Sunday, May 16, 2010
Despite a more than four-fold gain from its 2009 lows, the stock of Coromandel International (Coromandel) remains a good exposure for investors with a three-year perspective.
The company's adept handling of the ups and downs of the commodity cycle underline its cost and operational efficiencies. Growth prospects appear quite bright in both the fertiliser and agrochemicals business over the next three-five years.
Untapped potential in new businesses such as micronutrients, organic fertilisers and rural retail into which Coromandel has just charted forays also holds promise. At the current market price of Rs 395, the stock trades at a PE of about 10 times its estimated FY-11 earnings. While the stock's historic PE has been lower, higher valuations may be here to stay, with an increasingly friendly policy environment for fertilisers, the company's growth prospects and successful de-risking of operations from cycles.
Coromandel's prospects in its core business of complex/phosphatic fertilisers are underpinned by the big supply deficit in the domestic fertiliser market, which is met by imports. It is these domestic shortages that have helped Indian fertiliser producers register fairly strong volume growth even in the bad monsoon years in recent times. In 2009-10, a drought year, Coromandel's fertiliser sales volumes still grew by 33 per cent.
Increasing pressure to improve foodgrains availability and crop yields is expected to contribute to higher fertiliser use over the medium term. Over a four-five-year span, the market for DAP and complexes alone is estimated to increase from 160 to 200 lakh tonnes. Correcting the imbalance in fertiliser use also requires the government to incentivise DAP and complexes more than urea. Competitive edge
Having added steadily to its capacity through investments and buyouts , Coromandel today operates about 32 lakh tonnes of fertiliser capacity; this is proposed to be expanded to 42 lakh tonnes over the next two-three years at an investment of Rs 300 crore. While marketing this output should not pose a significant problem, it is raw material supply that could be a critical success factor. However, on this count too, the company appears to be making the right strategic moves, by inking overseas pacts and investing in capacity for phosphates and ammonia. These linkages have enabled the company to emerge as one of the low-cost domestic producers of its products.
NBS, more flexibility
Then, the policy environment for fertilisers is also becoming more conducive. Take the transition to the nutrient-based subsidy (NBS) regime, which has taken effect from April 1 this year. With both the selling prices as well as the subsidy elements on decontrolled fertilisers hitherto fixed by the government, the cost or procurement efficiencies of individual players did not make a material difference to their competitive position. That is set to change now. Subsidies for fertilisers too were based on the product and not on the nutrient content, placing products such as urea at an advantage.
With the NBS offering compensation to producers for every kg of N, P or K present in the product, such advantages will be removed. Players such as Coromandel will have vast flexibility to alter their product mix and differentiate its brands to capture market share. In another important move, the government has also allowed marginal leeway to producers to hike selling prices to make up for any under-recovery. While a sizeable increase in fertiliser prices may not be possible, this does allow efficient producers such as Coromandel to enjoy greater pricing flexibility.
In the near term, transition to NBS has meant substantial hikes in the subsidies for several grades of phosphatic and complex fertilisers. Taken with the modest price increases of 6-7 per cent in selling prices taken by producers, players such as Coromandel should see both price and volume driven growth accelerating this fiscal, making up for any raw material increases.
Coromandel has also charted forays into several new non-fertiliser businesses that could piggyback on its extensive rural distribution network. The company already markets agrochemical formulations and is building capacity to cater to the growing contract manufacture requirements of players in this market.
It is also investing in the manufacture of micronutrients and organic fertilisers, nascent markets with good potential. The company is investing in a rural retail network, which it plans to use both for procurement of farm products and to deliver consumer goods.
Coromandel has managed an impressive scaling up of its sales and profits over the last five years, helped partly by inorganic growth. While its sales expanded at 32 per cent compounded annually, net profits have risen at an impressive 47 per cent.
Given that Coromandel's sales realisations are linked directly to global fertiliser prices, the company did see a blip in its sales, reporting a 33 per cent decline in revenues in 2009-10, over 2008-09. . However, volume growth remained strong. And with raw material prices correcting even more sharply than product prices, Coromandel managed to marginally expand its operating profit margins and close the year with nearly flat profits.
Investors with a two-year horizon can consider taking exposure to the stock of Geometric, a software and engineering services provider, considering the improvement in the outsourcing budgets in key client segments such as automotive and Software ISV (Independent Software Vendors).
