How Lower Interest Rates will Benefit India Inc

A Cut on the Right Side

Equity markets need a positive sentiment and outlook to thrive. And they may be on the verge of getting that. At least, Mint St seems ready to help. But the policy front is still hostage to friendly pressure. So it remains to be seen whether the April rate cut is a sign of better things to come or just a short-term gamble.
ET Intelligence Group
tries to give you an idea of what lower rates would mean to India Inc, and the economy at large. That is if the inflation dragon does not play spoilsport, again

The underperformance of the Indian stock markets in 2011 was blamed on two major factors - policy paralysis and tight monetary policy. The emphatic upturn in the first couple of months of 2012 made one wonder if both these problems had vanished overnight. That surely was not the case and the markets soon stagnated.
It was only in the month of April that the Reserve Bank of India, in a surprising move, cut the benchmark interest rates by 50 basis points, offering hope that a solution had finally been found to at least one of the two major problems.
The rate cut has brought great relief to the corporate world. More so, to those companies which had suffered the most when the RBI governor kept raising rates in a bid to contain soaring inflation. Aggressive companies that had over-leveraged themselves to grow faster saw their earnings slide as the burden of interest costs mounted.
Today, there are a large number of companies that are spending a chunk of their earnings just to meet interest obligations. A lower interest burden would greatly help them in setting their shop in order.
Of course, not all of them will benefit equally as the rate cycle turns as they have different loan terms and their exposures to external commercial borrowings or foreign currency convertible bonds (FCCBs) etc vary.
ET Intelligence Group has tried to analyse a dozen such companies to ascertain how much their bottom lines stand to gain from a reduced interest burden. We have considered only non-finance companies with an interest coverage ratio below 2 — companies with an interest burden more than half of their pre-interest-and-tax profits of the last 12 months. We have excluded companies with bigger exposure to overseas borrowings such as Reliance Communications, since domestic rate cuts wouldn’t have any direct impact for them.
Most of these companies have started to work on plans to bring down debt to manageable levels. Some of those strategies involve selling non-core assets, seeking equity infusion or going slow on expansions. The success of these measures will only add to the gains they will derive from a general reduction in interest rates.
Interest rates within an economy greatly influence consumption and investment patterns. Lower interest rates not only boost consumption, but also make it less expensive for corporates to set up new factories and production capacities. Both these factors fuel overall economic growth. And it is when the outlook is positive that capital markets grow bullish.
We don’t know yet whether RBI governor has succeeded in taming inflation and hence the 50-basis point cut in interest rates. Or is it due to his growing concerns over India’s economic growth numbers, which have been weakening quarter after quarter. The governor did make it clear that, if inflation again becomes a menace, he wouldn’t shy away from raising rates. Hence, it will be hasty to conclude that interest rates are going to fall from hereon. One needs to closely watch the inflation numbers in the coming months to guess how the interest rates will move in future. At the same time, it could also be too late if one were to wait for the perfect picture to emerge. 

ADHUNIK METALIKS 
Adhunik Metaliks is engaged in mining, steel, power, transmission structures and value-added products. Its debt has increased considerably on account of its expansion in the power sector. As on September 2011, its consolidated debt stood at 3,614 crore, which is four times its equity. Moreover, it has an interest coverage ratio of 1.44, which is very low.
A 50 bps reduction in interest rates will result in a saving of about 4.52 crore per quarter for the company which will improve its profit by 20%. Its share price, however, hasn’t changed much since the interest rate cut announcement as it has other problems as well.
In addition to a high interest burden, the company has also been grappling with high raw material costs. Also, sluggish demand for steel and manganese ore has impacted its performance.

DLF 
High debt is the biggest problem for DLF, the country’s largest real estate company. Despite sale of non-core assets, the debt-ridden company has not managed to bring down its debt. Its total debt at the end of December quarter had increased to over 25,000 crore. Servicing this debt is putting significant pressure on the company’s bottom line.
For the quarter ending December 2011, the company’s consolidated interest outgo stood at 620 crore which was 62% of its earning before interest and taxes.
However, DLF’s management is not unduly worried as more than half of the net debt burden of over 22,758 crore is going to be self financed as the company develops its land bank. For the rest, the company plans to raise 5,000-6,000 crore from the sale of non-core assets over the next six months, but some of these deals are yet to be signed given the weak state of the markets and macro economic conditions. Falling interest rates will definitely bring down the borrowing cost for the company that is currently at around 13-14%. However, this factor has already been discounted in the current stock price of the company.

