Lead Story

There’s always an opportunity even in the worst of times. ETIG finds that investing in companies, which are thriving in these inflation-driven times, can provide some insulation against the rising cost of living

WHILE THE global media is making a hue and cry about rising inflation and its effect on the purchasing power of consumers, the other side of the coin seems to have been totally ignored. It is true that high inflation is hitting consumers hard, but investors can turn this to their advantage. Yes, there are a few industries which are gaining from inflation and investing in them will be a wise decision in the long run. The law of physics states that energy cannot be destroyed, but can be transferred from one form to another. Similarly, it can be said that in an economy, money cannot be destroyed (although unlike energy, it can be created out of thin air!), but transferred from one hand to another. Hence, if you are losing money due to inflation, there ought to be someone who is making money because of it. ETIG studied a host of industries to find out the leaders and laggards of inflation.

The A, B, C Of Inflation
But first, we need to analyse and understand the nature of current inflation. The current inflation is broadbased, as well as global. It is driven by rising demand for agricultural, metal and fuel products. Most experts agree that the present inflation is not a case of ‘lot of money chasing too few goods,’ but a genuine case of supply shortages.

India’s inflation, referred by the benchmark wholesale price index (WPI), had remained at around 4% for over six months since September ’07, but started rising in early ’08. For the week ended March 30, ’08, inflation reached a three-year high of 7.41% — substantially above Reserve Bank of India’s (RBI) target of 5%.

An important characteristic of the current rally in WPI figures is that it is widespread — the price index of manufactured goods jumped by 7.12%, primary articles by 8.89% and power & fuels rose by 6.65%. Primary articles have emerged as the largest driving factor for inflation over the past few weeks.

It must be noted that the current high inflation figure is suppressed, as the complete burden of rising oil prices is not passed on to consumers.

Losers & Gainers
There is a general belief that inflation is bad for the economy and industries. However, in reality, moderate inflation, coupled with adequate liquidity, is necessary for the industrial growth of any economy.
Amitabh Chakraborty, president (equity), Religare Securities says, “Moderate inflation is good for the stock market because a company’s pricing power increases, but a persistent inflation above 5%, with no growth, is stagflation, which is actually negative for the economy.”
Spiralling inflation above moderate levels hurts economic growth in different ways. The current inflation is building up raw material cost and hence, putting a pressure on margins. If this burden is passed on through an increase in prices of end products, the industrial sector will be least affected because of inflation.

But even the pricing capacities of these industries have limitations. Another factor is policy intervention to contain inflation and inflationary expectations. Fiscal and monetary measures undertaken for containment of inflation are more devastating than the underlying inflationary pressure.

Mr Chakraborty elaborates, “All interest-sensitive sectors will be hit, be it real estate, banking & financial services, automobiles and retail industry. We also believe the FMCG sector will be hit because higher inflation means less purchasing power in the hands of common man to buy soaps and oil.”

With a rise in prices of agricommodities, the FMCG industry may witness a pressure on margins if it cannot effectively raise prices. Vivek Pandey, fund manager, SBI Magnum Mutual Fund, says, “High costs will bring down operating margins of FMCG players by 30-40 basis points, which is more likely to be seen in Q1 FY09.”

But available evidence suggests that FMCG companies have so far done well and are posting strong growth in earnings, thanks to rising toplines and stable or rising operating margins. A similar trend is visible in other sectors including capital goods, chemicals, metals including steel, and cement among others (refer to Page 2).

Financials services, commodities and oil marketing companies are bound to face the brunt of inflation, says Rajat Rajgarhia, head of institutional research at Motilal Oswal.
He further adds, “It is a generally used strategy to raise interest rates to combat inflation. This will tighten money supply, which will affect the banking sector. Going forward, thanks to the government’s intervention, commodity industries such as cement or steel can also face a curb on free pricing.”

Make The Most Of It

Nonetheless, there is always an opportunity even in the worst of times. Out of the 16 industries analysed by ETIG, more than half show a positive or neutral impact of inflation. This offers investors a good opportunity to park their funds in inflationproof stocks. So, even though investors’ household budget may have gone out of shape, returns from the equity market may provide some insulation against the rising cost of living. Anyhow, in the long run, equity is the best hedge against inflation. As for your household budget, things may ease only after the next 6-7 months, when the government’s anti-inflationary measures begin to show results.

Natural Gas Companies: Pump Up The Volumes

The short-term outlook for natural gas companies has turned negative, but their long-term prospects remain bright. Investors can consider Gail, Gujarat Gas and Gujarat State Petronet with a horizon of 1-2 years

NATURAL GAS is a scarce commodity in India, with huge unmet demand and limited supply. It is a cheaper and cleaner source of energy compared to crude oil. However, it needs a network of pipelines for transportation from the point of production to the point of consumption. This has necessitated the development of natural gas transmission companies in bulk, as well as retail segments.

