IN SEARCH OF VALUE

With the markets continuing with their northward journey, investors should revisit Benjamin Graham’s value investing approach to emerge a winner in the long term

THE MARKETS have always had a fancy for companies on a high-growth path, giving them a premium valuation over others. Most of the investors, too, tend to follow this rule — put your money where the growth is. After all, the logic of growth — as the profits grow, so will the stock value — is so easy to understand.
Although this popular strategy appears logical and successful, it is the contrasting investment approach of ‘value investing’ that continues to score over ‘growth investing’ consistently in the long run. Various empirical studies in different time periods and on various sets of companies have shown that value-investing — investing in companies with low P/E, low P/BV, high dividend yield — can give an investor sustained better returns over a period of time.
The primary reason investment researchers give for this phenomenon is related to the tendency of corporate earnings growth to move towards its mean or, in other words, the sustainable rate of growth. Although growth stocks initially experience higher growth rates than value stocks, the growth rates of both quickly revert towards the mean. Both these high-growth as well as low-growth phases are temporary. But overoptimism for high-growth stocks and over pessimism for others is a universal investor tendency. According to a collaborative research work of three experts, Lakonishok, Schleifer and Vishny, published in 1994, investors put excessive weight on the recent past in attempting to predict the future. This is a common judgement error in psychological experiments and explains investor preference for glamour stocks. In the process, one of the key principles of investing is violated — good companies are not always good investments. This common investor tendency practically ensures that value investing will continue to make superior returns in a longer timeframe.
To explain the concept in simple words, value investing is buying a stock before its growth cycle begins, while growth investing is when you enter a stock after the growth momentum becomes visible. As an investor goes on to invest in such ‘glamour stocks’, where the market has already discovered the growth prospects, she inevitably ends up paying a premium towards the higher future earnings. Obviously, unless you are very early to catch the trend, the growth investing approach can land you with high value stocks in which most of the upside potential is already built in the prices.
In this context, it would be interesting to look at auto component companies such as Munjal Showa and Ahmednagar Forgings. Both these companies posted higher profits in the December ‘09 quarter and are well-positioned to benefit from a sustained recovery in the automobile industry. Currently, both the companies are trading only slightly above their FY09 book values. Considering the profits made during the year so far, both scrips would be trading below their respective FY10 book values.
The key, therefore, lies in investing in companies that are trading significantly below their intrinsic value. For example, caustic soda manufacturer Aditya Birla Chemicals or the security solutions firm Micro Technologies are trading at a 30% discount to their respective FY09 book values. Both the companies were hit badly by the economic slowdown last year and are now on a recovery path. The chemical company is also expanding capacities eyeing capacity addition in the aluminium industry next year.
When working with a large number of companies, it makes sense to use price-to-book value (P/BV) as a proxy for intrinsic value to avoid the tedious and subjective calculations of earnings projection and cash flow discounting. In fact, the study published by Bauman, Conover, and Miller in 1998, which studied 2,800 stocks in 21 countries over a 10-year time period, concluded that price-tobook ratio is a better indicator of value than priceto-earnings, price-to-cash flows or dividend yields.
The value investing approach shuns the conventional wisdom that higher returns are associated with higher risk by focussing primarily on eliminating the risk. ‘Limit the downside and let the upside take care of itself’ is, in fact, one of the most fundamental principles of the value investing approach.
This approach has a number of key benefits. First, as mentioned above, it limits the downside risk — or the risk of a significant erosion in investment value if the market falls. At a low market price, these companies have high dividend yields, which adds to the margin of safety. For example, companies such as SRF, Nippo Batteries, Munjal Showa, Cosmo Films and Shipping Corporation of India are available at dividend yields of around 4-5%.
Many of these companies including GNFC, Shipping Corporation, India Cements and OCL India are investing significantly in their respective businesses. The expanded asset base is likely to bring in additional revenues and profits in the years to come. Most importantly, such companies can witness a quick run-up as soon as their present problems go away or sentiments improve.
With the benchmark Sensex within striking distance of 17,700 on Friday — a peak briefly touched in January after nearly two years — and not appearing inexpensive at a P/E of 21.4, we believe investors should take a break and look out whether any value buys are around. ET Intelligence Group brings you a list of such companies that can be the starting point for the search of value.
The primary criterion used for selecting the stocks was the price-to-book value, which was capped at 1.25. Further, the list was pruned to ensure companies with a track record of profits, positive cash flows from operations and dividends were included. Then the highly indebted companies and those earning too low a return on employed capital were excluded. Finally, companies in a perpetual downturn or with known dubious management record were eliminated.
All said and done, investors must do their homework before staking out money in the stock market. As Warren Buffett, the great Oracle of Omaha, who has played an instrumental role in popularising the value investing approach, puts it, “Never invest in a business you cannot understand.”

IN SEARCH OF VALUE

With the markets continuing with their northward journey, investors should revisit Benjamin Graham’s value investing approach to emerge a winner in the long term, says Ramkrishna Kashelkar