GMR INFRASTRUCTURE 
Most of GMR Infrastructure (GMR Infra)’s debt of 26,000 crore is at the project level, which is to be paid over the concession period of the project. GMR Infra has 24 projects spread across airports, power and roads. Apart from high interest rates, the company has been impacted by low gas availability from the KG basin and delay in fixing tariffs at the Delhi airport. As a result, GMR Infra’s operating profits were not sufficient to service its interest payments in FY12. However, in FY13, five projects are expected to become operational. The new projects, softening interest rates and tariff revision at the Delhi airport would improve its profitability in the coming quarters. The stock is currently trading at 1.4 times its book value. The current market price has discounted most of the concerns pertaining to the company. Any positive development would result in an uptick in the stock price, which is currently at 28.5.

IVRCL 
IVRCL is one of the largest players in the irrigation segment. Over the years, the company has also ventured into BOT road projects. A BOT project is usually funded by 70% debt. Currently, the company has 11 BOT projects out of which four are operational. Because of these projects, the company’s gross debt has increased from 2,500 crore in FY09 to 4,300 crore in FY11. Although, the debt levels are reasonable, what has made the situation worse is the slow execution of the irrigation projects and rise in working capital requirement. To reduce its debt, the company intends to sell a part of its land bank at Noida. In addition, it is looking at stake sales in a few of its road projects.
While falling interest rates and sale of assets would improve its profitability, it is the pace of project execution that would determine its growth. In the current financial year, IVRCL has increased its order book by 9% to over 25,000 crore. But its revenues have been consistently decreasing on a y-o-y basis. IVRCL is currently trading at 0.6 times its book value, which is low compared to its historical price-to-book value of one.

JAIN IRRIGATION 
Jain Irrigation’s debt woes have emanated from its high speed growth in micro-irrigation systems facing delayed subsidy payouts from the state governments.
Since micro-irrigation systems contribute half of the company’s revenues, a slowdown in the subsidy payments has resulted in a bulging working capital burden. Although the central government has been consistently increasing its allocation for irrigation projects, the payments are routed through state governments, which leads to delays. JISL’s outstanding debtors doubled between March 2010 and September 2011, increasing the working capital by 60%. With rising costs, financing this huge working capital became more and more expensive. The company’s interest cost for the first nine months of FY12 at 251 crore was up 58% while its net profit almost halved to 95 crore against the same period a year-ago.
The company is going slow in states where its outstandings are high. Similarly, it is focusing on overseas operations and exports to drive its growth. It is also in the process of setting up a non-banking financial company (NBFC) to fund its working capital. The management was earlier planning to sell an equity stake to bring down the debt-equity ratio, but that became impractical as its stock price crashed. The current market price appears to discount most of the company’s problems and may see an upside once its efforts start showing results.

JP ASSOCIATES 
Jaiprakash Associates current debt stands at 45,000 crore, which is one of the highest among its peers. Its debt has grown over the past couple of years for its real estate development and greenfield expansion of cement plants. The company is in the process of doubling its cement capacity to 23 million tonne per annum (MTA). With this expansion, it would be one of the top five players in terms of capacity.
To reduce its debt, the company is looking to divest stake in a few of its cement plants. While macro-economic problems have resulted in underperformance of all infrastructure stocks, change in the UP state government has resulted in a negative sentiment for the company’s stock. Over the last six months, JP Associates’ stock has given a return of 8.2% while its peer Reliance Infrastructure has jumped 32%.

KEMROCK INDUSTRIES 
Kemrock Industries is India’s leader in plastic composite products or fibre-reinforced plastic (FRP) products that are used in a wide variety of industries such as wind mills, aerospace, petroleum, mass transport and infrastructure. The company has aggressively expanded its capacities in India due to which it has frequently raised debt and diluted equity. Kemrock has become India’s first company to manufacture carbon fibre on a commercial scale with the commissioning of its 400 tonnes per annum capacity last year, which it plans to double.
In the process, its debt-equity ratio rose to 1.6 at the end December 2011, while interest cost jumped 56% to 70.3 crore for the July-December 2011 period. In the last six months the company has made a $30-million GDR issue followed by a $100-million FCCB issue to fund its ongoing expansion plans. Lower domestic interest costs would surely help the company’s profitability in future.

MERCATOR 
At the peak of the shipping cycle, Mercator decided to diversify its business. The company bought coal mines in Indonesia and Mozambique in 2008. As a result, its debt went up from 1,834 crore in FY07 to 3,273 crore in FY11. The company’s businesses except the coal part have become less and less profitable. This has impacted the company’s cash flows from operations while the interest cost has surged.
In the first nine months of FY12, interest to earnings before interest and tax was almost 70% versus 28% in 2008 before the acquisition of the coal mines. Declining earnings and increasing interest burden did not augur well with the investors and the company lost 75% of its market capitalisation. The recent rate cut would not help the company much as it has significant foreign loans, but would boost investor sentiment. Besides, the company’s December numbers were also encouraging with the company posting its highest ever sales of 1,100 crore and the highest PAT in the last six quarters at 23.4 crore.

