earnings. This earnings/share also assumes dilution for the Rs 1500 crore of capital raising which is expected to be done over next few months.
JPVL (Jaiprakash Hyrdo) currently operates only a 300 MW run-of-the-river Baspa-II project in Himachal Pradesh . The merger of the former JPVL would mean that its total hydro generation capacity would reach 700 MW, post-merger. The merged entity would also have 12,770 MW of capacity added over the next nine years.
The merging company has a huge portfolio of power projects in the pipeline with good mix of hydro and thermal projects. High gestation period for the hydro projects under development may put pressure on the return on equity (ROE) of the company over the next few years, limiting the benefits from merchant power ROE (greater then 40 per cent).
The company will also benefit from CDM and certified emissions reductions on its hydro projects as well as due to the adoption of super-critical technologies for the thermal projects.
At the given swap ratio, the merging company's business has been valued at Rs 7.7 crore/MW (based on Mcap/MW for the projects which attained financial closure), expensive compared to the likes of NHPC and Tata Power (trading at Rs 4 crore/MW).
However, the valuation may be justified as the company may realise higher returns from merchant power sale for the company. The ROE for the merchant power will be higher and, during the initial years, this would compensate for the regulated ROEs of the long-term power purchase agreement. This would also allow the company to plough back higher profits into future projects.
As there are too many players in the power sector, we expect only the early movers in merchant power to take advantage of the power deficit scenario in the country. In this context, JPVL with a high proportion of hydro projects (which carry no fuel risks) may be able to capitalise well on the merchant power opportunity and could sell around 40 per cent of it as merchant power.
On the thermal facilities, too the company has managed to get captive coal mines for the Nigrie thermal project.
However, the other thermal projects are yet to get fuel linkages, which poses a significant risk. According to a CEA document, coal linkages of Bina TPP, which is expected to be commissioned by FY-12, is under consideration.
JPVL's earlier plans to come up with an IPO in 2008 were stalled due to weak equity market conditions. Though this merger may add scale, the funding of the power projects remains an area of concern.
The company now has plans to come up with a scaled-down Rs 1,500 crore follow-on offer or a private placement to take care of the future funding needs. As the projects are staggered over next nine years the company may not find it hard to fund equity of other projects with internal accruals.
The near-term funding for Nigrie thermal power project and Karcham Wangtoo hydro project is secured by discounting Rs 2,750 crore of future receivables and internal accruals.
The securitised receivables will be for a tenure of 14 years and may reduce the revenue base in the first two years. Once the new capacity additions kick in, the steep increase in revenue base may reduce the impact of this outgo.
The earnings of Jaiprakash Hydro were volatile in the last few years. As the company now operates only a 300 MW plant, the net revenues would depend on the output generated from the power projects and the pre-determined tariff which will moderate over the years. Over the next two years, investors in the merged entity have to budget, not only for limited earnings due to the regulated tariffs on current projects, but also for possible downside given that further securitization of revenues may put pressure on the topline.
However, beyond FY-12 with more than 1,500 MW coming up, the bottomline may see a sharp spike. By October, 2011 Karcham Wangtoo hydro project (55 per cent stake) and Bina Phase-I thermal power plants are the projects that may come on stream.
Jaiprakash Associates' expertise in EPC and BOP contracts in hydro project would reduce the execution risk to some extent. The company, in joint-venture with Power Grid, has also forayed into transmission. The key risks that apply to hydro-projects pertaining to natural disasters are relevant here. Rivers over which the company has projects are perennial and inconsistent water flow may lead to temporary plant disruptions.
According to the new hydro policy, if the projects get delayed, the proportion of power that can be sold through the merchant route will fall.
Shareholders with a long-term perspective can remain invested in the stock of Container Corporation of India (Concor) which, by far, is the most dominant multi-modal logistics player in the country.
Improving trends in container volumes helped by the recovery in Exim and domestic demand at a macro level, and Concor's superior rail infrastructure network, hinterland connectivity, deep pockets and established rapport with its clientele at the company-specific level, underscore our recommendation.
At the current market price of Rs 1,270, the stock trades at about 17 times its likely FY-11 per share earnings.
While this is a tad expensive, what also underscores our ‘hold' recommendation is the uncertainty over what market share gains would accrue to the many players, including Concor, in the container rail business, especially after the financial fortification of some of its competitors.
Note that to a great extent the premium valuation enjoyed by Concor during the slowdown (and before that) was due to the lack of financial muscle among its competitors.
Given the direct relationship between the capex incurred and likely revenues in the container rail business, the lack of financial strength among its competitors indirectly helped Concor's business model. That has now changed with some players getting access to private equity.
Braving the slowdown
When most other players were grappling with the economic slowdown, cutting down on their capex plans or shelling out significant interest outgo to meet funding requirements, Container Corporation, helped by the sheer size of its operations, zero-debt status and depreciated asset base, managed to fare fairly well; it did have its share of misfortunes though.
Falling revenues from the high-margin Exim segment and running of empties had suppressed the company's growth momentum, leading to lower revenues and profits.
From an over-20 per cent revenue growth levels in the three years to 2007, Concor's revenue growth fell to as low as 2 per cent last fiscal.
But what's commendable is that this did not prevent Concor from using the opportunity to add to its wagon fleet, improve its terminal infrastructure or even buy handling equipment. For instance, in FY-09 alone, the company added 1, 395 high speed wagons to its existing fleet of owned wagons; increasing its holding of high speed wagons to 8117.
What's also unique to Concor is the significantly lower fixed cost (about 10 per cent of total expenses) structure it enjoys.
This appears to have afforded it better control over its margins during the difficult years.
