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Sunday, March 11, 2007
Gremach Infrastructure: Avoid
Investments can be avoided in the initial public offer of Gremach Infrastructure Equipments and Projects (GIEPL). In the price band of Rs 75-90, the offer is priced at about 12-15 times its likely FY-07 per-share earnings, on a fully expanded equity base. In the business of renting construction and earth-moving equipment to various companies, GIEPL is well-placed to benefit from the booming activity in infrastructure. Notwithstanding the bright growth prospects for the industry, we feel that, at the given price-band, the company's valuations appear stretched vis-à-vis its more-established peer, Sanghvi Movers, which trades at 11 times its likely FY-07 EPS.
Also, given the recent correction in the market, investors with a long-term perspective and wanting to participate in the infrastructure boom, would be better off investing in pure construction or infrastructure companies, which are available at compelling valuations.
Business
GIEPL, in general, rents machinery to companies that build roads, airports, institutional and industrial complexes, multiplexes and residential buildings, power projects and so on. GIEPL also rents equipment that are hired from third-parties. The third-party hiring business comprises 83 per cent of its total rental income.
GIEPL has seen robust growth in earnings over the last three years, backed by improvement in rental income and operating margin. Increase in the number of orders, coupled with better capacity utilisation and addition of new machines, perhaps, explains the growth in earnings.
Investment rationale
Given the increased allocation in the Budget t for infrastructure development, the equipment rental industry is sure to witness significant growth. The probability of growth of recognised players such as GIEPL, which has such established clients as Larsen and Toubro, Punj Lloyd and Hindustan Construction, is likely to be higher. GIEPL's involvement in high-profile projects such as the Bandra-Worli Sea Link, Reliance Infocomm project and the Mumbai-Pune Expressway raises confidence in the company's ability to procure business.
However, it is to be noted that such high-profile liaisons could also limit the company's pricing power. However, regardless of the favourable industry dynamics, much would depend on GIEPL's ability to manage the overall requirement of its clients with its limited stock.
The company is also likely to have little control on the capacity utilisation of its machinery, given its project-specific business. Furthermore, the company runs the risk of technical obsolescence of its products. This essentially means that a significant portion of GIEPL's earnings would have to be deployed for the technological upgradation of its owned equipment. Besides this, since GIEPL's business depends wholly on the infrastructure play, any slowdown in the economy or delay in capex plans could pose a significant threat to its earnings.
Offer details
The offer is open from March 8-14. The company seeks to raise Rs 59 crore through this offer. RR Financial Consultants is the lead manager to the issue and Intime Spectrum Registry is the registrar to the issue.
Lessons from swarm intelligence
Consider this. A stock brokerage firm my friend does his business with has hit on a novel idea to increase its revenue. The firm displays everyday the top three stocks bought by its clients during the first two hours of trading. It has increased revenue by 15 per cent in one month. Why? The answer lies in "swarm intelligence". What is it?
Swarm intelligence studies the `intelligent' patterns that emerge from the collective behaviour of agents in an environment. Take ants. Each ant colony sends forager ants to hunt for food. When foragers find food, they drop a trail of scent for other ants to smell. Soon, all ants are on their way to get food. This is an example of swarm intelligence. It is the coordination among agents without evident communication.
How does swarm intelligence explain the increase in brokerage revenue? The firm tempted other clients to place orders by displaying the top three stocks that the active clients picked. It worked! When clients saw the top three stocks on the bulletin board, nearly 40 per cent placed orders for at least one stock.
EASY decisions
Our decision-making is always easy when we follow the crowd. The firm was simply exploiting this decision-making habit by telling the clients what others had bought. Amazon.com and other online retailers use similar strategies to attract consumers.
If you visit Amazon.com, you will be provided a list of books that are popular among other buyers. You will more likely choose from the list. The reason is because you think consensus opinion cannot be wrong. In fact, swarm intelligence studies have become so popular that scientists are now applying the findings to improve sales at large department stores!
Market View
A yen for carry-trades
If you are wondering how the strengthening of the yen vis-à-vis the dollar has anything to do with the the stock market meltdown, read on. Among the many reasons attributed to the slump in the world markets, the yen carry-trade is the one cited most often. But, before we learn how the yen carry-trade affected the stock market, a look at what "carry trade" is and how it works.
What is currency carry trade?
Currency carry-trade is a strategy by which an investor borrows in the currency of a market that offers low interest rates and uses the proceeds to fund the purchase of assets in a market that yields a higher interest rate. Thus, using this strategy, investors seek to pocket the difference between the rates, leading to gains, depending on the extent of leverage . Obviously, the key risk to such transactions is the uncertainty of how the two currencies will move relative to each other (exchange risk).
