Sunday, February 28, 2010
Investors with at least a two-three year perspective can consider buying the stock of Elgi Equipments, a manufacturer of air compressors and automobile service station equipment.
Revival in capex in the domestic market, manufacturing /trading presence in high potential developing markets such as China and Brazil and a strong cash position that allows scouting for acquisitions in new markets are factors that favour earnings growth for the company over the medium term.
At the current market price of Rs 80, Elgi's stock trades at 8.5 times its per share earnings for FY-11.
The stock is currently at a steep discount to its bigger peer Ingersoll-Rand; the latter not yet fully out of the slowdown.
We do not expect any significant ramp-up in revenues in the next few quarters, owing to peaking of demand (according to the management) for air compressors used for water wells and the continuing sluggishness in overseas market.
However, given that the industrial business segment has also been contributing actively to revenues and emerging markets such as Brazil and China are likely to buttress sales growth over the long term, Elgi may have to be a buy and hold candidate in one's portfolio.
The stock, at this point, could be a dark horse play; investors can consider buying it in small lots and accumulate on declines linked to broad markets.
Elgi is the market leader in air compressors (over 10 per cent) as well as automobile service station equipment and is also among the larger players in Asia.
Elgi has a very wide customer base, given the diverse application of its products in sectors such as mining, transport, power, railways, oil, textiles, shipbuilding, plastics and electronics, to name a few. It also has all major automobile manufacturers as its customers.
The extent of diversification has allowed Elgi to keep up growth momentum. Even as the capex slowdown hurt capital goods companies in FY-09 resulting in decline in sales/profits, Elgi managed to grow revenues, albeit marginally even as profits remained flat.
However, strong focus on global markets resulted in a slow recovery for the company in the current fiscal. The December quarter results though, have shown the first signs of a revival with all its segments reporting growth. Revenues for this period expanded by 30 per cent, even as profits jumped 70 per cent over a year ago, thanks to a low base and lower raw material costs. Interestingly competitors such as Ingersoll-Rand and Kirloskar Pneumatic are yet to demonstrate similar decisive revival signs. However, not all is well , since the company has admitted that its demand for air compressors in the water wells segment has peaked out, which effectively means that there could be some dent in revenues.
However, pick-up in auto equipment as dealers ramp up their capex, on improved auto sales could make up for the dip in the water wells compressor demand.
Besides, Elgi has utilised the slowdown period to test grounds and ramp up presence in the Brazilian and Chinese markets. In Brazil, where the company's products have for long had takers, the company has set up a wholly-owned subsidiary as a trading unit.
In China, it owns a manufacturing unit and also has trading presence; the company though, may take a longer time to ramp up demand in this market, as it has to compete with local players. Nevertheless, the scope of application for Elgi's products in China, given the latter's massive manufacturing activity, combined with superior technology, is tremendous. This market could, however, take a couple of years, before it contributes significantly to the bottom line, even as revenue flow may kick in early. Elgi products' application in the oil sector has also given it a market in West Asia.
The company has a presence in UAE. This market too, in the near term is likely to remain sluggish. Elgi is in the process of acquiring a European company, which makes compressors. This move too is intended to expand geographically rather than acquire new products, as Elgi's product range, thanks to its joint ventures with many overseas players, is fairly comprehensive.
We suspect this acquisition could come at attractive valuations, given the slowdown in the region. The company has stated that it will not go for any fresh debt, suggesting that internal accruals should meet the acquisition cost. Elgi has traditionally been a debt-free company has also has a lucrative investment book.
Elgi' sales grew at 20 per cent compounded annually (to Rs 595 crore in FY-09) over the last three years, while profits expanded by 25 per cent over this period. Operating profit margins, though healthy at 12 per cent levels, could come under pressure as a result of hike in cost of steel and copper.
While any excise duty hikes in its end product is unlikely to impact margins (as its products, mostly used as inputs by clients for their business enjoy cenvat credit), as they are passed on, whether its own raw material cost hikes will hurt margins, remains to be seen.
Shareholders with a long-term perspective can retain their holdings in Mahindra Holidays & Resorts, the leading vacation ownership provider in the country. With a business model highly dependent on the domestic consumption story, the slow uptick in the economy suggests improving prospects for the company. A strong brand equity, multiple sales channel and unique revenue model further fortify its investment appeal.
However, at the current market price of Rs 434, the stock appears fully priced, trading at about 30 times its likely FY-11 per share earnings. While not having any strict comparables and being the market leader do lend room for premium valuations, it appears fairly valued at the current price. Near-term upsides, therefore, may be limited.
In the business of vacation ownership, Mahindra Holidays' revenue model entails an upfront payment of the ownership fee with a recurring annual maintenance fee component thereafter.