PANTALOON RETAIL 
Pantaloon Retail is struggling with a heavy debt burden. In the last fiscal, the company’s debt increased by 80%. The main reason for this was aggressive expansion plans, which needed higher inventory and hence higher working capital. However, the company’s sales did not pick as expected, increasing the interest to sales ratio and affecting the company’s earnings.
In the December quarter, it posted a net profit of only 4 crore on sales of 3,175 crore. This is because of the high interest outgo, which was at 90% of the earnings before interest and tax in the quarter. Though the company is trying to sell stakes in some of its subsidiaries to reduce the debt, the recent rate cuts would give the company a breather, at least till it finds a buyer for the stakes that it intends to offload.

PIPAVAV DEFENCE 
The current debt of Pipavav Defence & Offshore Engineering Company’s (Pipavav) stands at 2,500 crore. The major portion of its debt was used for building necessary ship building infrastructure. The company has one of the longest shipyards in the world with the capability to build large-sized vessels. Although the company has world class infrastructure, its order pipeline is not encouraging. At present, it has an order book of 7,000 crore, which is quite low in comparison to its peer ABG Shipyard, which has an order book of 16,000 crore. Pipavav will not be able to repay its debt and post a decent growth with these orders. The company is banking heavily on the orders from the joint venture with Mazagon Dock. As on date, Mazagaon Dock has an order book of nearly 1 lakh crore and Pipavav expects some of these orders to flow to the JV. But the modalities of the JV are yet to be approved by the defence ministry. Without the deal, the company’s outlook looks bleak.

SHIV VANI OIL & GAS 
Shiv Vani Oil is India’s largest integrated service provider for onshore petroleum exploration and production. The services it provides include collection and analysis of seismic data, well logging, cementing, mud engineering, directional drilling, well testing etc till actual extraction of petroleum and well maintenance. The company’s debt-to-equity ratio stood above 1.9 at the end of September 2011, with the interest costs more than double its pre-tax profits in the first nine months of FY12.
The company has borrowed heavily in the past to augment its fleet of rigs and other equipment needed in the petroleum exploration business. However, its revenue growth failed to grow in line with the increased burden. In addition, increased interest and depreciation resulted in stagnat net profits in the last three years.

USHA MARTIN 
Usha Martin is one of the largest wire rope manufacturers in the world. In order to expand its value-added steel capacity as well as its coke oven and pelletisation capacities to meet growing demand the company borrowed heavily. As on September 2011, its consolidated net debt stood at 2,726 crore, which is 1.5 times its equity. Its interest coverage ratio has been falling over the past three quarters and currently stands at 1.6, which is very low.
Its stock, however, has not reacted to the recent rate cut and is hovering at around 30, which is close to its 52 week low of Rs 28.9. This is because the company has other problems to deal with such as the sharp rise in raw material costs, which it is unable to pass on to its customers.

CAIRN INDIA: Interpreting Numbers & Trends Cairn has formalised its dividend policy committing to distribute 20% of its profits every year. This will benefit investors in the long run Royalty a Drag, but Co can Bet on Rise in Reserves

Cairn India posted a 11% fall in its March ’12 quarter profits in spite of higher oil prices and higher production. While the . 217-crore forex loss is being blamed, the real culprit of profit stagnancy is the increased burden of government payments in the form of profit petroleum, royalty, cess and the income tax. The company’s contribution to the national exchequer stood at $2.4 billion, higher than its net profit for the whole year at $1.6 billion.
The March ’12 quarter saw Brent crude prices average 12% higher at $118.5 a barrel compared with a year earlier. Cairn’s share of production for the quarter also was up 11.3% to 107,292 barrels of oil equivalent per day (Boepd). In spite of both these key positive factors, the company ended up reporting a fall in net profit. The jump in its forex losses to . 217 crore from . 38 crore a year ago was responsible for the profit fall, no doubt. However, a bigger chunk of Cairn’s earnings are being consumed by government payments.
Thanks to the government’s pre-condition for Vedanta Group’s acquisition of Cairn about paying the proportionate royalty, Cairn India’s royalty burden has gone up. During the FY12 quarter, it paid . 3,688 crore as royalty against none last year. Cairn India also paid . 1,566 crore to the government in the form of profit petroleum or the government’s share in the producing petroleum blocks for FY12. This was its first year of profit petroleum.
Its cess payments to the government also shot up 34.7% to . 1,285 crore for the whole FY12. Cairn is also going to get affected adversely from the 80% increase in cess burden to . 4,500 per tonne or approx $12.3 per barrel in the recent Union Budget. The company’s cess payments for the March ’12 quarter were 46% at . 398.2 crore. Cairn India also provided for taxes at a higher rate in the March ’12 quarter compared to a year ago, because of deferred tax due to addition of the increased reserves. For the March ’12 quarter, Cairn’s effective rate of tax — calculated by dividing total tax provisions by pre-tax profit — jumped to 7.4% in the March ’12 quarter against 3.8% of March ’11 quarter.
The results were accompanied by quite a few important announcements that can benefit investors in the long run. The company has formalised its dividend policy committing to distribute 20% of its profits every year. Whether this becomes applicable from FY12 will depend on the completion of amalgamation process for its subsidiaries. At the current level of consolidated profits, the company can generate around 2.4% of dividend yield — may not be attractive right now, but which will become attractive in another 3-4 years’ time.
Increases in reserves estimates and the estimate of peak production are also a key positive. It has mentioned its recoverable reserves from the Rajasthan block are now estimated at 1.7 billion barrels, up 20% from 1.4 billion barrels estimated a year ago.
This can support a peak production rate of 300,000 barrels per day (bpd) compared to the earlier estimate of 240,000 bpd. Similarly, the discoveries in the Sri Lanka and KG onshore blocks are significant positive developments. If and when these get the necessary approvals, this will mean higher profits.