The yen carry-trade, in a similar manner, seeks to use the differentials between the Japanese yen and the US dollar. For example, an investor may obtain yen-denominated borrowings at an interest rate of 0.5 per cent. Now, as long as this can be invested for a higher return, investors could profit from the `spread' or `carry' between the two markets. Investing the funds in dollar-denominated bonds that pay 5 per cent, gives investors a spread of 4.5 per cent (5-0.5 per cent), assuming the exchange rate between the two currencies does not change during the holding period. When the same is done with leverage, the returns are phenomenal. If the dollar strengthens vis-à-vis the yen, profits get magnified; however, if the yen were to strengthen, losses can be sizeable too.
How carry-trade affects stock markets?
Since Japan has been holding its interest rates near zero for the past six years, the `yen' has emerged as a favourite currency for investors who indulge in carry trades. The ease of making money on the yen carry-trade has, in part, contributed to a higher risk appetite on the part of global investors. Investors began to take more risk, so much so that the funds arising out of yen borrowings were invested in emerging markets such as China and India, usually perceived more riskier than the developed markets. The going was good till the recent mark-up in Japanese interest rates and the meltdown in the Chinese market, which dragged portfolio values for many investors deep into red. Those who had borrowed a large sum of money in yen were forced to close their carry-trade positions to limit losses.
The hurried buying in the yen led to its strengthening vis-à-vis the dollar, forcing many investors, hitherto unaffected by the Chinese market correction, to unwind their carry-trade positions. This led to money flowing out of emerging stock markets, such as that of India, which depend to a significant extent on foreign institutional investors. A correction in the markets, thus, becomes imminent.
The sell-off in the Chinese market has snowballed into a global phenomena, leading to the meltdown in global indices. While such incidents have not made yen carry-trades unpopular, they have certainly forced investors to re-define their risk appetite.
Investment Nuggets
Irving Kahn is one more towering proponent of `value investing' who imbibed his investing principles from the legendary Benjamin Graham. Kahn worked as a second teaching assistant for Graham at his lectures at Columbia University that started in 1928.
Later, he also helped Graham with statistical material for Graham's celebrated book, Security Analysis, co-authored by David Dodd and published in 1934.
Though he is 101 years old, he still performs an active role as Chairman of Kahn Brothers & Co. Inc. — the firm that he founded with his sons, Thomas and Alan in 1978. Their investment philosophy is outlined in www.kahnbrothers.com.
He enjoys the distinction of being the founder of the Financial Analysts Journal, apart from being a distinguished member of the New York Society of Security Analysts.
"Kahn Brothers employs a bottom-up stock selection approach, and invests in undervalued equity securities that are usually out-of-favour in the market. We select securities one at a time based on assets, operating performance and long-term fundamental business prospects. Unlike many investment managers, our staff spend a considerable amount of effort evaluating the downside risk of every investment. We are long-term investors with a typical three-five- year, or longer, time horizon. If there are very few values to be found, we are comfortable holding cash."
"We study companies and try to find undervalued securities... We're absolute value investors focusing on asset values, book value discounts and low price to earnings ratios to normalised earnings. And we are not interested in the so-called relative values — you know, something selling at 20 times earnings in an industry group with a 35 multiple — Thomas Graham Kahn in Outstanding Investor Digest, spelling out his father's and the firm's philosophy in investing.
"The thing that makes our style different from the typical firm is that we read much more broadly outside Wall Street on subjects such as science and technology to locate trends that are not obvious. One reason that it is hard for many people to manage money is that they are influenced by what other people do. Buffett's not like that."
"Kahn Brothers views investing as a combination of art and science. Each investment decision has both quantitative and qualitative aspects. While the former can be readily duplicated by a novice, the qualitative component is acquired only from decades of analysing investment opportunities. A key element to outstanding investment performance is the discipline and patience to maintain principles that stand the test of time."
Reliance and IPCL: A plastic merger
The proposal to merge Indian Petrochemicals Corporation Ltd (IPCL) with Reliance Industries, now that it has been announced, appears a natural and obvious move, given that both operate in the same industry. More so, if you consider the Reliance track record of merging group companies with the flagship.
The Reliance Industries that we know today is an amalgam of Reliance Petrochemicals Ltd (which implemented a part of the Hazira complex), Reliance Polyethylene Ltd, Reliance Polypropylene Ltd (these two were floated to implement another part of the Hazira complex) and Reliance Petroleum Ltd (the original entity that was floated to implement the Jamnagar refinery).
