Kabra Extrusiontechnik: Rising demand comes in handy

Augmenting Product Portfolio To Help Kabra Extrusiontechnik Gain Market Share

MUMBAI-BASED Kabra Extrusiontechnik (KETL) gained 0.4% on Tuesday, outperforming an otherwise weak market, with the BSE Sensex tumbling 1.4%. The company has outperformed the market nearly tripling in the past one year against a 23% gain in the benchmark Sensex. Much of the scrip’s gain has come in 2010, as it jumped 81% in the past six months, while the Sensex stagnated.
In the second half of FY10, the company had emerged out of the stagnation that had engulfed its operations for the past couple of years. The company’s sales in the second half jumped 52% against the year-ago period, while profits soared 218%. Still, the company is seeing a strong order flow, which has enabled it to carry an order book of nearly Rs 100 crore in the first half of FY11. Considering the fact that the first half is typically a lean period for the company, the company’s order book is expected to strengthen further in the second half.
KETL is a cash-rich, debt-free company with a history of strong operating cash flows. Its cash and equivalent investments have grown at a cumulative annualised growth rate (CAGR) of 58% in the past five years to Rs 46.3 crore as on March 31, 2010.
The company is a leader in India manufacturing machines for the plastic processing industry. The demand for KETL’s extrusion machinery to produce plastic pipes and packaging films is growing fast, with the rising plastic consumption in India. According to industry estimates, India consumed 8 million tonne of plastics in 2009, which is expected to double in the next 5-6 years. It is estimated that the plastic processors will have to invest nearly $10 billion over the next 5-6 years to create the necessary plastic processing capacity.
The company has embarked upon an expansion plan to gain from this trend. It has embarked upon an investment plan of Rs 85 crore, which will more than double its gross block by FY12. The company is setting up an additional assembly shop in Daman by August 2010, which will improve the efficiency of its existing facility. Another manufacturing unit is being set up in Daman by end-2011.
The company is also augmenting its product portfolio with new offerings. It is the only company in India manufacturing machinery for window and door profiles. It has recently launched a new product to manufacture drip irrigation tube lines in collaboration with Drip Research Technology Services of the US. It is also planning to launch new high-speed multi-layer blown films plants by end-2010.

CAIRN India: EXPLORING GROWTH AVENUES

With the commissioning of its pipeline, Cairn India’s profits are set to soar in FY11 . Its growing resource base and focussed efforts on E&P make it lucrative for long-term investors

CAIRN India remains an attractive pick in the E&P industry despite the steady gain in its share price over the past one year. The commissioning of its pipeline marks an inflexion point, while its Rajasthan unit development and exploration efforts in other blocks offer a support for future growth. Long-term investors can add this scrip to their portfolio.

BUSINESS: Cairn India, a 62.4% subsidiary of Cairn Energy (UK), owns and operates petroleum E&P assets in Indian subcontinent that include Ravva field in KG basin and Cambay basin in Gujarat. Additionally, the company holds stakes in 13 blocks in India and one in Sri Lanka. The company’s most prolific field in Rajasthan began production in September 2009, which is scheduled to achieve a plateau level of 175,000 bpd in 2011. While Cairn is the operator with a 70% stake, ONGC holds the rest 30% stake in this field. Malaysian petroleum major Petronas owns over 14.9% in the company, institutional investors hold a 17.8% stake and retail investors hold around 2.5%.