THE MARKETS have always had a fancy for companies on a high-growth path, giving them a premium valuation over others. Most of the investors, too, tend to follow this rule — put your money where the growth is. After all, the logic of growth — as the profits grow, so will the stock value — is so easy to understand.
Although this popular strategy appears logical and successful, it is the contrasting investment approach of ‘value investing’ that continues to score over ‘growth investing’ consistently in the long run. Various empirical studies in different time periods and on various sets of companies have shown that value-investing — investing in companies with low P/E, low P/BV, high dividend yield — can give an investor sustained better returns over a period of time.
The primary reason investment researchers give for this phenomenon is related to the tendency of corporate earnings growth to move towards its mean or, in other words, the sustainable rate of growth. Although growth stocks initially experience higher growth rates than value stocks, the growth rates of both quickly revert towards the mean. Both these high-growth as well as low-growth phases are temporary. But overoptimism for high-growth stocks and over pessimism for others is a universal investor tendency. According to a collaborative research work of three experts, Lakonishok, Schleifer and Vishny, published in 1994, investors put excessive weight on the recent past in attempting to predict the future. This is a common judgement error in psychological experiments and explains investor preference for glamour stocks. In the process, one of the key principles of investing is violated — good companies are not always good investments. This common investor tendency practically ensures that value investing will continue to make superior returns in a longer timeframe.
To explain the concept in simple words, value investing is buying a stock before its growth cycle begins, while growth investing is when you enter a stock after the growth momentum becomes visible. As an investor goes on to invest in such ‘glamour stocks’, where the market has already discovered the growth prospects, she inevitably ends up paying a premium towards the higher future earnings. Obviously, unless you are very early to catch the trend, the growth investing approach can land you with high value stocks in which most of the upside potential is already built in the prices.
In this context, it would be interesting to look at auto component companies such as Munjal Showa and Ahmednagar Forgings. Both these companies posted higher profits in the December ‘09 quarter and are well-positioned to benefit from a sustained recovery in the automobile industry. Currently, both the companies are trading only slightly above their FY09 book values. Considering the profits made during the year so far, both scrips would be trading below their respective FY10 book values.
The key, therefore, lies in investing in companies that are trading significantly below their intrinsic value. For example, caustic soda manufacturer Aditya Birla Chemicals or the security solutions firm Micro Technologies are trading at a 30% discount to their respective FY09 book values. Both the companies were hit badly by the economic slowdown last year and are now on a recovery path. The chemical company is also expanding capacities eyeing capacity addition in the aluminium industry next year.
When working with a large number of companies, it makes sense to use price-to-book value (P/BV) as a proxy for intrinsic value to avoid the tedious and subjective calculations of earnings projection and cash flow discounting. In fact, the study published by Bauman, Conover, and Miller in 1998, which studied 2,800 stocks in 21 countries over a 10-year time period, concluded that price-tobook ratio is a better indicator of value than priceto-earnings, price-to-cash flows or dividend yields.
The value investing approach shuns the conventional wisdom that higher returns are associated with higher risk by focussing primarily on eliminating the risk. ‘Limit the downside and let the upside take care of itself’ is, in fact, one of the most fundamental principles of the value investing approach.
This approach has a number of key benefits. First, as mentioned above, it limits the downside risk — or the risk of a significant erosion in investment value if the market falls. At a low market price, these companies have high dividend yields, which adds to the margin of safety. For example, companies such as SRF, Nippo Batteries, Munjal Showa, Cosmo Films and Shipping Corporation of India are available at dividend yields of around 4-5%.
Many of these companies including GNFC, Shipping Corporation, India Cements and OCL India are investing significantly in their respective businesses. The expanded asset base is likely to bring in additional revenues and profits in the years to come. Most importantly, such companies can witness a quick run-up as soon as their present problems go away or sentiments improve.
With the benchmark Sensex within striking distance of 17,700 on Friday — a peak briefly touched in January after nearly two years — and not appearing inexpensive at a P/E of 21.4, we believe investors should take a break and look out whether any value buys are around. ET Intelligence Group brings you a list of such companies that can be the starting point for the search of value.
The primary criterion used for selecting the stocks was the price-to-book value, which was capped at 1.25. Further, the list was pruned to ensure companies with a track record of profits, positive cash flows from operations and dividends were included. Then the highly indebted companies and those earning too low a return on employed capital were excluded. Finally, companies in a perpetual downturn or with known dubious management record were eliminated.
All said and done, investors must do their homework before staking out money in the stock market. As Warren Buffett, the great Oracle of Omaha, who has played an instrumental role in popularising the value investing approach, puts it, “Never invest in a business you cannot understand.”

Petro Refining: Don’t read too much into rising margins

THE global refining industry’s woes may be coming to an end, with margins inching up. However, investors should not read too much into reports relating to rising margins — at least not yet — since the structural problem of overcapacity still prevails. BP’s global indicative margins have improved from $1.5 per barrel in the quarter ended December ’09 to $5.1 in early March ’10. However, it was the extended cold weather in the US and Europe, refinery strikes in France, refinery-run cuts and stagnant crude oil prices that supported the improvement. With winter waning, the demand for refined products is expected to weaken, which can put further pressure on refining margins. Although early signs of a shakeout are becoming evident, with a few refineries closing down, it will be months before gross-refining margins see a significant increase. Given the state of the industry, a number of European refineries are either closing down or are up on sale.
Europe has undergone a “structural and permanent decline in petroleum products demand”. The company is also looking for a buyer for its 220,000 refinery in the UK and aims to cut its overall refining capacity in Europe by 500,000 by ’11.
Petroplus, Europe’s largest independent oil refiner, recently closed its 117,000-bpd refinery in Teesside, UK. Shell is negotiating with India’s Essar Oil to sell off its three refineries — two in Germany and one in the UK — with a combined capacity of 340,000 bpd. Also on sale are Shell’s 78,000-bpd refinery in Sweden; Eni’s 85,000-bpd facility in Italy and Chevron’s 210,000-bpd refinery in the UK. In most cases, loss-making operations are expected to shut down, while tank farms and marketing infrastructure can continue to operate.
Benign crude oil prices and a rise in heavy-light differentials also played a key role in improving margins. While the benchmark WTI and Brent crude oil prices remained in the $75-80-per barrel range, the discount of heavy over light oils rose to $8.3 per barrel from $5.2 in December ’09. In the Indian scenario, the government’s move to raise fuel prices of Euro IV auto fuels to be introduced in 13 metros starting on April 1 will add to GRMs of domestic refiners. However, a negative duty protection created on LPG, kerosene and aviation fuel in the latest Budget was a key negative.
Although there are some positive indications of an improvement, one should not read too much into it. A permanent return of strength is unlikely until the painful process of consolidation, under which inefficient, old and small units would close down, establishes a demand-supply equilibrium. Economic growth may not directly lift the industry’s fortunes, as increasing usage of bio-fuels and hybrid, electric and CNG vehicles will continue to take away a portion of the incremental energy demand.