The company has a reasonably strong order-book and has managed to ramp-up on its key clients, suggesting that after a rather difficult FY-10 there could be better visibility on the revenue front. The company had managed margins well in 2009-10 by cutting manpower costs, reducing selling expenses and increasing the offshore component of revenues.
At Rs 68, the stock trades at 8 times its likely 2010-11 per share earnings. This is at a steep discount to similar players such as Persistent Systems and larger peers such as Infotech Enterprises and KPIT Cummins. Companies such as Geometric that cater to selective clients can take a hard hit in pricing and budget reductions during economic downturns, but the recovery tends to be sharper on the revenue front. Evidence of this is KPIT Cummins and Persistent Systems that operate in many of the segments that Geometric does, guiding for an industry-leading 22-25 per cent revenue growth.
The company saw its revenues fall by 14.5 per cent in FY-10 to Rs 511.5 crore; it posted net profits of Rs 46.6 crore from a loss in the previous fiscal. Forex losses of Rs 48.3 crore hit the company's profits hard in FY-09. Over a four-year period, the company has seen its revenues grow at a compounded annual rate of 31.8 per cent, while net profits grew at 21.8 per cent.
Geometric provides offshore product development, product life-cycle management and engineering services to clients. Its offerings are different from traditional IT services companies in the sense that it target audience is only two-three segments. These include software ISVs (47.5 per cent of revenues), automotive (32.5 per cent of revenues) and agricultural and construction machinery manufacturers. It counts GM, Daimler Chrysler, Caterpiller and ABB as its clients. Geometric which would be looking for increased outsourcing and offshoring from auto majors as a part of their cost-cutting measures.
A report from IDC indicates that R&D and product engineering services are set to grow from $40.1 billion in 2010 to $65.7 billion by 2013. The size of the offshore market within that is set to grow at a much faster clip from $8.9 billion in 2010 to $16.1 billion by 2013.
According to a Strategy Analytics Automotive Electronics Service report, the global market for automotive electronics systems is expected to bounce back strongly in 2010, with demand increasing 18 per cent to $147 billion from the 2009 low point. This, the report states, is a result of a forecast increase of 11 per cent in light vehicle production in 2010, alongside a shift back to larger, more electronics-rich vehicles in established markets.
These trends are suggestive of the fact that vendors such as Geometric that have existing relationship with key clients could benefit from the incremental pie.
The company has a favourable geographic mix with over 63 per cent revenues coming from the US and 26 per cent from Europe. Geometric could capitalise on the revival in IT budgets in the US. . Geometric has an order book of $48.9 million, as of FY-10, to be executed over the next year, compared to just $29.5 million as of FY-09.
Over the last fiscal, the company has managed to add a $10-million-plus annual run-rate client as well as two in the $1-$5 million category. The repeat business level has also increased by 5 percentage points in FY-10 to 89.8 percent. The company's top clients have increased contribution to revenues by 5-7 percentage points.
Geometric's performance in these metrics suggests better traction in client budgets, greater client-mining ability and sound execution capabilities.
The company has also increased its offshore operations by 5 percentage points to 49.5 per cent in FY-10, which provides for low-cost revenues and an optimal cost structure. This level still leaves sufficient room for the company to enhance its offshore component.
Geometric has also indicated that it is getting into fixed-price projects, which would ensure better realisations compared to time and material billing mode.
Rupee appreciation, although a risk, is largely mitigated by the fact that Geometric has hedged 70 per cent of its inflows for FY-11 at Rs 48-49 levels. A wage hike of 13-14 per cent has been announced by the company for its offshore employees, which would affect margins in the near term. But the company has indicated that the growth in the second half of this fiscal would compensate for this.
Cairn India (Cairn) is a good prospect for investors with a medium-term perspective and high-risk appetite. The company is a promising play on the hydrocarbon exploration and production sector in India, with reserves higher than initial expectations in its Rajasthan fields, and not being fettered by the subsidy regime. Recent significant increase in reserve estimates and production potential in its Rajasthan block, in-place sales arrangements, and good progress on processing and transport infrastructure, underpin our recommendation.
At the current price (Rs 291), the stock discounts its trailing 12 months earnings by a whopping 67 times. However, the company is likely to ramp up production and earnings significantly over the next two to three years, which should translate into reasonable valuation levels, going forward.
Despite its sharp run-up from the initial public offer price of Rs 160 in late 2006, and from lows of around Rs 100 in October 2008, we see further upside in the stock, primarily due to the company being at an inflection point in a market which depends significantly on imports to meet its oil and gas requirements.
