Engineers India

Engineers India

Weekly Watch - March 28 2010

Weekly Watch - March 28 2010

KSK Energy

Shareholders with a high risk appetite and long-term horizon can continue to stay invested in the KSK Energy stock. KSK Energy now develops and operates small (captive) power projects but is set to enter the big league with more than 10,000 MW of capacity additions in the pipeline.

At the current price of Rs 176.7, the stock is trading at 27 times its estimated FY11 earnings. However, valuations based on market cap per mega watt (assuming 4462 MW of power capacity) are reasonable and work out to Rs 1.4 crore/ MW compared with peer valuations of more than Rs 3 crore/ MW. The company attaining financial closure for the 3600 MW of upcoming capacity would be a key trigger to the stock. KSK Energy's earnings may expand over the next couple of years on new capacity, however it is the execution of the bigger projects that will hold the key to appreciation in the stock price.

The company, which hasn't seen significant capacity addition since its mid-2008 IPO owing to delays , is expected to witness five times' jump in its capacity by this time next year.

The current operating capacity of 144 MW is expected to go up to 862 MW in a year's time, as projects such as VS Lignite (with capacity of 135 MW), Wardha Warora (540 MW) and Arasmeta expansion (43 MW) come on stream. However, the manifold increase in top-line growth may not get translated into equivalent growth in profits owing to higher interest costs and depreciation likely for the larger capacity addition programmes in the pipeline.

In addition to the above 862 MW of capacity, projects with 10,000 MW of capacity are in various stages of planning and development and are expected to start delivering benefits to the company only beyond FY12.

The company plans to commission 1,075 MW of hydro power projects with 945 MW in planning stages. Operations of the existing plants have been encouraging with weighted average PLF of 76 per cent for the year 2008-09.

Fuel agreements tied up

The company has tied up fuel requirements for most of the projects that are under development. The company has secured coal linkages from Coal India and tied up with state mining development corporations that own captive blocks and lignite mines.

This may result in lower fuel costs when compared with peers who rely on imported coal. Domestic fuel linkages put the company in a better position to earn higher returns from surplus power. The company's model of selling equity stakes in its projects to users provides assurance on off-take, even while retaining economic interest with the parent company.

The company has signed off-take agreements for most of its projects for the medium to long-term with majority of customers being private industries . KSK Energy is selling power from VS Lignite and Wardha Warora at an average tariff of about Rs 2.85/unit. In case of offtake from GMDC (at least 1,010 MW) for the Wardha Chattisgarh (3,600 MW) project the tariff is at Rs 1.9/unit; this unit, however, enjoys low cost fuel supply from its captive mines.

Initially, KSK Energy plans to sell 38 per cent of the total power generated through short-term power purchase agreements (tied up with Maharashtra and Rajasthan SEBs) and as merchant power. As users ramp up capacity, this will later be sold at fixed tariffs to industrial customers.

Even as the delays in the expansion projects of some of its users have given it a longer window to realise higher tariffs, KSK's own project delays have reduced the opportunity to take advantage of these tariffs.

Concerns

As the size of the projects increases, the financing requirements for these projects are getting bigger, requiring it to infuse fresh equity from time-to-time.

In its IPO, the company raised around Rs 1,200 crore (including the pre-IPO placement). Since then, the company has also raised Rs 515 crore through QIPs in the current fiscal. These funds, including internal accruals, may be enough to fund the equity contribution for the 3,600 MW Chhattisgarh power project .

Equity contribution required for the projects in the planning stage would be more than Rs 7,000 crore and getting access to these funds would require that the 3,600 MW Chattisgarh project is fully operational by FY13. The debt-equity ratio on a consolidated basis stood at 1.54 times as of June 30 2009, and is expected to go up significantly. The company also has majority of its debt in the form of floating rate loans which exposes it to interest rate risk. KSK Energy is relying on Chinese equipment for its projects which may expose the company to operational risk, as there have been reports of incompatibility with domestic coal.

Lumax Industries

Lumax Industries, maker of automotive lighting systems, is a beneficiary of the 30 per cent growth in automobile production so far this fiscal. Investors with a two-year perspective can consider buying this stock at Rs 173. The price now discounts its trailing four-quarter earnings by 21 times.

This valuation may seem expensive for an auto-component maker. However, earnings for this 12-month period were weighed down by a loss of Rs 1.83 crore in March 2009 quarter. Moreover, a 60 per cent market share in the automotive lighting segment and broad-based customer profile have resulted in high valuations for this stock.

Investors need to set moderate return targets (between 12-15 per cent), due to the sharp run up in prices.

Lighting solutions

Lumax Industries is one of the oldest players in the organised automotive lighting solutions space and accounts for a 60 per cent market share in this segment. It has a two-decade long technical and financial collaboration with Stanley Electric Company, Japan, a world leader in lighting and illumination products for automobiles. Stanley Electric holds a 41 per cent equity stake in Lumax Industries.