KABRA EXTRUSION: Demand Pick-Up, New Plant to Put Co Back on Track

After a forgettable FY12, Kabra Extrusiontechnik is likely to have a better FY13. The company’s technical tie-ups with global industry leaders, healthy balance sheet and nearly 5% dividend yield mean that it will remain attractive for retail investors. 

BUSINESS Kabra Extrusiontechnik (KETL) is India’s leading manufacturer of machinery for plastic processing industry. It supplies plants to produce plastic pipes and packaging films. India’s growing consumption of plastic has ensured increasing demand for its products.
KETL has tied up with global leaders to access latest technology. Europe-based Battenfeld-Cincinnati holds a 14% stake in KETL. Similarly, KETL has picked up a 15% stake in Gloucester Engineering (GEC) in the US, which is another leading company in the industry. It also exports to 68 countries. 

INVESTMENT RATIONALE India’s polymer consumption, which was growing in double digits, slowed down in FY12 impacting KETL’s sales and profitability adversely. 
The polymer consumption, particularly in pipes that are used in irrigation, water management, construction, telecom etc industries and packaging films that are used for edible oils, milk, processed foods etc, is expected to resume its healthy growth in FY13. This will ensure improved demand for KETL.
The company has set up another unit in Daman at a cost of 35 crore and launched various new products. This additional capacity will be available through FY13 for its new products. KETL is expected to maintain its dividend from last year in absence of any major capex plans for FY13. This translates into a dividend yield of 5%. 

FINANCIALS During the first three quarters of FY12, KETL’s profits plunged 75% as against a 14% fall in its net sales. This was due to two factors. Its overheads increased with the new plant in Daman, while local electricity rates went up nearly 30% with retrospective effect in this period. In the five-year period ended FY11, the company’s revenues grew at a CAGR of 16.9% with profit growth at 32.5%. Its debt-equity ratio at end September 2011 stood at 0.1. 

VALUATIONS The company is currently valued at a price-to-earnings multiple (P/E) of 8 and price-to-book value ratio (P/BV) of 1, which fairly discount its weakened earnings of the last 12 months. The dividend yield works out to 5%, which is attractive. Nearly 8% of KETL’s m-cap is represented by thevalue of its investment in a listed sister concern.

RELIANCE INDUSTRIES: Interpreting Numbers & Trends With petrochem, refining and oil & gas seeing lower profits, investors need to worry about the value of their investments Other Income Saves Some Blushes for RIL

The 21.2% fall in the March quarter profits of Reliance Industries was in line with Street expectations. However, it’s not just the quantum of earnings, but even the quality of earnings that is seen deteriorating. Other income stood as the single-biggest contributor to the bottom line. This means that the investors need to be worried about the value of their investments in future.
RIL’s March quarter numbers were characterised by a fall in profitability across the board. All its three main pillars of growth — petrochemicals, refining and oil & gas — saw declining profits and depressed margins. Still the fall in its bottom line was cushioned to a certain extent thanks to the emergence of a new segment — other income. However, this underlines the company’s difficulty in finding suitable avenues of investment and future growth. Other income at . 2,295 crore for the March quarter represented over 42% of RIL’s pretax profits, which was its historical high. When compared to the three main segments, other income was higher than the pre-interest-&-tax profits of each of petrochemicals, refining and oil and gas segments.
The company is also running its plants at peak capacity, which is reducing its incremental revenue growth. During the March quarter, RIL’s total revenues at. 85,182 crore were 17.2% higher yo-y, which was the lowest growth rate for RIL in FY12. In the first three quarters, the company grew at an average 39.5%. RIL’s refineries, which are the biggest revenue generator for the company, worked at 109% capacity utilisation through FY12 to process a record high 67.6 million tonnes of oil.
Since the results were in line with most of the street estimates, little impact is expected on the scrip when the markets open on Monday. However, the medium-term outlook doesn’t look any brighter. A number of analysts may be preparing to downgrade the company or reduce their price targets depending on the management inputs. Dhananjay Sinha, co-head of institutional research at Emkay, mentioned, “Over a period of time, RIL share price faces downside risks, while the upside potential remains marginal. We will be reducing our target price of . 879 on the company.” 