India today consumes around 95 million standard cubic metres per day (mmscmd) of natural gas, of which, over 65% is produced by state-owned exploration majors ONGC and Oil India. Nearly 20% of this is imported by way of liquefied natural gas (LNG), while the rest is produced by private players.

Among listed natural gas companies, Gail is India’s largest cross-country transporter with pipelines stretching over 7,800 km. Gujarat State Petronet is another bulk transporter of gas, but its infrastructure is entirely located in Gujarat. Gujarat Gas and Indraprastha Gas are retailers with well-established city gas distribution (CGD) networks.

India’s natural gas industry appears to be on the cusp of a major change with Reliance Industries’ Krishna Godavari basin oil blocks expected to commence gas production in the second half of ’08. When the gas production reaches its peak in ’09, the output is estimated to be equivalent to nearly 80% of India’s current consumption.

This will be supplemented by output from other players such as Gujarat State Petroleum (GSPC) and ONGC, which are also developing their oil & gas fields on the east coast. All put together, the availability of natural gas is set to jump three-fold in the next four years. This augurs well for natural gas transporters. Their revenues will shoot up as capacity utilisation levels of their networks increases.

In the short term, however, government policies are adversely affecting the growth of India’s natural gas industry. The government recently revoked the freedom of sale to third parties granted to the Panna, Mukta, Tapti (PMT) joint venture and appointed Gail as the sole evacuee for its entire production of 17 mmscmd. According to the government, this decision was taken to ensure sufficient gas supply to the priority sectors, viz fertilisers and power. However, the move goes against the commercial interest of PMT, which is the country’s largest producer of natural gas.
In another development, the Petroleum and Natural Gas Regulation Board (PNGRB) unveiled regulations for city gas distribution (CGD) projects. Besides setting out eligibility criteria and granting exclusivity to the players, these regulations put a cap on network tariffs and compression charges. The regulations also seek to cap the rate of return on capital employed (RoCE) at 14%.

While Gail stands to gain from this, private players are at the receiving end. As a result, their stocks have fallen heavily over the past couple of months. Gujarat Gas has lost over 33%, Indraprastha 23% and GSPL 24% — which is more than the 16% fall witnessed in the Sensex. In contrast, Gail’s stock has sustained its level at around Rs 425 between February and April ’08.

The redistribution of PMT gas will impact final consumers as well as transporters. Gail’s pipelines will witness an increase in volumes, and with the $0.12 per mmscmd transportation charges, the company will gain from this arrangement. On the other hand, Gujarat State Petronet will witness a minor reduction in the volumes transported through its network. Gujarat Gas is set to suffer as its supply has been curtailed by around 0.7 mmscmd. This will leave the company with limited volume of gas, which will be just sufficient to satisfy its existing CNG and PNG customers. As no alternative sources of gas are likely to be available in the near future, this will hamper its growth in the near term.

The cap on network tariffs and compression charges will also have a negative impact on Gujarat Gas and Indraprastha Gas, which operate in the CGD business. However, Indraprastha Gas will suffer more as it mainly uses gas at administered prices (APM). Indraprastha’s RoCE has consistently stayed above 40% for the past five years, which will now reduce sharply. The only solace for these players is that their marketing margins continue to remain free of these restrictions.

Thus, while the short-term outlook for natural gas transporters has turned somewhat negative, their long-term prospects continue to remain bright. As more gas becomes available, all these players will register healthy revenue growth on the back of higher volumes. Since the scrips of these companies have come off their highs substantially, investors should consider putting their money in them — particularly Gail, Gujarat Gas and Gujarat State Petronet — with a long-term horizon of 1-2 years.

Himadri Chemicals: Black Gold

Himadri Chemicals’ ability to maintain strong margins and growth momentum, make its stock attractive for long-term investors

KOLKATA-BASED Himadri Chemicals (HCIL) has lost 45% of its market capitalisation in the past three months even though its future growth prospects continue to be strong. HCIL is a leading player in coal tar derivatives, which are vital inputs in the production of aluminium and steel. The company is now expanding its capacities as well as product portfolio which, considering its ability to maintain strong margins, makes the scrip attractive for long-term investors.

BUSINESS:
HCIL has a combined coal tar distillation capacity of 2,19,000 tonnes per annum (tpa). It manufactures derivatives of coal tar such as coal tar pitch (CTP), creosote oil and naphthalene. CTP is primarily used in the aluminium and graphite industries and HCIL holds over 70% market share in India. Its clients include Nalco, Balco, Hindalco, Indal and HEG among others.