GROWTH DRIVERS: The company has just recently commissioned its 590-km crude oil carrying pipeline from Barmer in Rajasthan to Salaya in Gujarat. Simultaneously, it has scaled up production from Rajasthan to 60,000 barrels per day (bpd) from an average of 17,500 bpd during March 2010 quarter. Commissioning of the pipeline will help the company sell its entire current output to refiners such as Reliance Industries, Essar Oil and Indian Oil. At the same time, the cost of transportation will come down significantly from $8.5 per barrel it was spending on trucks.
The Rajasthan fields are now firmly on their way to achieve the production level of 175,000 bpd by the end 2011 that can be further scaled up to 240,000 bpd with government approvals in 2012. The company has already signed agreements for selling 143,000 bpd of its oil that can be achieved sometime next year as domestic refiners gradually adjust to the new crude. With the consolidation of this mega-project, the company is focussing on exploration work in its other blocks. In the March 2010 quarter alone, it spent in excess of Rs 130 crore on exploration activities. It has completed 3D seismic data collection in Sri Lanka and Palar fields and 4D data collection in Ravva. Even in its Rajasthan blocks, the company has been continuously exploring possibilities to increase the reservoir as well as the recoverable reserves. Its gas fields named Raageshwari recently achieved production rate of 21 million cubic feet per day, which was almost five times of expectations.
The company has steadily increased its estimates of recoverable reserves as its exploration efforts in Rajasthan are on the fast track. The estimated overall reserves stood at 4.5 billion barrels of oil equivalent at the time of the company’s IPO in December 2006, which has been revised to 6.5 billion barrels in March 2010. Although only a portion of it is recoverable, the incremental benefit to the company will be huge over a period of time.

FINANCIALS: Despite higher production coming from the Rajasthan fields, Cairn’s profit for the March 2010 quarter was lower than the immediately preceding quarter as it wrote off over Rs 130 crore in exploration expenses. The company is selling the crude at nearly 12% discount to Brent prices.
The company has ensured strong cash flows in the past to enable timely execution of the large investment projects in Rajasthan. During FY10, the free cash flow from operations stood at Rs 808 crore, marginally lower than FY09. At present, it holds a cash balance of Rs 2,630 crore, with outstanding debt at nearly Rs 3,500 crore. The company’s stock performance in the past had been closely linked to the oil prices. However, the scenario has changed with the projects getting commissioned.

VALUATIONS: The company’s current valuations are linked to its future earnings from the Rajasthan fields. As a result, the market capitalisation appears very high at 56 times its earnings for FY10. However, the company’s net profits could touch Rs 4,500 crore for FY11, which discounts the current market capitalisation 13 times. This is comparable to the established oil producers such as ONGC and Oil India. However, the company has further scope for ramping up its capacity as it is aiming to reach 240,000 bpd in Rajasthan in 2012 that may boost its growth going forward.

CONCERNS: A sustained fall in the global crude oil prices could prove a depressor for Cairn’s profitability and share price. Similarly, petroleum E&P business has its own inherent risks and unsuccessful exploration efforts could impact the company’s

They Are Back!

The government’s move to deregulate oil prices may give a sigh of relief to the debtburdened industry. Investors of oil companies are also likely to benefit from this as they will be rewarded with good dividends in future. ETIG’s Ramkrishna Kashelkar takes a closer look

THE government’s decision to finally bite the bullet and raise retail fuel prices is indeed path-breaking. Petrol prices have been deregulated and diesel prices are set to go the same way, with minor increases in kerosene and LPG prices. Although these steps still fall short of what was required, a precedent has been set. And the principle to gradually move towards market driven prices has been recognised. It may be a matter of time — may be a few months — before the retail prices of transport fuels are fully decontrolled. For the three oil marketing companies (OMCs) — and also their battered investors — which had dropped in an abyss of losses for the past five years, there’s finally a light at the end of the tunnel. While OMCs can hope to get control over their profitability back, investors can hope for better days ahead. And if the mandarins in New Delhi take the next steps, investors’ gains could be really dramatic, given the size of the Indian oil economy.
Nothing is small, when it comes to the oil business. When the three oil majors lose money, it’s in hundreds of crores a day. When they will turn around, it could very well be likewise. The government’s decision on Friday is an effort to set the direction for this industry, while managing its public face and inflationary concerns. The decision to protect consumers, despite rising oil prices over the past eight years, came at a great cost for the government. It added over Rs 150,000 crore to the country’s debt burden and public sector upstream companies lost over Rs 120,000 crore. Still a huge chunk of the burden had to be borne by the trio. In the entire process, all these PSUs not only failed in creating wealth for their investors — the government being their single largest shareholder — but also had to curtail dividends. The three OMCs together recorded a turnover of Rs 530,000 crore in FY10 with net profit of just Rs 13,800 crore. However, they needed an assistance of Rs 26,000 crore from the government and discounts of Rs 14,500 crore from upstream companies, such as ONGC. Still they lost nearly Rs 5,500 crore by way of under-recoveries. Based on the figures of the last financial year, the industry’s current net profit margin works out to be just 2.6%. In pre-controlled days when companies had pricing freedom, the industry profit margin used to be around 5%. The gap indicates the upside potential available, if they are granted full control over their product prices. Considering the losses incurred by the companies in the first three months of the current fiscal and the continuing losses on kerosene and LPG, the industry’s gross under-recoveries for FY11 are expected to be higher than that in FY10. It’s therefore, unlikely that the upstream companies ONGC, Gail and Oil India would offer lower discounts this year. Similarly, unless further price increases are allowed, the government too will have to shell out substantially higher than Rs 26,000 crore it offered to OMCs in FY10.

