CAIRN ENERGY: Deal Price Revision Points to Hidden Value Risks

The unexpected and sudden waiver of non-compete fee by Cairn Energy seems to confirm the fears of retail shareholders that Cairn India’s valuations have more risks than what various brokerages would have them believe. The scrip, which had peaked ahead of Sesa Goa’s open offer during April–May 2011, is now trading nearly 15% lower. With crude oil prices on a downward journey, the scrip could lose further value in the coming days. This is surprising when Cairn India had only recently upgraded the production potential of Rajasthan field to 300,000 barrels per day (bpd) from an earlier estimate of 240,000 bpd. Similarly, its estimate of recoverable reserves was raised to 1.65 billion barrels from 0.7 barrels, which was formally approved. The currently approved production level is 175,000 bpd, of which the company has achieved 125,000 bpd.
The voluntary waiver of noncompete fee — or a 12.3% reduction in Cairn’s earlier price — is being termed as the company’s willingness to share the royalty burden with ONGC. Although no official announcement has been made yet, if true, this will have a negative impact on Cairn’s value. According to Goldman Sachs, the royalty burden would reduce more than 15%, or . 62 per share, from its current target of . 405 for Cairn India.
“In case Cairn India has to bear its pro-rata share of royalty, we expect its FY12 and FY13 royalty burden to increase to . 2,430 crore and . 2,940 crore. It will also have to provide for . 1,350 crore towards its share of past royalty. Our base case NAV would decline to . 250 per share from . 305,” says Sandeep Randery of BRICS Securities, assuming oil price at $75/barrel. This will benefit ONGC, which has a stake of 30% in the fields, but pays 100% royalty now. BRICS estimates additional net profit of close to . 1,600 crore for ONGC in FY12, if the royalty is shared by Cairn.
Even after a reduced share price, ONGC appears unlikely to announce a counter offer simply because Cairn Energy and the Vedanta Group, between themselves, control more than 80% of Cairn India’s shares. In such a scenario, a counter offer is bound to fail. Cairn India is now producing from the Mangala field while the Bhagyam and Aishwarya fields are under development. Production of 40,000 barrels per day from Bhagyam is expected to start in the second half of 2011, while the Aishwarya is scheduled to commence operations from mid-2012 onwards.
In the March 2011 quarter, Cairn India reported a 7.5% fall in its average daily gross production to 161,194 barrels as against 174,282 barrels for the Dec 2010 quarter. Resolving the royalty issue is the key concern in Cairn India’s valuations and the risk appears to be rising for the stock now.

Rising Rates May Add To India Inc’s Debt Woes

A debt build-up in FY11 could return to haunt India Inc. Interest rates are on the rise and are set to make a bigger dent in Corporate India's profits
An analysis of the balance sheet data available for 303 companies from the BSE500 group, excluding banking and finance companies, shows over half of them raised their debt level in FY11, while only a third of them managed reduce it. The quantum of debt raised by them was nearly five times the debt repaid by the latter group. Public sector oil retailer Indian Oil raised the most debt in FY11 at Rs 8,168 crore. Apart from work at its Paradip refinery, IOC's compulsion to sell oil below cost and the government's delay in compensating it for this forced the company to draw more debt. Adani Power, Bharti Airtel, Power Grid Corporation and NTPC were the other large borrowers.
A few companies ended FY11 with higher debt, but grew their cash balance by an even larger margin. For example, Reliance Industries' debt increased by Rs 4,069 crore, while its cash balance zoomed by Rs 13,673 crore. If its interest outgo increases, it will also earn higher other income on its bank balance. ONGC, Oil India, IRB Infra and JSW Steel are other such examples. Increased debt by itself is no worry if the balance sheet is strong and cash flows are sufficient to comfortably pay interest instalments.
The ratio between net debt - debt adjusted for cash balance - and equity gives an overview of how leveraged a company's balance sheet is. Among the BSE500 lot, Asahi India Glass appears the most leveraged with net debt 6.9 times that of equity. Jet Airways, JSL Stainless, Varun Shipping and Kesoram Inds are other companies with the leverage ratio higher than 3.
Rising interest costs will hurt more if companies are not generating sufficient profits to pay for them. The operating profit of Kingfisher Airlines, for example, was a fraction of its interest obligation in FY11. There were atleast six more such companies. (Refer chart) But one should not assume the scene is bad for everyone. Companies like BPCL, Adani Enterprises and Bajaj Auto were among the leading players to cut down their debt burden. Kingfisher’s debt restructuring brought its debt burden down substantially, although it is still 2.8 times its equity. Increasing rates together with rising debt burden and weak earnings are likely to form a dangerous concoction for some. However, there are companies thriving in this challenging environment, and should find preference with the investors.