Yet, the proposal seems to have caught the market by surprise for two reasons. First, the Reliance Industries and IPCL Chairman, Mr Mukesh Ambani, while speaking at the IPCL AGM barely 20 months ago in June 2005, had ruled out any move to merge the two companies.
Second, the IPCL-Reliance merger is unlike any of the other instances quoted above in that it is not something that will bring in significant synergies more than what has already been achieved by the two in their independent avatars.
Operational synergies achieved
The core function of marketing and sales was combined within a year of the acquisition of IPCL by Reliance in 2002, with agents selling both brands of polymers and fibre/fibre intermediates. Synergies have also been achieved in product exchanges between the two — Reliance supplies naphtha for the Vadodara cracker of IPCL and also minor quantities of ethylene to the Gandhar complex.
What the merger will help achieve is to rationalise the other functions of finance, secretarial and HR where there could be some synergies to be achieved. But the cost-savings and efficiency improvement here cannot be significant enough to justify a merger of the two companies.
The combined entity will produce more of the same products such as polypropylene and polyethylene and a couple of new products in polybutadiene rubber and acrylic fibre, products that Reliance does not produce now.
The merger will also diversify the feedstock profile of Reliance, which now runs its cracker — the mother unit of a petrochemical complex — on naphtha. IPCL's crackers at Nagothane (Maharashtra) and Gandhar (Gujarat) use natural gas as feedstock.
There are other aspects being discussed as providing the rationale for the merger such as the use of Krishna-Godavari Basin gas in IPCL's crackers and the fact that the merger would add Rs 11,000 crore to Reliance's balance-sheet helping it to raise further resources.
Nothing prevented Reliance from supplying K-G Basin gas to IPCL when it remained an independent entity and, again, the character of the K-G Basin gas is not known yet. For use in a petrochemical cracker, the gas has to have molecules of ethane and propane apart from methane itself.
The swell on the Reliance balance-sheet, post-merger, will be nothing noticeable, given that it is already about Rs 1,00,000 crore in size; adding Rs 11,000 crore to it will make but a marginal difference.
Again, Reliance has traditionally taken the equity route to growth which is why it has a very low debt-equity ratio. There is enough elbowroom for Reliance to borrow more and adding IPCL's balance-sheet is not really going to make an impact there.
So what is the rationale for the merger now? One factor motivating the merger could be the losses accumulated by Gujarat Chemical Port Terminal Company Ltd (GCPTCL), a company where IPCL is a joint promoter with a few other Gujarat government-owned companies. GCPTCL operates a chemical port terminal with a jetty at Dahej and is deeply in the red. A merger of GCPTCL with IPCL, before the latter's merger with Reliance, could bring in a significant tax shelter for Reliance.
But, again, this is still in the speculative domain and requires the consent of the joint venture partners of IPCL. Reliance could also be seeking to capitalise on the run-up in its stock value in recent times which will enable a relatively more favourable share exchange ratio.
Petrochem monolith
Speculation on the rationale for the merger aside, what it will achieve is in creating a monolith petrochemical company that will hold approximately half the polymer market in the country; in some specific products such as polypropylene, the Reliance-IPCL entity will hold more than three-quarters share of the market. Some rationalisation of capacity and product lines will probably materialise to unlock value from the merger.
There is the question of what to do with the Vadodara complex of IPCL, which is about four decades old with capacities that do not help in deriving scale economies.
Scaling up the capacity is a problem because, with the city expanding around the complex, questions of environmental pollution and safety arise.
The cracker now runs on naphtha supplied by Reliance from its Jamnagar refinery. Capacities of the other two crackers of IPCL at Nagothane and Gandhar may also have to be scaled up, but the critical factor here will be availability of the feedstock — natural gas rich in ethane and propane.
Reliance has already announced plans for a new two-million tonnes per annum mother cracker with downstream units at Jamnagar and it remains to be seen how IPCL's expansion plans are married to this.
Valuation issues
Between the shareholders of Reliance Industries and IPCL, the merger appears more favourable to the latter. IPCL is a pure petrochem play with its revenue and earnings subject to commodity price cycles. Reliance, though still largely a commodity play, is better balanced between oil refining and petrochemicals.
About two-thirds of its revenues comes from oil refining and the restfrom petrochemicals, but when it comes to earnings, both businesses contribute in almost equal measure.
The presence in businesses such as retail, oil exploration and production (E&P), and life-sciences also lends better balance to the revenue and earnings streams. Of course, this picture could change if the company were to hive off its E&P and/or retail businesses.