Lumax Industries makes head lamps, tail lamps, stop lamps, turn indicators, lighting equipment and rear-view mirrors for passenger vehicles, trucks buses, and two-wheelers, with over 54 per of its sales coming from the head-lamp assembly units. In the passenger vehicle segment, its main customers are Maruti Suzuki, Tata Motors, Mahindra & Mahindra and Honda Siel.

The company also supplies to Hyundai India, GM India, Toyota Kirloskar Motors, Fiat India Automobiles and Skoda Auto India. Similarly in the commercial vehicle space Tata Motors, Mahindra and Mahindra and Ashok Leyland which accounts for 87 per cent of the total market share in that segment are its main customers. Hero Honda, Honda Motorcycle and Scooter, Bajaj Auto and India Yamaha Motors are its clients in the two-wheeler segment.

OEM presence

High exposure to market leaders such as Tata Motors, Maruti Suzuki and Hero Honda is yet another plus point for the company, as these companies account for a sizeable chunk of Lumax Industries' sales. Many global auto makers such as GM, Skoda, Nissan, Mercedes-Benz and Volkswagen are ramping up their Indian operations and this is another positive factor for Lumax Industries.

Sales to Indian auto companies account for over 95 per cent of the company's total sales. Over 80 per cent of sales come from the OEMs. Unlike tyres and batteries, lighting equipment don't enjoy high replacement demand.

Also, the replacement market in the lighting solutions space is dominated by the unorganised players who offer cheaper products when compared to Lumax Industries. Due to negligible exposure to replacement market, the company has seen a relatively slow paced growth in sales till the December quarter.

OEMs concentrating on exhausting the present inventory levels of components before placing fresh orders with vendors could be another reason for the year-to-date sales growth of 17 per cent.

Host of new models being ushered into the market and aggressive expansion plans undertaken by auto companies to keep pace with demand, could soon ease this situation and Lumax Industries may once again on the 25-30 per cent sales growth track.

Head lamps, tail lamps and other lighting fittings play a major role in enhancing the aesthetic appeal of today's new-generation cars and bikes. With companies focussing more on these features, Lumax Industries has the potential to improve its operating margins by selling more high-value products. Increasing focus on LED-based technology will also hold potential for the company. It now operates on moderate 7 per cent operating profit margins.

To keep costs low and maximise resource utilisation, Lumax Industries has seven manufacturing facilities spread over Haryana, Maharashtra, Uttarakhand and Uttar Pradesh.

Financial scorecard

For three years till FY-08, Lumax Industries registered 24 per cent and 30 per cent CAGR growth in sales and net profits. The numbers hit a speed breaker in FY-09, when sales remained flat and the company posted a net loss of Rs 1.62 crore. Though financial stability set in by the first quarter of the current fiscal, recovery in profitability has been relatively slow when compared to tyre, battery or forging companies.

This can be attributed to the company's reliance on OEM supplies which are slower to recover from a slump. For nine months ended December 2009, Lumax Industries has recorded Rs 457.97 crore of sales (up by 17 per cent year-on-year), while net profits have expanded from Rs 0.22 crore to Rs 7.42 crore in this period.

Raw materials, mainly plastic powder, electric bulbs and motors account for over 60 per cent of total costs. Unlike other auto-component makers, Lumax Industries may not witness cost pressures in near future, given that prices of these input materials are likely to hold steady. Therefore, improved sales volumes may translate into quicker margin expansion. Given Lumax Industries' market leadership and the robust demand for automobiles, this should not be a challenge.

Petronet LNG

Petronet is a key player in the fast growing natural gas market of India and has had a decent run over the past few years.

The company is engaged in the import of liquefied natural gas (LNG) from RasGas of Qatar, which is regassified at its 11.5 million tonnes per annum (mtpa) terminal in Dahej, Gujarat. A second terminal is under construction at Kochi.

Natural gas demand is running far ahead of supply and there is tremendous scope for an established player such as Petronet to cash in on this. Yet, there are some key issues that continue to dog the industry such as the uniform gas-pricing policy which the government is studying now. The rising supply of gas from domestic sources, especially from the Krishna-Godavari (KG) Basin, at a competitive price is a critical factor that could slow down the growth of Petronet.

At its current market price of Rs 78.05, the stock discounts its trailing 12-month earnings by around 11.4 times. Shareholders can stay invested while keeping a close watch on the developing market and regulatory environment.

Well-positioned

The government is promoting natural gas as the preferred fuel due to the new domestic discoveries of gas reserves, the relatively cheaper price compared to oil and its environment-friendliness. The sector is expected to witness rapid growth in the coming years and demand is expected to exceed increased domestic supplies. The gas deficit situation bodes well for LNG importers such as Petronet which are almost assured of a ready market, provided the pricing is favourable.