RIL may Report Another Quarter of Profit Decline

Analysts estimate a net profit of . 4,012-4,380 cr, down 18.5-25.4% from the year-ago period

    Reliance Industries, India’s biggest company by market capitalisation, will most likely report a second consecutive quarter of lower profits when it announces March 2012 quarter numbers on Friday.
This will be the first time since 2009 that the petroleum major is witnessing two consecutive quarters of year-on-year profit fall. It will perhaps be the first time in the company’s history that its profits will sequentially fall for a second consecutive quarter. Things are not expected to improve in a hurry.
Various brokerage houses estimate RIL to post a net profit somewhere between . 4,012 crore and . 4,380 crore, which will be down between 18.5% and 25.4% from the year-ago period and down about 1.4% to 9.7% from the December 2011 quarter.
Reliance has been facing margin pressure in all its main businesses, with volumes growth suffering in the gas business. In its refining business, the gross refining margins (GRMs) — the difference between the cost of a barrel of oil and value of all the products made out of it — have been under pressure for the past few quarters. After reporting it at $6.8 per barrel in December 2011 quarter, there is apprehension that the company could post even lower margins for the March quarter.
“We expect RIL’s fourth quarter refining margin (GRM) at $6.5 per barrel. It would also be down 30% year-on-year and 4% quarter-onquarter. The 3-week shutdown of one of the two CDUs at its SEZ refinery would mean lower volume and affect its GRM by $0.2 per barrel,” noted a research report from Bank of America-Merrill Lynch.
Not all are, of course, so bearish. For example, CLSA pegs RIL’s GRM at $7.1 per barrel in March 2012 quarter up around $0.3 over the December quarter.
The petrochemicals business will also see falling profitability while the dwindling natural gas production from its KG-D6 block and Panna-Mukta-Tapti blocks will also mean lower profitability.
This has resulted in most brokerage houses either downgrading the company or reducing their earnings forecast. A report by Kotak Institutional Equities concluded: “We have further cut our SOTP-based target price to . 800 from . 830 previously.”
Similarly, BofA-Merrill Lynch has cut its FY12 EPS forecast by 3% to . 61.2 from earlier . 63.4, besides cutting its price target by 2% to . 831 per share. CLSA has cut its target price on RIL by . 25 to . 860 per share. 
Going by the predictions for the March 2012 quarter results, the RIL scrip is still not out of the woods after having under-performed the broader market indices over last few years. The company could, nevertheless, see some positive triggers emerging by the end of the current year, particularly in the form of upward revision in natural gas prices.
Some experts have also started viewing the company as a ‘value pick’, arguing a limited downside from the current levels. However, till such time any positive triggers emerge, RIL shares will continue to test the patience of its shareholders.

Dahej Project will Substantially Increase BASF India’s Scale of Operations

A debt-to-equity ratio below 0.1 should help co raise funds for the . 1,000-crore facility