For Reliance shareholders, the merger does not bring in anything extraordinary, even as it dilutes the equity capital by about 4 per cent from Rs 1,393 crore now to Rs 1453 crore, post-merger.
The merger would add about 12 per cent each to Reliance's revenues and earnings this fiscal (extrapolated latest nine-month earnings).
The stock price movement in the two days of trading since the first announcement of the merger reflects this clearly.
While the IPCL stock is up 16 per cent from Rs 231.65 to Rs 268.6, the Reliance stock is up by just 2.2 per cent in the same period. The share exchange ratio of one Reliance share for every five IPCL shares appears balanced in relation to the prevailing market prices of the two stocks, though from a book-value perspective it appears weighted heavily in favour of Reliance.
As of March 31, 2006, the book value of a Reliance share is Rs 324 and Rs 198 per share of IPCL.
An interesting aspect to take note is that the government holds 10.40 lakh shares accounting for 0.35 per cent of IPCL's equity capital as per the filing to the stock exchanges in January 2006.
Assuming that the government has already not sold this stake, it would become a shareholder in Reliance as a consequence of the merger, holding 2.08 lakh shares!
Coromandel Fertilisers: Buy
The stock of Coromandel Fertilisers appears a good `value' buy for investors with a one-year investment perspective.
After the recent market decline, the stock trades at Rs 71, at a price-earnings multiple of eight times the likely FY-07 earnings (based on standalone financials).
There appears scope for a significant ramp-up in the company's earnings from current levels — from the likely merger of Godavari Fertilisers, expansion into new markets for agri-inputs and the steady growth prospects in the fertiliser business, given the domestic shortages.
Though fertiliser and agrochemical businesses are generally perceived as cyclical and risky, Coromandel Fertilisers (CFL) has shown the ability to weather adverse business cycles in the past and has made the strategic moves to secure future earnings and growth.
Business
CFL's business operations span phosphatic and complex fertilisers, insecticides, fungicides and herbicides.
As one of the largest manufacturers of phosphatic/complex fertilisers with an extensive distribution network in the South and East, CFL is well-positioned to capitalise on the persisting deficit for phosphatic/complex fertilisers in the domestic market.
The company's strategic moves to secure raw material supplies through long-term supply arrangements with global suppliers, such as Groupe Chimique Tunisien and Foskor, are also a source of competitive advantage in an industry where players enjoy limited pricing power.
With effect from April 2007, the domestic phosphatic fertiliser industry is likely to move to a system of import parity pricing.
CFL will be a key beneficiary of the new policy regime, given its scale advantages, high cost-efficiencies and access to raw materials at globally competitive prices.
Strong balance-sheet
The company has also steadily ramped up production volumes and sales at the acquired facility of Godavari Fertilisers over the past four years, with the latter's operations turning around and registering a net profit of Rs 43 crore on sales of Rs 1,418 crore in the nine months ended December 2006. CFL's equity stake in Godavari may climb to 90 per cent after its recent move to acquire IFFCO's stake in Godavari and make an open offer to the latter's shareholders.
This raises the possibility of a merger between the two companies at a later date. The addition of Godavari Fertilisers' operations to CFL has the potential to add substantially to earnings and sales, at the cost of marginal equity-dilution.
Though the proposed capex plans for fertilisers may require an additional infusion of funds, the company has the balance-sheet strength to absorb additional debt, without straining the earnings.
The strengths
In the agrochemicals business, CFL's advantages lie in its extensive distribution reach, which leaves room for marketing alliances with multi-national corporations (MNCs) and low-cost manufacturing capabilities for generic agrochemicals catering to the domestic and export markets.
In this context, a recent move to set up a pesticide formulation unit at Jammu could give the company significant cost-advantages (due to excise and tax exemptions), crucial in the price-sensitive market for crop protection chemicals.
The acquisition of Ficom Organics — an agrochem manufacturer — has helped the company acquire production bases in the northern and western regions, enabling it to cater to new markets and widen its geographic footprint.
In the nine months ended December 2006, CFL reported a 28 per cent growth in net profits, on the back of a 24 per cent growth in net sales.
The above factors make the stock a good addition to the portfolio of a conservative investor.
nvestors can use the current price levels and any weakness in the stock linked to the broad markets, to accumulate the CFL stock.
TCS: Buy
Investors with a one/two-year perspective can consider taking exposure in the Tata Consultancy Services (TCS) stock. At the current market price, the stock trades at a price-earnings multiple of 29 times its likely 2006-07 earnings.
The robust demand environment for offshoring, the sustained focus on large deals, the encouraging contribution from new service offerings such as infrastructure management and the broad-based geographic exposure, play to the company's strengths in these areas.