The key benefits that the marketing companies get from the partial implementation of Kirit Parikh Committee recommendation is that their cash flow will improve and thus reduce their borrowing. This, in turn, will greatly reduce their interest burden and improve net profit. In FY09, for instance, the combined interest burden of the three OMCs amounted to Rs 8,724 crore, up by nearly nine times in five years. In FY04, these OMCs had spent just around Rs 900 crore in servicing their debt. In FY10, the industry interest burden subsequently declined to Rs 3,783 crore primarily due to a fall in international crude prices. The freeing of petrol pricing and rise in diesel prices will further reduce their funding requirement and help them save on interest cost.

It was way back in April 2002 that the government had discontinued the earlier administered pricing mechanism to link retail prices to market forces. This had fuelled a huge rally in the stock prices of all the three OMCs. Between March 2001 and March 2004, the combined market capitalisation of Indian Oil, BPCL and HPCL expanded at a compounded annual growth rate (CAGR) of 55%. The profits as well as dividends distributed by these biggies grew at a CAGR of over 40% in this period.

Since then their dependence on the government’s aid increased progressively as their selling prices stagnated despite rising international crude oil prices. Still the companies continued to diversify to generate profits that can augment the deteriorating bottom lines.

Investing inthe petroleum exploration business — a backward integration — or setting up petrochemical plant — a forward integration — have been their obvious choices. The players also invested in alternate energy sources, including bio-fuels, while also moving into natural gas value chain. However, compared to their traditional business of fuel retailing, these new initiatives still remain insignificant.

All these companies are also progressing well with their expansion plans, thanks to the understanding that the government will finally bail them out. BPCL’s sixmillion tonne refinery at Bina in Central India is nearing completion, which is likely to come out with an IPO soon. HPCL is also setting up a 9 mt refinery in Bhatinda in a joint venture with Mittal Energy to commence operations by the end of FY11. Similarly, Indian Oil is developing a 15 mt refinery at Paradip in Orissa that will be commissioned in 2012.

Although the players have been managing themselves somehow, they never really prospered all these years. All of them consistently underperformed the markets for the past five years. With their dividends also coming down, retail investors suffered both ways.

Set To Fire Up
IT WILL, therefore, be good to see them unshackled and able to compete freely. On the combined turnover of Rs 530,000 crore, if they are able to generate even 5% net profit, all three companies could figure in India’s top 10 profit making companies. This will not just boost their share prices, but will also benefit retail investors by way of attractive dividends. The oil industry’s deregulation is also essential to maintain the fiscal health of the country, which has a deficit target of 5.5% of GDP for FY11. India’s gross debt, as a proportion of GDP, is one of the highest among emerging markets. The sovereign debt crisis in Southern Europe shows that continued deterioration of public finances could easily snowball into rising interest rates and a period of painful economic adjustment. Though India’s debt burden hasn’t reached the Greek levels, given the size of India’s oil economy, it could be just a matter of time. In the short term, concerns on inflationary pressures caused by the fuel price hikes could be deterring. However, it is a necessary evil. It remains a fact that despite the hikes retail fuel prices in India continue to remain lower than those in most European and South Asian countries. The government has taken the first step after much dithering. We wish it the best luck for mustering enough courage to take the big plunge before it becomes too late.