The stock of BASF India has gained over 23% in the past seven trading sessions on the announcement that it would invest . 1,000 crore in a greenfield chemicals complex at Dahej. Considering its history of spending close to . 30-60 crore annually on capital expenditure, this is quite significant. This mega-project will more than double its gross block by 2014, thus substantially increasing its scale of operations.
BASF India is a leading producer of specialty chemicals used in industries such as leather, crop protection, textile and construction, apart from polystyrene and polyurethane. It also markets intermediate chemicals and catalysts for chemical and downstream industries. The proposed site at Dahej will be an integrated hub for polyurethane manufacturing and will also produce care chemicals and polymer dispersions for coatings 
BASF India is a leading producer of specialty chemicals used in industries such as leather, crop protection, textile and construction, apart from polystyrene and polyurethane. It also markets intermediate chemicals and catalysts for chemical and downstream industries. The proposed site at Dahej will be an integrated hub for polyurethane manufacturing and will also produce care chemicals and polymer dispersions for coatings and paper. This new production site will enable BASF target growing industries such as appliances, footwear, automotive, construction, adhesives, architectural coatings, paper and personal care. BASF India is 73.33% owned by German parent BASF SE. During FY11, BASF India merged all its local subsidiaries — BASF Coatings, BASF Construction Chemicals and BASF Polyurethanes — with itself. This was followed by the merger of Indian operations of Cognis, which was globally acquired by BASF SE in December 2010. BASF India has faced tough times in the first nine months of FY12. By December 2011, it had posted 36.1% higher revenues at . 2,717.3 crore while net profit fell 21.4% to . 92.9 crore. However, the quarter to December 2011 was bad with a 75% fall in net profit against the year-ago period.
The BASF share, which was trading in the . 650-670 range in July 2011, dropped one-third to . 440 levels by December 2011. Improved market conditions in 2012 helped it stabilise at around . 490 between end-January and end-March. The company carries a healthy balance sheet with a debt-to-equity ratio below 0.1 at end-September 2011, which means it won’t be too difficult to borrow funds for the planned . 1,000-crore Dahej facility. It has informed of its parent’s intention to introduce all its future products only through BASF India and also not to delist.

PETRONET LNG: Steady Earnings, Capacity Hike to Pump Up Show

Growing demand means operating cash flows will remain strong for Petronet. Also, the company has no problems in servicing its debt. The scrip should see a re-rating as the Kochi capacity nears commissioning

    India’s dwindling natural gas production and growing demand will sustain over-utilisation at Petronet LNG’s Dahej terminal. Debottlenecking of its existing terminal and a new terminal at Kochi will add further capacity in next couple of years, while the annual increase in regassification charges will ensure profit growth.
Petronet LNG’s robust business model coupled with undemanding valuations make it attractive for long-term investors. 

BUSINESS Petronet LNG is India’s largest importer of liquefied natural gas (LNG) at its Dahej plant. The company recently expanded the capacity to 10 million tonne per annum (equivalent of 40 million standard cubic meters per day or MMSCMD).
The company has a firm supply contract with Qatar’s RasGas for 7.5 MTPA for which it has a back-toback sales contract. It also imports LNG on a spot basis depending on its ability to market the same in domestic market. Similarly, it also imports cargos on behalf of other importers for a fee.
The company currently charges 35 per MMBTU as regassification charges, which are set to go up 5% every year in January. 

GROWTH DRIVERS India’s domestic natural gas production is dwindling, especially with the KG-D6 block output going down steadily. The East Coast block which was producing at an average rate of 41 MMSCMD in the December 2011 quarter is likely to go down to 36 MMSCMD in the March 2012 quarter and further to 28 MMSCMD in FY13.
Petronet LNG operated its Dahej facility at 115% capacity utilisation in the December quarter. This helped it clock its highest-ever quarterly volumes of 145 trillion BTU or 45 MMSCMD. Non-core sectors (industries excluding power and fertiliser) still find regassified LNG to be a cheaper option when compared to the liquid fuels, which will ensure high capacity utilisation for Petronet even in future. The company’s recent 0.6 MTPA deal with GDF Suez will help in this.
Petronet is setting up a 5 MTPA LNG import facility in Kochi which will be commissioned by the end of this year. When it is fully functional, the facility will grow total capacity by 50%.
The company also plans to add an additional jetty, which will add 5 MTPA of capacity at Dahej along with debottlenecking and brownfield expansion in FY14. It is also studying the possibility to set up another LNG import facility on the East Coast at Gangavaram.
Availability of LNG at reasonable prices on a long term basis has remained a key worry. LNG prices have remained at unreasonably high levels in spite of major LNG export facilities coming up globally. However, things are likely to change with the US becoming a net exporter and European demand slowing down. Petronet’s ability to sign any long-term supply contract could improve visibility to its earnings growth and prove a major trigger for appreciation. 

FINANCIALS Estimating FY12 numbers by annualising numbers for the 9-month period ended December 2011, Petronet’s revenues have grown at a CAGR of 37.2% in the last three years, while net profit is up 27.8% The company’s strong operating cash flows have enabled it to service its debts comfortably while ensuring low-cost funding for new projects. Its debt-equity ratio stood at 1:1 at the end September 2011. 

VALUATIONS The scrip is currently trading at 11.6 times its earnings of the past 12 months. This is undemanding in view of the strong visibility on steady earnings growth. The scrip should see a re-rating as the Kochi capacity nears commissioning. Retail investors should board the bandwagon well in time.