Leg-up to production
The onshore Rajasthan block (comprising Mangala, Bhagyam, Aishwarya (MBA), Barmer Hill and other fields), in which Cairn has 70 per cent stake and potentially its most prolific production interest, received a significant boost in March this year.
The company announced an increase in the field's potential resource base to 6.5 billion barrels of oil equivalent (boe) from 4 billion boe earlier. With this, the company estimates production potential of 240,000 barrels of oil per day (bopd) at peak capacity, significantly higher than the 175,000 bopd estimated earlier.
In the near term, the company plans to ramp up production at the Mangala field from around 30,000 bopd currently to 125,000 bopd in the latter half of the current fiscal, and going forward to 150,000 bopd subject to government approvals. The Bhagyam (40,000 bopd) and Aishwarya (20,000 bopd) fields are expected to commence production in the next calendar. With additional exploratory and drilling work underway and enhanced oil recovery measures also being undertaken, actual production figures may surprise on the positive side. Cairn's strong execution track record and low cost of production also lend confidence.
Cairn's other production blocks — Ravva (22.5 per cent interest) and CB/OS-2 in Cambay (40 per cent interest) are in declining phase. Efforts to halt the decline and increase production are being undertaken. In addition to the above, the company has eight exploration blocks, including one in Sri Lanka.
The company has also been provisionally awarded bids for two blocks in the recent NELP VIII auction.
Tying up other ends
The other pieces of the picture also seem to be falling in place for Cairn. Tie-up of sales arrangements for 143,000 bopd to PSU refiners, MRPL and IOC, and private refiners Reliance Industries and Essar Oil provide comfort on the off-take arrangement for potential increase in production. Negotiations for additional tie-ups are underway.
Uncertainties regarding pricing also seem to have been addressed with Cairn pricing the Rajasthan crude (a thicker variety akin to Nigerian bonny light) at 10-15 per cent discount to monthly Brent averages.
The company's current output of around 30,000 bopd at Mangala is processed using the Train 1. Commencement of operations at Train II (50,000 bopd capacity) in late April is expected to give a fillip to Cairn's increased production endeavours. Train III which is expected to be commissioned this quarter and Train IV in the next fiscal will also further production.
Work on the 670 km special heated pipeline to carry Cairn's crude to end-customers from the Mangala Processing Terminal has also made good progress, with the pipeline up to Salaya in Gujarat expected to commence operation this quarter. The additional stretch up to Bhogat is likely to be completed in 2011. Crude transport via the pipeline as against the special heated trucking arrangement currently is expected to translate into substantial savings on transportation for Cairn.
Financials revving up
At a consolidated level, the company turned the corner in the 15-month period to March 2009. It registered profits (Rs 803 crore) on sales of Rs 1,433 crore, as against losses of Rs 21 crore in the five-month period to December 2006 and Rs 25 crore in the 12-month period ending December 2007.
Commencement of production in the Rajasthan block in late August 2009 also had a significant positive impact on the company's financials in the December 2009 quarter, with net sales growing 135 per cent over the previous year to Rs 495 crore, and profits increasing 23 per cent to Rs 291 crore.
We expect both topline and bottomline to grow significantly with the planned increased production in Rajasthan in the current fiscal and production plateau being reached over the next two to three years.
Though the company has a healthy margin profile (net margins around 56 per cent in the March 2009 period and 59 per cent in the December 2009 quarter), its return on equity was quite low at around 2.4 per cent for the March 2009 period.
This is however expected to improve with increasing profits, going forward. Debt-to-equity at around 0.1 as on March 2009 was also quite comfortable, leaving enough headroom for the company to resort to leverage, if required, for additional capital requirements.
Being a strong proxy play on crude, Cairn's fortunes are in a way inexorably linked to that of global crude price movements. Its advantage might turn into a disadvantage if currently buoyant oil prices (around $75 to $85 a barrel) do an encore of 2008 and dip sharply, whether due to speculative reasons or from a weakening in global economic conditions.
Sustained rupee appreciation will also hurt the company. Also, hydrocarbon exploration and production being an inherently risky business, Cairn may incur losses if exploration efforts don't fructify into success or don't match initial expectations.
On the regulatory front, the company has been paying in protest, cess on crude at an increased rate (Rs 2,575 per tonne), pending a dispute with the Government and its 30 per cent joint venture partner in the Rajasthan block, ONGC. An adverse outcome of the arbitration proceedings will be a negative for Cairn.