RIL : Growth assured if you can play the waiting game

THE market’s expectations from Reliance Industries’ (RIL) annual general meeting (AGM) may have been pitched too high — as was evident from the 1.5% fall in RIL’s share price on Friday — although the chairman’s speech gave cues about the company’s future course of action. RIL, which until a few months ago appeared lacking sufficient investment avenues to utilise its strong and growing cash flows, suddenly seems to have its plate full.
However, most of these new initiatives are capitalintensive with long-gestation periods, which means investor wealth is not likely to grow in a hurry. Indeed Mukesh Ambani hinted that RIL’s future growth could be slower than India’s GDP.
“I feel hopeful and confident that Reliance can accomplish value creation of a similar magnitude in less than a decade,” said Mukesh, referring to the $80 billion of enterprise value RIL created in the past three decades. But his take on India’s GDP that reached $1 trillion after six decades was more bullish. “Our country is all set to reach the next trillionmark in less than a decade — indeed, within the next five years,” he said.
Doubling of enterprise value — a measure of the company’s value that is roughly defined as market capitalisation plus debt minus cash — within a decade, which translates into a cumulative annualised growth of 7.2%, is hardly exciting for RIL. The company’s market capitalisation grew at a CAGR of 26% in the past decade.
Apart from its commitment to growing the refining and petrochemicals business, the company unveiled plans to enter two new areas — telecom and power. In the telecom segment, the company has entered the broadband wireless access (BWA) or highspeed wireless data services space, thereby avoiding the crowded market for voice services. The phenomenal growth in the country’s telecom industry over the past decade has been predominantly fuelled by voice services, while broadband penetration is still under 1%.
This hints at huge growth potential. However, both initial investment and the waiting period for returns could be equally huge, until the industry reaches its inflexion point.
The power industry is, again, a similar story in terms of the waiting period. A big thermal power plant could easily take 2.5-3 years to build from zero date. A substantial time is also spent on bidding, government approvals and land acquisitions, which means that one should not expect any noticeable revenue for RIL under this head for the next five years.
In the organised retailing space, too, the company is losing money even after four years of operations, although the quantum of losses is shrinking. In FY11, the company could break-even in this venture. But when it comes to making any real addition to the company’s bottomline, it’s still a few years away.
The company’s initiatives in bolstering its position in the petrochemicals and polymer industry, making its refineries ‘bottomless’ and its focus on global E&P business — particularly shale gas in the US — are likely to generate great value in the long run.
Although one may discard Mukesh’s views on RIL’s growth for the next decade as prudent conservatism, investors need to be careful. The company’s strong balance sheet and an array of growth avenues certainly make it an attractive investment for every portfolio. However, the company, currently valued at Rs 3,45,000 crore, is trading at a price-to-earnings multiple of 21 — higher than that of the BSE Sensex — which can hardly be called a bargain. Long-term investors should buy this stock only on dips, if they wish to earn higher than market returns.

United Phosphorus (UPL): SPREADING WINGS

A steadily growing business and a ready war chest for acquisitions make United Phosphorus an attractive bet for long-term investors

AFTER spending over two years in consolidating its earlier acquisitions, India’s agrochemical leader United Phosphorus has given strong indications of renewed appetite for further takeovers. While a geographically spread-out business ensures a stable growth, possibility of growthaccelerating buyouts makes it an attractive buy for long-term investors.

BUSINESS :United Phosphorus (UPL) was incorporated in 1969. The company, which is one of the largest generic agrochemicals manufacturers in the world, has 21 manufacturing sites with its customer base spread across 86 countries. The company manufactures a wide range of generic agrochemicals, industrial chemicals and other specialty products.
During FY10, more than threefourth of the company’s total revenue came from international sales - 22% from North America, 29% from Europe and 27% from other countries. Of these, Europe’s share in the total sales saw a slump while other parts of the world saw the highest growth of 26% in the previous year. The remaining one-fourth of the revenue came from domestic sales.
To expand its product portfolio and market reach, the company acquired a number of companies between FY04 and FY08, which helped it in gaining product registrations and access to regulatory data in various parts of the world. Starting with US-based AG Value buyout for $36 million in November 2004, it has bought Spanish company Cequisa, Shaw Wallace Agrochemicals in India and Reposo in Agentina in 2005. Dutch seed manufacturer Advanta, South African Crop Serve and French company Cerexagri were acquired in 2006. It acquired Argentina-based ICONA in 2007 and Colombia-based Evofarms in 2008. After a gap of two years, the company in Jnue 2010 acquired DuPont’s mancozeb fungicide business, including inventory, formulation plant in Colombia, brands, trademarks and registrations.