FORGET WARREN, AND BUILD YOUR OWN BUFFETT

Want to play the Street, but don’t know all the twists and turns? Chasing the Holy Grail of that “Perfect Portfolio”, but not sure where to begin? Don’t lose heart. It may not be as difficult as you imagine. ET Intelligence Group’s Ramkrishna Kashelkar suggests simple steps to help an average investor build a portfolio

An investor, who has never dreamt of becoming a Warren Buffet, may be impossible to find. After all, it is every investor's dream to possess a portfolio that beats the market year after year and is the talk of the town. What Mr Buffet has achieved in an investing career of over six decades may well be impossible for an average investor to replicate. But that is no reason to get disheartened. As they say “well begun is half done”. If the investor is able to create a robust equity portfolio, he would have already achieved half his goal. Just like sowing a seed, it will need minimal ongoing effort to maintain and grow the portfolio and patience to wait for the fruits to ripen. Building a perfect equity portfolio is not only a science, it is also an art. The aim should always be to maximise returns while reducing risks to a minimum.

PORTFOLIO RISK: The most general definition of investment risk is “volatility in returns over a period of time”. A stock's volatility is calculated with the help of a measure called 'beta', which represents the stock’s tendency to respond to swings in the market. It is crucial for an investor to manage the portfolio volatility in good as well as bad times. This can be achieved through proper asset allocation and diversification.

ASSET ALLOCATION: This is your most important decision when managing overall portfolio volatility. While in a broader sense this involves allocating resources to alternative investment avenues such as debt, gold, real estate and equity among others, we will mainly look at the equity angle.
Studies have shown that proper asset allocation is more important to long-term returns than specific investment choices. But since guessing which stocks or sectors will perform better at a given time is very difficult, diversification helps.

PORTFOLIO DIVERSIFICATION: Diversification means owning stocks as different from each other as possible. While individual stocks may tend to follow market movements closely, the total value of a well-diversified portfolio is not as responsive.
When it comes to how many stocks make up a really diversified portfolio, experts differ. For some around 15-16 is a good number while others say not less than 40. One thing is, however, certain — greater the diversification, lesser is the risk. However, this can not guarantee that the value of a portfolio won't fall in a market crash. But it certainly ensures that the long-term goals of the investors will be met. Mutual Funds are an easier option for investors without resources to achieve such diversification.

HOW TO DIVERSIFY

SECTORAL DIVERSIFICATION: The sectors that are out of fashion today may well catch the market's fancy a few months later. This market leadership by various sectors rotates unpredictably. A recent example would be the revival in valuation of paper companies after the AP Paper deal. Exposure to multiple sectors ensures that not only are such opportunities captured, but the impact of a negative surprise is also low.

DIVERSIFICATION BY SIZE: While small and mid-cap companies have the maximum potential for high-speed growth, large caps provide the necessary stability to a portfolio.

OWNERSHIP STRUCTURE: Apart from well-known business houses such as Tatas and Birlas, an investor should also have government-owned and multinational companies in her portfolio. Companies without a promoter group (L&T, ICICI Bank etc) and companies controlled by financial investors (Gokaldas Exports, etc) could be the other types.

GROWTH PHASE: The portfolio should also try to strike a balance in terms of the various growth phases that companies pass through. This could include companies expanding aggressively and those that are generating a substantial cash surplus.

GEOGRAPHY: One may also try to take exposure to overseas equity markets to truly diversify the portfolio. Even within the country, one should ensure that the companies are not concentrated in a single geographic region. Having looked at the basic principles of building a portfolio, it will be interesting to see how we can apply it to the current economic situation.

THE DON’TS
While it is necessary to know what to do, it is equally important to define what should be avoided when building a perfect portfolio. Here are some key points:
DON’T BUY ON TIPS
A retail investor is typically the last one to know of the tip. Hence he is most likely to invest when the stock has already run up and hence at a risk to lose money.

DON’T INVEST IN A COMPANY YOU DON’T UNDERSTAND
This is one of Warren Buffet’s well-known principles. Only a thorough study can give an investor enough confidence not to sell at the first sign of trouble

DON’T CONFUSE INVESTING AND TRADING
Trading is short-term and investing is long-term. Getting confused between the two can be a sure way to lose money.

DON’T PANIC AT SHORT-TERM TROUBLE WHEN YOUR GOALS ARE LONG-TERM
Volatility is the basic characteristic of a stock market. Capital erosion in short-term should be considered as normal.

IF YOU ARE GOING TO NEED CASH IN THE SHORT TERM, DON’T INVEST IN STOCKS
In stock markets one can benefit only if one can hold on for a reasonably long period.