This provides for higher visibility and a more stable stream of revenues compared to that of pure hospitality players. And unlike the asset-heavy hotel industry, the company does not operate on a capital-intensive business model. It adds to its assets only against the payment received on member additions. As a result, it enjoys strong cash flows and has near-zero debt on its books.
Mahindra Holidays, however, sells a significant majority of its memberships through financing schemes (monthly instalment options) and even securitises a portion of its receivables. While financing the vacation ownerships helps add to its member count, it also complements the revenue stream by way of interest income.
The risk of default is low here considering the overall profile of its member base — consisting of mostly employed professionals who are reasonably sound financially. And since MHRIL continues to hold the assets, the impact of defaults, if any, would only be negligible.
Besides, that it has so far managed to operate with near negligible rates of default lends confidence. That said, it still remains to be seen how the company would manage member additions in an increasing interest rate regime.
High interest rates tend to curb discretionary spending by consumers and so can pose a threat to member additions. This is especially relevant in the case of MHRIL since its business operates on the difference between the interests its pays to banks and the interest rate in-built into the EMI schedule of its members.
Growing membership enrolments — which is the key driver for future growth — at historical growth rates may, therefore, not be as easy (34 per cent compounded rate over the last four years).
Even though the company has a diverse source of income, its key contribution still comes from member additions only. Of the total membership fee charged, the company books nearly 60 per cent of that in the same year, while the rest is spread over the life of the membership (typically 25 years for the flagship Club Mahindra product) as entitlement fees (annuity income). It also charges an annual subscription fees over the life of the membership.
Over the last four years, Mahindra Holidays has grown its revenues and profits at a compounded annual growth rate of about 40 per cent and 76 per cent, respectively. In the same period, both its operating and profit margins have expanded significantly to about 34 per cent and 18 per cent, respectively.
For the nine-months ended December 2009, the company managed to grow its revenues by about 18 per cent. Profits surpassed last fiscal's full year earnings helped by a slew of cost-control measures, which helped expand the operating margins by about 4 percentage points to 38 per cent.
The company, however, is required to spend considerably towards sales and marketing exercises (its largest cost component), as member additions hold the key to its growth.
While bringing down the sales and marketing expenses last quarter helped it better its operational performance, it may pose a threat to member additions if the cost component is brought down drastically. This cost component therefore may have to be monitored vis-à-vis member additions in the coming quarters.
But to its credit, MHRIL enjoys a fairly strong brand loyalty; over 35 per cent of the vacation ownerships sold in 2009 came through member referrals.
Health check since IPO
The company had raised roughly Rs 177 crore through its public issue in June last year for funding the proposed addition to its room inventory (capex to extend up to FY11).
As against 1,105 rooms in FY-09, the company had, as of December 2009, created an inventory of 1,403 rooms.
Member additions in the nine months from FY-09, however, have been lower than its yearly average, growing by about 17 per cent; it now has 109110 members as against 92,825 vacation owners in FY-09.
The member per room ratio too has improved, decreasing from 84 in FY-09 to 78 members per room now. And with average occupancies hovering around 75 per cent, the proposed addition to room inventory will further help the spread. It plans to expand its property in Coorg, Ooty and Ashtamudi and set up of new ones in Tungi and Theog.
One of the turnaround stories in the banking industry, IndusInd Bank continues to be a good investment opportunity for investors with a penchant for risk. We expect the return on equity (ROE) of the bank to improve from 10 per cent in 2008-09 to 17.5 per cent this fiscal, helped by improved net interest margins, better credit growth and operating efficiencies. ROEs even in the current year would have been better but for the equity dilution.
The bank's operating parameters have improved sharply over the past two years with a new management taking over. Consider this. IndusInd Bank's credit-deposit ratio has improved from 67 per cent to 77 per cent in the 21 months since the new management took over. This has aided improvement in the net interest margin to 2.94 per cent for the quarter ended December 31, 2009 from 1.37 per cent in the March quarter of 2008. The cost-income ratio too improved from 67 per cent in March 2008 to 50 per cent in December 2009, even as the net NPA ratio fell from 2.27 per cent to 0.67 per cent during the same time. However, the bank has still a long way to go before it can be comparable with the best in the industry.
While the bank consistently managed more than 90 per cent net profit growth over the last four quarters, this rate of growth may moderate, going forward. An increasing base and treasury losses from hardening interest rates may temper profit growth compared with historical rates.
At the current market price of Rs 149, the stock trades at a price-to-estimated FY11 earnings multiple of 13 and at a price-to-FY11 adjusted book value of 2.6 times. This is at a discount to Yes Bank, Kotak Mahindra Bank and HDFC Bank. High earnings growth may provide justification for this valuation.