The back-to-back long-term (typically 20 to 25 years) purchase and sales arrangements entered into by Petronet provide some comfort on revenues and earnings.

While long-term contracts comprise the bulk of its business, Petronet also supplies gas on a spot basis on which it enjoys marketing margin in addition to re-gasification margin. The re-gasification charge on long-term contracts is subject to a 5 per cent escalation annually.

The expansion of the Dahej facility from five mtpa to 6.5 mtpa through de-bottlenecking in 2007 and recently to 11.5 mtpa in June 2009 through capacity expansion may help Petronet increase volumes. The company has tied up additional supplies from RasGas for 2.5 mtpa from January 2010, in addition to the existing supplies of 5 mtpa.

Thus, supply linkage for 7.5 mtpa out of the 11.5 mtpa capacity has been tied up. The company has recently acquired a third LNG shipping vessel “Aseem” to transport additional LNG from Qatar to Dahej. Petronet has also tied up supplies of 1.5 mtpa LNG from the proposed Gorgon project in Australia for its 2.5 mtpa LNG terminal in Kochi, which is expected to be operational in 2013.

Besides, the company is also developing a solid cargo port at Dahej, and power plants near the Dahej and Kochi terminals.

Financial metrics

Petronet's annual growth from 2005 to 2009, both on the topline (around 45 per cent to Rs 8,428 crore) and bottomline (from losses to Rs 520 crore) has been impressive. This has been driven by increase in volumes (spot cargoes in addition to long-term contracts) and improvement in price realisation. Growth though, has been decelerating over the years due to base effect.

The company disappointed in the third quarter with sales and profits declining 9 per cent and 21 per cent respectively over previous year, primarily due to expiry of the Ratnagiri Gas Power Plant contract, and also due to significantly higher depreciation and interest cost incurred on expansion of the Dahej terminal.

However, growth could be back on track with higher spot cargo volumes, and additional supplies (2.5 mtpa) from RasGas being tied up in the current quarter.

Petronet's single-digit net margins (around 6-7 per cent) till 2009 declined this fiscal to less than 4 per cent, mainly due to increased depreciation and interest charges. Return on equity was healthy (above 25 per cent) till 2009. Margins are expected to be under pressure, going forward, given the effects of the increased capex.

Headwinds

Tying up additional LNG supplies at competitive rates to meet potential increased demand remains a key challenge. As against the increased nameplate capacity of 11.5 mtpa at the Dahej terminal, Petronet has tied-up sourcing of about 7.5 mtpa, leaving a deficit of about 4 mtpa (almost 35 per cent of capacity).

While the recent offer by Qatar to supply an additional 4 mtpa over the next few years could help tide this deficit, pricing remains a contentious issue.

Reports suggest that the asking price by Qatar for the new supplies (upwards of $10 per mmbtu) is quite steep compared with the pricing of existing LNG supplies (around $7 per mmbtu) and, more importantly, above $4.2 per mmbtu fixed by the government for Reliance's KG gas. Even at current levels, LNG is significantly more expensive than gas produced domestically.

Sourcing at higher prices could further aggravate the situation and reduce competitiveness. Also, supplies for only 1.5 mtpa of the proposed 2.5 mtpa LNG terminal at Kochi has been tied up, pricing details for which have not been disclosed. Idle capacities built at huge cost, could prove to be a drain on the company.

While the government has announced its intent to bring about a unified gas pricing policy, till such time this takes shape, LNG is expected to remain costlier than gas produced domestically.

This could lead to pricing pressures and reduction in margins, going forward. Commencement of production from the KG Basin discoveries of ONGC and GSPC could further skew the picture.

Regulatory intervention by the downstream regulator (though unlikely in the near term) to moderate re-gasification margins and returns on equity, and execution delays at the proposed Kochi terminal pose additional risks.

Welspun Gujarat Stahl

Investors can consider buying shares in steel pipe maker, Welspun Gujarat Stahl. The price of Rs 277 gives the company a price earnings of 11.3 times the trailing four quarter earnings.

An integrated business model, improving margins and product mix and impending domestic and global demand make this business attractive. The above considerations may justify the premium over sector peers such as MAN Industries, PSL and Jindal SAW, which trade at seven times, eight times and 10.6 times respectively.

Over 80 per cent of the company's sales are accounted for by exports to markets such as the US and Canada. Sales and net profits have grown at a compounded rate of 54 per cent and 58 per cent between FY-05 and FY-09.

The first nine months of FY-10 saw sales rise by 27 per cent and operating profits by 77 per cent on the back of expanded capacity and lower raw material costs compared to the same period last year.