CAIRN INDIA: Investors can stay invested

CAIRN India’s latest move to upgrade its reserve base has boosted investor sentiment, with its scrip gaining nearly 4% in a flat market. The company will now be able to extend its peak production level by 37%, compared to its earlier target of 175,000 barrels of oil per day (bopd). Higher peak production rate is linked to both finding new reserves and extracting more from the existing reserves. Cairn is using superior technology, both in mapping the geologies as well as in production to achieve this enhanced target. The crude oil in Rajasthan being highly viscous less than 10% of reserves can come out on its own, which is known as primary recovery. Further production will be possible by injecting water into reservoir, which is known as the secondary recovery and can take the recovery factor beyond 20%. The company plans to introduce enhanced oil recovery techniques (EORs) — chemical, polymer and alkali-surfactant-polymer flooding — earlier than usual to boost the recovery factor above 45%. The proposed increase in production would take at least a couple of years to materialise and necessitate further investments and government approvals. However, funding these additional investments should pose no problems for the company, with production from current facilities ramping up.
Cairn’s discoveries in Rajasthan now hold in-place reserves of close to 4 billion barrels of oil — a 10% upgrade from earlier estimates. In addition, it’s hopeful of finding reserves of another 2.5 billion barrels of oil, going ahead.
At present, the company’s production rate remains a depressed 20,000 bopd, while it has entered into agreements with four domestic refiners to supply 143,000 bopd. The delay in completion of its 670-km pipeline proves to be its main bottleneck.
This heated and heavily-insulated pipeline was earlier scheduled to be commissioned by the end of 2009, but is now expected to become functional only in the second quarter of 2010. The company that is currently trucking its output to the Kandla port will then be able to ramp up volumes to 125,000 bopd, to be further raised to 175,000 bopd by mid-2011. Investors should continue to stay invested in the company for the next few years to derive the full benefit of the company’s investments so far.

Nitin Fire: cylinder unit holds the key to future

NOTWITHSTANDING the 10% fall in the last four trading sessions, Nitin Fire Protection (NFP) has substantially outperformed the markets over the last one year. The scrip has nearly tripled during the past 12 months against a 105% appreciation in the benchmark Sensex during the period.
The company which had launched its IPO in May 2007 to raise Rs 65 crore was commanding a price above Rs 600 per share at its peak in January 2008. But the stock fell below Rs 120 in March 2009 when the market tanked. However, the recovery since then has been sustained.
Earlier in FY10, NFP’s two main segments — fire protection and CNG cylinders — had hit the slow lane as demand weakened owing to the economic downturn.
As a result, the company posted numbers that hinted at stagnation in the first half of FY10. However, with a strong demand recovery in its user industry, the company posted a 72% jump in its December 2009 quarter profits.
NFP also holds a stake of 11.1% in a 4,613-sq km petroleum exploration block in Rajasthan, where exploratory drilling is underway. By September 2010, the results of exploratory drilling will be known.
The main problem for the company today is the ramping up of its CNG cylinder manufacturing unit in Vizag SEZ. NFP had set up the 5-lakh units per annum in 2008, but is able to operate it only at 25% capacity, which is expected to go up only to 30% in FY11.
The use of natural gas is increasing across the globe recently surpassing 24% of all energy consumed. The automobile industry is also fast adopting this fuel, particularly in Pakistan and Iran.
Although this paints a rosy picture for the demand for NFP’s products, it does not reflect in actual sales. The company has tied up with Tata Motors and Swaraj Mazda — two leading producers of commercial vehicles — for supplying CNG cylinders.
In the integrated building management business, which includes the fire protection business, NFP holds around Rs 80 crore of outstanding order book. It already has a number of large corporate clients in this business.
Recently, it won a single contract of $3.5 million for installing firefighting and safety equipment for utility tunnel project outside India. It recently announced its intention to go for an acquisition particularly in Europe and in the fire protection business.
Other than inorganic growth plans, it’s not contemplating any major capex next year. However, there is little clarity at this point in time on the company’s inorganic growth plans.
At the current market price, the scrip is trading at a price-to-earnings multiple (PE) of 13.3. The March 2010 quarter results are expected to be better against the year ago period. NFP’s growth will depend on the ramping up of the cylinder unit.

ESSAR OIL: Big profits may still be elusive

AFTER A long phase of investment, India’s second-largest private refiner Essar Oil is slowly seeing some light at the end of tunnel. The company had invested over Rs 6,100 crore in its business between FY06 and FY09, without a single year of profits. However, with its Raniganj coal-bed-methane (CBM) block in West Bengal set to commence operations, the company could see a steady and growing line of profits.

The company has already drilled 15 wells and is laying the infrastructure. It is targeting test production by the end of March 2010 and commercial production is scheduled to begin by December 2010. As more wells are drilled, the peak output could touch 3.5 million cubic meters a day (mmscmd) in FY13 — equivalent to around Rs 800 crore in annual revenues at current prices.
The company, which is currently expanding its 14-million tonne (MT) refinery at Vadinar to 18 MT by March 2011, hopes to make it more efficient in the process. This expansion will enable it not only to process higher proportion of heavy and tough crude, but also improve the production of light and middle distillates to 79% from current 73%. Increasing availability of Cairn’s crude oil, which comes at 10-15% discount to the benchmark Brent, could also prove a booster.
Essar Oil has also been investing heavily in petroleum exploration (E&P) business and today claims to own petroleum reserves equivalent to nearly a billion barrel of oil. The portion of recoverable reserves could, however, be substantially lower. However, the hurdles for the Ratna and R-series blocks in the western offshore are not over, which the company had won in 1996 but has not been able to get regulatory approvals. It expects to sign a production sharing contract with the government by June 2010 and is estimated to commence production by December 2011.
With the refining margins weakening globally, the company reported a net loss for the December 2009 quarter, which was higher than the preceding September 2009 quarter. Although the company is operating its refinery over and above its rated production capacity, its limited ability to process cheaper crude and produce higher quality products hampered its margins.
Essar Oil has moved ahead with amalgamation of its subsidiary Vadinar Oil and plans to raise funds for its capex programme. The company recently reported that its promoters are conducting a strategic review and may raise capital to fund Essar Oil, in addition to the $2-billion limit that the company is authorised to raise through preferential allotment.
The much-needed steady and assured cashflow that the commercial production from CBM block represents is a key milestone for the company, which carried a debt-equity ratio of around 2.8 for the year ended March 2009. While bad times may be over for the refining industry, Essar’s refinery is not expected to start earning serious profits before the upgradation is completed.