On the flip side, however, the US slowdown and its impact on discretionary spending on IT development services, managing supply-side pressures such as attrition and wage inflation, handling margin dilution in large deals and appreciation of the rupee vis-à-vis the dollar remain key areas of concern.
In a highly volatile milieu, if the broad markets slip over the next few weeks, investors can capitalise on dips to step up exposure in the stock.
The introduction of minimum alternate tax and the fringe benefit tax on employee stock options (ESOPs), announced in the Budget, are unlikely to materially impact the company's financials.
Core strengths
Four key variables working in favour of TCS, as spelt out by the top management and lending greater thrust to its financials, are:
Focus on large deals: The company has consistently maintained the view that it will focus on large deals. And there is a distinct acceleration in the number of such deals that the company is participating in.
To reinforce this view, TCS has stated that in the first half of 2006-07, it participated in twice as many deals of $50 million or more, than in the four quarters of 2005-06.
As of the third quarter ended December 31, 2006, it also indicated that it is pursuing 10 deals that are greater than $50 million-plus, though without defining any timeline on when they will be closed.
Global Delivery Network: As India 's largest IT services player, TCS is ahead of its peers in building its global delivery network beyond India. Its global delivery network spans Latin America, Eastern Europe and China.
The total employee strength in global delivery centres has more than doubled to 2,665 since the first quarter of 2005-06. And the company has also stated that 31 of its top 100 customers are being serviced from one of these global delivery centres outside India.
Strategic acquisitions: The acquisitions made by TCS over the past few years are beginning to pay dividends slowly.
For instance, Bank of China and Banco Pichincha are key clients being serviced directly through FNS, TCS' Australian banking product acquisition, or in combination with its Chilean acquisition, Comicron.
Similar acquisitions by TCS in the airline space of ASDC and AFS have improved its capabilities in the hospitality and travel industry practice.
Geography/Service offerings: The contribution from the UK, Continental Europe and Asia-Pacific has been increasing for TCS.
This enhanced geographic footprint is encouraging as itderisks the company, to some extent, from the prospects of a sharp slowdown in the US. The contribution of new services such as BPO, infrastructure management and assurance, has been growing over the past year.
Apart from generating higher revenues, these new service offerings are also likely to drive the offshore shift for TCS.
This will continue to be an important lever in improving the operating margins of TCS in the coming quarters.
Maruti Udyog: Buy
Investors with a medium-term outlook can consider taking exposure in the stock of Maruti Udyog Ltd. The stock trades at a little over 15 times its trailing 12-month earnings. With market conditions turning volatile, the stock of Maruti Udyog could remain vulnerable to short-term price fluctuations.
However, the medium-term outlook for the company's earnings appears reasonable, in light of increasing traction in compact car sales, good market response to the Swift Diesel variant and the likelihood of new product launches over the next few months.
The recent price decline in the stock appears to be triggered by short-term factors. The Maruti Udyog stock has declined by about 16.3 per cent from February 9, even as the benchmark BSE Sensex has slid about 12.5 per cent from its all-time high. The relative underperformance of the stock seems to have been influenced by two factors.
First, the poorer than expected performance of the Suzuki Zen Estilo, the newly launched replacement for the Zen small car, has affected the stock. Secondly, it was widely expected that the Union Budget would come up with a further round of sops to boost small car manufacturers, a proposal that would have potentially made Maruti one of the biggest beneficiaries. But the lack of any incentives for passenger car manufacturers in the Budget proved to be a big dampener of sentiment in the Maruti stock.
However, there could be a reversal in sentiment for the stock with a couple of positive new developments in the company. For one, Maruti's launch of the Swift diesel has been well received in the market. And contrary to the company's earlier experience with the Zen and Esteem diesel versions, the Swift diesel has found willing takers. There is a three-month waiting period for the model both due to robust demand and low engine assembly capacity. With the likelihood of the new, attractively styled SX4 sedan being launched in May this year in both petrol and diesel versions; the company could break into this segment, where its only entry is the Esteem, as of now. The Nissan small car OEM contract that will commence late next year would also improve capacity utilisation and profitability at the company's facilities.
In the meanwhile, while the sales of the Maruti 800 (currently the world's cheapest car) have been slipping every month, the Alto has been gaining ground and has managed to bolster Maruti's sales numbers. The Alto's sales numbers recently crossed two lakh units for the 11-month period till February this year. The car could replace the M800 as the Maruti's entry-level car and prove to be the company's best bet to take on new competition.
Saturday, March 10, 2007
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