PNGRB ORDER ON INDRAPRASTHA GAS: Oil & Gas Sector Now Faces Higher Regulatory Risk, Lower Investor Interest

The petroleum and natural gas industry in the country, dominated by several large staterun companies, is becoming increasingly unattractive for retail investors. The sharp cut in tariff rates of Indraprastha Gas by the Petroleum and Natural Gas Regulatory Board or PNGRB underlines the fact that regulatory risk has risen substantially for the sector.
The PNGRB’s order on Indraprastha Gas would not only cut tariffs by nearly 60% and impact its future profitability, but will also deal a body blow to the company considering that the cut is going to be with retrospective effect.
“In case IGL has to refund the excess charges with effect from April 1, 2008, the resultant . 1,530 crore charge would wipe out the company’s FY12 net worth of around . 1,290 crore,” says Sandeep Randery of BRICS Securities. Almost all analysts have expressed surprise at the PNGRB order while downgrading Indraprastha Gas. However, most of them reckon that the company would challenge the order, which could result in a prolonged legal tussle.
The impact of this regulatory change will not be restricted to Indraprastha Gas alone. Nomura, in its report on this regulatory action, says that such a drastic reduction in tariffs of IGL also raises the prospect of likely tariff cuts for networks where tariffs are not yet determined — in particular, it notes, for Gujarat Gas and Gujarat State Petronet.
“Investor interest in gas stocks would likely wane with such decisions,” the report adds. While IGL lost over 33.6% of its value on Tuesday, Gujarat Gas and GSPL lost 15.1% and 7.5%, respectively. In the natural gas sector, while network tariffs and compression margins are regulated by PNGRB, marketing margins are not. In January this year, the government mounted an attempt to control even that. It entrusted PNGRB with the task of determining marketing margins on the basis of the costs incurred. This effectively increases the regulatory risk for the sector.
India’s petroleum sector has always remained captive to government interference, which has been detrimental to their valuations. Ad hoc decisions on retail subsidies, price increases and sharing of subsidies make it tough for the three oil retailers — Indian Oil, BPCL and HPCL — to create shareholder value.
Similarly, the uncertainty in profit forecasting for ONGC, Oil India and Gail due to the ad hoc subsidy sharing mechanism has always been the key negative factor in their fair valuation.
Even private companies are not spared. Last year, Cairn India was forced to pay royalty on its portion of Rajasthan crude oil while seeking permission for the Vedanta deal. This year, within days of share sale by ONGC, the government raised the cess on crude oil to . 4,500 per tonne in the Union Budget, which could impact all oil producers.
All this goes on to show that regulatory risk is rising for the entire sector. A company like Indraprastha Gas, which has long been praised for its stable and growing business model, is overnight being viewed as a risky investment because of a single regulatory action. Retail investors may not have the appetite to take such a high level of risk. 

KEY POINTS The PNGRB’s order on Indraprastha Gas not only cuts tariffs by nearly 60%, but also does it with retrospective effect
The drastic cut in tariffs of IGL also raises the prospect of likely tariff cuts for other similar networks
Ad hoc decisions on retail subsidies make it tough for oil retailers such as Indian Oil, BPCL and HPCL to create shareholder value
Within days of ONGC share sale, the government raised the cess on crude oil to . 4,500 per tonne

PETROLEUM SECTOR: Rising Crude Prices, Subdued Demand for Petro Products to Keep Cos in a Bind

The quarter to March 31, 2012 was characterised by rising crude oil prices which, in the absence of retail price hikes, sent the under-recoveries of state-owned oil firms soaring. Private sector companies had their own set of woes, including margin pressure. Several firms increased refining capacity, while most natural gas companies are likely to witness stagnancy due to shortage of gas. 

UNDER-RECOVERY PROBLEM The benchmark Brent crude oil prices rose 9% from the December 2011 quarter to about an average $119.6 per barrel in the March 2012 quarter. In the absence of any revisions in the prices of petrol, diesel, LPG and kerosene, the sector’s under-recoveries are set to range between . 41,000 and . 43,000 crore in the quarter, against an average of . 32,438 crore in the three previous quarters. 
As a result, the profitability of the oil PSUs will depend directly on the government’s subsidy payments. The petroleum ministry has sought . 40,000 crore from the finance ministry towards the final subsidy for FY12, which, if accepted, will boost the final quarter numbers of Indian Oil, BPCL and HPCL and help them close the year in the black. ONGC, Oil India and Gail could also see their last quarter subsidy burden easing from the previous quarter. 

PETROLEUM REFINERS Petroleum refiners such as Reliance Industries, Essar Oil, MRPL and Chennai Petroleum are expected to see margin pressures due to high crude oil prices. “For RIL, we factor in lower GRMs for Y-o-Y and Q-o-Q at $6.6 per barrel, on the back of a decline in diesel and lightheavy crude oil differential. Difference between Dubai and Arab Heavy has turned negative during the quarter, effectively leading to higher crude cost for RIL,” a result preview report by Emkay said. Petrochemical margins have also come down from the preceding quarter, which will weigh on the performance of Reliance Industries. “We expect a 10.9% Q-o-Q decline in petrochemicals EBIT,” according to an Edelweiss report. 