While operating profit margins did contract during the slowdown (it went down from over 29.1 per cent in FY-07 to 27.2 per cent in FY-09), the extent of contraction would have been higher but for its many cost-management initiatives.
The tight leash on costs plus lack of any interest liability (zero debt on its books) and a largely depreciated asset pool seem to put in their bit in helping the company sustain its net profit margins (at about 23 per cent) over the two-year time period.
After having roughed it out during the economic slowdown, the recent uptick in trade volumes portend better days for the company. Container volumes in November grew 21 per cent over the corresponding period last year and 7 per cent over the previous month.
The growth also appears to have been broad-based with volumes across major ports showing positive growth signs, albeit on the low base seen last year.
But the reversal in trade volumes would benefit Concor as also its competitors. It is in this context that the extent of gains that the company can extract for itself remains to be seen.
Though there's no doubt that the balance is weighed in favour of Concor given its strong infrastructure, strategic alliances, end-to-end logistics solutions as well as the yet to be proved execution capabilities of some of its competitors may also keep a lid on its overall realisations. The company may even have to resort to aggressive pricing to keep its competitors at bay.
The onus of driving growth, therefore, may depend on the container volumes that it would be able to attract.
Here again, if the mix of domestic and Exim business continues to be tilted towards the low-margin domestic business, the company's overall margins may get pressured.
The company's performance over the next couple of quarters, therefore, may bear a close watch.
Mid-cap indices out-performed, but not all mid-cap stocks did. The losers' list had a clear sector theme, but the winners' didn't. Value investing delivered more than growth investing. These were some of the trends that emerged this year, as the stock market did a complete volte-face to push up benchmark indices such as the Sensex and the Nifty by over 60 per cent in 2009.
To sign off for the year, we took a look at a simple theme — stock price returns (for the BSE-500) from January 1 to December 18 (the cut-off date) and the trends they throw up.
Gainers: No sector bias
Among the stocks that make up the BSE-500, nearly half doubled from January 1 till now. A good 13 per cent of them gained more than 200 per cent, while 57 per cent outpaced the BSE-500. Indeed, the top gainer, Ahluwalia Contracts, zoomed six-fold, while Aurobindo Pharma and McLeod Russell shot up about 400 per cent. There was a clear lack of sector bias in the top ten performers, with sectors ranging from construction and pharmaceuticals to finance and tea making it to the top.
The top twenty performers, though, saw a number of IT stocks — surprising in a year when the sector remained on tenterhooks about the fate of global IT spending. Other oft-repeated sectors include steel and automobiles.
Only one in 20 stocks now trades at prices below the levels at the start of the year. For instance, Cranes Software dropped 57 per cent, while REI Agro is floundering 38 per cent below its January price. Stocks that underperformed did show a sector bias with a predilection to telecom and retail. About one in five stocks that make up the bottom 20 of the universe operates in the telecom space.
Sector winners and losers
If you were looking to pick an out-performer in January this year, you would have maximised your chances by selecting automobile, steel, sugar or metals.
Nine out of ten automobile stocks in the BSE-500 beat the index returns and these also, at the least, doubled during the year. Steel has similarly out-performed — nine in ten stocks bettered the broader market. Other sectors with glowing performances are metals and minerals and sugar, with all stocks in these sectors at least doubling their prices.
Healthy returns, even if not at the levels recorded by automobile or steel companies, were notched up by sectors such as cement and IT, where seven of every 10 stocks beat the broader market. Banking, pharma and finance stocks were middle-of-roaders, with just half the companies delivering returns above broad market.
Investing in telecom, refineries and retail stocks increased your chances of picking a lemon, with all three sectors throwing up just a single outperformer.
Mid-cap indices outperformed
As is the case with every bull market, mid and small-cap indices raced ahead of the Sensex or Nifty this year. But as an investor, you would have had a tough time matching up to this performance.
Less than half the stocks in the mid-cap space and only 65 per cent of those in the small-cap space beat the larger indices. Investors thus had to be choosy when it came to selecting stocks, even within the wider mid-cap and small-cap areas. Indeed, a higher number of small-caps stocks declined during the year compared to both large- and mid-caps.
Small-caps in the BSE-500 averaged a 104 per cent return. This, however, is lower than the 107 per cent returned by the BSE small-cap universe. Similarly, while the mid-cap set in the BSE-500 clocked a 93 per cent average gain, the BSE Midcap index was a step ahead, with a 95 per cent gain.
With investors just recovering from the carnage of 2008, it is no surprise that they paid close attention to PEs while picking stocks. 2009 was a year in which value investing outdid growth investing.
Stocks that traded at PEs of less than 15 times in January galloped to average a 119 per cent return. Almost seven in ten stocks in this group registered returns superior to the broader market's.
In contrast, stocks priced between 15 and 20 times earnings averaged a 70 per cent return, a figure better than the stocks at higher, plus-20 times valuations. Strangely enough, with average returns of 78 per cent, stocks of companies that sustained losses, rendering computation of their PE impossible, did better than those valued above 15 times.
With low PE stocks getting re-rated, their valuations have shot up, rendering them quite expensive in view of their fundamentals.
For instance, Brigade Enterprises was at a PE of 7.4 times in January, moving to about 55 times by the end of the year. Delivering on such high valuations may thus pose a challenge from here on.
Retail investors have often identified penny stocks that transformed into multi-baggers. But, going by the performance of the NSE-listed stocks, this year you would have been better off sticking to stocks with higher absolute prices.
While just about half the stocks with prices of less than Rs 10 did overtake returns of the CNX-500 from January 1 to now, with average returns at 85 per cent, those priced higher turned in a better showing. Stocks priced above Rs 50 averaged 92 per cent in returns, and had six in every ten stocks beating broad market gains.