RIL: Aggressive Steps Needed

ALTHOUGH the market did not react negatively to the unsuccessful attempt by Reliance Industries (RIL) to acquire petrochemicals major Lyondell-Basell (some analysts cheered the development), the key challenge for the RIL would be how to drive the next phase of growth.
The company, which commissioned two mega-projects last year — the new refinery and KG basin gas — and scaled them up progressively to near full capacity, has added nearly 30% additional capital to its business annually in the past five years. Over the next five years, this rate is expected to halve. The implication is that the company could get saddled with surplus cash, if it is unable to find new avenues to invest its growing cashflows. RIL, which raised over Rs 9,300 crore from sale of treasury stock and has another Rs 18,000 crore worth of treasury stock, was generating over Rs 15,000-crore cash from operations annually for the past five years. These cashflows are only set to go up further considering its new refinery and the KG basin gas production.
According to Goldman Sachs, RIL is set to generate around $25 billion of excess cash over and above its committed capex in four years, from FY11 to FY14. If not reinvested, these cashflows could make RIL debtfree by FY13 — that is within the next three years. Thus, the company is entering a new phase, where it has lots of resources to invest, but no significant avenue to deploy them. In this sense, securing the LB deal was important for the company.
The rate of growth in RIL’s annual capital expenditure has been phenomenal in the past few years. The company, which spent just Rs 2,100 crore in FY06, incurred a capex of Rs 24,700 crore in FY09. In the first nine months of FY10, it has spent over Rs 7,800 crore on capex, excluding capitalised interest and forex fluctuations. During the next couple of years, the main item on RIL’s capex plans will be the upgradation of the KG basin producing assets to a plateau level of 120 MMSCMD from existing 80 MMSCMD. This is estimated to take up around Rs 17,000 crore of incremental investments.
Besides, the company will continue to incur around Rs 3,000-3,500 crore annually on upgradation of petrochemicals and refinery projects. Still, the incremental capex is likely to fall short of its operating cash flows.
In this scenario, going for an acquisition makes a lot of sense for RIL. Even before the outcome of LB bid was confirmed, the company had reportedly made an acquisition bid for a Canadian company. However, there again, it’s pitched against stiff competition from other global energy majors and the outcome remains far from clear. While RIL’s cautious approach to the LB deal was free of the overpaying risk, the company will have to take aggressive steps to ensure its long-term growth trajectory.

GUJARAT GAS: Long-term gas tie-ups crucial for higher profits

A GRADUAL increase in retail prices of natural gas has helped Gujarat Gas post a healthy 42% jump in profits for the quarter ended December 2009. It logged 17% higher net sales at Rs 386 crore, while margins improved by 570 basis points to 19.9%.
Gujarat Gas, which operates city gas distribution networks, has been suffering from a reduced availability of natural gas for past two years. The company, which grew its profits at a cumulative annualised growth rate of 22.7% between 2002 and 2007, could grow only at a CAGR of 6.7% in the subsequent two years. The company sold 2.88 million standard cubic meters of gas every day (MMSCMD) in 2009, 13.4% lower than 2007.
In 2009, the company invested Rs 155.3 crore in expanding its distribution network, significantly higher than Rs 100 crore in 2008. However, the investments have been in Surat, Bharuch and Ankleshwar where it has been operating for the past several years. But it is yet to get the approval from the Petroleum and Natural Gas Regulatory Board to operate in the adjoining areas. The investment has predominantly been incurred in compressed natural gas and PNG distribution, which get priority treatment in gas allocation from the government. After the expansion, the company managed to increase the sales in these two categories up to 19% in 2009 from 15% in 2008.
In 2009, it managed to increase its gas sales to 3.1 MMSCMD from 2.58 MMSCMD in the beginning of the year. Unable to secure longterm supply contracts domestically, the company had to increasingly rely on the LNG imported on spot basis, which does not bode well for the long-term prospects of the company. However, it was able to improve its realisations by raising retail prices by nearly 13.5% in 2009 to Rs 13.36 per standard cubic meter. As a result, the net profit earned on sale of every unit of gas moved up 14% to Rs 1.69 per cubic meter. The scrip, which is trading nearly 18.2 times its consolidated profits for the trailing 12 months, appears to be fairly valued. The company has declared a dividend of Rs 8 per share, which translates in a yield of 3.1%. The company badly needs to tie up for long-term gas supply, which can sustain its growth momentum, going forward.

Chennai Petroleum: Too Cheap to Resist

The steep valuation differential compared to its peers makes Chennai Petroleum a great value buy. Dividends can add a new flavour going forward

ALTHOUGH somewhat disadvantaged compared to its peers, the market is valuing Chennai Petroleum a bit cheaply. The company is investing in making its operations and profitability more robust and reliable while the restoration of its long dividend paying tradition this year bodes well for the long-term investors.

BUSINESS
Chennai Petroleum(CPCL) is a standalone refinery with 9.5 million tonne capacity operating in Tamil Nadu on the eastern coast of south India. The company is 51.9% owned by Indian Oil and Iran’s National Oil Company holds 15.4%. Being old units, the company’s product slate comprises around 20% light distillates, 50% middle distillates and 21% heavy distillates with the rest 9% representing fuel loss. The proportion of heavy distillates in the output and fuel loss is higher compared to other domestic refineries.
Besides LPG, petrol, diesel, kerosene, aviation fuel and fuel oil, the company also produces propylene, lube oil feedstock, wax and bitumen. It exports around 10% of its output and sells the rest in the domestic market.

GROWTH DRIVERS
The company has been on an investment spree that will extend into the next couple of years. The completed projects include 17.5 MW of wind power, 20 MW gasbased power plant, seawater desalination project and revamp of catalytic reforming unit for converting naphtha into petrol.
The company is currently implementing a debottlenecking project to increase its refining capacity by 10% to 10.5 MTPA by the end of FY10. Similarly, the upgradation project is nearing completion to meet the April 1, 2010 deadline to introduce Euro III/IV grade auto fuels.
The company has also gone ahead with setting up a single point mooring (SPM) facility integrated with crude oil terminal for its Manali Refinery to enable crude imports through very large crude carriers (VLCCs). Similarly, it is considering an upgradation project to improve product yield by 7-8%. All these projects will not only optimise its costs and improve operations, but also make its profitability more sustainable.

