CAIRN INDIA & SESA GOA: Investors can afford to shrug off deal shock

THE Cairn-Vedanta deal may have upset shareholders of both the Indian companies involved — Cairn India and Sesa Goa whose shares fell between 6% and 9% — while their UK-listed parents — Cairn Energy Plc and Vedanta Resource Plc — gained. The deal indeed raises certain concerns about these two Indian companies. However, long-term investors should not act based on the market reaction on Monday.

The promoters of the oil exploration company do appear to have made a killing, selling off their controlling stake in Cairn India, without sharing the spoils with local retail investors. Cairn India’s shares were hammered on Monday with record volumes — a testimony of the disappointment this caused among retail shareholders. As a new promoter group gains control without any attractive exit route for retail shareholders, those hoping to stay invested in the company for the long haul will have to live with worries about Vedanta Group’s lack of experience in the oil industry and its stretched balance sheet.

For Sesa Goa, which will pick up a 20% equity stake in Cairn India by investing over $3 billion, the longer-term perspective doesn’t appear as bad as its 9% fall on Monday leads one to believe. The company had nearly $1.5 billion of cash and equivalents at the end of March 2010. Its relatively unleveraged balance sheet as well as strong operating cashflows will enable the company to fund the transaction effortlessly.

The management has strictly maintained that the company’s growth plans in iron ore business won’t get hampered due to this deal. The deal will be earnings-accretive for Sesa Goa as Cairn India continues to ramp up its production, while a future stake sale can unlock value. Cairn India, which has raised production from its Rajasthan fields to 120,000 barrels per day from close to 17,500 bpd in the March 2010 quarter, is set to attain the target of 175,000 bpd by 2012. The company is hopeful of ultimately moving up to 240,000 bpd depending on government approvals. The company had $0.55 billion of cash on hand and $0.74 billion of unutilised loan facility at the end of June 2010 in addition to growing cashflows from operations to fund its expansion plans. The exit option for Cairn India’s retail shareholders will come at Rs 355 per share, although Cairn Energy Plc nicked a 14% higher price — Rs 50 premium for agreeing not to compete in India, Sri Lanka, Bhutan and Pakistan. The open offer price of Rs 355 per share is barely higher than the scrip’s average price in the first fortnight of August 2010 and effectively means that the scrip will remain range-bound in the coming months between Rs 355 and Rs 310, which appears to be its fair value.Although the Vedanta Group is planning to replicate the success of BHP Billiton by entering the oil production business after mining, the analyst community is concerned about its lack of familiarity with the new business. The oil exploration business has become an extremely hightech industry over the past few years with oil prices staying high and new discoveries becoming difficult.

Although the deal signals a disappointment for shareholders of both Cairn India and Sesa Goa, the long-term view should remain stable for both. For Sesa Goa it is a strategic investment, which puts to use its surplus cash. The existing strong management team at Cairn India can take care of the concerns of its shareholders over the entry of new owners who are inexperienced. One needs to also watch how institutional investors — particularly Petronas of Malaysia, which holds 14.9% in Cairn India — react to the deal and the ensuing open offer.

Indraprastha Gas (IGL): Full Steam Ahead

Although growth in quarterly profits of Indraprastha Gas (IGL) was lower in the June 2010 quarter as compared to the previous two quarters, its outlook remains positive. The company witnessed a jump in its costs, eroding operating margins during the quarter. However, the price hikes it imposed towards the end of the quarter will revive its profits in the coming quarters. The company, which primarily depended on the APM gas for its business, witnessed a massive jump in costs with the government decontrolling gas prices. Higher volumes of RLNG and RIL’s KG basin gas also raised the raw material cost. The company increased its CNG as well as PNG prices subsequently but with a lag. IGL’s June quarter profit was 18% higher y-o-y at 57 crore on a 44% jump in sales at 335 crore. The company, which typically enjoys operating margins of around 35% on its net sales, registered a lower 32% margin during the June 2010 quarter. A fall in other income and higher depreciation lowered the growth rate in profits to 18%. Indraprastha Gas continues to do well on volumes with a 17.8% jump in CNG and doubled PNG sales during the June quarter against the year-ago period. The growth is expected to remain in double-digits at least for the next couple of years, thanks to the increasing number of CNG vehicles. The scrip, which is trading above 313, is now being valued at 19.6 times its earnings for the past 12 months. The company has marginally raised dividend to 4.5 per share for FY10 after paying 4 for two consecutive years. With the dividend yield of just 1.4% and a high P/E the company appears richly valued. While existing investors may continue to hold, new entrants may not find investment remunerative.