DON’T HAVE EXCESSIVE EXPECTATIONS ABOUT RETURNS
If a fixed deposit gives you 10% per annum, equity investments should typically give a return of 18%-20% per annum. While you can occasionally find a multi-bagger, it is unreasonable to expect every scrip to turn into a multi-bagger.

DON’T TRY TO TIME THE MARKET
Timing the market, ie, buying at the exact bottom and selling at the exact top, is next to impossible. Take ‘Buy’ and ‘Sell’ calls based on your views on valuations

DON’T INVEST WITHOUT A PLAN
A well thought-out plan and discipline in implementing it can safeguard your portfolio from impulsive mistakes.

Vinati Organics to Stay on Track, but must Overcome Hurdles

Margins to remain strong as co has a higher share of high-margin products

The strong growth in the past couple of quarters and further investment plans for FY12 indicate that the growth tempo for specialty chemicals maker Vinati Organics will continue. The company's two major products are doing well globally and it is now investing . 100 crore to further raise capacity through FY12.
The second half of FY11 saw Vinati Organics post a 48.8% net profit growth, which was muted at 7.3% in the first half. This was the result of a spurt in revenues supported by improved margins. The company’s operating profit margin for the second half of FY11 was 23.1% against 19.6% in the first half.
The company debottlenecked its ATBS plant in mid-FY11 to add a capacity of 20% to 12,000 tonnes and is expanding it further to 18,000 tonnes. It will also expand capacities of other products — TBA from 700 to 1000 tonnes and industrial polymers from 1500 tonnes to 4,500 tonnes. In addition, it will be setting up a greenfield plant to manufacture 1,000 tonne of DAAM — another specialty chemical used in coatings and personal care industries. All these expansion plans will be completed by March 2012 at a capital cost of . 100 crore. The company has tied up $16 million funding from IFC for this — $11 million of borrowings and $5 million of FCCB — at extremely attractive rates. The rest of the funding will be through internal accruals.
The company needs to overcome a few hurdles on its way. The sales of its erstwhile main product IBB — an input for ibuprofen — could weaken due to emerging competition. Its isobutylene plant, onethird output is internally consumed, is running below optimum capacity due to weak domestic demand. Finally, the lapsed tax benefits of its Lote unit means its effective tax rate will go beyond 30% from around 17% in FY11.
From a turnover of . 317 crore in FY11, the company aims at achieving . 600 crore turnover by FY13 as the full benefits of expansions this year come onstream. The company ended FY11 with a debt-to-equity ratio of 0.54. Its interest coverage ratio too was very comfortable at 17 in FY11. The increasing proportion of high-margin products such as ATBS in total sales means its operating margins are unlikely to weaken substantially. The expansion projects offer a visibility to the company’s steady growth. The scrip is currently trading around 7.2 times its FY11 earnings.

VAVA Wabag’s Cash Balance Holds Promise For Growth

With a strong order book & war chest, Wabag has a bright future

While the fall in VA Tech Wabag’s March ’11 quarter profit came on the back of exceptional one-time expenses and weakness in Euro, it wasn’t much of a surprise. Although trading below its IPO price, the scrip did not witness any sudden jolt following the announcement. With a strong order book and a war chest for possible acquisitions, the company is well placed to capitalise on growth prospects.
Wabag’s consolidated net profit for the March ’11 quarter fell 17.8% to . 46 crore, while revenue growth was muted at 6.4%. Its operating profits were down 4% year-on-year thanks to a 170 basis points weakness in operating profit margin. However, a steep reduction in depreciation and interest costs enabled it to report 4.3% higher pre-tax profit. It was the . 12.9 crore extraordinary expenditure towards settlement of arbitration in its subsidiaries that resulted in a net profit fall.
The company also has improved its consolidated balance sheet with a cash balance of nearly. 325 crore, which it plans to utilise for inorganic growth. After couple of quarters of negative operating cash flows, it earned around . 50 crore of cash flow from operations in FY11. In December ’10 it formed an alliance with Japan’s Sumitomo Corporation, which will enable it to bid for bigger projects. In January ’11 it floated a subsidiary in Oman with a local partner Zawawi to bid for local operations and maintenance (O&M) jobs.
The company ended FY11 with consolidated firm order book at . 3,402 crore, which is up 20%, which is almost three times its annual turnover of FY11. In addition, there are . 1,367 crore worth of orders for which the company is awaiting receipt of advance or letter of credit to call them firm orders. Since all these projects are to be executed within 24 months on an average, the company has a strong revenue visibility. The scrip is trading at 25.8 times its consolidated earnings for FY11, has already outperformed the Sensex in the past one month, indicating a better future ahead.