FINANCIALS
The company’s net worth has increased at a cumulative annualised growth rate (CAGR) of 13.7% over the past five years, while the gross block grew at 6.6%. Even despite a net loss reported in FY09, the debtto-equity ratio has gradually improved to 0.5 from 0.7 in FY08 and 1.5 in FY04.In FY09, CPCL posted a net loss for the first time in the past 15 years due to the unprecedented volatility in oil prices and missed the annual dividend. However, the earlier track record represents a healthy 30% portion of profits distributed as dividends in the previous decade. CPCL’s refinery is currently undergoing a partial shutdown for hooking up new units. This is likely to impact its March 2010 quarter numbers.

VALUATIONS
At the current market price, CPCL is trading at a price-to-earnings multiple of 3.8, which is at a substantial discount compared to its domestic peers. At this valuation every tonne of CPCL’s refining capacity is being valued around Rs 3,800, considerably cheaper to its peers. CPCL’s share price is just 1.2 times its FY09 book value, but lower than expected book value for FY10. The company is expected to end the FY10 with a net profit of around Rs 800 crore and distribute around 30% of it as dividend. This works out to nearly 6.6% dividend yield, which adds to the margin of safety for the investors.

CONCERNS
In case of very high volatility in crude oil prices, as witnessed in the second half of 2008, CPCL will likely face the largest impact on profits compared to its domestic peers.

GUJARAT GAS : Long-term gas tie-ups crucial for higher profits

A GRADUAL increase in retail prices of natural gas has helped Gujarat Gas post a healthy 42% jump in profits for the quarter ended December 2009. It logged 17% higher net sales at Rs 386 crore, while margins improved by 570 basis points to 19.9%.
Gujarat Gas, which operates city gas distribution networks, has been suffering from a reduced availability of natural gas for past two years. The company, which grew its profits at a cumulative annualised growth rate of 22.7% between 2002 and 2007, could grow only at a CAGR of 6.7% in the subsequent two years. The company sold 2.88 million standard cubic meters of gas every day (MMSCMD) in 2009, 13.4% lower than 2007.
In 2009, the company invested Rs 155.3 crore in expanding its distribution network, significantly higher than Rs 100 crore in 2008. However, the investments have been in Surat, Bharuch and Ankleshwar where it has been operating for the past several years. But it is yet to get the approval from the Petroleum and Natural Gas Regulatory Board to operate in the adjoining areas. The investment has predominantly been incurred in compressed natural gas and PNG distribution, which get priority treatment in gas allocation from the government. After the expansion, the company managed to increase the sales in these two categories up to 19% in 2009 from 15% in 2008.
In 2009, it managed to increase its gas sales to 3.1 MMSCMD from 2.58 MMSCMD in the beginning of the year. Unable to secure longterm supply contracts domestically, the company had to increasingly rely on the LNG imported on spot basis, which does not bode well for the long-term prospects of the company. However, it was able to improve its realisations by raising retail prices by nearly 13.5% in 2009 to Rs 13.36 per standard cubic meter. As a result, the net profit earned on sale of every unit of gas moved up 14% to Rs 1.69 per cubic meter. The scrip, which is trading nearly 18.2 times its consolidated profits for the trailing 12 months, appears to be fairly valued. The company has declared a dividend of Rs 8 per share, which translates in a yield of 3.1%. The company badly needs to tie up for long-term gas supply, which can sustain its growth momentum, going forward.

PLASTICS: Innovation, Quality hold key to growth

THE word ‘plastic’ may no longer imply fake or cheap, considering the emerging trends in the Indian plastic products industry. The industry is fast moving up the value chain, from manufacturing lower-end everyday products like buckets and mugs to high-end applications such as auto fuel tanks or hot-water pipes.
These new plastic products are also transforming a number of other industries where they are used. Using plastic pipes for plumbing and sewerage has become increasingly common in the construction industry, which was totally dominated by galvanised iron or cement till a few years back. The conventional brick-and-mortar used in construction is being challenged by plastics as seen in the success of prefabricated structures pioneered by Sintex Industries in India.
India’s plastic consumption has traditionally been low. As against world average of 25 kg and 125 kg in the US, an average Indian consumes just around 6-kg per annum of plastic products. This could go up to 12 kg in the next couple of years, mainly due to these increasing usages of plastic.
Consider household furniture where plastic is replacing wood or steel at the lower end of the market. The packaging industry, too, is increasingly using plastic. Supreme Industries, for example, launched a new type of film last year for packaging meat and marine products.
Emmby Polyarns has developed flexi-tanks that are cheaper and lighter compared to the conventional tanks. The consumer experience could also undergo a dramatic change in the entire process. The in-mould labels (IML) technique pioneered by Moldtek Plastics, a leading manufacturer of plastic pails used for packaging paints and lubricants, could bring in an element of aesthetics and decoration to pail packaging, hitherto not available in India.
“Consumer tastes have changed with rising per capita income. They are demanding better quality, aesthetically superior packaging for whatever they consume,” observed Arvind Mehta, former chairman of All India Plastic Manufacturers Association. “The new age plastic products have the benefits of a long life, high performance and cost advantage. Besides, the polymer products have the inherent advantages of no rusting, no corrosion, no paint peeling off. These features shall make the application of polymers more wide in the years to come,” claimed Anil Jain, managing director of Mumbai-based Time Technoplast. Currently, Time Technoplast is investing Rs 55 crore in setting up a plant, which will manufacture one-million LPG cylinders made up of polymers. The company has already launched plastic fuel tanks for the automobile industry and a new range of containers and crates for material handling, which can be folded, returned and economically reused.
“Everyday, newer and newer plastic products are coming up replacing usage of glass, wood or metals. Today, every car has nearly 125 kg of plastic products fitted in against just around 20 kg a few years ago,” said Deepak Lawale, general secretary of the Organisation of Plastic Processing Industry. “We will continue to see more and more plastic products coming up in healthcare, infrastructure and railways sectors,” predicted Arvind Mehta.