GROWTH DRIVERS: The company’s recent acquisition of DuPont’s mancozeb business hints at the revival of its appetite to go for inorganic growth. The company also has readied a war chest of over Rs 1,800 crore for this purpose and the management is actively scouting for suitable candidates.
Last couple of years has seen agricommodity prices soaring to very high levels due to demand growth outpacing supply. The increasing need to improve farm yields globally has become one of the major drivers of demand for agrochemicals. At the same time high prices are enabling farmers to spend greater amount on pesticides the world over. UPL enjoys the benefits of a global presence, which enables it to safeguard its revenue flows from vagaries of weather or pest attacks in individual regions. Besides, it is taking continuous efforts to backward integrate so as to safeguard its operating margins.

FINANCIALS: The consolidated bottom line of the company grew at a CAGR of 28% over the past five years with the net profit for FY10 being Rs 529.6 crore, a 10% increase over the previous year. During the year, the company reported a 10% increase in its net sales to Rs 5,290 crore primarily due to the improved performance in sales from Latin America. According to the company, 1% of its sales growth came from rupee depreciation, while a 14% jump in volumes was partially negated by 5% fall in prices. Operating margin weakened by 110 bps to 18.4% owing to high raw material costs, which as a percentage of net sales, increased 470 bps to 55.8% compared to the previous year. An exceptional cost of Rs 26.7 crore towards the restructuring of two of its plants also affected the company’s annual profit.The company’s borrowing in FY10 increased 13% to Rs 2,382 crore. It has FCCBs worth nearly $67.9 million issued in FY06 that are waiting to be converted.

VALUATION: At the current market price of Rs 189.2, the scrip is trading at 15.8 times its earnings for the year ended March 2010. We expect the company’s existing business to end FY11 with an EPS of Rs 13.2, which discounts the current price by 14.5 times. Its peers like Bayer Cropscience and Rallis India are currently trading at P/E of 20-24. Relatively cheaper valuation and strong possibility of inorganic growth make United Phosphorus an attractive bet for long term.

Set For A Long Haul

Valuations of natural gas players appear attractive for a long term, considering the expected growth in profit in the coming years