IndusInd Bank raised Rs 480 core through a QIP issue this fiscal thereby witnessing a 15 per cent equity dilution, giving the bank much needed capital to fund high rate of loan growth.
The capital adequacy of the bank improved to 14.91 per cent in September 30, 2009 from 13.14 per cent on June 30, 2009. The capital adequacy ratio of the bank stood at 13.84 per cent at December 2009. Given the current levels, capital adequacy could be maintained above 12 per cent even if the bank's loan book grows by 30 per cent over the next one year, with the aid of internal accruals. IndusInd Bank also has significant headroom in terms of Tier-II capital raising to support loan book growth. However, the cost of Tier-II capital is expensive. Further equity dilution in 2011-12 cannot be ruled out.
The loan book of the bank grew by 15 per cent compounded annually during the period 2004-09 and 32 per cent as of December 31, 2009. However, the loan book growth over the period 2009-11 may improve to 30 per cent annually, helped by better credit offtake, its commercial vehicle portfolio and retail lending. Around 32 per cent of IndusInd Bank's loans are auto loans with commercial vehicles forming a significant proportion. However, the proportion of these loans has come down from 44 per cent at the end of March 2009. However, with the revival in the auto industry, these loans, coupled with retail loans that have better yields, may form a significant portion of the loan book thereby helping the bank maintain its margins.
For the first nine months of the current fiscal (2009-10), the net profit of the bank grew by 158 per cent. Improving margins due to improving credit-deposit ratio, high rate of loan book growth (32 per cent as of December 31, 2009) and re-pricing of the advances led to high levels of profit growth. Helped by branch expansion, the proportion of low cost deposits has also improved to 22.5 per cent from 15 per cent as of March 31, 2008, also reducing the cost of deposits.
With the bank starting to meet most of its priority sector lending targets, it may not be required to invest in low-yielding bonds, which further help improve the margins. NIMs can be maintained at current levels even as the rates rise if the bank manages to improve its CASA and re-prices its loans. The lower proportion of treasury income compared with its peers would also help it survive rising interest rates efficiently. Fee income continues to support profit growth. The ‘other income' component to total net revenues stood at 40 per cent for the nine months of this fiscal.
Asset quality improved
Sequentially, even over the last quarter, the bank improved its provision coverage ratio from 35 per cent to 50 per cent. The bank is positive on improving its provision coverage to 70 per cent by the mandated period. Lower NPAs coupled with high provisions would improve the coverage and also shield the bank against any credit losses going forward. IndusInd Bank's restructured assets are one of the lowest in the banking industry with only 0.36 per cent of the total advances book restructured. While a high proportion of the current NPA is from the two-wheeler and the cars industry; this may fall as the revival in economy improves the credit worthiness of these borrowers.
Around 52 per cent of the loans in the book are fixed, which may expose it to interest rate risk. The impact of the base rate implementation could be a bit higher for the bank due to a higher cost of funds and moderate profitability margins.
Investors with a long-term perspective can consider accumulating the stock of Piramal Healthcare. A strong presence in the domestic pharmaceutical market, established relationships with several global pharma majors, and its firming hold over the high-margin inhalation anaesthetics space underscore our recommendation.
While the restrained growth in CRAMS (Contract Research and Manufacturing Services) business so far this year could mar the company's overall growth picture, signs of restocking by global pharma majors suggest that a revival may be in the offing. With innovator companies under increasing pressure to manage costs, the low-cost, high-quality offering of domestic CRAMS companies may not be easy to ignore.
Valuations too appear reasonable. At current market price of Rs 397, the stock discounts its estimated FY11 per share earning by about 15 times. Piramal's increasing domestic market presence offers it a considerable long-term growth potential. The company has been improving its market share going by its better-than-market growth in six out of the seven last quarters. While growing competition, with MNCs too entering the fray, could throw up challenges, Piramal's large field force and growing focus on tier-II and semi-urban cities will provide it an edge. New product launches (26 so far this year) and focus on lifestyle products could further complement growth.
For CRAMS, the consolidation in the global pharma landscape, in addition to restructuring of manufacturing operations at Piramal's end, appear to have cast a cloud on the segment's near-term prospects. For the nine months ended December 2009, the CRAMS business shrank by about 12 per cent. In that too, while the business from overseas was impacted significantly due to the closure of its Huddersfield plant (which has been moved to India), the India operations managed a growth of 27 per cent. The management expects the segment to get back on the growth track by next year; its strong relationship with other MNC clients, as also the long-term contract with Pfizer giving it a fillip. The other business segment that offers a significant growth potential is the global critical-care segment. Piramal now has the intellectual property to manufacture inhalation anaesthetics across the pyramid, thanks to its last year's acquisition of the US-based Minrad International. The inhalation anaesthetics present an addressable market of about $435 million in the US.