PLASTICS: Innovation, quality hold key to growth

THE word ‘plastic’ may no longer imply fake or cheap, considering the emerging trends in the Indian plastic products industry. The industry is fast moving up the value chain, from manufacturing lower-end everyday products like buckets and mugs to high-end applications such as auto fuel tanks or hot-water pipes.
These new plastic products are also transforming a number of other industries where they are used. Using plastic pipes for plumbing and sewerage has become increasingly common in the construction industry, which was totally dominated by galvanised iron or cement till a few years back. The conventional brick-and-mortar used in construction is being challenged by plastics as seen in the success of prefabricated structures pioneered by Sintex Industries in India.
India’s plastic consumption has traditionally been low. As against world average of 25 kg and 125 kg in the US, an average Indian consumes just around 6-kg per annum of plastic products. This could go up to 12 kg in the next couple of years, mainly due to these increasing usages of plastic.
Consider household furniture where plastic is replacing wood or steel at the lower end of the market. The packaging industry, too, is increasingly using plastic. Supreme Industries, for example, launched a new type of film last year for packaging meat and marine products.
Emmby Polyarns has developed flexi-tanks that are cheaper and lighter compared to the conventional tanks. The consumer experience could also undergo a dramatic change in the entire process. The in-mould labels (IML) technique pioneered by Moldtek Plastics, a leading manufacturer of plastic pails used for packaging paints and lubricants, could bring in an element of aesthetics and decoration to pail packaging, hitherto not available in India.
“Consumer tastes have changed with rising per capita income. They are demanding better quality, aesthetically superior packaging for whatever they consume,” observed Arvind Mehta, former chairman of All India Plastic Manufacturers Association. “The new age plastic products have the benefits of a long life, high performance and cost advantage. Besides, the polymer products have the inherent advantages of no rusting, no corrosion, no paint peeling off. These features shall make the application of polymers more wide in the years to come,” claimed Anil Jain, managing director of Mumbai-based Time Technoplast. Currently, Time Technoplast is investing Rs 55 crore in setting up a plant, which will manufacture one-million LPG cylinders made up of polymers. The company has already launched plastic fuel tanks for the automobile industry and a new range of containers and crates for material handling, which can be folded, returned and economically reused.
“Everyday, newer and newer plastic products are coming up replacing usage of glass, wood or metals. Today, every car has nearly 125 kg of plastic products fitted in against just around 20 kg a few years ago,” said Deepak Lawale, general secretary of the Organisation of Plastic Processing Industry. “We will continue to see more and more plastic products coming up in healthcare, infrastructure and railways sectors,” predicted Arvind Mehta.

Chemicals Industry: Asian M&A frenzy to target Western Cos

ACROSS the world, the chemicals industry is undergoing the process of globalisation, consolidation, product innovation and cost rationalisation. This has resulted in a steady shift of manufacturing from western countries to Asia — mainly India, China and West Asia. No wonder then that the domestic chemical production and exports are increasing steadily, with domestic players expanding and increasing foreign investment. The chemical industry, which carries a weight of 14% in India’s index of industrial production (IIP), registered a yearon-year growth of 12% in the April-December 2009. This was the best performance for the industry since April-December 2004, when the index had grown 16% year-on-year.
For the December 2009 quarter, the industry did an excellent turnaround. After four consecutive quarters of falling profits, the aggregate profit of 71 listed Indian chemical companies jumped 280% to Rs 1,418 crore. Although a part of this growth can be attributed to a particularly low base of December 2008 quarter when the profits fell by 66% y-o-y, a strong production recovery played a vital role. In the past one year, the industry has done well on the bourses. The 15-share ET Chemicals index gained 103.5% compared to the 89.8% increase in the benchmark ET 100 index. The Indian chemical sector is also attracting foreign investments. During FY09, the foreign direct investment (FDI) in the domestic chemical industry jumped 227% to $749 million against $229 million in FY08.
In view of the demand destruction following the economic slowdown, this has prompted a number of M&As globally. According to a recent KPMG study, the massive capacity expansion in bulk chemicals in West Asia between now and 2015 may make around one-fifth of the European petrochemicals industry uncompetitive. This will reinforce the desire of western players to move away from bulk chemicals into downstream specialty chemicals with innovative, sustainable solutions that help them stay ahead of emerging market competition.
However, with the companies in the West available for buyouts, Asian companies prefer to buy these ready-built businesses at attractive valuations rather than setting up new facilities. Such acquisitions can grant them ready access to better technologies as well as markets. One should view Reliance’s efforts to acquire LyondellBasell or the Kiri Dyes’ acquisition of Dystar in this light.
Companies from China and Middle East too are not to be left behind in this race. Experts are predicting an increase in the M&A activity in the chemical industry over the next couple of years with companies in the West likely targets and firms from West Asia and China the buyers.

CHEM INDUSTRY: Asian M&A frenzy to target western cos

ACROSS the world, the chemicals industry is undergoing the process of globalisation, consolidation, product innovation and cost rationalisation. This has resulted in a steady shift of manufacturing from western countries to Asia — mainly India, China and West Asia. No wonder then that the domestic chemical production and exports are increasing steadily, with domestic players expanding and increasing foreign investment. The chemical industry, which carries a weight of 14% in India’s index of industrial production (IIP), registered a yearon-year growth of 12% in the April-December 2009. This was the best performance for the industry since April-December 2004, when the index had grown 16% year-on-year.
For the December 2009 quarter, the industry did an excellent turnaround. After four consecutive quarters of falling profits, the aggregate profit of 71 listed Indian chemical companies jumped 280% to Rs 1,418 crore. Although a part of this growth can be attributed to a particularly low base of December 2008 quarter when the profits fell by 66% y-o-y, a strong production recovery played a vital role. In the past one year, the industry has done well on the bourses. The 15-share ET Chemicals index gained 103.5% compared to the 89.8% increase in the benchmark ET 100 index. The Indian chemical sector is also attracting foreign investments. During FY09, the foreign direct investment (FDI) in the domestic chemical industry jumped 227% to $749 million against $229 million in FY08.
In view of the demand destruction following the economic slowdown, this has prompted a number of M&As globally. According to a recent KPMG study, the massive capacity expansion in bulk chemicals in West Asia between now and 2015 may make around one-fifth of the European petrochemicals industry uncompetitive. This will reinforce the desire of western players to move away from bulk chemicals into downstream specialty chemicals with innovative, sustainable solutions that help them stay ahead of emerging market competition.
However, with the companies in the West available for buyouts, Asian companies prefer to buy these ready-built businesses at attractive valuations rather than setting up new facilities. Such acquisitions can grant them ready access to better technologies as well as markets. One should view Reliance’s efforts to acquire LyondellBasell or the Kiri Dyes’ acquisition of Dystar in this light.
Companies from China and Middle East too are not to be left behind in this race. Experts are predicting an increase in the M&A activity in the chemical industry over the next couple of years with companies in the West likely targets and firms from West Asia and China the buyers.