ALTHOUGH natural gas players have weathered the storm much better in the past couple of months and are apparently fairly priced, retail investors can still find the sector attractive for long-term investments. The industry has showed a robust performance in the last quarter for FY10, which is likely to continue in future as the availability of gas increases and the necessary infrastructure is put in place.
The total natural gas supply in the country has risen to 175 mmscmd from 114 mmscmd last year, thanks to RIL’s KG basin fields. While the domestic demand for gas remains robust, the companies transporting gas continue to earn higher revenues from increasing volumes. The four listed companies in the industry — Gail, Gujarat State Petronet (GSPL), Gujarat Gas Company (GGCL) and Indraprastha Gas (IGL) — posted a healthy growth in net profit for the Mar ‘10 quarter.
The industry leader Gail posted a 17% rise in profits of its natural gas transmission business to Rs 506 crore in the quarter, as gas volumes jumped 39% to 114 mmscmd. Similarly, GSPL nearly doubled its bottom line to Rs 108 crore as its volumes nearly tripled to 36.2 mmscmd. The two listed city gas distribution (CGD) entities — Indraprastha Gas and Gujarat Gas —reported profit growth of 28% at Rs 51 crore and 73% at Rs 62 crore, respectively in the March 2010 quarter. The volume growth for them was around 22%.
As the availability of the natural gas is growing and demand remains strong, the transporting infrastructure is the only bottleneck in the future growth of the industry. All the companies have lined up heavy capex plans to extend their pipeline networks and increase their gas carrying capacity.
Gail alone is investing nearly Rs 35,000 crore between FY10 and FY14 to double its pipeline network. GSPL, which has already incurred a capex of Rs 2,800 crore in the past 4-5 years to set up a pipeline network spanning most of Gujarat, is further planning a capex of Rs 1,500 crore to augment its existing pipelines and set up CGDs.
IGL is also investing nearly Rs 3500 crore in next 5 years to expand its CGD business within the NCR region as well as Noida, Greater Noida and Ghaziabad. In view of the pending regulatory approvals, Gujarat Gas has not drawn any major capex plans except Rs 300 crore of annual capex.
With this the gross block of the gas industry is expected to double within the next 3-4 years, which will necessitate the players that were debtfree so far to borrow.
The players have started gradually cutting down on their dividend payouts to preserve cash. Although all the companies increased their dividends for FY10, the growth was lower than that in the profits marking lower payouts. Only in case of Gujarat Gas the payout increased as it gave a special one-time dividend of Rs 5 per share.
The recent dismantling of administered pricing mechanism for natural gas will have a great impact on this industry, although it is not the ultimate consumer. Gail stands to benefit due to the$0.11/mmBtu marketing margin it will now be able to charge , while passing on the increased cost to its customers. Gail is expected to earn additional net profit of around Rs 200 crore from this.
Contrary to the belief that the CGD businesses would find it difficult to pass on the price hike to the final consumers, Indraprastha Gas last week raised the CNG prices by around 25% across all its geographies. This won’t affect IGL’s volume growth, as gas still remains a cheaper option to liquid fuels and IGL holds a monopoly in its region.
The impact on Gujarat Gas is insignificant as less than 5% of its gas came from APM sources. Gujarat State Petronet being a pure transporter of gas won’t have any impact from the development.
The industry’s improving prospects have hardly remained a secret among investors. The industry has consistently outperformed the market over the past one year. With huge capex plans coming on stream, the industry is expected to continue with the growth momentum in the coming years. All the companies are currently trading in a priceto-earnings multiple (P/E) range of 13 and 18.5 as against the Sensex P/E of 20.3. These valuations appear attractive for long-term investment, considering the expected profit growth in the coming years.

Indraprastha Gas’ profits to chart a steady growth

Steep Hike In Retail CNG Prices Will Not Hit Sale Volumes

THE Delhi-based natural gas retailer Indraprastha Gas (IGL) jumped on the bourses on Friday following its announcement to raise compressed natural gas (CNG) prices to touch a historical new high above Rs 258. The scrip has outperformed the market in the past one year, gaining 83% as against an 18% rise in Sensex.
After the government decided last month to decontrol the price of natural gas sold by ONGC and Oil India under the administered pricing mechanism (APM), the scrip had lost over 11% in four trading sessions on fears of depressed margins. As a result, the stock has underperformed the Sensex since mid-May. However, Friday’s spurt has more than made up for the lag.
The company raised retail CNG rates by Rs 5.6 per kg in the Delhi region, by Rs 6.9 in Noida and Greater Noida and by Rs 4.9 in Ghaziabad, which, on an average, works out to 25%. With this price hike, IGL’s CNG business, which contributed over 88% to its net sales in FY10, will fully pass on the increased cost of gas to the final consumers. The hike also covers the internal consumption of gas for running compressors. The company has yet to take a final decision on its piped natural gas (PNG) business.
Despite the steep hike in retail CNG prices, IGL’s sale volumes are unlikely to take a hit, going forward. This is because using CNG is a cheaper option compared to liquid fuels. Secondly, IGL has a monopoly in the Delhi market. The government’s push for increasing the usage of natural gas ahead of the Commonwealth Games in October this year is also contributing to a steady growth in demand. In fact, the company, which increased its volumes by 18.6% in FY10 to 2.1 million standard cubic meters per day (MMSCMD) against the previous year, is expected to cross 2.6 MMSCMD by end FY11.
IGL, which had invested a cumulative Rs 820 crore in its business by end FY09, is entering a high-investment phase. In the coming three years, it will invest over Rs 1,600 crore to expand its PNG network and establish itself in new areas like Sonepat and Panipat in Haryana.
Going forward, IGL could face some pressure on its operating margins due to increasing sales volumes and rising raw material costs. However, its steady profit growth is likely to continue.