The company's order book stands at Rs 7,800 crore, which is just over one time the estimated FY-10 revenues. . The company's leverage as of March 31, 2009 stood at 1.4:1, which is higher than peers. However, with a good portion of the capacity expansion programme implemented, capital needs over the next few years may moderate. Interest coverage over the trailing 12 months stood at a comfortable 4.6 times (EBIT/interest costs).

The other possibly explosive driver could be government spending on water and sewage management for urban areas whose allocations are encouraging signs of things to come.

Growth drivers

Welspun produces 1.5 million tonnes of pipes at manufacturing locations in Gujarat and the US. The company produces 900,000 tonnes of helical submerged arc-welded (HSAW) pipes, 350,000 tonnes of longitudinal submerged arc-welded (LSAW) pipes and 250,000 electric resistance-welded pipes (ERW).

They are expected to add 600,000 tonnes over the next two years. Capacity utilisation figures which averaged 65 per cent through FY-09.

Simdex, which publishes upcoming pipe projects, indicates about 320,000 km of pipeline to be laid globally over the next five years.

This works out to 65 million tonnes of demand for the next five years at an approximate cost of $70 billion. Bulk of this demand will come from the US and Asia.

Welspun may have an edge by virtue of having supplied and being accredited by global oil majors, including Chevron and Aramco.

Domestic scenario

India's own natural gas plans include 7,500 km worth of gas pipeline spending over the next two years translates into 1.5 million tonnes of piping. Sewage lines and water lines will be another source of demand with both being an important part of the governments plan to improve rural life and upgrade decaying urban infrastructure. Roughly Rs 80,000 crore is expected to spent over the next five years under the Urban Renewal Scheme to improve waste management and water lines. All of the above make for a healthy demand side of the equation over the next five years.

. Welspun recently started producing its own slabs and coils which should give it tighter control over its supply chain, considering the risk a tightly supplied domestic market poses.

The biggest cost component remains steel, whose depressed prices through a large part of 2009 helped producers.

Raw material cost pressures and demand recovery are driving up steel prices this year and will result in margin pressure on pipe-makers, whose ability to pass on costs may be limited, given the abundant capacity.

Moves towards vertical integration include the recent Rs 400-crore acquisition of MSK Projects through a recently-formed subsidiary, Welspun Infratech.

The acquisition was funded through internal accruals. The intended 75 per cent stake in MSK will result in the ability to build pipes and lay them through the engineering, procurement, construction model.

This move would give the company a presence in the construction segment through MSK's Rs 500-crore order book.

Risks

A weakening dollar can result in lower realisation. This is hedged by raw material purchases from abroad and forward currency contracts.

Andhra Bank

Fresh investments can be considered in the Andhra Bank stock, as a defensive option in the banking space.

The stock's low valuation and the fact that it is relatively better placed than peers to weather credit and interest rate risks, makes it a good investment option.

In addition, strong profitability ratios, stable margins, improving operating efficiency (cost-income ratio of 40 per cent) and adequately capitalised loan book are the other positives.

As overall bank credit picks up, Andhra Bank may continue to grow at higher than industry rates. The bank's credit growth for the year ended December 31, 2009 stood at 22 per cent against 13 per cent for the entire banking system. Credit growth for scheduled commercial banks has accelerated to 16 per cent according to the latest data. As the economy revives, the bank may be in a position to pass rate hikes to its customers, there by protecting its margins.

Andhra Bank scores on two counts over its peers who are grappling with deteriorating asset quality and falling bond prices. The net NPA ratio of Andhra Bank was a low 0.17 per cent as of end-2009. With only 2 per cent excess gilt securities and a credit-deposit ratio of 77 per cent, the bank is less exposed to treasury losses from hardening interest rates.

Andhra Bank also has a high provision coverage ratio of 91 per cent; well above the RBI-mandated 70 per cent.

At current market price of Rs 100, the stock is trading at a modest valuation of 4.5 times its estimated FY10 earnings and 1.1 times its FY10 adjusted book value. The dividend yield on the stock works out to 4.5 per cent, even assuming that dividends are not increased.

Andhra Bank, a mid-sized public sector bank, is aggressively expanding its branch network which would help increase its low-cost deposit base and increase fee income. Net interest margin has steadily improved over the last few quarters aiding profit growth.

Advances growth was aided by MSME, agriculture and retail loan growth (especially gold and housing loans). High cost deposits currently getting re-priced at a lower rate would continue to aid margins over the next couple of quarters.

However, for Andhra Bank to maintain the margins of 3.35 per cent (December 2009) would be a challenge due to lower proportion of low-cost deposits (30 per cent) and higher rate of interest payable on these deposits from April 1, 2010.

The current levels of capital adequacy (14.95 per cent) along with internal accruals may be sufficient to maintain a 30 per cent asset growth in FY11. The bank also has more than Rs 4,000 crore of headroom to raise tier 1 and 2 capital, but may have to step up its core equity contribution beyond next year.