Great Offshore: Back in Safe Waters

Great Offshore is settling down under the new management. Considering the better growth prospects of the company, it seems an attractive buy for long term


GREAT Offshore (GOL) has come a full circle from getting demerged from GE Shipping in 2006 to getting acquired by Bharati Shipyard recently. The company’s aggressive inorganic growth plans backfired in the past, but the organic growth continues at a healthy pace. With the valuations dipping to a low, investors can enter for long-term gains.

BUSINESS
Great Offshore came into existence through a demerger of GE Shipping’s offshore division in October 2006 with 37 vessels. Today the number of vessels increased to 65 — the largest in Indian offshore support industry. The company’s aggressive growth plans coupled with low promoter group holding heavily backfired when the stock market crashed in 2008. The promoters have pledged their holding to Bharti Shipyard and as such lost their control over the company to the latter. In 2007 when the markets were booming and the offshore industry was doing particularly well, GOL drafted aggressive growth plans in line with most other offshore players. It raised Rs 350 crore in October 2007 — Rs 150 crore by issuing convertible preference shares and Rs 200 crore through FCCBs — and went on to announce an acquisition in January 2008. Unfortunately, the equity markets took a plunge subsequently and the dynamics of the offshore industry also took a hit.
GOL’s attempts to keep the deal alive by curtailing the scope of its acquisition in June 2008, proved in vain. The company launched a share buyback scheme utilising Rs 55.2 crore in September 2008 and acquired two Andhra-based companies for Rs 160 crore. However during these activities, the promoters’ stake continued to fall. At the time of its birth, GOL’s promoters held 27.7% stake in the company, which dipped to 15.7% within just two years — by the end of 2008. Weak market sales and stepping down of promoters were the two main reasons behind this fall.

GROWTH DRIVERS
The company is now settling down under the new management. GOL has added five vessels in FY10, including one floating dry dock. The company further has one jack-up rig and one multi-support vessel to be delivered by the end of 2011. All these assets will help bring in incremental revenues in the coming quarters. At the same time, the company secured a 50% jump in daily charter rates for its rig to ONGC at $69,000 recently.
The global offshore E&P industry is coming back to normalcy with better prospects of economic growth. This will bring about a revival in the investment flow in the global E&P. The offshore E&P continues to grow unabated with a series of successful NELP rounds in India in the past decade. Under the new management, GOL got the approval for raising up to Rs 1,750 crore by issuing equity or bonds to augment its resources to provide for offering broad-spectrum services to customers.

FINANCIALS
The company’s net sales have grown at a cumulative annual growth rate (CAGR) of 40.7% and net profit at 41.5% in the past three years. During FY09, the company paid off entire Rs 150 crore preference capital raised in FY08, while an additional Rs 1,000 crore of loans were taken. This worsened the company’s debt-equity ratio to 2.76 at the end of FY09 from 1.1 in FY08. In the past, the company enjoyed nearly 50% as operating profit margin and 25% net profit margin, which has dropped to 43.9% and 18%, respectively, in the 12-month period ended December 2009.

VALUATIONS
The recent crash in the market has brought down the company’s valuation to 8.1 times its 12-month profits and 2.2 times its book value. All its peers are trading at slightly higher valuations. Considering GOL’s fleet size, the discount appears unjustified. We expect the company to post per share earnings of Rs 48.3 and 65.8 for FY10 and FY11, respectively, which are 8.8 and 6.5 times, respectively of the current market price. The stock seems to be a value buy at the current levels.

Fertiliser Industry: Exciting Future Ahead

FOR the Indian fertiliser industry, which remained severely constrained under the government regulation for more than a decade, some light appears at the end of the tunnel. The past couple of years have witnessed a gradual but positive change in the government policies towards the industry. The changes so far may not boost the industry’s profitability in the short run, but they do impart flexibility and cut the manufacturers dependence on subsidy.
Recently the government announced nutrient-based subsidy (NBS) policy and price decontrol for non-urea fertilisers, while raising the urea prices by 10% to be effective from April 1, 2010. Henceforth, the subsidy component for non-urea fertilisers will remain fixed while the retail price will fluctuate in line with international prices. However, the government has so far not disclosed the specific subsidies or the implementation mechanism.
Since competitive pricing becomes possible, companies that have better sourcing, distribution or operational efficiencies and can keep their costs low can see an improving profit margin. The new policy also proposes incentive for innovative products and investment in superior technology or greater capacities. For urea manufacturers, the 10% increase in retail prices means little apart from reduced subsidy dependency, which had gone up to 65% - 75% of its fertiliser revenue in FY09.
During the December 2009 quarter, the domestic fertiliser companies showed an excellent performance with the aggregate profit of 24 fertiliser companies growing 88.5% against the year-ago level, although the sales fell 28.5%. Nagarjuna Fertilisers, Tata Chemicals, Deepak Fertilisers and Aries Agro led the charge with multi-fold jump in their profits.
The industry, which had been a darling for investors, appears to have hit a slow lane in the past few months. The ET Fertiliser Index, which outperformed the markets gaining 122.5% against 91.5% gain in benchmark ET 100 index over the past one year, has underperformed in the past three months.
The global population continues to grow and is expected to reach nine billion by 2050. At the same time, the economic growth is changing the food habits of the people as the preference towards high-protein food, such as meat, rises. Since fertilisers play a key role in improving the productivity of land, the industry’s future looks bright.
Although there has been a little investment in the domestic fertiliser industry over years, globally the industry is witnessing a flurry of takeovers. World’s largest urea manufacturer Norwegian company Yara recently paid $4.1 billion to acquire its American peer Terra. Similarly, Brazilian mining major Vale Corporation recently acquired local fertiliser businesses of two US-based companies for over $4.8 billion. BHP Billiton, the world’s largest mining company, also bought out Canadian fertiliser manufacturer Athabasca Potash for $320 million in January. In the meanwhile, Canada-based Agrium continues to woo the shareholders of rival fertiliser player CF Industries for an acquisition valuing it at $5.36 billion. Industry experts are expecting more such deals in the near future, including deal such as between USbased Mosaic and Brazil’s Copebras.
The future appears exciting for the fertiliser industry globally, and the Indian industry is gradually coming out of the government-imposed shackles. The recent changes have been slow, but mark a positive trend. In July 2008, the government shifted to import-parity pricing from earlier cost-plus approach. April 2009 onwards, the industry benefited from the increasing availability of natural gas. Now the nutrient-based pricing is introduced. Although, these won’t boost the industry’s profitability much, they will incentivise further investments. While the gradual process of deregulation moves ahead, the industry will continue to gain from higher volumes or cost controls.