Fresh investments can be considered in the Kotak Mahindra Bank (KMB) stock. Even as the bank closed 2009-10 with a doubling of its net profits, it is likely to sustain high earnings growth over the medium term due to strong advances growth, high margins and a ramp-up in subsidiary profits, linked to equity markets. Over the medium-term, a loan book growth of 35 per cent appears quite possible for the bank, given a scenario of reviving retail credit and the bank's increased focus on corporate credit.
At the current market price of Rs 760, the stock is trading at 16 times its estimated 2010-11 consolidated earnings. After removing the fair value of subsidiaries (estimated at Rs 342/share), the price to book ratio for KMB stood at 2.85. This represents a discount to private peers such as HDFC Bank and Axis Bank, but is at a premium to ICICI Bank and YES Bank. Valuations are justified by strong loan growth prospects and high margins.
High capital adequacy levels (18.4 per cent), high return on assets (3 per cent), best-in-industry net interest margins (6.3 per cent), high credit-deposit ratio (87 per cent) with increasing subsidiary contribution to the earnings are key positives for the bank. While net interest margins may see some moderation over the next few quarters due to cash reserve ratio hikes, any increase in policy rates may be passed through to the customers, thereby limiting the margin contraction.
KMB's loan book too is tilting towards corporate loans, with the corporate-retail mix moving from 20:80 to 35:65 this year. The current mix (after reducing unsecured lending) augurs well for high margins to be maintained. In terms of funding, the bank has been improving its proportion of core deposits by reducing high-cost borrowings and focussing on retail deposits. The gross NPA ratio stood at a relatively high 3.6 per cent as of March 31, 2010. But increasing provision coverage may help mitigate this. The bank's current coverage of 58 per cent may improve to 70 per cent over the next couple of quarters. The bank has also cut back on unsecured lending and is focussing on secured mortgages and auto loans.
KMB is present across the financial services value chain, with good market shares in broking and investment banking activities. The company also has NBFC arms: Kotak Prime, which disburses auto loans, and Kotak Investments, which disburses loans against shares. For 2009-10, Kotak's subsidiaries chipped in with over 53 per cent of the consolidated profits.
With more household savings expected to come into the equity market, both directly (broking segment) and indirectly (through mutual funds and insurance), Kotak stands to see strong growth in its subsidiary businesses. The investment banking and advisory arms are highly leveraged to the revival in the primary market.
After a hectic trading week, the markets ended with gains, despite the near 300-point fall in the Sensex on Friday. The BSE benchmark index rallied to a high of 17,389, but closed the week with a gain of 225 points at 16,995.
Among index stocks, Mahindra & Mahindra and Tata Motors rallied 7 per cent each to Rs 523 and Rs 763, respectively. HDFC Bank, DLF, Reliance Infrastructure, Wipro, ICICI Bank and Tata Power were the other major gainers. Cipla and Bharti Airtel tumbled over 8 per cent each to Rs 313 and Rs 264, respectively. Reliance Communications, with a fall of 5.5 per cent, was the other major loser.
The markets’ failure to sustain at higher levels is a sign of concern, and with every passing day it seems the bears are tightening their grip. For the moment, it looks like the bears will continue to have the upper hand as long as the Sensex stays below 17,080
On the downside, the Sensex may revisit its recent low of 16,700, and has an outside chance of dropping all the way to 15,400 in case of extremely negative global factors. Next week, the Sensex is likely to face resistance around 17,220-17,290-17,360 and get support around 16,770-16,700-16,630.
The NSE Nifty moved in a range of 186 points — from a low of 5,027, the index surged to a high of 5,213, but finally settled with a gain of 75 points at 5,094.
The corresponding pivot level for the Nifty is 5,130. It will be advantage bears as long as the index stays below 5,130. Above this, the index may face resistance around 5,185-5,210. On the downside, the index is likely to find support around 5,020-5,000-4,980.
The medium-term (50-days) moving average of the Nifty has now crossed its short-term (20-days) moving average, which suggests bearishness in the sort term and a neutral trend in the medium to long term. The medium-term moving average is 5,219 and the short-term moving average is 5,200.
The momentum indicators, MACD, Directional index and Stochastic slow, are in sell mode. However, the strength of the directional index is below 30 per cent, which suggests the trend is rather weak. Hence, there could be whipsawn movements till we get a clear indication.