Melting Pot

Although commodity-based companies have fallen in line with the overall market in the past one month, earnings growth prospects for them in FY11 appear limited as the global commodity prices stay under pressure. Investors should ask for solid justification before investing in commodity stocks, say Pallavi Mulay and Ramkrishna Kashelkar

WHEN clouds start gathering in the sky, it always pays to run for shelter. Be it the monsoon clouds in India or the clouds that are gathering over the prospects of the world’s socalled advanced countries. Just like Indian consumers are making a beeline to umbrella shops, the investor community is going towards safer assets. It is no wonder, therefore, that we saw gold as well as US dollar appreciating strongly in the past one month.
Global commodity prices, which had run up substantially, thanks to the sustained growth in liquidity, cooled off suddenly last month. As speculators rush away, commodity prices are unlikely to revive in the near future, which has put the FY11 earnings forecast of commodity companies under pressure. Investors are advised to be extra cautious while investing in such companies going forward.
After attaining the lifetime high levels around mid-2008, commodity prices — that of steel, base metals, crude oil, cement, etc — crashed substantially amidst the global meltdown. The fall in prices was in the range of 55-75% from the peak and the prices bottomed out in December 2008. The bear-run in commodities was, however, short-lived. On account of easy liquidity, signs of economic recovery globally and return of risk appetite amongst investors, commodity prices once again rallied from March 2009 onwards fuelling a run-up in the stock price of steel makers, aluminium makers, iron producers and sugar manufacturers.
Base metals such as copper, aluminium were up almost 72% and 150%, respectively, while crude oil was up 123% from the bottom, which they had attained earlier. Prices of regionallytraded commodities such as cement and steel have also shown a smart recovery in the past one-and-a-half years. In short, the year gone by proved to be a boon period for commodities. A strong rally in commodities took the prices within striking distance of their earlier historical high levels by April 2010. (See chart)
However, the party got disrupted as the world abruptly woke up to the European debt crisis. The cautious efforts by the Chinese government to cool down their own economy further added to the worries. Commodity prices fell around 10% in May 2010 and continued to fall further.
Last month, we saw crude oil prices falling from $85 level to $70 per barrel. Other internationally traded commodities, such as base metals, have also started softening. The S&P Industrial Metal Index lost 12.5% in the past one month. Prices of commodities, such as cement and steel, which are regionally traded and hence don’t have much speculative demand, are also on a downward journey. The prices were beaten so badly that it is now time to review what is in store for commodities going ahead.
As the European economic problems unfold and the Chinese economic juggernaut slows down, the genuine as well as speculative demand for commodities is expected to remain depressed throughout FY11. In fact, a further 10% correction in commodity prices could put them in a phase of consolidation in the first half of FY11.
Provided the economic problems are contained, the high level of global liquidity may enable commodity prices to gain momentum in the second half of FY11. However, considering the high base of last year, commodity prices may not rule higher on a y-o-y basis. As a result, companies selling these commodities could see their realisations almost stagnant throughout the year. Any profit growth, therefore, can come only from volumes growth. But given the high fixed cost of commodity producers, volume-led profit growth will not be juicy enough to excite markets.
Although a number of brokerage houses are reiterating their buy recommendations on metal or cement companies, their EPS growth projections for FY11 are stagnant. In fact, they are cleverly pitching their investment ideas based on earnings estimates for FY12.
METALS
The steel industry has witnessed prices easing while the iron ore prices are strengthening, of late. Although the domestic demand remains strong, global uncertainties are affecting the pricing environment. While a further fall in prices may not take place due to high costs, the margins are expected to remain under pressure throughout the year. Tata Steel, which is only partially dependent on third party sources for raw materials, will be the most insulated, except for the fortunes of its much bigger European subsidiary. Companies such as SAIL and JSW Steel that buy coking coal or iron ore from third party could take a bigger hit. A similar fate lies in store for base metal producers such as Hindalco, Sterlite, Nalco and Hindustan Zinc. In fact, these companies could experience greater volatility in their quarterly profits as unlike steel, base metals, such as aluminium, copper and zinc, are actively traded on exchanges and their prices fluctuate widely on a daily basis. Hindustan Zinc, the world’s least cost producer, is most protected from a fall in zinc prices. And if you are looking for a contra-pick in aluminium sector, Hindalco seems to be the best bet. The country’s largest aluminium producer has the most diversified product base and with the acquisition of Novelis, it now has a big presence in the consumer market for aluminium products. This cushions it from the fluctuation in the commodity price of aluminium.
CEMENT
The cement industry, unlike other commodity industries, is largely dependent on domestic demand and supply factors. The cement industry has been grappling with a difficult operating environment, especially in the southern region due to sluggish demand conditions, at a time when output has been expanding in this region. The industry’s total capacity utilisation at the end of March 2010 was at 85% levels, at a time when its capacity had grown 12.4% on a y-o-y basis to nearly 245 million tonne. In the cement industry, where players typically raise prices when capacity utilisation crosses 85%, witnessed prices actually wilt in southern and western regions.
The industry is expected to see addition of 50 million tonne capacity in FY11, followed by another 30 million tonne in FY12, which could depress capacity utilisation levels and pull the prices lower.
CRUDE OIL
Crude oil prices crashed to $70 level from $85 during May 2010 as uncertainties about oil demand re-surfaced amid concerns about impact of Europe’s debt crisis. Speculative activity in the crude futures market declined as money managers cut net long positions by almost 60%, as mentions OPEC’s latest report.
The global crude oil industry is facing an oversupply situation that can keep its prices under pressure throughout FY11. Global oil inventories have grown substantially to near-historic levels, while the OPEC’s production capacity has grown substantially higher than what is necessary.
India’s largest oil producer ONGC is little affected by the changes in oil prices since it has to share part of the marketing companies’ subsidy. However, the net realisation of private producers, such as Cairn India, can remain depressed if the oil prices stay range-bound.
The stock market performance of commodity companies have strongly been linked to the commodity price cycles in the past. The reversal in the cycle has pulled the valuations of these companies lower. However, a further downside still remains for them. Further clarity is also needed on Europe’s health and China’s growth momentum. Hence, investors should postpone their investment decisions in these companies till the second half of FY11, when some reversal is expected.