Oil & Gas: Win Some, Lose Some

THE BUDGET INDICATES THE government’s intention to pay the oil subsidy only in cash and not in bonds, as was the practice till last year. This will automatically put a cap on how much the government can pay and indirectly encourages market-linked prices of fuels as suggested by the Kirit Parikh committee
The Union Budget 2010-11 proved to be a mixed-bag of goodies for the domestic petroleum industry. The industry was looking for the solution for mainly two issues in the Budget — whether the government has taken any decision on Kirit Parikh committee report, and whether the anomalies created last year by excluding production of natural gas from income-tax benefits will be rectified. However, the Budget disappointed the industry on both these counts. The Budget mentioned the government’s intention to pay the oil subsidy only in cash and not in bonds, as was the practice till last year. This is a positive move for oil marketing companies that together are looking at an aggregate loss of Rs 45,000 crore for the year 2009-10
The finance minister’s decision to restore customs duty on crude oil and petroleum products to pre-July 2008 levels and increase excise duty on petrol and diesel by another Re 1 per litre were totally unexpected. Since the marketing companies immediately passed on the tax burden their finances remain unaffected. The increase in customs duty, however, is a boon in disguise for the domestic petroleum refiners as the effective rate of protection goes up and will add a few cents to the gross refining margins. In the same way, as the landed cost of imported crude oil goes up, the domestic oil producers will be able to charge a little higher and earn a better realisation. Companies, such as ONGC, Oil India, Cairn India, Reliance Industries, Hindustan Oil Exploration and Selan Exploration stand to gain marginally. The reduction in surcharge on corporate tax from 10% to 7.5% will also benefit oil companies. However, increase in the minimum alternate tax (MAT) from 15% to 18% is a negative for companies like Reliance Industries, Essar Oil and Cairn India.
The Budget has also raised the cost for the upstream E&P industry that routinely avails technical services from the foreign companies. As informed by Sanjay Grover,
partner (Oil & Gas), Ernst & Young, earlier, the fees paid for such technical services were taxable in India only if the services were both rendered and utilised in India. However, the Budget proposes to tax these fees if paid by a resident Indian, irrespective of whether rendered or utilised in India. Similarly, foreign upstream services providers having an establishment in India were assuming 10% of their net receipts as profits. However, the Budget has proposed to remove this benefit. Both these developments could have a negative impact on upsream companies and may lead to increased cost and litigation.

BUDGET WINNERS

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OIL & GAS Win Some, Lose Some
THE BUDGET INDICATES THE government’s intention to pay the oil subsidy only in cash and not in bonds, as was the practice till last year. This will automatically put a cap on how much the government can pay and indirectly encourages market-linked prices of fuels as suggested by the Kirit Parikh committee
The Union Budget 2010-11 proved to be a mixed-bag of goodies for the domestic petroleum industry. The industry was looking for the solution for mainly two issues in the Budget — whether the government has taken any decision on Kirit Parikh committee report, and whether the anomalies created last year by excluding production of natural gas from income-tax benefits will be rectified. However, the Budget disappointed the industry on both these counts. The Budget mentioned the government’s intention to pay the oil subsidy only in cash and not in bonds, as was the practice till last year. This is a positive move for oil marketing companies that together are looking at an aggregate loss of Rs 45,000 crore for the year 2009-10
The finance minister’s decision to restore customs duty on crude oil and petroleum products to pre-July 2008 levels and increase excise duty on petrol and diesel by another Re 1 per litre were totally unexpected. Since the marketing companies immediately passed on the tax burden their finances remain unaffected. The increase in customs duty, however, is a boon in disguise for the domestic petroleum refiners as the effective rate of protection goes up and will add a few cents to the gross refining margins. In the same way, as the landed cost of imported crude oil goes up, the domestic oil producers will be able to charge a little higher and earn a better realisation. Companies, such as ONGC, Oil India, Cairn India, Reliance Industries, Hindustan Oil Exploration and Selan Exploration stand to gain marginally. The reduction in surcharge on corporate tax from 10% to 7.5% will also benefit oil companies. However, increase in the minimum alternate tax (MAT) from 15% to 18% is a negative for companies like Reliance Industries, Essar Oil and Cairn India.
The Budget has also raised the cost for the upstream E&P industry that routinely avails technical services from the foreign companies. As informed by Sanjay Grover,
partner (Oil & Gas), Ernst & Young, earlier, the fees paid for such technical services were taxable in India only if the services were both rendered and utilised in India. However, the Budget proposes to tax these fees if paid by a resident Indian, irrespective of whether rendered or utilised in India. Similarly, foreign upstream services providers having an establishment in India were assuming 10% of their net receipts as profits. However, the Budget has proposed to remove this benefit. Both these developments could have a negative impact on upsream companies and may lead to increased cost and litigation.