HCIL is a leader in a market that is growing fast resulting in improved operating margins. HCIL has also drawn up an aggressive capex plan to quadruple its capacity by ’12 at a cost of Rs 1,600 crore. Recently, HCIL raised Rs 118 crore through preferential warrants allotment and the board has approved an $80-million FCCB issue to finance the expansion.
In January ’08, it commissioned its 120-tpa advance carbon material plant in West Bengal, which will be expanded to 4,500 tpa by ’12. This plant will produce special grade carbon required for manufacturing lithium ion batteries. Further, HCIL has acquired a company in Hong Kong to expand its geographical footprint. It has also opened a representative office in China to streamline its import activities.

GROWTH DRIVERS:
Under the current expansion plan, HCIL’s distillation capacity will double to around 0.5 million tonnes by the end of FY09. Similarly, its 50,000-tpa carbon black plant will be commissioned during the year, while the full benefits of the advance carbon plant commissioned in January ’08 will also be available to the company. These will drive HCIL’s sales growth during FY09. On the other hand, the margins will be maintained at the current levels, thanks to rising demand and new value-added products.
The aluminium industry, which consumes nearly 80% of the coal tar pitch produced globally, is expected to grow at a CAGR of 7.5% over the next 3-4 years and the production of steel representing around 13% of the CTP consumption, is growing at around 6%. This, in turn, will boost demand for coal tar pitch.

FINANCIALS:
Since FY01, HCIL’s net profits have increased at a CAGR of 110% to Rs 323.3 crore in FY07 while sales have posted a CAGR of 32.5%. In the same period, the RoCE improved from less than 10% to 30%. During the quarter ended December ’07, HCIL posted 30% growth in net profit despite a 3% increase in revenues. The sales growth appeared muted mainly because of a weak pricing scenario. However, HCIL improved its operating margins even as its other income came down sharply.

VALUATIONS:
As HCIL’s expanded coal tar distillation capacities come on stream over the next year, the company is likely to nearly double its operating profits. Taking into account the recent preferential warrant issue, HCIL’s equity on a fully diluted basis stands at Rs 34.27 crore. It is expected to post earnings of Rs 39.9 per share for FY09 — nearly 70% above the EPS of 23.4 projected for FY08. This provides an attractive opportunity for long-term investors.

Crude transport clouds over Cairn despite many positives

OIL exploration and production company, Cairn India, has for the first time, come out with a reserves estimate for its exploration activities, apart from the Rajasthan fields. The development is likely to boost its valuations in coming days. The company disclosed that its exploration portfolio provides exposure to net unrisked recoverable resources in excess of 1 billion barrels of oil equivalent (BoE). This is a significant reserve accretion for the company, which could be valued at around $4-5 billion adding over 40% to its current market capitalisation of $10 billion.
Despite the positives, the company has been unable to resolve uncertainty over the cost of pipeline to transport crude oil to a port in Gujarat. The government has not approved the company’s request to include the $800 million cost of constructing the pipeline in the field development plan (FDP). However, it has already awarded the contract to construct the pipeline and work is expected to begin from second half of 2008.

Cairn India has also raised its estimates of proven and probable (2P) gross reserves from the three main Mangala, Bhagyam and Aishwariya (MBA) fields by 9% to 685 million barrels. The other Rajasthan fields have a gross 2P estimate of 1.7 billion barrels of oil equivalent (BoE). With the increase in reserves, the company also increased its production target from these fields by 16.7% to 1,75,000 barrels of oil per day (BOPD), while emphasising the production to start in H2 2009.

While exploring in different blocks for hydrocarbons, Cairn is also working on methods to extract more from the existing reserves. The production from its Cambay basin field reached its highest ever level in February 2008 as new wells drilled recently became operational. To boost its recoverable reserves from its Rajasthan fields, Cairn India has successfully tested enhanced oil recovery (EOR) techniques in laboratories. This is likely to add nearly 300 million barrels of incremental recoverable oil once implanted from year 2013 onwards.
Cairn posts Rs 24.5-cr loss

Cairn India has reported a loss of Rs 24.5 crore for the year ended December 31, 2007, compared with a loss of Rs 18.7 crore in the previous year. The strengthening of the rupee against the dollar resulted in the company recognising an accounting loss due to foreign exchange fluctuation of Rs 14.05 crore ($34.5 million). This arises on account of deposits held in dollars by foreign subsidiaries, which are intended to be used for capital imports. For the fourth quarter, the company has posted a loss of Rs 13.9 crore.