OMCS: Deregulation may improve valuation

INDIA’S three oil marketing companies — Indian Oil, BPCL and HPCL — ended FY10 in black as the government doled out mega bucks generously in the past quarter. Together, the three companies received 75% higher assistance from the government at Rs 18,110 crore in the March 2010 quarter. At the same time, the discounts extended by upstream oil companies at the behest of the government jumped more than six times to Rs 6,062 crore as against Rs 950 crore in the March 2009 quarter.
The companies were also assisted by favourable swings in the forex rates as IOCL and BPCL booked gains of Rs 890 crore as against just Rs 245 crore in the year-ago period. Better liquidity position also enabled the companies to cut down their interest costs in a big way. The interest burden of the trio went down 56% to Rs 806 crore as against Rs 1,833 crore in the March 2009 quarter.
However, despite all these heavy positives, the three companies reported a fall in their past quarter profits. Indian Oil’s net profit was 16% lower at Rs 5,557 crore while net profit figures of BPCL and HPCL were 80-85% lower against the corresponding period of last year. BPCL’s and HPCL’s profits took a particularly bad hit as they chose to write off the diminution in the value of oil bonds in the past quarter.
It was amazing to see the companies coming out with generous dividends despite their well-known cash crunch. Even after a 1:1 bonus during the year, which doubled its equity, IOC raised its dividend to Rs 13 per share from Rs 7.5 last year. Similarly, BPCL and HPCL also raised their dividends to Rs 14 and Rs 12 per share, respectively. Together, this will necessitate a cash outgo in excess of Rs 4,500 crore for the three companies.
The companies are eagerly awaiting government’s decision on the Kirit Parikh committee recommendations to be discussed by the empowered group of ministers (eGoM) on Monday, June 7, 2010. The companies could become good investment bets even for the retail investors if the retail petroleum product prices get deregulated. Due to its size, Indian Oil will be the biggest gainer if any of the recommendations is accepted. The company is currently trading at the lowest price-to-earnings multiple (P/E) compared to its peers and gives highest dividend yield at current market price, which makes it the best bet for the investors.