Jain Irrigation System: Investors need to wait for the cool-off phase

ALTHOUGH Jain Irrigation System’s (JISL) operational performance for the June 2010 quarter appears strong, weaker consolidated numbers for FY10 mean the scrip is trading at unsustainably high levels. The company, which doesn’t publish consolidated numbers every quarter, revealed a lower consolidated net profit compared to the stand-alone, indicating its subsidiaries had made a loss during FY10 in spite of a net profit in FY09.
For the year ended March 2010, the company reported a net profit of 271 crore on a stand-alone basis, while reporting 248 crore of consolidated profit as subsidiaries made loss of Rs 23 crore. The subsidiaries contribute nearly one-fifth to the company’s consolidated net sales. The company’s current market valuation stands high at 10,055 crore, which translates into a price-to-earnings multiple of 40.5 based on the fullyear numbers.
During the June 2010 quarter, it was mainly the forex losses of 20 crore and a 36% jump in depreciation that played a spoilsport on an otherwise operationally strong stand-alone performance. JISL had booked 21 crore of forex gains in the year-ago period. The company improved its operating margins and registered a 31% growth in operating
profits. However, the pre-tax and post-tax profits were down marginally against the year-ago period.
JISL’s largest business segment of agri-input products enjoyed a healthy jump in net sales as well as profits during the June quarter, while the industrial products suffered a significant margin erosion. This business, which contributed one-fourth of JIL’s stand-alone revenues, reported a 3% fall in the pre-interest-andtax profits.
The company continues with its strong volume growth in the micro-irrigation and PVC pipes segment with healthy operating margins. It has announced a dividend of 4.5 per share and proposed to split shares in 1:5 proportion. However, its valuations appear to have run ahead of its fundamentals with the price-toearnings ratio above 40 — a level it had not crossed even at the height of market euphoria in the month of January 2008. Long-term investors should wait for the scrip to cool off before investing.

Gei Industrial Systems (GEIISL): High return seekers can bet on Gei Ind’l

SHARES of Bhopal-based Gei Industrial Systems (GEIISL) have outpaced the market over the past one year on a consistent basis, rising 176% against benchmark BSE Sensex’s 14% gain. The company’s consistent profit-growth trajectory in FY10 has contributed to its performance on bourses.

After reporting a 43% profit growth for FY10, the company continued with its growth momentum for the June 2010 quarter, posting a 50% jump in its net profit to 4.1 crore, as net sales grew 29% to 50.3 crore. Improvement in the operating margin, higher other income and lower interest costs have mainly driven up the company’s performance.

The company is greatly benefiting from the rising demand for its airbased cooling systems from power and petroleum industries, since availability of water recedes. In India, these two industries are highly dependent on water for their cooling needs and have faced operational problems at times, when sufficient water is not available. Gei Industrial Systems dominates the market with a 70% market share in airbased cooling solutions.

After successfully converting several captive power plants to this system, GISL has shifted towards commercial power plants, enabling it to obtain orders with large ticket sizes. In February this year, the company for the first time obtained single order worth nearly 100 crore for a 150-MW power plant. The company is well placed to obtain orders from new as well as existing power plants in India.

The company currently carries an order book of 500 crore — which is more than twice its net sales of FY10 — to be executed over the next 12 months. Almost 75% of the order book is represented by the power industry. The company has embarked upon an 100-crore expansion, which will ultimately quadruple its capacities by the end of 2011. Under the first phase, it invested 20 crore in FY10 and has a planned capex of 35 crore for FY11. This capex programme is set to more than double its gross block within three years from 57 crore in March 2009.

The company, which had been struggling till FY05 when it had to undergo a debt-restructuring programme, has grown consistently since then. Its profits in the past five years grew at a cumulative annualised growth rate of 50%, as sales grew at 32%. In the process, operating and net profit margins have improved. Considering the rising demand for its products and services, the company could offer healthy returns to investors in the coming years.

Natural gas biz seen future growth trigger

UNLIKE its larger peer in the oil E&P industry, Gail was able to shrug off the heavy subsidy burden in the June ’10 quarter and post a handsome profit growth, mainly due to higher volumes and improved margins across all its segments. The results have been more or less better than the Street’s expectations and should strengthen investor confidence in the company’s growth, going forward. Although the company’s current valuations appear somewhat stretched, a majority of broking firms have this stock in their ‘top picks’ from the petroleum sector. Although Gail’s subsidy burden rose for the June ’10 quarter, it jumped only six times against the year-ago period, unlike the 12-fold jump in ONGC’s case. In view of the overall volumes and margins expansion, this spurt in subsidy burden proved benign. In fact, it’s the LPG & hydrocarbons business, which absorbs the subsidy burden, registered a strong 56% profit growth to Rs 233.3 crore due to higher volumes as well as higher prices. The segment’s 14% net sales growth was contributed equally by volume and price hikes.

The company owning the longest natural gas transmission capacity has found itself in a sweet spot, as the natural gas availability within the country grew steadily last year. Similarly, the government’s diktat to decontrol the natural gas pricing enabled it to charge marketing margins. Both these factors boosted the profitability of its natural gas trading segment by nearly 50%, as the margin improved 60 basis points to 2.9%. The transmission business also registered a double-digit profit growth.