ADITYA BIRLA NUVO: Co Needs to Tackle Rising Costs that Hurt Margins

Aditya Birla Nuvo’s March ’11 quarter results, excluding telecom firm Idea Cellular, were substantially better as the company continued with the trend seen in past four quarters. In the past few quarters, it was mainly the turnaround in textiles, BPO & IT and insurance businesses that drove growth. However, many of its segments reported margin pressures, both year-on-year and sequentially, which could be of concern to investors, going ahead. Idea could not publish its March ’11 quarter numbers as it is awaiting judicial approval for the merger of Spice Communications. On a comparable basis, the company’s consolidated net profit for the March ’11 quarter was 64% up at . 180.2 crore. However, unlike in the past, its standalone profits fell against the March ’10 quarter due to margin pressure. Several of its businesses faced margin pressure despite a healthy revenue growth. Earnings before interest and tax as a proportion to net sales was the lowest in the year for segments such as garments, carbon black, insulators, textiles and financial services. A superior show by BPO & IT and insurance businesses helped it post a decent profit growth.
The stock has gained 7.3% in the past one week against a rise of 0.8% in the BSE Sensex. It is now trading at 13.7 times its consolidated earnings of FY11, excluding Idea.
It has lined up a . 667-crore capex programme for FY12 and FY13, of which . 243 crore will be the expenditure on expanding capacities and . 435 crore on process improvement and upgradation.
It follows a strategy of using strong cash flows from its mature manufacturing businesses to invest in its service verticals for future growth. In line with Idea’s listing in FY07, it plans to list its financial services and IT services subsidiaries. Although this may not happen for another couple of years, it would be a healthy trigger for the scrip’s valuation. The company needs to battle inflation woes that are hurting margins. In the last quarter, nearly one-fourth of its consolidated net sales went towards raw material costs — a ratio that was between 15% and 20% in the past couple of years. Its ability to maintain buoyant margins will be the key to its future performance.

RIL: Co will Continue to Face Pressure on Earnings

Mukesh Ambani’s speech at the 37th annual general meeting of Reliance Industries (RIL) was more of a review of the year gone by, but fell short in terms of providing clarity on the future. The projects he listed at the AGM will come up only down the line except in the petrochemical segment.
The pressure on earnings will continue for India’s largest private company, especially in refining and oil & gas segments. Mukesh Ambani’s statement that the company will be debtfree in FY12 comes hardly as a surprise. More than a year ago, Goldman Sachs had projected that this would happen by FY14, but the $7.2-billion deal with BP earlier this year will help the company become debt-free sooner than expected. In FY10 and FY11, the company’s operations generated more cash than its annual capital expenditure – a trend likely to continue in the future.
Being cash-rich may be construed as lacking in investment options and diluting return on equity. However, given the economic recovery is yet to gather pace and investment gurus like Mark Mobius predicting another financial crisis ahead, being debt-free can be a virtue.
In other words, the cash pile may be an indication of muted growth but signals better stability. For investors, this may mean a limited upside in stock prices and low downside risks. The challenge now relates to utilisation of the huge cash pile. One option could be to go in for a special dividend or a buyback.
The other alternative is to hoard it for future acquisitions. The second option makes more sense given there could be exciting opportunities for acquiring distressed assets in the backdrop of a muted economic growth in the West.
The company appears more gung-ho about its petrochemicals division compared to the refining segment, which has always been its highest revenue earner.
While referring to the petrochemicals division, Mukesh Ambani had said, “As we diversify our portfolio from commodities to specialities, we will accomplish in the next five years what we have achieved in the past thirty years in terms of earnings from this segment.” In FY11, the company’s earnings from this segment stood at . 9,540 crore and will need to grow at 15% every year to achieve the feat of doubling in five years.
In case of the refining business, Mr Ambani made the point that in FY11, the company had done well. “Our refineries had the best refining margins in the world,” he said. Ambani had also said that Reliance is best positioned to capture top quartile margins, citing its crude sourcing strategies, low operating cost and production of cleanest fuels. However, being the numero uno is not the same as being in the top 25, and hints at some weakness in earnings from the refining business going ahead. Even in the case of its thirdlargest earnings contributor — oil & gas segment — there was hardly any clarity on how and when the decline in production from the Krishna-Godavari basin block (KG D6) would be arrested.
With two of its three main business segments likely to stagnate, RIL will find it very tough to show incremental earnings. Reliance Retail, which, according to Mr Ambani, is now at the inflection point of a new paradigm, is still to break-even and at least a couple of years from making any sizeable impact on the company’s overall earnings. All these could lead to the stock’s continued under-performance for months.