>MERCATOR LINES (RELIGARE)

Winds of change

We met the management of Mercator Lines (MLL) recently to discuss the current outlook on the shipping sector and the company’s business prospects. Following are the key takeaways:

■ Surge in Baltic Dry Index reflects changing conditions: The Baltic Dry Index has tripled over the past five months on increase in Chinese import of iron ore, increase in tonne-mile demand on Brazil-China route and congestion at Chinese ports.

■ Tanker market to recover only in winter: The tanker market is expected to remain subdued in the near term. However, we anticipate a recovery in the winter months on account of seasonality and indications that the OPEC is unlikely to cut production at current crude rates.

■ Contract renegotiation crucial for MLL: Currently, time charter rates are 2–3x higher than spot market freight rates. We believe that MLL will strike term contracts sooner than later given that supply in the dry bulk market is slated to increase in CY10. The company’s term clients have sound credit ratings as certified by various rating agencies. Hence, the risk of default is minimal.

■ Rig contribution set to increase: We anticipate that the rig contracted to Great Eastern Shipping is likely to contribute 8% of the topline and 18% of the profits in FY10 on a consolidated basis. The rig, operating under the Singapore subsidiary, MLL Offshore, is exempt from paying tax for a period of five years.

■ Dredger and coal mining business to supplement shipping performance: A major capital dredging project at Sethusamundaram is currently being carried out, in which an estimated 83mn cubic metres of sediment has to be dredged. As per the last update, only 34% of the dredging work has been concluded, leaving tremendous untapped potential for coming years. MLL has indicated the likelihood of further dredger acquisitions to tap the market in India. Also, its coal mining contribution is expected to supplement performance as and when global coal prices exhibit signs of improvement.

■ Revised target of Rs 79: We are rolling forward our target price to FY11, valuing the stock at 4x EV/EBITDA. Our revised target price stands at Rs 79 (earlier Rs 65), offering a 22% upside from current levels. We maintain our Buy rating on the stock. At our target price, MLL is trading at a P/E of 5.5x, EV/EBITDA of 4.9x and P/BV of 0.7x FY11E. We note that an unanticipated increase in dry bulk tonnage or change in contract mix (spot to term ratio) will depress freight rates and impact our estimates.

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