In the polymers segment, the company registered a 4% volume drop, which was made up for by 4.4% higher prices. The company posted a 7.7% increase in the segment’s profits. After scaling to a high of Rs 516, Gail’s shares have retreated below Rs 450. Considering the current quarter’s earnings, the share is now trading at a price-to-earnings multiple (P/E) of 16.8. Going by its historical valuations, Gail’s current valuation appears somewhat stretched. However, its stable business and plans to lay new pipelines over the next 3-4 years appear to justify it.

The company has embarked upon a heavy capex programme that will triple its gross block within the next four years. At present, the growth in India’s natural gas consumption has slowed down due to lack of transmission infrastructure. As Gail’s new pipelines come up, the availability of gas in India — through production as well as imports — is set to grow rapidly. With a strong balance sheet and an array of supporting businesses to diversify earnings, Gail’s growth in the future will continue unabated. Natural gas being a cheaper alternative to liquid fuels also makes it a recession-proof business.

TATA CHEMICALS: Consider it a good proxy to bet on farm sector

TATA Chemicals’ strong results for the June 2010 quarter, although not repeatable, confirm the change in trend. The company, which was weighed down both operationally as well as financially by its overseas subsidiaries for the past couple of years, has turned the corner and is expected to resume its normal growth trajectory.

There were three main reasons behind Tata Chemical’s 408% profit spurt in the June 2010 quarter against the year-ago period. The company had written off Rs 87 crore in the June 2009 quarter towards closure of the Netherlands unit of Brunner Mond. That quarter, the company was also saddled with high-cost inventory that further pulled lower its margins, particularly in the fertiliser business. Thirdly, the company went on to acquire over 50% of the shares of sister concern Rallis India in November 2009 — the numbers of which are now included in the June 2010 quarter, but not in the June 2009 quarter. All these factors were one-time in nature.

The focus of the company, which in FY10 was mainly on slowing demand and falling prices, has now shifted to managing costs — particularly energy costs — to maintain margins. The company spent almost the entire FY10 on consolidating the acquired businesses, streamlining operations and strengthening balance sheet. It divested non-core investments and repaid debts to bring down its net debt to equity ratio from nearly 1 in June 2009 to 0.7 by end June 2010. It further arranged Rs 400-crore equity infusion from Tata Sons on a preferential basis.

Among the operational set-backs of last year, the company lost about 20 days of production in Brunner Mond, around eight days of operations in General Chemicals due to extreme cold weather and close to 60 days of production at Haldia due to industrial unrest.

Although the scenario was challenging, the company took upon several strategic decisions for future growth. Firstly, it raised its stake in Rallis India beyond 50% to make it a subsidiary. It also launched a domestic water purifier under the brand ‘Tata Swach’ as part of its consumer product portfolio, commissioned pilot plant for bio-ethanol and initiated process to set up 1.5 lakh tonne per annum speciality fertiliser unit in Babrala. The company is planning to set up another 10 such units in the next three years. It also readied its plans to double its urea capacity at a capex of Rs 4,000 crore, subject to firm allocation of natural gas. For the past two years, the company’s scrip has generated almost no returns for its shareholders — a scene which is likely to change. Since the company has streamlined its international businesses and is now present in both fertilisers and agrochemicals businesses, it can be considered a good proxy to bet on India’s agriculture sector.

Cairn India: Sound investment

Cairn India’s results for the June ‘10 quarter, although substantially better compared to the year-ago period, fell short of analyst’s expectations. However, they underline the key change in the company’s growth trajectory, which is likely to continue growing till its production from Rajasthan fields reach a plateau level of 175,000 barrels per day by mid-’11.

It was mainly the multi-fold spurt in interest and depreciation cost that weighed heavy on Cairn’s profits. The interest cost jumped to Rs 49.3 crore from Rs 0.73 crore in the year-ago period, while the depreciation rose to Rs 166 crore from Rs 41 crore.With the commissioning of its pipeline, the company ramped up its Rajasthan production to an average of 44,400 barrels per day from 17,500 bpd in the March quarter. At present, the production has been further increased to nearly the 100,000 bpd level, which will be scaled up to 125,000 bpd by end-’10.

Rising oil production as well as higher oil prices also brought in substantially more cash in business. Cairn’s operating cash flows increased to Rs 493 crore compared to Rs 108 crore in the year-ago period. As the company chose to repay a part of its debt, the unutilised portion of its debt increased to Rs 3,991 crore by end-June from Rs 3,387 crore as at end-March ‘10, while the cash kitty came down marginally to Rs 2,544 crore from Rs 2,631 crore.The average oil price realisation in the June ‘10 quarter was $72 per barrel as against $60.2 during the corresponding quarter of the previous year.

Cairn’s scrip has continued its steady upward movement even in the last few days of market turbulence. Since its results, the scrip has gained 1% as against a 1% fall in BSE Sensex. Although considering historical profits, the company’s valuations appear stretched over the next 12-18 months as it reaches its full earning capacity from current assets, the valuations will appear attractive. Long-term investors should remain invested in the company for rich returns.