UPSTREAM OIL COMPANIES Cairn India is likely to post substantially better numbers helped by the rise in crude oil prices and commissioning of the 40,000 barrels-per-day production unit at Bhagyam mid-January. ONGC’s profit will depend on the subsidy it pays. Analysts expect the subsidy bill to range between . 11,500 crore and . 15,400 crore, which puts the net profit figure between . 2,200 crore and . 4,500 crore. The increase in cess on crude oil in the recent budget will add to the cost of these companies. 

NATURAL GAS At a time when falling KG-D6 production is creating a volume shortage in the natural gas industry, imported LNG is becoming more acceptable. Thus, some companies are set to do well, while others face stagnancy. “The natural gas universe is likely to report revenue and profit growth of 33.5% and 3.9% Y-o-Y, respectively, primarily driven by higher realisation from Petronet LNG, Indraprastha Gas and Gujarat Gas,” said the Emkay report. 

OUTLOOK The outlook for the petroleum industry isn’t rosy, particularly with no solution in sight for under-recoveries. Global crude prices may not cool off in a hurry, which means oil PSUs will continue to face subsidy-related problems. The margin pressure for the refining industry is likely to continue as crude prices stay high and demand for fuels remains subdued. Capacity closures in Europe and the US could give a positive impetus for this sector. Among the gas companies, Petronet LNG and city gas players will continue to do well, while Gail faces volume stagnation. 

ESSAR OIL: Refinery Expansion may Help Offset Tax Hit, Rising Debt Burden

Interpreting Numbers & Trends The sales tax ruling for the debt-ridden oil refiner means that the company has to immediately pay . 6,300 crore to Gujarat

The current market valuation of Essar Oil does not provide any hint of the heavy loss the refiner had to bear recently on account of removal of sales tax deferment benefit. The loss lopped off a significant portion off its net worth, apart from creating an additional debt burden. The company recently completed a crucial expansion at its refinery, but will need urgent infusion of equity besides needing to lower its debt and interest burdens to stay in shape for the long term.
For a debt-ridden Essar Oil, the recent sales tax benefit denial has meant a repayment of . 6,300 crore to the Gujarat government. This made the company post nearly . 4,000 crore of net loss in the December ’11 quarter. Considering its net worth was just . 6,840 crore at the beginning of the quarter, a large chunk of it has now been wiped off.
That apart, repayments would necessitate further borrowings. At . 21,290 crore, its debt burden is way too high. The net impact will be a further weakening of its balance sheet and increased burden of interest costs.
The recent completion of its refinery expansion provides some hope. The company’s refining capacity is now 70% higher at 18 million tonnes annually, while its ability to process worst grades of crude oil — that are cheaper — has improved substantially. This should enable Essar Oil earn around $2-3 extra for every barrel of oil it processes. However, this is likely to be good enough only to make up for the loss of sales tax benefit.
The company is also taking steps to improve its balance sheet. Recently, its promoters agreed to convert $262 million of optionally convertible bonds into compulsorily convertible ones giving it the characteristics of convertible preference shares. 
The company is also trying to move out of the corporate debt restructuring (CDR), which will offer them greater flexibility in raising funds. The company plans to borrow $400 million in foreign currency to reduce its interest burden, which was . 1,264 crore for the last 12 months. Similarly, a stake sale is on the cards to raise close to . 3,000 crore. Since the promoters hold nearly 90% of the equity in the company, selling shares to institutional investors or to the public will also help it conform to rules on a minimum public holding of 25%.
The Essar Oil stock has lost heavily in the last one year, but still commands premium valuations if one considers the December quarter losses. If that was to be ignored as extraordinary and one-time in nature, its price-to-bookvalue (P/BV) of 1.13 and a price-to-earnings multiple (P/E) of 11.8 are in line with its peers such as Reliance Industries, MRPL and Chennai Petroleum.
A lot will depend now on Essar Oil’s ability to repair its balance sheet. However, considering its existing debt burden, raising funds is not going to be easy. A dampened outlook over the global refining industry is not going to help either. 

KEY POINTS The ruling has resulted in the company post nearly . 4,000 crore of net loss in the December ’11 quarter
Considering its net worth was just . 6,840 crore at the beginning of the quarter, a large chunk of it has now been wiped off
The recent completion of its refinery expansion provides some hope. The company’s refining capacity is now 70% higher at 18 million tonnes annually
The company plans to borrow $400 million in foreign currency to reduce its interest burden